OT - Federal bankruptcy law vs. pensions backed by state constitution

Submitted by karpodiem on July 19th, 2013 at 8:46 AM

While there is a four page thread already discussing Detroit's bankruptcy, I'd like to discuss the legal (absent political/social concerns) aspects of the bankruptcy.

While I am not an attorney, I find this case to be fascinating and legally unprecedented; the size of the pension obligations owed (Orr has said that a majority of Detroit's debt consists of legacy pension obligations) is unprecdented for a city that has declared Chapter 9 bankruptcy.

There have been a few other instances similar instances(Jefferson County Alabama, Stockton California) the obligations owed by these municiplaties pale in comparison to what Detroit owes to its pensioners. In the prior instances, I believe the state stepped in and helped meet the financial shortfall. Is the state of Michigan in strong enough financial shape to pay out $10+ billion over the course of the 20-30 years as the pensioners age? I believe the answer to this question will be yes (frankly, there is no alternative; PBGC is only for non-government pensions), but it's going to be a very drawn out legal fight between the pensioners and the Lansing until then. 

tldr; will this reach the supreme court?

ps - while initially researching this topic, I came upon this paper - http://www.aefpweb.org/sites/default/files/webform/Stuart_Buck,_Legal_Obstacles_to_Pension_Reform.pdf , which I thought was a great read

Comments

BlueMarrow

July 19th, 2013 at 9:18 AM ^

I'm not a lawyer either. My understanding is that states can write whatever they can get passed into their constituion. But if they write something that cannot be upheld on the federal level, then it will obviously fail when it is challenged accordingly. Take, for example, the recent marijuana laws in some states.

Can Michigan bail out Detroit? Of course it can, if it is willing to divert it's tax revenues. Do the majority of the voters in Michigan wish to do so? Is it political suicide to propose to do so?

I'm betting on the 10 cents on the dollar scenario. And they may be lucky to get that much. Detroit is only the first of many, public and private. Sometimes, it's good to be first. Especially when the line will grow long.

The PBGC does not have nearly enough money to pay 10 cents on the dollar for everything that is currrently underfunded in the private sector. And the public sector? IL? CA? And that's with the market at an all time high. What happens if it crashes:

The governments next move will be to roll everyone's 401 into the new "Social Security" program.

It's the only trough left big enough to feed the hogs.

jblaze

July 19th, 2013 at 9:58 AM ^

no politician will get elected on the premise of paying 100% of Detroit pensioners. It won't happen. Michigan will not pay, unless the Federal Government makes them (which would be a relief to the politicians).

I don't think the Federal Government wants to touch this with a 10' pole. They can pay, but what happens to the other (mid to larger) cities that are on the brink of defaulting? If the government pays now, that's sending a bad message to all of them.

Unfortunately, the pensioners get screwed and the gov't maybe can create a special social security payment to make up for this.

James Burrill Angell

July 19th, 2013 at 9:33 AM ^

They won't get rid of them entirely. Just reduce the payout and increase the amount the retirees have to pay for medical. Not sure if court will determine exactly what future payouts would be but what I've heard kicked around is that those with the more expensive pensions will be cut harder than those receiving less and early retirees who either can or did get other jobs after they retired will be hit hard.

Believe me, this sucks. I wish none of these guys had to take a hit but the pension funds are like $3 billion underfunded due to mismanagement of the fund and the fact that there isn't enough income coming in to the City to support all the retirees. There really is no choice.

Colin M

July 19th, 2013 at 11:03 AM ^

I'm not sure I understand your question. I think you're asking "on what basis is it reprehensible."

I would argue that it's reprehensible on both moral and ethical bases. I don't think people are really stopping to consider the magnitude of human suffering that is about to occur. As a poster below pointed out, most public sector retirees are not eligible Medicare. They are also sometimes ineligible for social security, or have their benefits reduced. Additionally, consider that workers took lower annual salaries in exchange for higher deferred compensation in the form of pensions and health care benefits. 

And yes, some of these people will be eligible for Medicaid, but consider the implication of their eligibility. It means that they will literally have been impoverished by this bankruptcy. In order to be eligible for Medicaid must be at 133% or less of the federal poverty line.

