Detroit Bankruptcy Likely to Spark a Pension Brawl

Demonstration by AFSCME workers in Detroit at City Hall opposing emergency management. The workers are facing pay, job, healthcare and pension cuts. (Photo: Abayomi Azikiwe), a photo by Pan-African News Wire File Photos on Flickr.

July 19, 2013, 8:09 p.m. ET

Detroit Bankruptcy Likely to Spark a Pension Brawl

Filing Will be a Test Case of How Far a City Can Go in Shedding Retiree Costs

By MICHAEL CORKERY And MATTHEW DOLAN CONNECT

Detroit's historic bankruptcy filing will be a test case for how far a major U.S. city can go in dealing with a chronic problem facing many local and state governments: unsustainable pension costs.

Emergency manager Kevyn Orr has said all city workers, both current and retired, could see pensions cut to help resize Detroit's finances.

It is a scary prospect not only for Detroit workers who have been counting on these guaranteed benefits, but for workers in cities across the U.S. who have assumed that their pensions were untouchable, even in bankruptcy.

Almost every state in the U.S. has made cuts to its public-employee pensions, seeking to dig out from the economic downturn. But many of these changes apply only to newly hired workers, not to retirees.

States aren't allowed to file for bankruptcy protection. But in a few cities—including Central Falls, R.I., and Prichard, Ala., that like Detroit have filed under Chapter 9 of U.S. Bankruptcy Code—bankruptcy has led to big cuts to retired city workers.

"These cases are exposing the fact that many municipal workers are unprotected and suffering big losses of income that they thought were pretty much guaranteed,'' said Robert Flanders, a judge, who was appointed by Rhode Island to help oversee and guide Central Falls through bankruptcy.

Retirees in Central Falls agreed to 50% cuts in pension benefits, in many cases, after the small city filed for bankruptcy in 2011. By contrast, the city's bondholders were paid in full.

Bankruptcy lawyers and pension experts say these cases—and Detroit's filing Thursday—prove it can be less painful for public-sector unions and city officials to agree on how to curb high pension costs before reaching bankruptcy court.

Filmmaker Heidi Ewing's documentary "Detropia" presented a collage of Detroit on the brink of dissolution, taking the prize for editing at the Sundance Film Festival in 2012. She joins the News Hub to offer her perspective on the city's bankruptcy filing. Photo: Loki Films.

"The lesson of Detroit is that it is better to take care of this issue before bankruptcy,'' said James Spiotto, a lawyer at Chapman & Cutler LLP. "Even if you think you have the right to get paid, you are taking a big risk in bankruptcy."

Pensions are an important way that state and local governments compensate and attract workers. But the spate of recent municipal bankruptcies are showing that public pensions may lack the basic safety nets that private-sector benefits enjoy. Pensions granted by companies are typically backstopped by the Pension Benefit Guaranty Corp. and regulated by federal law. Public pensions are not.

It is unlikely that the federal government would intervene in the Detroit bankruptcy to bail out city workers or any other creditors, according to state and White House officials. But such aid is not without precedent. New York City received federal financing to help ease its fiscal crisis in the 1970s.

Detroit's road to financial ruin started decades ago with city leaders agreeing to generous pension benefits, which were managed by boards with overly optimistic projections for investment gains, state officials say.

Detroit officials failed to anticipate how the drastic loss in revenue coming into city coffers from local taxes and state aid would drain the funds' assets. State officials say that the funds performed poorly as a result of mismanagement, and federal investigators have probed their operations in an continuing criminal investigation.

Of the city's $18 billion in long-term liabilities, $3.5 billion is now owed to city pensions, while another $6.4 billion is owed to fund other employee benefits, largely retiree health care.

The General Motors headquarters building is seen in the distance past a run down building in Detroit in April.

"We cannot pay it," Mr. Orr said in an interview Friday. "Everyone has known that for the last 20 years, and no one has wanted to deal with it."

The gap became even more acute in the last decade as the city struggled to pay its pension obligations using complex financial swaps.

But instead of alleviating Detroit's debt burden, the complex deals further tied the city's hands and eventually cut off access to millions of dollars in casino revenue.

