$195M pension payment might derail Detroit's recovery

Post-bankruptcy Detroit is obligated to pay little to nothing into employee pensions over the next nine years. But then, an enormous bill comes due that has caught city and pensions officials off-guard, raising doubt about the data used in bankruptcy to calculate the city's obligations.

According to new actuarial estimates in documents reviewed by the Detroit Free Press, the city's balloon payment due in 2024 for its two pension funds has risen to $195 million, or about 71% above the original $114 million projected under the city’s bankruptcy exit plan approved by a federal judge last year. No one has a recently updated forecast yet of what the city's pension bills look like in the decades after that.

"The risk of the whole plan is that in year 10, the city gets an invoice and it’s going to be a big number and how well did they plan for that," Robert C. Smith, chairman of the Detroit Police & Fire Retirement System Investment Committee, said in an interview.

The unexpected jump could challenge funding behind the city's financial road map approved as part of the nation's largest municipal bankruptcy. It could also be politically contentious for elected leaders and the residents they serve if the city decides to boost pension payments at the expense of other investments such as public safety and blight removal.

The original balloon payment was calculated with help from the pension consultant used by former Detroit emergency manager Kevyn Orr, a gubernatorial appointee who ruled the city for almost two years including its time in bankruptcy court. Reached Friday, Orr declined to comment about revised pension projections for this report, saying he had not reviewed them.

But the actuaries for the city's two pensions funds say the lower estimate used in the bankruptcy plan was based on outdated information, including projections that didn't allow for the longer life expectancy of retirees or that the city would be hiring new employees after filing for bankruptcy who would need to become part of the pension system.

The old calculation also was based on pension cuts taking effect in June 2014, instead of nine months later in March, which underestimated the liability for the pension system, officials from the Gabriel Roeder Smith & Co. actuarial firm told its Detroit pension fund clients in recent weeks.

Others argue the issue is more than manageable, even if Detroit decides to make bigger pension payments sooner. The city's post-bankruptcy budget was designed with a surplus for contingencies, which Orr predicted would be $100 million before he left the city in December 2014.

"While the books are not yet closed on FY 2014-15, the projected budget surplus for that year exceeds the emergency manager's original estimates," Finance Director John Naglick said in an e-mail Friday.

City coffers could also grow, improving the city's ability to pay in the future. Returns on pension investments over the next nine years may outpace expectations, lowering the city's estimated payment.

Time for more pension payments?

Actuaries advising the pension funds insist there is a significant risk of keeping to the original payment schedule and not adding more money: "Every potential action" should be pursued, they say, to provide additional funding into the funds well before 2024.

"If not, there could be significant risk of contribution defaults and/or further benefits cuts," Gabriel Roeder, the actuarial firm that has advised Detroit’s pension trustees for 75 years, concluded in a new draft report presented to one of the city's two pension boards last week.

​The revised estimate still counts on the pension funds’ assets earning 6.75% a year on its investments agreed to by the city's emergency manager and pension officials in bankruptcy mediation talks.

Early returns weak

Instead, the funds this year are both on track to earn less than 5%, according to pension fund officials. A lower average rate of return over the next several years could further inflate the city’s pension fund obligations starting in 2024 and beyond.

The city has two pension funds — one for police and fire employees and one for non-uniformed employees — that cover more than 25,000 retirees and active city workers.

Under the bankruptcy plan, general pensioners were hit with 4.5% cuts, the elimination of annual cost-of-living-adjustment (COLA) increases, and a clawback of excessive interest from annuity savings. Police and fire pensioners saw a reduction only in their COLA increases.

Without an $816-million payment from a group of local and national foundations, Detroit Institute of Arts and state lawmakers, dubbed the "grand bargain," the pension cuts would have been much worse, city leaders say. In exchange for the financial support, DIA masterpieces were protected from being sold to pay off city debt, and the institute was spun off into its own independent nonprofit to be forever shielded from city finances.

