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Tuesday, April 15, 2014

The Solution to Detroit's Pension WoesTurns Out to be Ipse Dixit

CNBC reports that the City of Detroit has reached agreement with its retired police and firefighters on revised pension terms.  The City apparently went in, asking for 6% cuts in annual payouts and an end to cost-of-living increases.   The retirees apparently went in, asking for no concessions.  With the assistance of mediators, they seem to have settled at: no cuts, but "reduced" cost of living increases, and "As part of the deal, Detroit has reportedly agreed to increase the projected return on its pension funds to 6.75 percent, up from 6.25 percent and 6.5 percent, according to USAToday." 

Now that is definitely not a solution anyone has ever thought of before in relation to pension shortfalls -- assume investment performance will compensate for the gap between what the employer pays in and what the retirees are promised to receive.  This is really an approach that everyone should be able take to a difficult financial situation.  For example, why didn't GM or Chrysler think of it? 

Banker: "I am worried that your cash flow is not going to be enough to enable us to meet our obligations to creditors on time."
CEO: " Yeah, I can see how our forecasts might lead you to think that. Let's fix that by just assuming we sell more cars at higher prices."
Banker: "Oh, wow! I never thought of that. I can see why you deserve to be CEO."

And then the banker can employ this solution with regulators, too. 

Regulator: "I am worried that your loans to the auto companies might be impaired; I want you to establish reserves against potential losses."
Banker: "They won't be impaired if the auto companies sell more cars at higher prices than they have been forecasting."
Regulator: "Why, yes, if that happened, indeed, your loans would be sound.  Let's use that assumption going forward."

Now, it is definitely true that in reorg negotiations, one of the things that  often helps to get deals done is to acknowledge that there is room for upside over the debtor's base case, such that, if the prospective pie is perceived to  be a little bigger, there is more to move around and placate potentially objecting constituencies.  OTOH, Judge Rhodes has stated he will focus on the feasiblity of the City's reorganization plan, it will be interesting to see how much scrutiny he gives to what is ultimately an of unprovable assumption.  Because this assumption is related to feasibility and the judge has announced he will be giving close scrutiny to that issue, I don't think the agreement is reviewed by the usual, lenient, settlement standard of "lowerst level of reasonableness" which it would seem to satisfy. How certain does the city's forecast have to be for him to call the plan feasible in his opinion, and does the plan need to contain any kind of backup protection against future default? Or does he decide to bless the mediated result, after grilling the retirees' representatives over their degree of confidence in the forecast, and getting them to acknowledge that the City is no longer responsible to make up a shortfall if the forecast is not achieved.    It will be interesting to see. 

Update on April 17th: From the website of Detroit's police and fire retirement system, I pulled the following facts: as of the latest (end of 2011), calculations, there were two retirees for every active memember covered by the plan; the average annual benefit payout was over $57,000; the plan considers itself, as of March 2014, fully funded as to all retired members, but only 47% covered as to active members, but the deficiency is mainly due to payments missed during the chapter 9 case; prior to the case, the plan was almost completely funded as to all possible participants (the news reports I read on the settlement do not say whether those missed payments will be cured upon emergence, although I think that is likely; still it would appear that the active force will bear the burden of limits to the cost of living adjustments, since they will live longer than the retirees).  From the standpoint of the health of the reorganzied entity which is what should be the main focus of a reorganization, one would rather the retirees bore the brunt of any sacrifice, so that the City can offer the maximum incentives to the police and firefighters it needs to employ.  But with a 2:1 retiree-to-active ratio, that seems politically impossible.