July 3 (Bloomberg) -- The emergency manager in charge of keeping Detroit afloat says the city’s $20 billion debt load can’t be reduced to manageable levels without “shared sacrifice” from all stakeholders, including retirees.
Pension and retiree-health-care obligations make up the bulk of the city’s unsecured debt, and their costs are rising rapidly. The emergency manager, Kevyn Orr, is right that Detroit must reduce its retirement-related debt to secure its future, but he has to be more specific about his target. Cutting retiree health care -- also referred to as “other post-employment benefits,” or OPEBs -- should take priority over pensions.
Detroit’s health-care benefits are generous even by the standard of its free-spending public-sector peers. On a per-household basis, the city owes more for retiree health care than any of the cities at the center of the 30 largest U.S. metropolitan areas except for Boston and New York. Retiree costs make up two-thirds of the city’s annual health-care bill, swamping those for current workers.
Estimated at $5.7 billion in 2011, Detroit’s OPEBs are certain to grow when Orr’s office completes its revaluation of the costs. They already surpass most of Detroit’s other liabilities, including general-obligation debt ($1.1 billion) and pensions (recently revised higher to $3.5 billion).
Beyond the sheer magnitude of the liability, there are three additional reasons Orr should place higher priority on cutting retiree health care than cutting pensions.
First, the only responsible way for any government to manage its retirement liabilities is by pre-funding them. Governments expect to pay for 60 percent of pension benefits through investment returns from their pension funds. Detroit has no fund for OPEBs and no way to pay for starting one anytime soon.
Second, the long-term OPEB cost is dangerously uncertain. Whereas a pension promises a fixed payment, health care is a service whose precise future cost no one can be sure about. In addition to the basic uncertainty of medical inflation, future public-policy changes could have a profound impact on costs. For example, raising the Medicare eligibility age to 67 from 65 would add two more expensive years of health coverage to state and local OPEB programs, and liabilities would swell substantially.
Third, legal protections for other post-employment benefits are much weaker than for pensions. The Michigan Supreme Court has ruled that Article IX, Section 24, of the Michigan constitution, which confers strong restrictions on cutting pensions, doesn’t apply to OPEBs. Detroit would face a protracted and expensive legal process if it took on pension funds, which have already set aside $5 million for potential litigation.
Emphasizing OPEB reductions over pensions would follow precedent. In its 2008-2011 bankruptcy, Vallejo, California, cut health-care benefits and didn’t touch pensions; Stockton, California, which filed for bankruptcy in 2012, is pursuing the same strategy. Rhode Island’s Central Falls cut pensions in bankruptcy but only with the assistance of a Draconian state law that gave bondholders first claim on assets. No such law exists in Michigan, and state law protects pensions more strongly than Rhode Island law does.
Not that pensions aren’t a problem. Because Detroit has been understating its liability and deferring annual contributions, costs are projected to more than double next year. Orr has called for “significant cuts on accrued, vested pension amounts for both active and currently retired persons.” At the very least, the city should switch to a 401(k)-style defined-contribution system for both future hires and current workers’ future benefits. (The Michigan constitution places no restrictions on cutting future accruals.)
Orr has proposed shifting Detroit’s retiree health-care burden to the federal government by moving the 65-and-older cohort into Medicare (many retirees hired before 1986 remain on the city’s plan) and retirees under 65 to the subsidized health exchanges mandated by the Affordable Care Act. Orr should hold firm on these proposals, regardless of where he gets with pensions. Michigan’s general approach to fiscal distress is basically sound in trying to avoid bankruptcy without definitively ruling it out, thus enhancing distressed cities’ leverage in debt negotiations.
But if we assume that Orr won’t get every last demand he has made of creditors, priorities will have to be set. As a tactical matter, it’s more important now for Detroit to get out of the retiree-health-care business than the pension business.
(Stephen D. Eide is a senior fellow at the Manhattan Institute’s Center for State and Local Leadership. He is the author of “Defeating Fiscal Distress: A State Responsibility.”)
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