Detroit's Bankruptcy Could Spread Nationwide if We Don't Control Pensions

American cities are dealing with severe financial stress. Burdened by mounting debt to service existing debt and pay retirees, major cities will have to decrease services and renegotiate long-standing union contracts to get on solid financial ground. If this does not occur, we will likely experience an exodus of Americans from urban areas, marking a return to the physical and cultural deterioration of inner cities that occurred during the 20th Century.

An article in the New York Times on August 5, titled "A Plan To Avert The Pension Crisis," is revealing. It offers a solution that will further erode the federal budget and will not address the true causes of the public pension crisis.

The article refers to the bankruptcy of Detroit, the largest municipal bankruptcy to date. What are the reasons for the city's demise? They include: "white flight…, the collapse of auto manufacturing, [and] decades of inept, corrupt municipal government." But equally important is that many cities, along with Detroit, are being ravaged by “unaffordable pension and retiree health costs."

Like the auto industry that went bankrupt recently, Detroit "made deals” with city unions that created humongous future liabilities. The city fathers, at the time, sold out future residents by agreeing to outrageous and onerous benefit packages to avoid union unrest. These concessions abetted the political aspirations of the leaders, essentially kicking their problems down the road for their successors to wrestle with. It is difficult to assess the culpability of union leaders in this Ponzi scheme, one that pays off old players with money from new players who ultimately lose everything.

The reference to the auto industry is that the large manufacturers were paying more to retirees than to current employees, similar to Detroit and many other municipalities. Demographics caught up with the companies when current cash flow was insufficient to support ever-growing pension and health care costs. The result was bankruptcy and significant heartache for current employees whose benefits are now in jeopardy.

The scope of Detroit's problems is staggering. It has approximately $18.2 billion in debt, more than $26,000 for each of its 700,000 residents (partially attributable to the city’s declining population). Employee pension and retiree health care "schemes" account for $9.2 billion of the liabilities, and at least $3.5 billion of these liabilities are unfunded. One reason for the latter problem is the overstated investment rate used by pension administrators. In other words, the city overestimated investment results on the cash that was contributed into these programs. Similarly, California assumes a 7.75% rate on its investments while its actual results are about half that rate. This near-fraudulent technique has created a mammoth overestimation of the state’s pension funding. Other cities are in the same boat, accruing liabilities far greater than what they are recording and then reporting to their constituencies.

Total annual state pension liabilities compared to revenues are reason for great concern. Moody’s, the credit agency, indicated that Illinois pension liabilities are 241% of the state's annual revenue and Connecticut pension liabilities are 190%. This isn't just a problem with one city, however poorly managed it's been. This is something that concerns some of the wealthiest and most populous states in the union, and if we don't get the problem under control, sooner or later we will all feel the pain of bankruptcy.