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.

About Larry M. Elkin 553 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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