The Detroit bankruptcy ruling and the new bookkeeping rules from the Government Accounting Standards Board (GASB) could trigger a wave of changes for the US state and local pension funds this year. Government leaders struggling with budget problems, bondholders that lend money to municipalities and states, and unions that negotiate pension benefits all have to deal with the impact.
The new GASB rules, applicable from the fiscal year 2014-15, will require underfunded pension funds to project lower rates of return on their investments, closer to the yield on tax- exempt 20-year, AA or higher rated municipal bond. They will also ban smoothing, which allows pension funds to book investment gains and losses slowly for as long as five years.
The two measures together will force most local governments to face the poor financial health of their employees’ defined benefit pension funds. Major public retirement systems use a 7-8% projected rate of return, about twice the bond yield imposed by GASB. If the rate of return is lower, future liabilities increase and the funded ratio worsens. A ratio of 80% is considered healthy but the new rules will cut the average funding ratio of assets to liability to 57%, according to a study by the Center for Retirement Research, down from 75% in 2011.
Local governments with heavily underfunded pensions and highly troubled finances could follow Detroit’s example. In the US there are 61 cities – including Atlanta, Boston, Chicago, and New Orleans – with a gap of more than $217bn (€158bn) between the benefits they promised in pensions and retiree health care and the assets they have to pay for them, according to a study by the Pew Charitable Trust.
At the state level, the situation is no better and nine state retirement systems have a funded ratio of less than 60%. Illinois has a ratio of only 43%, the worst in the country, and a $81.3bn pension shortfall. Last year, the state was
even accused by the Securities and Exchange Commission of misleading investors about its unfunded pension liabilities and was forced to settle with the regulator. Last December, Illinois passed a reform that is supposed to save $160bn over the next 30 years by reducing cost-of-living adjustments, increasing retirement ages and capping pensionable salaries.
This kind of reform – already adopted by Oregon and Rhode Island – is likely to become more common. In December 2013, Judge Steven Rhodes ruled that, under chapter nine
of the US bankruptcy code, Detroit could cut public pension benefits, which were considered contract rights without any special protection. The ruling was a shock for unions because Michigan’s constitution protects public pensions – as do those of Illinois and California. The unions have already announced they will appeal, and the Detroit case could go to the US Supreme Court, according to legal experts.
In the meantime, other cities dealing with chronic debt and spending a large portion of their budget on pensions may use Detroit’s precedent to corner the unions. Either the public employee representatives agree on reforms and cuts, or the administration can ask for bankruptcy protection and get the savings anyway. Actually, according to Judge Rhodes’ remarks, cities do not necessarily have to negotiate before filing for bankruptcy if they show that the crisis is urgent and needs immediate action – one more reason for the unions to discuss reforms before it is too late.
Three Californian cities are able to take early advantage of the Detroit ruling. Vallejo emerged from bankruptcy protection in 2011 but is still struggling with rising pension costs. San Bernardino and Stockton were both judged eligible for bankruptcy last year, but they have not targeted pension cuts yet.
Another consequence of Detroit’s ruling might be a push in favour of greater transparency in the accounting methods of public pension funds. The inadequacy of financial disclosures by states and cities about pension obligations is a problem affecting the $3.7trn municipal bond market.
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