Pensions and Bankruptcy: A Tale of Three Cities

At least for now, municipal bankruptcy is a rare -- and headline-grabbing -- occurrence. And the cities that recently filed for Chapter 9 protection didn't end up in bankruptcy court out of the blue: They can thank economic decline, dwindling revenues and population, steep increases in labor costs, mismanagement, corruption, politics, and legal or fiscal impediments to reform for their misfortunes. Yet three recent cases -- those of Vallejo, Calif.; Central Falls, R.I.; and Detroit, Mich. -- also illustrate something that doesn't portend well for many other American cities: Government accounting dramatically underestimates the true value of pension benefits for workers.

The funding gap for legally protected obligations is a lot wider than states and cities recognize. And thanks to fictional accounting, these cities made their pension problems worse in the years leading up to bankruptcy court. Vallejo gave workers generous wage increases that inflated pension payments. Central Falls didn't always make the full payment to its local police and firefighters plan. And Detroit skimmed money out of the city's pension fund to cut "excess checks" to workers.

The degree to which cities are underfunding pensions is certain to trigger more financial trouble in the coming years. One can only speculate as to which cities are likely to file Chapter 9. What is known is that municipal-bankruptcy options are as varied as the circumstances and laws operating in the local governments now navigating that reality. Only 27 states allow cities to file for Chapter 9 under the federal bankruptcy code. The cases of Vallejo, Detroit, and Central Falls are likely to affect how other governments think about their fiscal situation as they consider bankruptcy as an option, negotiate collective-bargaining agreements, and try to overcome the effects of decades of deferred decisions and dodgy accounting practices.

Vallejo, Calif. -- Dozens of California cities fit Vallejo's fiscal profile during the Great Recession: weak economic growth, declining revenues, and growing debt. Vallejo was the first to end up in bankruptcy court. Standard & Poor's points to "financially imprudent labor contracts" with salaries and benefits equal to 80 percent of general-fund expenditures, which drove the city of 118,000 into a tailspin.

Chapter 9 gave the city the opportunity to reject its costly collective-bargaining agreements. To deal with rising costs, city officials cut health-care benefits, laid off public-safety workers, and reduced services and payments to bondholders. But left untouched was the source of Vallejo's budgetary morass: $128 million in unfunded pension obligations. Two years after the city emerged from a bankruptcy, its labor costs are eating up more of the general fund than they did before the filing.

In FY 2013 the city confronts a deficit of $5.2 million. Vallejo's experience is a warning for the state of California, as much as it is for two other cities that have since filed for bankruptcy: San Bernardino and Stockton -- where pension costs for the California Public Employees' Retirement System (CalPERS) present a crushing bill. CalPERS' response to San Bernardino's struggle to make its pension contribution was unprecedented: It moved to sue the city. CalPERS was blocked from going forward with the suit, but the implications are serious. In California, pensions come first -- before bonds and before a city's solvency. This sends a clear signal to the market about the risks of investing in California bonds.

Central Falls, R.I. -- In 2011 Rhode Island's smallest town filed for bankruptcy. With $16 million in revenues, the city owed $80 million in pension and health-care benefits and was sinking under a $6 million budget deficit. The town grossly underfunded a pension and generous benefits, allowing public-safety workers to retire at 43 with a reduced salary. A recent Pew Center report on Central Falls' experience with bankruptcy notes that 60 percent of workers took advantage of these generous terms. And to add to the problem, the city skipped out on payments to the pension between 2009 to 2011.

In contrast to California, the state of Rhode Island made a preemptive decision to protect bondholders, giving them the ability to place a lien on property-tax revenues. The move helped preserve state and municipal credit. Central Falls' bankruptcy proceeding was efficient -- taking about a year -- but also costly to public-sector workers. Retired firemen saw their benefits cut by 55 percent, and property taxes were increased.

Today, Central Falls is out of receivership and the state of Rhode Island took action to reform the state's pension system, relieving municipalities of a portion of their fiscal stress. But in addition to the state-run plans, dozens of Rhode Island municipalities offer additional local plans, and -- like in Central Falls -- these are deeply underfunded. Unions are contesting the state pension reforms that intend to help municipal governments save money. Should the unions win the battle to sustain higher state pension payments, it is sure to affect the ability of towns to make good on local plan payments.

Detroit, Mich. -- Detroit sent a clear message to bondholders before its historic filing: Consider taking 20 cents on the dollar. Since then, the city failed to make its October 1 payment on $411 million in unlimited-tax general-obligation bonds and $202.8 million in limited-tax GO bonds. In addition, the city isn't making payments on its pension-obligation bonds. As a result Fitch downgraded the city to a "D" rating, which may have implications for the interest rates investors will demand on Michigan debt.

For now, Detroit must prove it is eligible for bankruptcy protection, with arguments being heard over the next week. Unions, public workers, and retirees claim Detroit filed for bankruptcy under what they consider Michigan's unconstitutional financial emergency-manager law. The unions claim the law is a ruse to get out of Michigan's constitutional provision that protects pension benefits. But the accounting is not on the unions' side. Before filing, the city reported that its unfunded pension obligations totaled $644 million. On further inspection, emergency manager Kevyn Orr determined it was $3.5 billion. On a fair-market basis, I calculate Detroit's pension obligations are closer to $9.5 billion.

Interestingly, The New York Times reports that decades of mismanagement within the pension system may help the unions' case against bankruptcy by showing the city didn't bargain in good faith with its employees. For years, officials skimmed money off of what they believed was the "excess" in the pension system to cut extra checks for employees. The practice harmed the system, costing billions and contributing to the city's downfall, but a labor judge held the payments were legal.

The judge ordered the city to continue paying them, despite the city's weakening fortunes.