Legacy costs push communities to the brink

October 2013 | FEATURE | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

Increasingly, for many US communities, municipal or Chapter 9 bankruptcies are becoming a stark reality. Last year alone, 12 Chapter 9 insolvencies were filed in the US, with a further four seen in 2013 so far.

While no two cases are ever the same, one of the most common themes running through the majority of insolvent cities and towns is the presence of crippling legacy costs.

The question of legacy costs will undoubtedly play a significant role in the future of many US communities. At present it remains to be seen how local governments handle the burden of large and increasingly overwhelming pension costs. However, after Detroit filed for the largest municipal bankruptcy in US history, the issue of legacy costs has been pushed to the forefront of public consciousness. As such, it is clear that legacy costs can no longer be ignored.

Currently, too many local governments are failing to fund their current operating budget’s pension obligations and retiree healthcare costs. When the city of Detroit filed for Chapter 9 bankruptcy protection on 18 July, it listed around $644m in unfunded pension liabilities. However, according to Detroit’s state appointed emergency manager, that number is reportedly closer to $3.5bn if “more realistic assumptions” are taken into account. Detroit’s other unfunded post-employment liabilities, which include retiree healthcare costs, account for $5.7bn of the city’s outstanding debt of $18.5bn. Indeed, Detroit’s two largest unsecured creditors are the city’s general retirement fund and the police and fire departments’ respective retirement funds. Clearly, the city must take action to tackle its public debt, 38 percent of which is estimated to be related to legacy costs. At present, Detroit, which has twice as many retirees as it does active workers, spends around 43 cents of every dollar it takes to service its legacy costs. By way of comparison, other US cities of Detroit’s size spend no more than 20 cents per dollar.

Detroit is not alone in suffering at the hands of crushing pension obligations. Many municipalities are increasingly confronted by the conundrum of how these huge commitments are to be met. According to the think-tank Pew Research Center for the States, state public pension plans across the US were underfunded by an estimated $1.4 trillion in 2010. The magnitude of the overwhelming deficit for all pension plans across the US ranges from $900bn to over $4 trillion, depending on the estimates used.

The underfunded and overbearing nature of these legacy costs serves as an unwelcome reminder of the collapse of the automotive industry in Detroit. As the city embarks upon its long journey back from financial ruin, the spectre of what happened to the city’s automakers still looms. The Chrysler Group LLC and the General Motors Company underwent wholesale restructuring in 2009, aided by long term government support in the form of bailouts and loans from the US Treasury Department.

However, the Obama administration has already set the precedent for municipal bankruptcies. There will be no handouts for bankrupt towns and cities. The Federal government’s unwillingness to intervene in the bankruptcy of a former industrial powerhouse such as Detroit will have caused alarm among state and municipal officials across the country. Union leaders and retirees in cities such as Chicago and Los Angeles will also have taken note.

The financial crisis and resulting downturn have brought both state and municipal government pension issues to the fore; declining state tax revenues and pension plan assets have made pension costs a mainstream issue. From a peak of $2.3 trillion in September 2007 to a low of $1.2 trillion in March 2009, state and local government pension fund equity holdings lost nearly half of the their value according to the Board of Governors of the Federal Reserve System. Although the value of many state and municipal pension plan equity holdings have subsequently recovered to more than $2 trillion, public pensions remain under intense scrutiny. To that end, credit ratings agencies have begun to incorporate unfunded pensions liabilities into their borrower risk assessments.

In late July, Chicago saw its general obligation debt rating downgraded by ratings agency Moody’s due to a $19bn unfunded pension liability, a liability which Moody’s places closer to $36bn. This liability, coupled with what Moody’s termed “unrelenting public safety demands” on the city’s budget, forced the downgrade. Moody’s also placed a negative outlook on Chicago’s $7.7bn in general obligation bonds, suggesting that a further downgrade may be around the corner. In April, Moody’s began a revaluation of the credit effects of municipal retirement obligations. Los Angeles could also be facing up to a liability of more than $30bn according to some estimates.

For a number of years the concern for analysts and industry watchdogs has been that in many cities, revenues cannot keep up with spiralling debt costs. As such, it is becoming increasingly likely that other towns and cities will be caught up in legacy cost battles such as those engulfing Detroit. Legacy funding can become a staggering financial burden on local governments, and soon come to threaten core services as well as retiree benefits. The question, therefore, is how can administrators and governments best handle and resolve the impending threat of spiralling legacy costs?