You've made a separate point that there simply isn't enough money to go around. Fair enough, and I think it's clear that nobody is going to get 100% of what they're owed. But offering 10% to people who need these benefits to maintain a decent standard of living is laughable. No amount of cynical posturing about hard realities will change that.

Huma

July 19th, 2013 at 2:28 PM ^

Orr has to make tough decisions based on the hand dealt.  It is ridiculous for you to suggest he is immoral and unethical to offer only 10 cents on the dollar.  The city is in a tough spot and is insolvent -- meaning it does not have enough money to pay what it owes to lots and lots of companies and people and those companies and people are absolutely going to get screwed and paid out at pennies on the dollar.  The real immoral and unethical activies here are the decades of mismanagement and corruption that has destroyed the once-great city of Detroit. 

OlafThe5Star

July 19th, 2013 at 10:25 AM ^

No, I think pension payments to retirees would have to be cut by about 1/3:

There are two funds, GRS and PFRS (General and Police/Fire, respectively)

As of FY11 (6/30/11, the latest data available), they have a combined balance of about $5.8B in net fund assets available to pay retirees.

The pension funds claim they are unfunded by ~$1B, but the EFM estimates they are actually underfunded by ~$3.4B.

So, if they were fully funded using reasonable assumptions, they'd have $9.2B of net fund assets. Well, the current assets are untouched by bankruptcy. And if the unsecured creditors end up with 10c on the dollar, they'd recover another 340M from the bankruptcy, leaving the system with assets of $6.1B vs liabilities of $9.2B. So the system would by ~2/3 (6.1/9.2) funded, implying cuts of ~1/3. 

Not clear how those cuts would be parceled out... do you cut everyone by 33%, do you cut higher pension amounts by a larger percentage (ie, make it regressive), etc. 

In addition, retirees currently have health care costs covered by the city. There are no assets held against this liability, so the entire thing is unsecured. EFM estimates that to be a $5.7B liability. That gets cut to $570M. So healthcare coverage is basically out the window. I have absolutely no idea how they backfill this. You (or a spouse) have to have worked for 10 years in a Medicare-eligible job to be eligible for Medicare. City jobs do not meet that requirement, although many retirees may be eligible through another job they held or a spouse. Many, particularly if their pension is cut, could find themselves eligible for Medicaid, and many more should be able to get health care through the new exchanges. But no matter how you slice it, it is going to be quite bad for healthcare for retirees. If you are a medical professional in metro Detroit, and especially in the city proper, prepare for a dramatic reduction in revenue. 

 

Sources:

Current net fund values:

http://www.pfrsdetroit.org/images/pdf/financial%20PFRS_2011%20AR.pdf

http://www.rscd.org/financial%20annual%20rpt%20GRS%202011_F-4.pdf

Restructuring plan:

http://www.myfoxdetroit.com/link/641483/read-detroits-proposed-restructuring-plan-presented-to-creditors

Colin M

July 19th, 2013 at 10:36 AM ^

My understanding is that there is about 11B in unsecured debt. 6B of that is Health/Other benefits and 3.5B is Pensions. This WSJ Article states that retirees were offered "less than 10% of what they are owed." It also said that all unsecured creditors were offered 2B of the total 11 That's consistent with pretty much every article I've read. 

You're obviously more knowledgeable about bankruptcy proceedings in general. Do you have some specific information that contradicts this reporting? I would seriously be glad to hear it.

CooperLily21

July 19th, 2013 at 10:44 AM ^

The reorganization plan will be very, very complicated.  There will be several classes of creditors (senior secured, mezzanine, priority employee, other priority, bondholders, general unsecured, etc.) and each will receive a different distribution.  I suspect that the 10% was mentioned in reference to general unsecured creditors like trade vendors, consultants, landlords, even lawyers that the City hired. 

As for returns on the pension, based on what you all have said about the MI state constitution, is the state going to be responsible for the shortfall coming out of the bankruptcy case (like the PGBC would for private pensions)??