In 2011, the city had used the casino tax revenue as collateral to secure swap agreements, interest-rate bets the city made with Wall Street banks years ago in the hopes of avoiding higher rates. Detroit's swap agreements are tied to $1.4 billion in bonds the city issued to help address funding shortfalls in its pension funds.

The city also borrowed millions from its own pension funds while underfunding them by more than $100 million in recent years, according to Mr. Orr. The final break before bankruptcy came last month when the city defaulted on a scheduled, $39.7 million payment for pensions, arguing Detroit needed to conserve cash or risk running out of money completely.

The city now argues that a bankruptcy filing will pay retirees what Detroit can truly afford, while giving a voice to the 20,000 individual retirees on city pensions, double the number of current city employees, who are represented by unions. Mr. Orr in legal documents filed Friday called on federal bankruptcy Judge Steven Rhodes to appoint a committee to represent retiree interests.

"We want them at the table. We want to hear their voice," said Michigan GOP Gov. Rick Snyder, who appointed Mr. Orr as emergency manager in March.

The governor also noted that the proposed cuts by the emergency manager's plan for pensions only affects the unfunded portion. There is still a debate over how well funded the pension funds are. Mr. Orr has said that one fund for most city employees was underfunded to such a level—potentially less than 70%—that he would have the power to take it over completely.

The pension funds have challenged Mr. Orr's assessment of their funding levels. They have also taken the fight to state court where they persuaded an Ingham County judge Thursday to bar the city from moving to reduce pension benefits, including a filing for bankruptcy.

Michigan Attorney General Bill Schuette filed an appeal on behalf of Mr. Snyder, who approved the bankruptcy filing on Thursday.

Pension holders will continue to make the argument that the governor cannot impose a Chapter 9 filing that would impair the pensions, based on the Michigan state Constitution, said Robert Gordon, head of the corporate restructuring and bankruptcy practice at law firm Clark Hill PLC, which represents many city employees through the General Retirement System and the Police and Fire Retirement System.

"This is a valid issue, and we will press that issue in the appropriate forum," he said.

The pension holders have considered the issues in their lawsuit for some time, Mr. Gordon said, but sped up the clock after groups of Detroit city workers and retirees filed lawsuits in Ingham County, Mich., and after media reports this week that the bankruptcy filing could come within days.

"We remain committed to pursuing the parallel path of negotiations with the emergency manager," Mr. Gordon said. "And it would be our expectation that those discussions will commence at some point."

Mr. Orr and Mr. Snyder said in a joint interview Friday that the litigation wouldn't impede their march through bankruptcy court.

The legal battles and policy debates have real consequences for retirees like Don Taylor, 64 years old, a Detroit police officer for 26 years.

Retired in 1998 after making $36,000-$37,000 a year, he is now drawing a pension of roughly $2,300 a month and gets a $45-a-month increase each year as part of a cost-of-living adjustment. He said loss of the annual increase is "something I can live with, but it depends if they're looking at steeper cuts. Nobody knows what's going to happen."

Rose Roots, 76, who spent nearly 30 years working as an employee trainer for the city before retiring in 1996, has lived in the same house on the city's west side for 30 years. Not counting Social Security, her pension, which she described only as modest, is her sole source of income to pay her mortgage, keep up her home and occasionally visit out-of-town relatives and friends. City benefits also cover the cost of some drugs she takes that aren't included under Medicare.

Detroit City Council President Saunteel Jenkins said in an interview Friday that keeping up with the city's Big Three auto makers' pensions had helped lead the city down an unsustainable path.

"I think we all know that the levels of salaries and benefits were set by the autos," Ms. Jenkins said. "We couldn't pay as much as the private industry, but we provided great pensions, great benefits, as a way to compete. As the playing field started to level and as our resources started to dwindle, we never addressed that issue."

Mr. Snyder said that the city could now try to replicate what the state has already done: move away from defined benefit pensions and stand-alone retiree health care and into 401(k)-style contributions for retirement and health-care benefits that supplement existing federal programs.

—Emily Glazer and Christina Rogers contributed to this article.
Write to Michael Corkery at michael.corkery@wsj.com and Matthew Dolan at matthew.dolan@wsj.com

A version of this article appeared July 19, 2013, on page A1 in the U.S. edition of The Wall Street Journal, with the headline: Detroit's Bankruptcy Sparks Pension Brawl.