EDITOR’S NOTE: This is the second in a series on the impacts of the Detroit bankruptcy.
“Just a city boy … born and raised in south Detroit; He took the midnight train goin’ anywhere.” — “Don’t Stop Believin’ ” by Journey
Detroit’s financial problems included a downturn in the auto industry which decimated the local tax base, unsustainable public pension commitments, and poor pension investment management. Combined with municipal corruption, its finances became a tangled disaster.
Public pension funds were partly managed by “consultants,” or friends of the mayor, who convinced the police and firefighter pension boards to invest heavily in disastrous real estate projects. One investment even directed funds toward a failed housing development in Sarasota. According to Bloomberg Businessweek, “Detroit’s general-employee pension fund and its police-and-firefighter fund … real estate investments dropped by 47 percent and 33 percent, respectively, over the four years ending June 30, 2012.”
According to Riordan and Rutten of the New York Times, “Detroit’s municipal debt is around $18.2 billion … Employee pension and retiree health schemes account for $9.2 (over half) of the liabilities … Detroit consistently overestimated investment returns on its pension funds …”
“It (Detroit) is not alone in this kind of wishful actuarial accounting. California’s giant state pension fund, the world’s sixth largest, continues to assume it will earn 7.75 percent on its investments, even though its actual returns have been less than half that for a decade.”
“The Pew Center … estimated that public pension plans nationwide were underfunded by $1.4 trillion in 2010,” said Jeff Dorman in Forbes. “An improving stock market since then has assumedly made the shortfall smaller by now, but most … government pension funds are still well short of where they should be … The Government Accountability Office recently … suggested that some of them have no hope of paying all the pensions promised.”
Should other pensioners be concerned? Most definitely. Pensions of all kinds will likely undergo radical future changes. Municipalities and states may essentially decide that they can pay their employees now, but that providing retirement pay, along with health care costs, is simply unaffordable.
Should muni bond holders in general be concerned? About default, probably not. Very few muni bonds default. But bonds are taking a beating in the current rising interest rate environment, and many bondholders are paring away their longer duration fixed income holdings. Interest earned from muni bonds is tax free, and muni’s are exempt from the new 3.8 percent surtax on net investment income, so it’s difficult for some investors to part with them completely. Floating rate bonds, short duration bonds and senior bank loans are three types of bonds that historically have held up in a rising interest rate environment.
Pensions, politics and corruption are a lethal financial combination, especially in a city with a withering tax base. But even well-administered municipalities and states may undergo future financial strain in meeting pension obligations.
Margaret R. McDowell, ChFC, AIF, a syndicated economic columnist, chartered financial consultant and accredited investment fiduciary, is the founder of Arbor Wealth Management, LLC, (850-608-6121~www.arborwealth.net), a fee-only registered investment advisory firm located near Sandestin.