Cuts and tax increases

One idea espoused in some circles is levying higher taxes against residents.

In response to Detroit’s mounting financial problems, the city’s government opted to raise taxes. As a result of these increases Detroit’s residents now face some of the highest taxes in the US, as well as the highest income tax rates permitted by state law. These increases have been labelled unsuccessful and inappropriate – as the number of Detroit citizens living under the poverty line continues to increase, the city struggles under the highest per capita tax burden in the state.

For property owners in Detroit, property tax accounts for a huge portion of this tax burden. In 2011, Detroit ranked first in a study of property tax rates in the 50 largest cities in the US. Furthermore, assessments of the properties themselves tend to run high, with many houses within the city assessed at ten times their actual value.

Furthermore, Detroit, as in many other municipal bankruptcies, opted to slash funding for public services. In recent years the city has cancelled plans for its long awaited light railway project. It has also made drastic cuts in the city’s police funding, which in turn has caused average police response times to rise to 50 minutes. This, and the fact that nearly 40 percent of the city’s street lights are inoperable, has seen Detroit become one of the most dangerous cities in the US, regularly topping FBI lists ranking violent crime.

Widespread increases in taxation, coupled with the sweeping cuts to the city’s services, have only served to exacerbate Detroit’s financial situation, and a major outcome has been the migration of the city’s population. Over the last decade, 25 percent of Detroit’s population has left for greener pastures. From a peak of around two million in the 1960s, just 700,000 residents now remain. This, in turn, has had a crippling effect on the city’s economy. Tax receipts have dropped 40 percent, and state funding is also down 50 percent due to the population drain.

Maintaining a healthy tax base is crucial to the economic stability and longevity of municipalities, and ratcheting up taxes to increase revenue is not in the best interest of any towns or cities facing mounting legacy costs. Higher taxes and declining public services are more likely to drive residents away, which, in turn will result in the local government’s legacy costs being borne by the few citizens who remain behind. Those businesses and residents that depart will not be around to fund the legacy costs that were incurred when they were inhabitants of the city. Therefore, unless alternative sources of income can be found, or permanent legal relief from their commitments can be obtained, municipalities across the country will face tough decisions about where compromises are to be made.

Haircuts

Although the option is by no means popular, the most realistic means by which local governments can restructure their crippling legacy costs going forward will be by imposing haircuts on various parties. Chiefly it would seem that creditors – unions in particular – must be asked to take cuts.

Pension and health benefits for employees of the city of Detroit cost the local government roughly one-third of its total revenues. Therefore, in June, Mr Orr outlined a scheme that would see Detroit workers not already vested in a city pension excluded from doing so in the future. Furthermore, the scheme would see many retirees moved to federal healthcare programs. Those retirees already included within a plan would also have their benefits frozen. Others would be transferred to a defined contribution savings plan.

At the time of writing, Mr Orr has not made clear the extent of any haircut for future or current retirees, pending an actuarial analysis. However, it is known that the new plan would remove automatic cost of living raises. Meanwhile, worker contributions into the system would have to increase.

Mr Orr has made it known that restructuring the city’s legacy costs is pivotal to Detroit’s future, noting “We can’t pay benefits with money that’s not there. It can’t be done.” Although critics of the plan have noted that city retirement benefits are protected by the constitution of Michigan, Mr Orr maintains that Federal bankruptcy laws would supersede the state’s constitutional protection. As such, the city’s 31,000 retired workers will see “some adjustments” to their benefits in the near future.

Understandably, the decision to ‘adjust’ the benefits of the city’s retired citizens has been wildly unpopular. Three separate legal challenges have been filed by both current and retired workers in an attempt to challenge Detroit’s bankruptcy filing. A move to block the filing was carried out in a Michigan state court on the same day as the city’s filing in federal court, but despite these challenges Detroit’s path seems clear.

New dawn

Detroit’s bankruptcy filing and subsequent haircut plan have been, and will continue to be, painful for the city and its residents. However, the filing could also be a turning point for the city. In some respects the local government’s position will be strengthened by the insolvency. Rather than imposing an even greater burden on the city’s dwindling populace, Detroit will be forced to get around the table with its creditors, including pension groups, and reach something of a compromise. Whatever the outcome, the situation should serve as an example to other municipalities to tackle their costs before it is too late.

Richard Summerfield