Wouldn't it be great if you could just decide that your monthly cellphone bill was too high and only pay half? That might work for a while, but eventually Verizon or AT&T would turn off your phone.
Municipal governments have been trying the same thing with their pension bills, and it hasn't gone well. One result is a spate of municipal bankruptcies from Rhode Island to California, including Detroit's dramatic filing last year.
According to Detroit's latest plan, city pensioners could see their benefits cut 10% to 30%, while bondholders will face cuts of 10% to 80%.
To understand the problem, it's important to know how the system works. A traditional pension is a promise to pay workers a fixed income when they retire. This requires that governments know how much money to set aside while employees are still working. If a city promises to pay a teacher $100,000 in 20 years, pension actuaries have to figure out how much that $100,000 benefit will cost in today's dollars — and this is based on an assumed interest rate known as the "discount rate."
Most government pension plans are legal guarantees, meaning teachers get paid regardless of the city's investment performance. Economists agree that if the payout is guaranteed, the discount rate should be as close to guaranteed as possible. The closest you can get is the yield on a 10- or 20-year U.S. Treasury bond, which currently returns about 3%.
Yet surprisingly, most cities assume they'll earn about 8% annually on the stock market. This optimistic assumption allows them to set aside far less money to pay future retirees.
When the market was booming, it seemed to work. But that changed with the Great Recession, when pension assets suddenly met financial reality.
Now, for cities looking to correct the problem, the financial shortfall is staggering. Assuming that stock markets will rise at fantastic rates forever conceals a massive funding gap and the need for painful reforms. In some cities, this leads to a barrage of dueling pension estimates between reformers and politicians or special interest groups who don't like their bill.
Until Detroit filed for bankruptcy protection, officials claimed the pension system had a manageable funding shortfall of $600 million, but that assumed the city's investments would earn 8%. When emergency financial manager Kevyn Orr asked for a new estimate using the fund's actual earnings, it revealed a shortfall of $3.5 billion. Using a more conservative "guaranteed" rate, the gap widens to $9 billion.
Now a court will decide whether benefits must be cut because Detroit didn't act in time. When cities go bankrupt, public employees lose.
Unfortunately, other cities are following Detroit's beleaguered path. Based on a 7.5% discount rate, Memphis' pension unfunded liability was valued last year at $709 million. The city's employee associations disagree and hired their own consultants — who used an even higher rate of 7.9%, dropping the shortfall to $300 million. Meanwhile, the Memphis City Council hired another consultant to compute its own estimates of the unfunded liability. If Memphis treated pensions like guaranteed debts, the shortfall would be $2.8 billion.
By tinkering with technical details, governments can essentially hide what they owe — but only for a while.
Picking a discount rate to fit your own budget is as helpful as jumping on a scale with one foot on the ground: You might like the number you get, but it doesn't mean you're in good shape.