The battle of Detroit

IT WAS inevitable that the rights of creditors and pensioners would come into conflict, especially in places that suffer from high debts, sluggish growth and an ageing population. Admittedly Detroit, where a bankruptcy plan proposes deep cuts to the wealth of both bondholders and retirees, is an extreme example. But it does point to where future battle lines will be drawn.

The city, which filed for bankruptcy last year, has an estimated $18 billion of debt and has seen its population fall by more than half since 1950. There are no easy solutions. Retired workers will face an immediate 34% cut in their income, although police and firemen will only suffer a 10% hit; these reductions will be trimmed if they agree to a quick deal. (The same reductions apply to the accrued benefits of existing workers, although the final-salary pension scheme will stay open.) On the creditor side, secured bondholders will be repaid in full but unsecured creditors (deemed to include, controversially, holders of general-obligation bonds) will get only 20 cents on the dollar.

It does not seem unreasonable that retired workers should be treated more generously in bankruptcy than unsecured bondholders (although that may drive up borrowing costs for other cities). An occupational pension will probably be the main source of income for a retiree and the average benefit received by a retired worker in Detroit is around $19,000 a year, according to AFSCME, a public sector union. Some, but not all, of the city's workers will also qualify for Social Security, the national pension scheme. But it pays around $15,000 a year on average, so the cut to total income might still be 20%.

Once a worker has retired, it is very hard to replace lost income. Pensioners may have started working for Detroit in the 1970s; they cannot reasonably have anticipated the city's current problems.

In contrast, most municipal bonds are held as part of a diversified portfolio; any loss resulting from a writedown will cause only a small dent in the investor's wealth. Most bonds will also have been bought in recent years when the city's problems had become well-known and were reflected in its credit rating; the city's bonds were first classed as junk in 1992. Thus investors were making a conscious decision to grab a higher yield in the face of higher risks.

It is often said that public-sector workers get better pensions than those in the private sector. In this case, Detroit workers will be worse off than private-sector workers in final-salary schemes. The latter are covered by the Pension Benefit Guaranty Corporation (PBGC), an insurance scheme which protects benefits, subject to a cap of around $59,000 a year. No such scheme exists in the public sector and it is highly unlikely that any plan will be agreed.

By the standards of other states and cities, Detroit's scheme was not particularly underfunded or expensive. Figures from the Centre for Retirement Research (CRR) at Boston College show that the city's pension costs comprised 7.7% of its revenues, much less than New York or Philadelphia; its ratio was tied at 65th highest out of 173 cities surveyed. In 2012 the funding ratio for the general retirement scheme was 77%, compared with an average of 73%. Admittedly, that ratio was calculated on absurdly generous assumptions about long-term investment returns, but such assumptions are commonplace in America. As it happens, the stockmarket did extremely well in 2013 so the funding ratio has probably risen.

That said, Alicia Munnell of Boston College notes that some city employees also belonged to a supplementary defined-contribution plan called the Annuity Savings Fund, which appeared to offer returns to its members that exceeded the fund's investment returns. She rightly says that 'if benefits have to be cut, it would seem desirable to claw back these unjustified gains before slashing the benefits of the average worker'.

More broadly, Detroit shows the importance of correctly accounting for pensions. Final-salary pension promises are expensive to make, but states and cities have been too willing to assume that the markets will bail them out. They stint on contributions for fear of alarming taxpayers. Even on the current accounting assumptions, American public employers have been paying just four-fifths of the required contributions. The problem will not be solved by pretending it does not exist; reform should happen now.

The bill for past complacency has come due. In most cases, it will fall on taxpayers but at the extreme, the burden will fall on elderly people who can ill afford to see any cut in their income.

Lokasi:

Share :