By Cyril Tuohy
A U.S. bankruptcy judge’s ruling that pensions can be cut to reduce the city of Detroit’s $18 billion long-term liabilities is a “watershed” event in the history of municipal bankruptcies, according to a credit analyst.
“From a pensions perspective, this is a watershed event,” said Rachel Barkley, a municipal credit analyst with Morningstar in Chicago and author of a recently published report on the shortfalls and surpluses of city pension plans.
“This is huge and I’m not sure that is something the whole market saw coming,” Barkley also said, in an interview with InsuranceNewsNet.
Although U.S. Bankruptcy Judge Steven Rhodes said that pensions legally could be cut as part of the city’s financial reorganization, it doesn’t necessarily mean that the cuts will be approved in the city’s final reorganization plan.
On Dec. 3, Detroit became the largest municipality in U.S. history to enter Chapter 9 bankruptcy, and the question now turns on where and how best to cut $18 billion in debt and long-term liabilities from the beleaguered city’s balance sheet.
Rhoades ruled that it is legal to cut pensions in this case because the pension benefits are a “contractual obligation” of a municipality, and not entitled to any extra protection in bankruptcy. U.S. law allows for contact cuts in bankruptcy, and supersedes Michigan law protecting pensions.
Barkley said upcoming discussions between negotiators and mediators about where and how to cut while still providing for an equitable outcome will provide a tantalizing case study. “It will be fascinating on how they go about doing that,” she said.
Pension and benefits were a big factor in the Motor City’s pre-bankruptcy proceedings, as the city could not keep up with its contractually obligated payouts. This was due to a shrinking tax base coupled with long-term economic decline and mismanagement.
Barkley said Detroit does not set a precedent for other cities because many states don’t allow cities or municipalities to go bankrupt. States that allow municipalities to file for bankruptcy protection typically have procedures in place to prevent long, drawn-out disputes between unions and city managers.
“Detroit was definitely a special case,” she said. “It had been fiscally stressed for many years. In general, city governments are stable and revenues are increasing. Governments are in better shape now than a few years ago.”
Other cities that may be eligible for bankruptcy might also find that pensions are subject to negotiations, but “in no way do we think this will unleash an avalanche” of precedent with regard to cutting pension or contractual obligations, she said.
Detroit’s fortunes have been declining for so long that no one expected the city to avoid bankruptcy, not with ratings agencies progressively downgrading the city’s debt ratings from one junk status to another, and negotiations at a standstill.
Nevertheless, the city’s financial turmoil stands as a reminder to other local governments — Jefferson County, Ala., and the cities of Stockton and San Bernardino, in California, all of which have also filed for Chapter 9 bankruptcy protection.
The lesson from Detroit’s latest legal proceedings is that a federal bankruptcy judge has the power to override a state constitution, said Barkley.
For employees of San Bernardino, pension benefits are provided through California Public Employees’ Retirement System (CalPERS), a cost-sharing multiple-employer plan. San Bernardino has missed $13 million in pension payments to the plan, which is protected by state law, and CalPERS has filed suit against San Bernardino’s bankruptcy filing.
Barkley writes in her report titled “The State of City Pension Plans 2013: A Deep Dive into Shorfalls and Surpluses,” that the bankruptcies of Detroit and San Bernardino have “potentially far-reaching implications on state protection of pensions liabilities during bankruptcy proceedings.”
“If they are successful in trimming these liabilities, other entities that cannot afford to support operations, debt payments, and retiree costs at the same time may look to emulate their actions,” Barkley wrote.
Among the top 25 cities in the country, funding levels of city pensions are generally good but several cities bear watching, even if they are in much better fiscal shape than Detroit. Chicago’s funded ratio is only 35.2 percent, and Philadelphia’s is only 48.1 percent.
“Some places like Chicago and Philly with low pension levels and high unfunded levels will have to be addressed,” she said.
Detroit’s funded ratio, ironically, is 91.4 percent, but that is due to actuarial assumptions used in the calculation. Determining an accurate pension liability is one of the contested issues surrounding the bankruptcy.
Washington, D.C., with a funded ratio of 104.9 percent, is the highest of the nation’s top 25 cities, and the aggregate funded ratio for all 25 cities was 64.6 percent, the report found.
Funded ratios of 80 percent or better are considered good. Funded ratios of less than 70 percent are considered poor and affect a municipality’s credit quality.
Cyril Tuohy is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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