Case in Detroit Highlights Costs of ‘Extra’ Pension Payments

The constitutions of some states, including Michigan, explicitly bar the cutting of public pensions. But what about extra payments promised to Detroit’s workers and retirees?

The city’s pension system made extra payments for decades to thousands of people, on the thinking that the base pensions were too small. The pension board thought it found the money for the extra payments by skimming off “the excess” when returns on investments exceeded the plan’s target â€" 7.9 percent in Detroit.

But the pension fund also had years when its investments fell short of the target. And with millions of dollars being paid out each year in the extras, the fund missed out on all the investment income that money would have brought in. So the extra payments fundamentally undercut the health of the pension plan.

Nor is Detroit alone in making the extra payments â€" known variously as “the 13th check,” “the skim fund,” “the bump up,” “the waterfall” and so on. New York City; Phoenix; San Jose, Calif.; and Tampa, Fla., along with some of the public plans in Illinois, Indiana, Texas and Mississippi also have the add-ons.

The problems with the extra payments have long been known. San Diego ran into a financial quagmire in the early 2000s after years of removing “excess earnings” from its pension fund to sweeten benefits. The city finally had to bring in a forensic team led by Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, to sort out the mess. Mr. Levitt found “not mere negligence, but deliberate disregard for the law” in San Diego’s pension practices.

Unlike company pension plans, which are tightly regulated by the federal government, public plans are largely governed by their boards of trustees. And officials outside San Diego seem not to have thought that Mr. Levitt’s message applied to them.

The federal judge dealing with the Detroit bankruptcy is left, then, with a conundrum: The pension extras have cost Detroit billions of dollars over the years, hastening the city’s downfall, yet state laws say the extra payments must continue.

Earlier this month, a state labor judge ruled that Detroit illegally interfered with its pension system two years ago, when it stopped the extra payments in a last-ditch effort to save money and avoid bankruptcy. (The base pensions are still being paid.)

“The city’s conduct was unlawful and constitutes a refusal to bargain in good faith,” wrote Doyle O’Connor, a state administrative law judge. Unions are likely to cite his finding in bankruptcy court this week to bolster their arguments that Detroit should not even be in federal bankruptcy court. Bankruptcy law requires that Detroit show that it bargained in good faith with its creditors, to no avail, before seeking relief in federal bankruptcy court.

Judge O’Connor said he was not ruling on the wisdom of the add-ons, only on whether the City Council could unilaterally stop them. He ordered that the add-ons for 2011 and 2012 be paid retroactively. But, given Detroit’s bankruptcy, he likened his order to a ticket refund for passengers on the deck of the Titanic.

If Detroit does qualify for protection under Chapter 9 of the bankruptcy code, the presiding federal judge, Steven Rhodes, may override Michigan’s constitution and cut the pensions.

Cities and states around the country are watching Detroit’s case closely. Many of them are struggling with pension plans that are overwhelming their finances, and a surprising number also make the extra payments.

Detroit’s pension trustees distributed the extra payments not only to retirees and active workers, but also effectively gave some to the city in the form of reduced annual pension contributions.

“We were saving the city money,” said Tina Bassett, a spokeswoman for Detroit’s pension trustees.

But a study in 2011 by an outside actuary showed that the extra payouts were actually costing Detroit billions of dollars, although it was hard to see because the city’s disclosures were sketchy. Actuaries model pension costs over the long term, and when trustees find “excess” money year by year and spend it, they defeat the fundamental premise of the plan â€" that investment gains, not local taxpayers, will pay most of the cost.

“This sounds like San Diego,” Mr. Levitt said when told about Detroit’s program. “It appears to lack transparency, and it appears deceptive, in terms of not defining the true cost of the pension.”

In San Diego, officials also decided that the “excess earnings” of the pension fund allowed the city to reduce its required annual contributions. In fact, that worsened the damage because after making all the extra payments, the pension fund needed more money from the city, not less.

The San Diego pension fund seemed to doing fine for a while, but under the surface it grew shakier and shakier, and finally broke down after the technology stock crash in 2001. The resulting scandal led to a shake-up of the city government, indictments, civil lawsuits and a federal charge of securities fraud â€" the first against an American city for pension malfeasance.

Auditors called the notion of excess earnings “the snake in the garden,” and San Diego lost vital access to the municipal bond market for a time. Its pension fund was found to have a huge shortfall, and officials openly discussed declaring bankruptcy.

For all that, San Diego’s retirees still receive their extra checks â€" about $4.7 million worth last year. The add-ons remain contentious, though. Last year, city residents voted overwhelmingly to close the existing pension plan to new hires. Savings from that change will take many years to appear.

The actuary advising San Diego’s pension trustees at the time, Rick Roeder, said the disaster was caused by faulty thinking about pension math.

“There is no actuarial justification for 13th checks,” he said in a telephone interview from his home in La Mesa, Calif. “A 7-year-old child could understand this. It’s laughable that this could happen, but it did.”

Mr. Roeder and his firm, Gabriel Roeder Smith & Company, were both sued by San Diego’s city attorney during the pension scandal there, but he was soon dropped as an individual defendant. When his contract with the San Diego pension board expired, he did not seek to have it renewed. Gabriel Roeder Smith settled with San Diego for undisclosed terms.

The firm has also advised Detroit’s pension trustees and has been subpoenaed in that city’s bankruptcy case, but the documents it provided are not in the public record. The firm said in a statement that its role was limited, that it did not determine the payment of benefits, that decisions were made by the trustees and that it was not a fiduciary, with the associated higher duties to the plan and its members.

“Gabriel Roeder Smith & Company has consistently performed its work for the Retirement Systems professionally and in keeping with industry standards,” the firm said.

In San Diego, Mr. Levitt wrote: “Of all of the board’s advisers, Mr. Roeder was most qualified to understand, and explain to the board, the basic conceptual mistake” it was making in removing “excess earnings” from the pension fund. By failing to do so, and giving the pension fund “sound” annual valuations, “Mr. Roeder facilitated the perpetuation of the underfunding scheme and breached his professional obligations.”

Mr. Roeder said in the interview that he thought “the actuarial community, in general,” had not been “as explicit as we could have been” about unsustainable pension costs. He said many places in California had granted rich benefits, then sought relief when they found they could not afford the contributions. When he tried to warn clients, they dismissed him, he said. He is now semiretired.

“Many entities in California are watching the Detroit situation like a hawk,” he said. “There will be a number of entities, in my opinion not a small number, that will be willing to put up with the expense and stigma of bankruptcy if the judge says, ‘Look, federal bankruptcy law supersedes the state law protections of pensions.’ ”