A tentative agreement between the city of Detroit and its largest union would limit pension cuts to 4.5 percent instead of the 27 percent cuts proposed in the bankrupt city's reorganization plan. The city and American Federation of State County and Municipal Employees (AFSCME) Council 25, which represents the city's non-uniformed employees, announced the settlement late Friday. If ratified by the union's rank-and-file and approved by the state, the deal would clear a major hurdle in the largest municipal bankruptcy case in U.S. history. It would also set a major precedent for struggling cities seeking to reduce their pension obligations in the face of stiff union opposition.

Nonetheless, the agreement "presents the best possible outcome under uniquely difficult circumstances," the union said in a letter to members, obtained by CNBC, urging them to vote yes. "A 'no' vote risks much worse outcomes for our active and retired members," the letter says. The letter explains that if the union rejects the compromise, private and state funds pledged to shore up the pension system would go away and the deeper cuts would be imposed.

Detroit filed the historic Chapter 9 bankruptcy last July citing some $18.5 billion in unfunded obligations, including more than $3 billion related to the city's pension plans. AFSCME pensions in Detroit average about $19,000 per year. Detroit's unions had opposed any cuts in their retirement benefits, citing a provision in the Michigan constitution protecting municipal pensions. But their case suffered a major blow when the federal judge overseeing the bankruptcy, Steven Rhodes, ruled last year that federal bankruptcy law trumps the state provision. The tentative agreement mirrors settlements reached earlier this year with the city's pension funds and a court-appointed committee representing retirees.

In addition to limiting pension cuts to 4.5 percent—and even less for retirees living near the poverty line—the union compromise includes a five percent raise for city employees under a new collective bargaining agreement, followed by annual increases of 2.5 percent through 2018. Cost of living adjustments to pension benefits would be eliminated under the agreement, and active employees would begin contributing to a new pension system under which they would "bear some risk for investment losses," the letter says. The tentative agreement, reached after months of confidential mediation sessions, was made possible by a so-called "grand bargain" featuring more than $800 million in contributions from the state, private foundations, the Big Three automakers, and fundraising by the Detroit Institute of Art, which hopes to head off the forced sale of the city-owned art collection by transferring it to a private organization.