Colin M

July 19th, 2013 at 11:03 AM ^

I'm talking about what Orr offered prior to the bankruptcy filing. The article specifically mentioned the 10% figure specifically in relation to retiree benefits, including pensions. Maybe the WSJ reporters (and several others) had it wrong, but it's right there in black and white. 

OlafThe5Star

July 19th, 2013 at 1:24 PM ^

tl;dr summary: people are confusing what entity is owed what. Detroit owes its pension $3.5B. The pensions owe retirees about $9b. The difference is the current amount of assets in the pension fund that will be unaffected by the bankruptcy. 

Longer: OK, quick lesson on different legal entities and pension underfunding. 

Basics on underfunded pensions

[Note: I'm making up all of the numbers here to illustrate the impact. There are many actuarial assumptions that go into calculating these numbers that are way beyond the scope of MGoBlog, or even most intro finance courses at business schools!]

Pensions in Detroit (as most places elsewhere in the U.S., other countries use different systems) are supposed to be pre-funded. So, every paycheck the city should set aside the money required to eventually pay the pension amount associated with that wage. Example: you get paid $50K in a year, and the city should put away $2.7K for your eventual retirement That $2.7K gets paid into a pension fund, which is a trust that takes that $2.7K and invests it, so that by the time you retire after 35 years of work it has grown, and, when collected over the course of your working career, the idea is that the accumulated contributions (plus related investment earnings) should be enough to pay out your pension until you die. 

Let's say that a typical worker making $50K a year has been contributing $2.7K/year for 35 years and has been earning 8% (Detroit's assumption, incidentally). They'd have accumulated about $500,000 when they retire, and if they live for an average of 20 years after that, the pension would perfectly be able to pay out $50K/year (and actually have a tiny surplus left over). That is how the system is supposed to work. (One important note: it works because of averages: some people will live more than 20 years and would need more money; but some people will die younger, and hence need less. Pooled together, they cancel out. That is a key benefit of pensions -- they provide insurance against outliving your savings, what is known as "longevity risk.")

However, that system is INCREDIBLY sensitive to the interest rate assumption. Remember I said you had to contribute $2.7K every year to make the math work if you can earn 8% returns? If you only earn 7% returns, you would have to contribute $3,600 every year over 35 years to make it work. At 6%, you'd have to contribute $4,800 or so. 

So, what Detroit did (partly due to elected officials and partly due to union leaders) was do a few things wrong plus become the victim of low rates. First, Detroit assumed a higher rate of return than they were likely to get. Second, they (quite famously) mismanaged the money. Third, not Detroit's fault, but interest rates have come WAY down, and investment returns are ultimately a function of the rates set by the Federal Reserve. 

The upshot is this: Detroit should have been putting $5K into the account, and instead they were putting about 2/3 of what is required to be put into the account. 

The current impact of that is that, if you use more reasonable assumptions for the rate of investment return Detroit will earn on its pension assets, it would need a little more than $9B in its pension funds to pay out to retirees. It currently only has about $5.8B. The difference is that 3.4B or so number that people are throwing around. 

Pensions and bankruptcy

The pension fund (actually, its two separate funds: one for police and fire, and one general) is a completely separate legal entity than the City of Detroit. While Detroit declared bankruptcy, its pension funds did not. The assets in those pension funds are not part of the bankruptcy proceedings -- the $5.8B in those funds that belongs to retirees is entirely safe from the bankruptcy proceedings. They are, in the industry term, "bankruptcy remote." 

However, the City of Detroit owes those funds $3.5B or so still. That $3.5B is the part that the bankruptcy could reduce substantially. If the previous 10c/dollar number thrown out stands, the pension funds obviously collect only $350M instead of $3.5B. So, they would then have $6.1B of assets in total. 

The pension would be underfunded... either it needs to reduce payments to retirees, or eventually the fund will run out of money before all of the retirees have died (shortfall risk!). The amount is simply assets/liabilities (or [5.8 current assets + 350M bankruptcy recovery = $6.1B]/9.1B of total pension liabilties = 6.1/9.1 =~ 2/3)

Even in the (unlikely) case that retirees get absolutely zero from the City of Detroit, they would still have the assets currently in the pension funds, so their "worst case" scenario is not much different than what I've already outlined: the liability is unchanged, but they'd only have their existing assets of $5.8B, so 5.8B/9.1B= 64%, so they'd take a 36% reduction instead of a 33% reduction or so. 

