As Detroit Goes…

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. And indeed 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.

But 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 off-kilter. 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.

Here’s the punchline: the calculations that Detroit’s municipal authorities relied on to say that they were perfectly solvent follow 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 7% and 7.5% at least 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.

Why is this a problem? If you’ve ever happened to glance at your own portfolio statements, you may have noticed that no conservatively-managed investment portfolio has earned anything close to 7% a year since 2000. But Detroit’s actuarial team accounted for that by “smoothing” the projections–a fancy way of saying that they assumed higher returns in the future would offset the lower returns they’d experienced.

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.

It doesn’t take a rocket scientist to notice, as a writer did recently at The Economist magazine, 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. Some states and cities, when they post job listings for staff actuaries, require that the potential hires hew to the generally-accepted principles. No sober doses of reality will be sought or tolerated.

Why hasn’t anybody blown the whistle on this long-term overstatement of returns and understatement of liabilities? Who benefits from putting that whistle to their lips? The city employees, whose monthly statements show returns and benefits that are orders of magnitude higher than they could get in the open market? The city officials, who would then have to deal with the scandal of underfunding and have to make huge tax dollar commitments to catch up, often with money they don’t have? The municipal bondholders, who are clipping coupons and whistling in the dark, hoping they’ll be paid off before somebody tells them, as Detroit bondholders are now being told, that their investment is worth pennies on the dollar?

Taxpayers, who could be on the hook for billions of dollars worth of promises that the state constitution and city charter declare must be kept?

In fact, the New York Times recently reported that the Society of Actuaries itself is revisiting its generally accepted principles, fearing a black eye for the profession. The debate could lead to a policy that favors more realistic investment assumptions, while officials running for office may have uncovered the next scandal that could shoo them into office.

Either way, you can expect to hear more about bankrupt cities and municipalities, and the next headline probably won’t 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.

Sources:

http://www.realclearmarkets.com/articles/2013/07/24/the_real_message_behind_detroits_decline_100499.html
http://www.irishtimes.com/business/economy/detroit-bankruptcy-filing-comes-after-long-financial-decline-1.1469526

http://www.economist.com/blogs/democracyinamerica/2013/07/detroit-s-bankruptcy

http://dealbook.nytimes.com/2013/07/19/detroit-gap-reveals-industry-dispute-on-pension-math/?ref=marywilliamswalsh

This article was written by Bob Veres and re-printed with his permission.

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