You've probably read that the city of Detroit has filed for bankruptcy protection. If you're like most Americans, you assumed that this is because the city has been declining economically for decades. It's true that America's 18th largest city, once the 4th largest, has seen its population fall by 1.3 million people, leading to a 40% aggregate drop in tax revenue despite property taxes that are now twice the national average. Detroit's unemployment rate is more than double the U.S. average--a situation which is unlikely to slow the exodus.
However, Detroit's fiscal problems actually have little to do with its woeful economy. The problem lies in the assumptions that the city made about future returns in its investment portfolio--the portfolio that funds all city pensions and retirement benefits. With the benefit of hindsight, it is clear that these assumptions were disastrously aggressive. Recent estimates say that the discrepancy between what the city has promised to its current and retired employees, and the money the city has to pay for those promises, could be anywhere between $3.5 billion and $9 billion dollars.
Bottom line: the calculations that Detroit's municipal authorities relied on to say that they were perfectly solvent followed generally accepted actuarial principles. Many other cities and states appear to be making the same mistake, and it's perfectly legal.
Without getting too deeply into the complicated math, the bottom line is that the city has been assuming that its portfolios would generate a steady return of between at least 7% and 7.5% since the turn of the century. In 2011, as the city's financial picture worsened, its pension fund managers increased their projections of future investment returns to 8%, which made the pension system seem potentially better-funded in future years.
These assumptions had two highly-desirable results: they allowed the city to make much smaller contributions to the pension fund than would have been necessary with more realistic investment projections, and they allowed the city to promise future retirement (income and healthcare) benefits that were much more expensive than the city could actually afford.
The problem is that Detroit is not alone.
A writer at The Economist recently noted that the New York City public school system account statements show a yearly return on teacher annuities that is six percentage points higher than the highest going rate on bank savings accounts. New Jersey recently cut its investment projections to 7.9 percent, a mere ten basis points less than Detroit. Over the past ten years, the giant California pension, Calpers, has been using various smoothing techniques to give its municipalities the illusion of greater solvency.
It seems likely you will hear more about bankrupt cities and municipalities, and the next headline may not be about a city whose population has been declining since the Eisenhower Administration. How far and how deep this readjustment will go, how much has been overstated across millions of workers and hundreds of thousands of retired municipal workers, is a potentially alarming mystery.
At Pauley Financial, we seek to responsibly help our clients achieve financial freedom, in part, by taking a conservative approach to material components of one’s retirement picture such as pensions. We also ask our younger clients to consider the possibility that they will not receive Social Security at all. For those that have municipal pensions, it is clearly worth looking into how solvent those plans are, and considering contingencies that may include adjustments to the projected benefits.
Posted on Mon, July 29, 2013
by Kimberly Pauley filed under