Detroit Bankruptcy Risks Pensions as Cuts Ruled Possible

Police, firefighters and other municipal workers can no longer count on a financially secure retirement based on a city-sponsored pension.

A federal judge yesterday ruled that Detroit, the largest U.S. city to file for bankruptcy protection, may cut employees’ retirement benefits as it looks to emerge from $18 billion of debt with a sputtering economy and a declining population. The ruling cast uncertainty on the incomes of thousands of former workers of Michigan’s largest city, where pensions average $19,000 a year and were assumed to be protected by state law.

“There are a lot of hurdles before you can go into bankruptcy,” said Peter Henning, a professor of constitutional law at Wayne State University in Detroit. “It does send a message to retirees that you can’t assume that because there’s a state constitutional protection that your pension can’t be cut.”

The judge’s decision is the latest challenge to local government employees’ pensions, which guarantee fixed annual payments based on how long workers were on the job. Stung by investment losses and the failure to set aside enough money, the twenty-five largest U.S. cities have $125 billion less than they will need to pay for benefits they have promised, according to Morningstar Inc.

The shortfalls are forcing governments to put more money into their pensions and have led officials to propose lifting retirement ages, requiring employees to contribute more out of their paychecks, or put new employees into 401(k)-style accounts commonly used outside of the public sector.

Illinois System

In Illinois, where lawmakers yesterday approved a bill to rescue its underfunded pension system, Chicago’s pension burdens have sent the city’s credit rating tumbling. In California, San Jose Mayor Chuck Reed is leading the push for a statewide initiative that would let cities cut benefits already promised to employees. And in Central Falls, Rhode Island, a judge last year approved cutting pensions to help it emerge from insolvency.

U.S. Bankruptcy Judge Steven Rhodes, who’s overseeing the Detroit case, yesterday ruled that the city can try to reduce workers’ retirement checks under its plan to emerge from court protection, saying federal law trumps the pension safeguards in Michigan’s constitution.

Rhodes’s decision is the first to reject arguments by union and pension officials that a state constitution shields retiree paychecks, said bankruptcy attorney Jim Spiotto, an attorney with Chapman & Cutler LLP in Chicago.

Former Firefighter

No specific benefit cuts were approved under the ruling. Those decisions will be made later, as the court evaluates competing interests of pensions and other creditors, including owners of debt backed by the city’s general pledge to repay.

Brendan Milewski, a 34-year-old former Detroit firefighter who was partially paralyzed when a building collapsed on him, said public employees are preparing to see their checks cut and to pay more for their health care. He said he receives $2,800 a month from the city.

“It’s going to be devastating,” he said. “We got assurance that all our worst fears are coming true -- we just don’t know how big the hit is going to be.”

The Detroit decision was criticized by the California Public Employees’ Retirement System, the largest U.S. pension fund, which has been fighting with the city of San Bernardino as it deals with bankruptcy. Calpers has argued that state law protects cutting the city’s debt to pension funding in Chapter 9 proceedings.

Ruling Faulted

“The ruling is short-sighted and does not take into account the promises made in exchange for the financial and physical investments that public employees and retirees make in our communities,” Brad Pacheco, a Calpers spokesman, said in an e-mail.

David Crane, a one-time economic adviser to former California Governor Arnold Schwarzenegger on pension issues, said the Detroit case may pressure employee unions into accepting curbs on retirement benefits should a city’s financial distress push it toward insolvency.

“What you really hope something like this does will lead the unions to recognize that there is a chance that their benefits could be cut back in bankruptcy and they’re better off working with these cities now to share in the pain,” he said.

While three California cities -- Vallejo, San Bernardino, and Stockton -- filed for bankruptcy after being stung by the housing market collapse and the recession, such filings by municipalities are rare.

Rare Filing

From 1970 to 2009, only a handful of cities and counties filed for bankruptcy protection, according to the National League of Cities. This year, U.S. city finances are mending from the recession that ended in 2009, with an expectation that revenue will rise for the first time since 2006, according to a survey by the League released in October.

Few cities are struggling as much as Detroit, which has lost a quarter of its population since 2000, following a decades-long slide that eroded its tax base as the U.S. automobile industry’s fortune’s declined.

A study of 173 cities by the Center for Retirement Research at Boston College found that the pension funds typically consumed 7.9 percent of city tax revenue -- though for some, including Chicago, the figure was twice as high.

“Most cities and towns are not faced with the issues Detroit is,” said Jean-Pierre Aubry, the center’s assistant director for state and local research. “The city has been shrinking for the last 30 years. The bankruptcy just made it official.”

Few Followers

Trident Municipal Research, a firm in New York that tracks local finances, said the possibility of pension-benefit cuts raised by the Detroit case probably won’t prompt other cities to declare insolvency. To qualify for bankruptcy, a city needs to prove its insolvent, not just seeking to use the courts to rid itself of its debts.

The ruling ``in no way opens the door for a flood of Chapter 9 filings that may be presumed to be ‘waiting in wings,''' Trident said in a note to clients. ‘‘The reality of the handful of bankruptcies in the post-crisis era is that bankruptcy is painful for all involved.’’