What America can learn from Detroit's pension blues

In the week since Detroit became the largest U.S. city to declare bankruptcy, many commentators have speculated about what, if anything, this action means for the rest of the country.  One narrative is that Detroit is sui generis – a city whose fiscal problems were long in the making, aided by broad macroeconomic forces and the city’s own political dysfunction.  Indeed, Detroit’s previous mayor is in jail and several former officials, including a city treasurer, are under investigation for pay-to-play scandals at the city’s pension funds.

Another popular story line is that Detroit provides a glimpse into the future for states and localities where politicians made unrealistic promises to public sector workers and shifted the bill on to future taxpayers.  A look at local pension finances across the country provides some support for this view.  By their own math, locally administered pension plans had assets to cover 72 percent of their projected liabilities in 2011.  However, this funded ratio dropped to 50 percent when future obligations were treated as more certain (like contracts, as state constitutions and some courts have required) and therefore on more equal footing with present day costs.

In Detroit, state appointed Emergency Manager Kevyn Orr has calculated the city’s unfunded pension liabilities at a whopping $3.5 billion.  Pension costs have escalated even though the city eliminated more than 40 percent of its workforce (7,000 full time equivalent employees) over the past decade.  One reason for this apparent disconnect is that pension contributions must cover both active workers and a portion of unfunded liabilities from the past.  As a result, it can be very difficult for cities to get out from under a pension overhang.

Like other mainly Midwestern and Northeastern U.S. cities, Detroit used to be big, but now it is small.  Its ratio of public sector workers to retirees has dropped from more than 3 at the end of the 1950s to less than 1 today.  Cities like Chicago, Pittsburgh, and Baltimore also show big declines in their worker-retiree ratios.

This may sound a lot like the U.S. Social Security system.  However, state and local pensions are not social insurance programs; they are part of public employees’ compensation packages (a fact underscored in today’s Comprehensive Revision of the National Income and Product Accounts).  Because they are payments for services already rendered and consumed by current taxpayers, they are supposed to be at least partly prefunded, not financed on an ongoing or “pay-as-you-go” basis.

However, even a cursory look at pension finances suggests this is not the case.  Even growing cities without declining worker-retiree ratios such as Atlanta and San Jose also suffer from pension funding shortfalls.  Although some local elected officials have made recent strides in pension reforms, in the past they all too often skipped contributions or made them with borrowed funds, essentially doubling down on debts.

Shortchanging pensions creates problems, even more so for cities than states.  At the local level, it is far easier for residents to flee higher taxes levied to pay off legacy debts.  There is already evidence that new residents demand lower home prices when pension shortfalls become apparent – because they know they will have to pay more in taxes later.  The result of selective out- and in-migration can be a downward spiral of lower tax collections, worse public services, and more severe underfunding.

So, how can cities get out from under a pension mess?  There are no easy answers, and federal policymakers have already indicated they won’t get involved.  State intervention – ranging from ongoing monitoring programs to one-time borrowing assistance with the added discipline of a control board – can help.  In the end, however, there’s no substitute for a thriving economy and governance structure.  That’s where all stakeholders in Michigan should be directing their efforts.

A modified version of this post appeared in Real Clear Markets and on the Brookings Institution website.