Who else might fill that gap?

It is NOT the Pension Benefit Guarantee Corp (PBGC). It only covers corporate pensions. Nor will it be the Federal government. It would require an act of Congress most likely. Our own beloved alumnus-President set precedent on that by famously telling New York City to "Drop Dead" when asking for a bailout: http://www.nydailynews.com/news/politics/ford-city-drop-dead-president-snub-inspired-discouraged-ex-gov-hugh-carey-article-1.947295

It could be the State of Michigan -- this will be contested both in the courts and in through the political process, almost for sure. 

 

Detroit will fill part of the gap (that is the 10c/dollar offer; to be negotiated in bankruptcy for sure. Detroit would probably issue new, post-bankruptcy bonds and put the proceeds into the funds to do this. Or, an alternative I'd be interested in proposing, would be that the pension could agree to take X% of the city's total tax revenues for some period of time. That would give the unions incentives to help increase the cities tax revenues, most importantly by increasing employment, helping to raise property values, etc. It would sort of be like giving them equity in the new Detroit, which is what usually happens in corporate bankruptcies.)

But if I were a betting man, I'd say that the retirees are going to bear the brunt of this. I would be awfully surprised if they didn't take a haircut of at least 25% through this process... 

Colin M

July 19th, 2013 at 1:53 PM ^

This was an amazingly clear explanation. Every article I read made it sound like retirees would get 10% of their pension, which is clearly not their case. As you explain the pension fund would get 10% of the outstanding amount. Anyways, thanks again for laying out the facts. I also thought the equity proposal you put forth was a great idea.

MaizeAndBlueWahoo

July 19th, 2013 at 7:44 PM ^

I would say that's largely because the pension fund lawyers want to make it sound like retirees will get 10% of their pension.

The figures I've seen say the Police and Fire fund is about 96% funded and the general fund is about 77% funded.  So actually even though UWS did a marvelous job breaking the position down, I think retirees will probably see even less than a 1/3 cut.

(Figures are here: http://www.detroitnews.com/article/20130614/METRO01/306140038)

The other problem is that broke is broke.  Orr just can't offer more money than there is, and he can't offer negative money to "Wall Street" creditors in order to give the pension funds more.  If we start arguing about what's morally reprehensible I think we'll be in no-no land, but the basic fact is, the law just doesn't allow Orr to hand over everything he's got to one or two creditors and tell the others to pound sand.  Orr is very limited by both the law and the numbers on the balance sheet.

klctlc

July 19th, 2013 at 10:08 PM ^

Great post, Nobody wants people to lose their pensions. But it is simple math.  I would ask the people that say 10% is not moral, what is? please provide a moral number that is fair to secured creditors who keep most cities, counties and states functioning by by bonds?

My wife is a teacher in IL, her pension will get cut, It is not fair, but what can we do.

Finally the people collecting these pensions are not totally innocent, who voted for the city council, mayors and John Dingell the last 40 years?

Colin M

July 19th, 2013 at 11:05 AM ^

This is what he offered prior to the bankruptcy and one of the reasons the retiree board sued. If he had been willing to budge from that number, it's possible they would have avoided bankruptcy. He didn't. Now they're in bankruptcy court and a judge will decide who gets what.

bronxblue

July 20th, 2013 at 10:20 AM ^

There's not much he can do.  It's not like the cuts are being placed unnecessarily on retirees.  I was reading that current residents of the city receive services that are about as poor as possible (few working street lights, long delays in police response, etc.).  The city is in a massive hole, and while I feel bad that pensioners feel the pinch, I also doubt that many of them are overly surprised by this turn of events.  But unless you know of some way for the city to recoup billions of dollars to pay down their bills, this is one of the options that has to be addressed.

jblaze

July 19th, 2013 at 10:03 AM ^

I'm not a resident of Michigan so I don't pay anything into Detroit's pension system or fund it. I do fund Fereral assistance programs, though.

