Do Detroit’s Pension Funds Need Reform

Few would deny that Detroit’s city government has been a model of corruption over the past few decades. Most agree that the sky high property and income taxes have to be slashed (its just a question of how to do it when short-term revenue flow is already so challenged). And no one is going to suggest the status quo of Detroit city services are at peak performance.

But when it comes to Detroit’s public pensions–the General Retirement System (GRS) and Police and Fire Retirement System (PFRS)–there is far less agreement over whether a problem exists… and if so how to fix it.

Thorny view: Most of the arguments that the city’s public pensions are in trouble have focused (justifiably) on generosity of pay, the so-called “13th Checks” that were commonplace up until a few years ago (which if never allowed would have meant $1.9 billion more in pension assets today), the $1.4 billion pension obligation bond taken out in the mid-2000s that made the pension funds look as if they were fully funded when it was just on borrowed money, and the unfunded liability of $3.5 billion estimated by Emergency Manager Orr. Andrew Biggs hit most of these in a post for the American this weekend, and they are fair.

Rosy view: Those points have been countered by advocates pointing out (justifiably) that the funded ratio of the pensions are relatively okay–GRS is funded at 77% and PFRS is funded at 96%. It is also pointed out that the 13th Checks were technically legal under the accounting standards for the pension funds, and the city has actually filed for bankruptcy because of bonds issued to creditors and not the $1.4 billion pension obligation. These points are technically true too.

So are the pension funds in trouble or not?

The problem with the rosy view is that it rests on the assumption that the actuarial standards adopted by the Detroit pension funds are responsible. In fact, they are setting the systems up to fail over the long-run, and Detroit pensioners should be aware of the coming challenges.

Consider the funding ratio. For GRS this has been falling rapidly over the last five years (since the financial crisis) and is unlikely to stop. Back in 2008, GRS was fully funded, but its added some $200 million a year to its unfunded liability and now has at least $840 million in debt-and most certainly more than that if using more realistic assumptions about future investment returns (see p.26 of this PDF report). The PRFS looks stronger over the last few years, but it (along with GRS) has to contend with an investment assumption challenge too.

Currently GRS assumes an investment rate of return of 7.9%, and PFRS 8.0%. There is also an annuity plan available that promises a guaranteed 7.9% return minimum to those who choose to participate. These return assumptions are unrealistic. Emergency manager Orr has assumed a discount rate of 6.9% to 7%. A safer assumption would be something just above long-term yield on Treasuries, so roughly around 4%.

Just look at what the last few years have wrought for Detroit pension investments. In market value terms PRFS had negative investment returns of 4.4%, but because it spreads losses and gains out over a seven-year accounting period, PRFS reported a funded value return of positive 3.8% (see p.12 of this PDF report). The later number still missed the target 7.9% though, which is not one-time occurrence. As we mention in the op-ed, Detroit will need to revise down its assumed discount rate (what it expects it’ll get from investing pension assets on an annual basis, averaged out over seven-years).

Detroit should also reduce its actuarial method of seven-year “smoothing” to something more like two or three years. Every year the city actuary estimates how much will be needed to pay benefits, and then tells the city to pay a lump sum into the assets that will then be invested (supposedly with a 7.9% return). But if losses aren’t recognized on an actuarial basis sooner than later, then those estimates can be off, which means the city winds up not contributing enough, which means whatever investment return it does get wouldn’t be enough even if it hit the 7.9% assumption, and taxpayers wind up having to contribute more from the city budget.

This has a ripple effect of forcing the city into more debt and/or reduction in city services since the cash is all going to fix previous pension accounting mistakes.

According to the most recent financial reports on GRS and PRFS, there is a $1.35 billion difference between the “funding value” of the combined assets and the “market value” of the combined assets. That difference is the real loss suffered from investments not hitting assumed targets that are being distributed over a seven-year smoothing period. Those losses were suffered primarily during the financial crisis (FY2008 & FY2009). The funds saw strong market returns in FY2010 and FY2011, as the Federal Reserve juiced the equities market, but FY2012 was a flatline year for investments and may become common place in the coming years (depending on what Fed QE policy is and the portfolio mix of GRS and PRFS assets). Here is the audit language directly:

“As of June 30, 2012, the funding value of assets was nearly $650 million dollars greater than the market value (see page A-12). As that difference is recognized, computed employer contribution rates will continue to increase by approximately an additional 13%-15% of payroll over the next several years, unless the losses are offset by future experience gains. On a funding value basis the system is 77% funded. On a market value of asset basis, the system is 59% funded.” – GRS FY2012 annual report, p.A-5

“Because of the past unfavorable market returns and the 7-year smoothing, the funding value of assets exceeds the market value by $701 million. Unless the market recovers remarkably within a relatively short period of time, upward pressure on the employer rate can be expected in each of the next several years. If there are no experience gains during the next 7 years, the employer contribution rate could double during that time.” – PFRS FY2012 annual report, p.12

So those arguing that pensions are well funded in Detroit may be technically correct under the particular accounting standards the city has adopted, but in the long-run the pension system needs to be robustly reformed. It is shortsighted to think that they are not in trouble. The funding ratios would be much worse if the accounting wasn’t delaying realization of losses. Unless Detroit’s pensions are adjusted to address these challenges, even the best bankruptcy deal wouldn’t keep the city from burning down again and being right back in this place a few years from now.