Original forecasts submitted in the bankruptcy case showed the city paying roughly $92 million into the pension funds from now through 2024 plus help from the proceeds from the grand bargain.

Mayor Mike Duggan said in an interview this month he remains unhappy with the size of Detroit's pension obligation.

After living under a budget largely preset by the city's former emergency manager, the mayor and city council will assume a greater control of the city's budget process starting next spring even as a separate financial review commission has the final say.

Detroit chief financial officer John Hill said in a separate interview that revised estimates produced by the pension's actuaries could prompt the city to make payments earlier than expected.

But he cautioned there's also a risk to making early payments because if good money is poured into pension funds ahead of schedule but the market does not perform well, or even loses ground, it could cost the city more in the long run.

“If you pay more now, it only helps you if the plan earns more money than you expect it to,” he said during an interview earlier this month. “If you put money in the plan and it loses, then you’re going to owe more and the amount you put in would’ve been better sitting in your account than it would’ve been sitting in the pension fund.”

Hiring an expert

Hill said the city intends to hire an outside firm to help the city test various actuarial assumptions and help the city determine how much it owes the pension funds.

“I’m pretty confident that we’re going to come up with a reasoned solution that will have us continue to be in compliance with the plan of adjustment,” Hill said. “We recognize that this is a liability — no question — for the city and it’s a responsibility that we have as a city and it’s something that we agreed to do.”

In an interview, Gov. Rick Snyder, who authorized the city's bankruptcy filing more than two years ago, said he believes it's a "normal process" to commission and absorb the findings of updated actuarial reports.

"I view it as prudent that you do this," said Synder, who is also a certified public accountant. "So if you have an issue, you can identify it years out and do something about it."

He said that his administration has not shied away from trying to tackle the pension funding gap issue.

"I never underestimate long-term liabilities," he said. "As a state, I think we’ve done a good job to address them."

Cleaned-up balance sheet

Detroit's original pension obligation estimated at $3.5 billion was one of the key reasons used to justify its historic bankruptcy, the largest-ever municipal filing in the nation.

To be sure, there were other problems with the city's balance sheet. Compared with pensions, the city's retiree health care system was cut much more deeply at roughly 90%. Other creditors were paid less than 10 cents on the dollar.

In the end, an estimated $7 billion of the city's $18 billion in long-term liabilities was eliminated as part of the city's plan of adjustment. About $1.7 billion of the cuts came from pensions.

Supporters of the bankruptcy plan also argue that new accounting changes smartly eliminated a widespread practice across the nation of low-balling pension contributions to force greater payments in the future. The change in Detroit is meant to inject more reality into what the city's true obligations are, even though the positive results of paying into the funds won't be seen for years down the road.

But the expensive, 18-month-long restructuring was also billed as a financial reckoning day to help prevent Detroit from facing future balloon payments it could no longer afford. It was a $39.7-million missed payment in June 2013 on debt issued to bolster its pensions that served as precursor to the city's filing for Chapter 9 protection weeks later.

As part of the bankruptcy adjustment deal, Detroit was to be given a break in funding its pensions directly through 2023 in part because of the massive grand bargain aid package worth $816 million largely making up the difference.

Negotiators feared rejecting the deal might lead to further benefit cuts. The deal approved in a vote by city employees and retirees was also greased by a rosy projection for improved pension fund returns due to the stock market’s performance in 2013, further reducing the city's anticipated liabilities estimated by Orr's team in conjunctions with unions and retiree groups.

But assumptions adopted only a year ago may have led to a sharp miscalculation.

Retirees living longer

Part of the reason for the new spike in projected pension payments? An updated mortality table for city workers and retirees used to calculate how long retirees are expected to live and receive pension benefits.

Milliman, hired by the city under emergency manager Orr, used older tables, according to the pension funds' own actuaries. A Milliman spokesman said in an e-mail Friday that "we have a longstanding policy not to comment on our client work."

But Gabriel Roeder officials said they applied updated calculations in their new reports.

