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READ: Pensions and bankruptcy: How cities and companies deal with both by Professor Jay Prag

Published on Tuesday, July 30, 2013

 

by Professor Jay Prag

[From the Inland Valley Daily Bulletin]

From San Bernardino to Detroit and in many smaller cities in between, a legal question rages that could change the course of American politics forever. When a city declares bankruptcy, does it still have to pay the retirement benefits promised to its city workers?

Getting this one right is a truly daunting legal challenge.

Bankruptcy is a legal process that allows a judge to determine who gets what, when a debtor doesn't have enough money to pay its debts.

If the debtor is a company, there are two primary types of bankruptcy.

The company can "restructure" its debts and continue operations or the company can close down and sell all of its assets to pay its creditors. Many issues go into the choice of bankruptcy including the business' viability and fairness to those who are owed money. And these two issues are not independent.

Suppose Bill's machine shop borrowed $50,000 just before the economy tanked to buy a new computerized lathe. When the recession hit, Bill's business fell off, Bill couldn't make his debt payments, and Bill ended up in bankruptcy court. If Bill could show the judge that he had a plan for paying off the debt as soon as the economy recovered, Bill's business could continue under a restructured set of payments. If the bankruptcy judge doesn't think that Bill's business will ever recover, Bill will have to close down, sell all of his assets and pay the creditors as much of what he owes as he can.

Let's switch gears (possibly gears that were made in Bill's shop) and talk about pensions.

Broadly defined, there are two types of pensions: Defined contributions and defined benefits. Most of us have defined contribution pensions: a 401k -- The employee and the employer set aside a fraction of the employee's pay into an investment account and the employee gets whatever that's worth when he or she retires. There are no guarantees with this type of pension since the value depends on the return on the investments.

A defined benefits pension is one in which the employer agrees to pay a particular amount of money to the retiree based on years of service, wage or salary level while working, and other factors. Social Security is a defined benefits pension; so are most municipal employee pensions. This type of pension is much more likely to be problematic for employers, who need to set aside enough money over the years to guarantee their ability to make the promised payments. There's a really bad incentive in any defined benefits plan. Employers can "promise" their employees anything today, knowing they won't have to figure out how to pay it for decades.

Private sector employers have moved away from defined benefit plans; governments still use them.

Let's see why.

To a private employer, these defined benefits plans are more trouble than they are worth. If the company sets aside the exact right amount of money and invests it in the right set of investments, it will be able to pay the retiree what's promised. If the company underfunds a defined benefits plan, it has to make up the difference in the future; and if it overfunds the pension, it forgoes other uses of the money.

Either way, the company is worse off.

It's better for the company to just pay the contribution to the employee upfront, let the employee invest it in a 401k and be done with it.

Governments see it differently. Or at least politicians do. An elected official can get a lot of support from government workers by promising a defined benefits pension -- and a somewhat generous one at that. And that elected official, while caring about his city or state today, can see the payment of the pension as someone else's problem; someone who gets elected 20 years from now. So the incentives to provide overly generous defined benefits pensions are easy to understand.

Let's circle back to bankruptcy. If Bill's business goes bankrupt and, in the worst case scenario, closes, his employees lose their jobs and future pay and benefits, but their defined contribution pension is safe. They already have the money. In the case of most private employers these days, bankruptcy and pensions don't have any conflicts.

For a municipal government it's different: the defined benefits pension is just another debt and thus, just another thing that the bankruptcy court has to figure out. If pensions are considered untouchable, and elected officials are too generous, cities may find themselves in a circumstance in which their pension payments to retirees become a large fraction of their current budget.

Vicious circle time: suppose the bankruptcy court says pensions cannot be touched and the bankrupt city has to spend, say, 40 percent of its budget on pension payments. How can that city ever recover?

It will have to cut police, teachers, city services, and everything else to make payments to people who aren't working anymore. People will move away, businesses will move away, everything will be gone except the shell of the city and the retirees. In the worst case scenario, the retirees will get nothing.

Cities cannot "close down" and sell their assets to pay off creditors.

While dissolution of a city is being discussed in theory, the assets simply can't be sold; at least not in the same way that Bill's lathe can. A reduction in pension payments thus has to be part of the workout for a bankrupt city. The alternative might be no city and no pension at all for the city's retirees.

 



Jay Prag is a clinical associate professor at the Peter F. Drucker and Masatoshi Ito School of Management at Claremont Graduate University. Prag also serves as academic director for the school's Executive Management Program, and can be heard weekly on "Inland Empire News Hour" on KTIE-AM 590.

 

 

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