Pensions are a disaster and very few companies still have them. The issue is that there are defined benefits (specifically medical) that are comletely out of line with all assumptions of healthcare spending made in the 70s-90s. People are living much longer now and medical care costs so much more that the pensioneers are getting 10x the benefits that they put into the system. 

Therefore, companies switched to 401Ks and other savings plans.

goblue20111

July 19th, 2013 at 10:49 AM ^

How about contributing to their own retirement as a contigency plan? I get they were promised something but I still think it's incredibly dumb to not plan ahead. These are the same people who kick and scream when asked to contribute for part of their own healthcare benefits. I'm not anti-union per se, but I'm very much against public sector unions. 

Colin M

July 19th, 2013 at 11:15 AM ^

Let's leave the union debate alone so that this thread can stay up.

I think you are sorely mistaken about the facts if you think that these people didn't contribute to their retirement funds. Additionally, these benefits are not gifts they were "promised." They are part of a compensation package that they negotiated in return for accepting lower annual salaries. Finally, they aren't eligible for the same federal benefits as private sector employees.

bluebyyou

July 19th, 2013 at 1:55 PM ^

Putting all political issues/public sector unions aside, as you may know, pension planning requires certain assumptions, not the least of which is anticipated investment yield.  There is no way the average pensioner would know to challenge that the yields built into the actuarial calculations which govern future pension growth were unrealistically high for Detroit, to say nothing of an awful lot of other state, county and municipal pension systems across the US which used poor assumptions in their models.

The pensioner also had no way of knowing when he/she started working for the city of Detroit 40 or 50 years ago that the city would face huge erosion from its tax base.  From what others have said, it looks like most pensions will be cut by about a third.  I might just tread a bit easier on some of these folks.  They are going to get hurt, through no fault of their own and realistically, I highly doubt the citizens of Michigan are going to assume the tax burden to bail them out. 

Tater

July 19th, 2013 at 10:45 AM ^

Why offer a pension if it isn't guaranteed?  When Denny McLain used pension funds for other purposes, he went to jail.  Why is it OK for goverments to dip into pension money that should be in a separate account, and why shouldn't those who were offered a pension in good faith as part of their pay be able to collect what is rightfully theirs?

Baldbill

July 19th, 2013 at 10:58 AM ^

who is held accountable? The union bosses? the politicians...how many of them? over what time frame? The issue isn't that someone is responsible but how many...they will never be able to punish them all or prove enough in a court.

James Burrill Angell

July 19th, 2013 at 9:26 AM ^

If I remember correctly he said he was a bankruptcy attorney.

My limited knowledge on this is that bankruptcy law is federal law and would trump/preempt any state law including the constitution. It certainly would stay (stop) any further proceedings in the State courts and there is no question in my mind th bankruptcy filing happened when it did to stop hearings on motions the pension boards filed. No doubt the pension boards made the constitutional argument b/c they know any ruling from a state court will be trumped.

Big picture, the whole case rides on how much credence the court gives to the pension board motions. If they get a judge who blows off the pension boards this case will fly through the court. If they get a judge who wants to give the pensions play it will really drag out. Watch who gets appointed judge very carefully. The appointment could come from any bankruptcy judge in the 6th Circuit. Detroit has five bankruptcy judges, one of whom is crazy, one of whom is a Bush appointed creditor oriented conservative who is from Ohio who would be hard on Detroit. One is too inexperienced in this kind of matter and wouldn't likely get the call. The best two options are a near 90 year old judge who has seen and done it all and the Chief Justice who is a long time Chapter 11 attorney. Hopefully they don't pick either of the Grand Rapids judges as one is nuts and the other is known to be very hostile towards attorneys from the east side of the state and is one of those "GR should be the center of Michigan and not Detroit" types.

ED yes I'm an atty, yes been before all of these judges but its not what I usually do.

BiSB

July 19th, 2013 at 9:28 AM ^

Even for the "seen it all"-type judges, this will be really new, because Chapter 9 is a strange beast that almost never gets used.

