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All Eyes on Detroit: What Happens to Unfunded Pension Liabilities When a Municipality Files for Bankruptcy?

James Spiotto
James Spiotto, Partner, Chapman and Cutler, LLP
August 21, 2013 · Print · Email

While Detroit’s recent Chapter 9 municipal bankruptcy filing has certainly posed a variety of challenges for the City’s citizens and creditors, it may also serve a greater social benefit.  Participants in the Detroit bankruptcy are presently considering the legal and metaphysical question of whether a state constitutional provision can mandate that, unlike other contracts, unfunded pension obligations must be paid in a municipal bankruptcy without any impairment or reduction. 

Unfortunately, bankruptcy is the land of broken promises and impaired contracts but, regardless of the outcome of the legal debate, there may be practical answers emanating from the case for all those who are watching Detroit.  In the interview that follows, James Spiotto, co-owner of MuniNet and a partner with Chapman and Cutler, LLP, specializing in municipal bankruptcies and workouts, elaborates on the lessons learned from Detroit’s unfunded pension fracases. 

MuniNet: Let’s review the facts of Detroit’s Chapter 9 filing - and why pensions have taken the front and center stage in recent headlines.

Spiotto:  Detroit filed for Chapter 9 municipal bankruptcy protection on July 18, becoming the largest U.S. city to file for bankruptcy.  It was also the first instance where the largest city in any state has had to file for bankruptcy, unable to work with the state to come up with a solution to its financial struggles.

Detroit’s pension obligations are the subject of current legal debate, as participants in the bankruptcy try to determine if and how these unfunded pension liabilities - contractual obligations - should be handled in the absence of adequate revenues to cover them.

When obligations become so overwhelming to a municipality as to crowd out necessary expenses for essential governmental services and infrastructure, the consequences can be devastating and lead to the meltdown of the municipality ...  

Pensions are long-term obligations.  As we are seeing in Detroit’s case, the failure to fund them today can lead to insurmountable problems tomorrow. A municipality’s ability to adequately fund pensions is inextricably intertwined with its ability both to have funds to pay the pensions and also to meet the necessary costs to govern effectively and survive.  Municipalities cannot pay that which they have no revenues to fund.

MuniNet: Can unfunded pension liabilities prevent the necessary recovery that everybody wants?

Spiotto:  Absolutely.  When obligations become so overwhelming to a municipality as to crowd out necessary expenses for essential governmental services and infrastructure, the consequences can be devastating and lead to the meltdown of the municipality (as Detroit has amply demonstrated).  From Bridgeport, Connecticut in 1991, we learned a truth applicable here:  if a municipality is required by state law to balance its budget and consequently cuts expenses for essential services and raises taxes, the net result is fewer citizens, fewer corporate and individual taxpayers, and the subsequent lowering of revenues.  If the municipality attempts to correct for this by raising taxes and/or cutting expenses and services, meltdown continues and the death spiral will begin.

In reality, the future of pension funding, workers’ continued employment, and the recovery plan for Detroit is dependent upon determining what costs and expenses are sustainable and affordable.  

It appears self-evident that if a municipality (such as Detroit) is required to first and foremost pay everything it owes on its pensions now, it will not be able to succeed because it cannot afford such payment in full. Consequently, the municipality will not be able to develop a recovery plan to stimulate and encourage business with the accompanying creation of jobs that are sorely needed in the community.  In such a situation, funds necessary for essential governmental services (such as public safety, education of future workers and infrastructure improvements necessary to move goods, services and workers through the community) will not be there.

MuniNet: Can the “death spiral” be reversed?  Does Detroit have a chance for a bright future down the road?

Spiotto: Yes, if we realize that the first step is a successful recovery plan that is sustainable and affordable.  Without that first step, there won’t be enough funds to employ workers, provide essential services or pay pensions. In reality, the future of pension funding, workers’ continued employment, and the recovery plan for Detroit is dependent upon determining what costs and expenses are sustainable and affordable.  This would include determining what amount of pension obligations can be paid that is reasonable, prudent, and feasible.  Such determination must take into account the necessity of sufficient funding for a recovery plan whereby essential governmental services can be raised to an acceptable level and infrastructure provided to encourage, stimulate and ensure business growth and expansion, with its accompanying creation of good new jobs, especially for the young citizens of Detroit.  This will ensure not only Detroit’s short-term recovery but also its long-term success.

MuniNet: And what about the pensions?

Spiotto:  If we were honest with ourselves, we would all admit that there is a simple answer to this controversy.  Workers (current and retired) who have labored hard and especially those who are necessary for the recovery and success of a municipality deserve to be paid for past efforts.   As much as can be paid should be paid to meet these obligations as promised.  Likewise, workers and retirees rely on the continued success and growth of the municipality for continued employment and pension payments.  If the municipality continues to erode and does not succeed with its attempted recovery, there will be less not more to fund pensions and to keep workers employed. 

Rather than positioning and fighting among ourselves as to what can be paid, what cannot be paid, and what must be paid, it is in the best interests of all parties working on the recovery and success of the municipality to recognize and determine what is sustainable and affordable.  Acknowledging the resulting adjustments is simply a recognition of reality.  In exchange for that adjustment to an affordable pension payment, the municipality can provide a dedicated, sustainable and sufficient revenue source to pay annually the so determined pension contribution.  Periodically, the determined affordable pension contribution can be adjusted in order to ensure that which can be paid will be paid from future revenues, including any increased revenues created by the recovery plan, without sacrificing essential governmental services.  In this way the municipality never again repeats the unfortunate scenario that to balance its budget it forgoes pension contributions and promises pension benefits that are not sustainable and affordable.  In the long run, this approach of adjusting pension contributions so they are affordable and sustainable will pay more than the best litigation strategy.

Editor’s Note: Click here to access a full version of the article, “Less is More - Lessons Learned from Detroit Bankruptcy’s Unfunded Pension Battles.” 

Also see “Roadmap for Driving in Constitutional Hazard of Detroit’s Pension Obligations,” published in the August 15, 2013 issue of Pension & Investments.

 

 

 

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