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Detroit’s Wishing Well Runs Dry

Our march toward the Era of Broken Promises took another big step this week with the developments in Detroit’s massive municipal bankruptcy, though the ultimate destination of this journey is still just a dim speck on the horizon.

On Tuesday a federal judge ruled that Detroit could formally enter the bankruptcy process. The judge, Steven Rhodes, also specified that the city’s pension obligations are fair game for adjustment - meaning, in all likelihood, sharp reductions - in the process. The New York Times reported that Detroit has $3.5 billion in unfunded pension liabilities among its other municipal debts. And though the Michigan Constitution specifically protects pension obligations, Rhodes made clear that federal bankruptcy law overrides state law in this instance, setting a precedent for other municipal bankruptcies.

Not surprisingly, public employee unions and pension fund representatives promptly began to discuss appealing the decision. At least one union filed a notice of appeal the same day the decision was announced. Bruce Babiarz, a spokesman for the Detroit Police and Fire Retirement System, called the ruling “the canary in a coal mine for protected pension benefits across the country.”

I expect there will be a big difference between what public employee unions should do and they probably will do. Unions across the country would be wise to try to reach settlements with state and local governments before additional fiscal crises like Detroit’s erupt. Getting ahead of such situations would give unions more room to negotiate, and a chance to secure larger and more financially viable solutions for their members; waiting will mean letting problems fester until, like Detroit’s, they yield dire outcomes.

If I were a union leader, I would want to protect the benefits my members have already earned, and change the way they earn benefits going for forward. Detroit makes it obvious that, for future work by current employees and future hires, unions should demand cash on the barrelhead, in the form of higher salaries or employer-funded defined contribution plans, in which workers’ shares vest promptly and which workers themselves can individually own.

In effect, what I advise is that public sector unions secure their workers’ current and future benefits today, even at the cost of a haircut, rather than maintain the fiction that public employees can continue to benefit from unfunded deferred compensation as long as the costs are back-loaded and thus shifted to tomorrow’s taxpayer-voters, rather than today’s, who enjoy the benefits of those workers’ services. Detroit has shown everyone that once the future becomes the present, such benefits are likely to prove to be a mirage.

Lest non-Detroit unions feel that the era of broken promises is unlikely to affect them, it is worth noting that The New York Times ran two articles concurrently with the story of Rhodes’ decision: one about the Illinois Legislature’s attempt to support a flagging pension system and one describing how the Detroit decision may alter the course of municipal bankruptcies already underway in California. California bankruptcies that previously left pension plans untouched may be revised, especially as opponents of the current plans have said that leaving pensions alone would mean not saving enough money to restore cities’ financial health.

As for Illinois, though the Legislature passed a deal to shore up the state pension system, The Wall Street Journal critically pointed out that the defined contribution plans designed to replace traditional pensions remain under state control, allowing lawmakers to “raid” them at any time. This situation is the worst of both worlds for public sector employees, but since unions across the country have, for the most part, staunchly refused to compromise, this sort of last-ditch fix might be the only choice some states or municipalities have left by the time they get around to addressing the problem. Critics of the Illinois bill have pointed out that even these changes will be insufficient to meet the state’s pension funding shortfall.

What I think Detroit’s public employee unions will do, in contrast to what they should do, is first appeal Rhodes’ decision. I expect such appeals to be unsuccessful; I think the judge was both correct and realistic, and I suspect higher courts will agree. The same will likely hold true on the municipal level in other places.

Next the unions are likely to fight to have municipal obligations, like those in Detroit, treated as contracts that are binding on the state level, effectively asking the state to make up the gap where municipal promises fall short. While the results of this gambit will vary depending on local politics, it will probably have limited success, since people in localities that have not made unrealistic promises are unlikely to want to foot the bill for their neighbors in places that have.

But the most interesting, and perhaps the most damaging, potential strategy unions might employ will be to go to Congress, seeking to change the bankruptcy law in order to give public employees and their unfunded pension promises priority over other municipal creditors - namely bondholders. In other words, as the picket signs already read in Detroit, demand that Congress “protect people, not banks.” Of course, bonds that banks sell are ultimately owned by people too (just not always unionized people). If the unions succeed in winning this legislative change, the risk, and the price, of municipal credit will rise. It is already too risky for my taste.

The impossible never happens. The message from Detroit’s bankruptcy is that promises that are impossible to keep will, ultimately, not be kept. Those depending on such promises elsewhere should take note.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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