As I mentioned yesterday on Twitter, this is throwing the switch in Jurassic Park. No one knows exactly what is going to happen. But raptors may be involved.

James Burrill Angell

July 19th, 2013 at 9:37 AM ^

True but I can tell you based on judicial temperament and past rulings, there are definitely some judges that will make the process easier or harder. Why do you think no large corporations file Ch 11 in Michigan? It's because they fear certain judges and the NY and Delaware judges are known to be very hands off, quick and friendly to the filing parties.

CooperLily21

July 19th, 2013 at 10:33 AM ^

Cases file in NYC and DE because lawyers know what to expect from the process there and the judges have seen many more cases than in other states.  Its basically the lawyers that decide and its actually refreshing that Jones Day had to file this in MI for several reasons, two of which are that its great for the MI bankruptcy bar to get some high-level work but also because it will be fun to watch Jones Day lawyers have to play nice (as apposed to playing NYC "nice").  Going from DE bankruptcy court to a smaller bankruptcy court practice was fun - a drastic change!

BiSB

July 19th, 2013 at 9:24 AM ^

But the State Contitution doesn't prevent the bankruptcy court from modifying pension obligations, nor does it require Michigan to fund any short fall in the event those obligations are modified. The Michigan Constitution basically says that Michigan and its political subdivisions have a contractual obligation to pay pensions, and that they can't diminish or impair those benefits. In this case, Detroit isn't diminishing benefits. A COURT is diminishing them, and eliminating/modifying the contractual obligations themselves. Whatever pension obligations SURVIVE will be protected by the Constitution, though.

CooperLily21

July 19th, 2013 at 10:10 AM ^

You're all over it.  That ND education blew my Pitt education out of the water!  Of course, you'll be paying for it.  LOL

Like BiSB hints, federal law >>>>>>> state law (including the state constitution).  But my new understanding of the constitutional amendment is that the state is responsible for pension benefits so if the benefits get altered in the bankruptcy case it will be the state taxpayers that make up any shortfall.  Smart amendment?  Not my place to say but it looks as though the voters are going to pay for their choice ...

The FannMan

July 19th, 2013 at 4:17 PM ^

The provision you are referring to is not an amendment.  It is Article 9, Section 24 of the Michigan Constitution of 1963

Also, I do not think that the State has any role in terms of pensions.  The relevant part of the provision states:

"The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby."

Prior to this, public pensions were considered a gratuity which could be changed at will.  Thus, you could work for a city for 30 years.  Then, after your retired, your political enemies could take over and vote to erase your pension and there was nothing you could do about it.  Thus, the people of Michigan voted this section into their Constitution when it was redone in 1963.

The use of the word "and" refers to the entities that are covered - the state and any political subdivision (Detroit in this case).  However, the obligation is not shared by the state and the city.  Rather, Detroit (like other municipalities in the state) is a separate legal entity from the State of Michigan, with a separate pension system.  There is no requirement that the State cover  the City's pension system.  If there was, Detroit would have handed it over years ago.

This, combined with the fact that the PBGC does not back these benefits, makes the pension issue really tough. Assuming the supremacy argument goes the way that everyone seems to think, the Judge could wipe out pensions for thousands of retirees [EDIT - Please see UWS- Blue's post above.  "Wipe out" is an overstatement.  I should ahve said "reduce."]  who are, in many cases, too old to return to the work force and depend on those benefits.  Also, many of them do not qualify for social security since they worked for a municipality. 

jcouz

July 19th, 2013 at 9:43 AM ^

A pension is part of a job's compensation plan that is promised to mostly public workers when they retire.  The whole premise of a pension is not that great.  It seems to me that individuals should have control of their own retirement funds like 401k's.  The problem is, the pension is what was presented to many employees as their retirement option.  I am not really sure how moral it is to just decide to take it away or modify it however the city would like.  It is not the retirees fault that the concept of the pension is stupid.  I am currently in a pension plan where I contribute over 10% of my gross salary to the fund.  It is ridiculous to think that somebody could decide not to give me "my money" when it is time for me to collect.  I would have preferred to control my own money from the get-go but it was not an option when I started working.  I am sure it was not an option for these folks either.