"Many of the changes we've made here," Gabriel Roeder's Kenneth Alberts told the city's police and fire pension system board of trustees at a meeting Wednesday, "were mandated by the city's plan of adjustment bankruptcy plan."

Early warning signs

How much of this increase should have been anticipated? Experts warned early on that the ability of Detroit to know its true pension obligations was always unsteady even as the city was set to emerge from bankruptcy.

Martha Kopacz, who analyzed the plan for U.S. Bankruptcy Judge Steven Rhodes and found the city's plan feasible, cautioned in her report last year that the city must be "continually mindful that a root cause of the financial troubles it now experiences is the failure to properly address future pension obligations."

But she also conceded that "despite the relative importance, the magnitude of the city’s retirement obligations and the methods for calculating them are largely unknown."

One major risk, she concluded, was that the pension plans are "not able to defer plan payments during down markets, and therefore, in significant down markets, the loss of principal as a result of making payments to pensioners, without offsetting investment returns, can result in a plan that “locks in” losses. These 'locked in' losses create underfunding."

That, among other factors, led Rhodes to conclude last year that his greatest concern for the city “arises from the risks that the city retains relating to pension funding.”

How can we afford this?

How might the city pay its looming pension bills? It is possible that Detroit's financial position will be much better in 2024, giving the city a much greater ability to pay its pensions, even an inflated bill.

But some say the city's budget — $1.1 billion for the 2015-16 fiscal year — could still be tight in the coming years, making the possibility of any new pension fund spending a challenge. In that case, Detroit could be forced to shift money away from city services in the next 10 years in order to shore up pensions if an increase in municipal revenues can't cover the difference.

Some in Detroit remain worried about the fragile state of the city's nascent recovery.

"We’re nowhere out of the woods," former Detroit Mayor Dave Bing said in a recent interview. "A lot of people say we’re no longer in bankruptcy, so things must be great."

Bing said that isn't the case. He praised the work of the bankruptcy leaders and the city's resurgence in downtown and Midtown. But he added, "All you have to do is go into any neighborhood and ask somebody 'are things better for you' and 99% of the people would probably say no."

The city's financial review commission, a body charged with keeping the city on track with its bankruptcy-exit plan, discussed pensions in its May report but did not foresee the larger balloon payment estimated in documents revealed last week.

The revision for the year 2024 from Gabriel Roeder — $81 million greater than the forecast in the plan — is considered solid enough to be cited in the draft of an upcoming report from Detroit's financial watchdog commission to be submitted to Snyder by Dec. 1, according to a person familiar with the matter.

Missed opportunity?

Some critics say Detroit missed a critical opportunity to restructure its entire retirement system to relieve the city of a risk it can ill-afford.

Among them is the Detroit bankruptcy judge who found the city's original plan to be feasible.

In an interview, Rhodes said that the city may have missed a cost-saving and risk-reducing opportunity in bankruptcy to move all city workers to a 401(k)-style retirement system built in part on employee contributions.

Instead, the city kept its defined-benefit pension plan for older workers and retirees and moved newer workers into a so-called hybrid plan intended to shift some risk to a smaller number of employees.

"I did approve that as a reasonable settlement," Rhodes said in an interview. But he said the vestiges of the city's defined-benefit pension leave a substantial risk on the city's shoulders alone.

"So I did think it was a missed opportunity," he added.

But Orr, one of the bankruptcy plan's chief architects, defended the direct-benefit pension system in an interview late last month. He argued it was substantially reformed as part of a compromise with pension funds and labor unions during the bankruptcy mediation that sped the city's exit from bankruptcy.

He said it remains an important entitlement to city workers, many of whom receive wages and salaries below the private sector. For new city workers, Detroit started a hybrid system expected to reduce the city's financial burden, aiding its ability to pay all of its obligations.

"The reality is that it is a compromise solution," Orr said.

Contact Matthew Dolan: 313-223-4743 or msdolan@freepress.com. Follow him on Twitter @matthewsdolan