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The real size of Detroit's pension funding gap

by Cory Eucalitto | July 15, 2013

Detroit teeters on the brink of bankruptcy. Questions about the city's pension obligations loom large.  According to Moody's Investor Services, one of the ratings agencies that will play a role in assessing the city's future credit status, Detroit's unfunded public pension liabilities are much larger than previously reported.

Moody's updated its process for adjusting public pension plan liabilities earlier this year with a goal of enhancing both transparency and comparability. The process involves discounting liabilities at a rate lower than the 8 percent average currently used by most public plans, which, in most cases, shows that plans are far less well funded than reported.

Using this method, the combined funded ratio of Detroit's two pension systems is just 69 percent, as opposed to the 91 percent reported by the city itself. Detroit's unfunded liability, money owed to retirees not currently backed by assets, is $3 billion. That is $2.4 billion more than the city reports.

The city's funded ratio was determined using discount rates of 7.9 and 8 percent for the General Retirement System and the Police & Fire Retirement System, respectfully. Under the new guidelines, liabilities are discounted according to Citigroup's Pension Liability Index. Since Detroit's pension plans were last valued on June 30, 2011, that rate is 5.67 percent.

To make matters worse, the discount rate that Moody's will use for the city's June 30, 2012 valuation is just 4.13 percent. At that rate, the city's unfunded liabilities grow by $4.5 billion.

Detroit Pension Funding

Kevyn Orr, Detroit's state-appointed Emergency Manager, has similarly found the city's pension liabilities to be understated. In his initial report on Detroit's finances, Orr found that "more realistic assumptions," especially reducing the discount rate by just one percentage point, suggested that the unfunded liability would be $3.5 billion by June 30 of this year. As things stand, the city is unable to finance just the $600 million unfunded liability that current reporting standards show.

Detroit also has $1.5 billion in outstanding Pension Obligation Certificates. This money was borrowed in 2005 and 2006 to cover required contributions, but now stands as additional debt holding back the city's attempts to achieve fiscal normalcy.

Importantly, the reduced funded status revealed by the adjustment process does not directly factor into how governments fund public pension plans. It is simply a tool that Moody's uses to evaluate the health of public pension plans as a portion of a state or municipality's overall credit rating. It nonetheless provides a more accurate assessment of the challenge presented governments by their employee retirement obligations.

Moody's recently released an initial report detailing the funded status of state governments under the new adjustment method. It found the aggregate funded ratio was just 48 percent, compared to the state-reported figure of 74 percent. State Budget Solutions has previously used Moody's new method to determine the adjusted liabilities of several California municipalities.

Many signs point towards Detroit becoming the largest municipality in the nation to file for Chapter 9 Municipal Bankruptcy. This decision should not be taken lightly. Above all, it must be rooted in an accurate understanding of the hurdles that the city faces. The fact of the matter is that Detroit's public employee retirement plans are far less well off than many of its leaders believe.

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