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Bondholders Over Pensions

December 4, 2013

Yesterday’s court ruling in Michigan on Detroit’s bankruptcy will have a ripple effect across the country, effecting not just municipalities but also state governments, town governments…. and school districts. How so?

School districts, like urban municipalities such as Detroit, offer or negotiate pension payments as part of their compensation package for employees: not only teachers, but administrators, custodians. In most cases the pensions are largely funded through the state governments who require the local school district and the employee to contribute toward the pension in the same way employers and employees contribute to social security. When state budgets are challenged, as they have been since 2008, they often seek a higher share from the local governments and/or employees— both of whom are also strapped for funding. This, in turn, forces the local governments or school districts to either cut their expenses or seek higher taxes. In the last year I served as Superintendent this scenario was playing out in our school district and local community. In the case of the school district we needed to raise roughly the total compensation of one teacher in order to meet our increased obligation to the state pension… and at the same time our employee’s were losing a small percentage of their pay because heir share was increasing. At the bargaining table teachers argued that they needed a small percentage increase to have the same take home pay and we were pointing out that if we met their demands we’d need to find even more money in our budget by cutting staff or seeking more funds from the taxpayers who recently voted down a budget. We were not the only district facing this kind of dilemma: every school district in New Hampshire had the same problem.

Detroit’s situation was FAR worse than ours for several reasons. The city government offered far more generous pensions than most state and local governments, the tax base of the city was eroding at a far more rapid pace than any in the country, and the costs for social services were skyrocketing. The city government also made several questionable decisions, to put it mildly. At the same time, the city sold bonds to fund infrastructure including things like sports venues, shopping areas, and office parks in hopes of restoring the city’s economic base. Nothing worked… and the city found itself drowning red ink in a State that was suffering far more than others as a result of the decline of the automobile industry. Making matters worse from a political vantage point, most of the voters in the state worked directly or indirectly for the auto industry. They had no sympathy for the city’s profligacy and a degree of resentment for city employees and pensioners who had pensions and health benefits that matched those formerly offered in the auto industry but exceeded those typically available today. The city, therefore, could not turn to the state for relief and could not count on its voters or the state voters to provide more money to bali them out. Detroit’s death spiral ended when the State governor appointed an “emergency manager” to sort out the finances and determine how best to balance the budget going forward. Given the huge percentage of the budget devoted to pensions, the emergency manager’s solution was to declare bankruptcy and then decide how to divvy up the resources to those owed money…. and the ultimate choice will be between bondholders and pensioners.

For school districts this is a lose-lose proposition. If the city short changes bondholders the financial industry will likely respond by downgrading all state, municipal, and local bonds driving up the cost of infrastructure upgrades for public schools. If the city shortchanges pensioners it will diminish the incomes in the region and drive voters to reject school budgets out of financial necessity. An arguably worse secondary impact would be the disillusionment of current and prospective teachers and municipal employees, many of whom accepted lower wages in exchange for pensions that were heretofore guaranteed by the state of Michigan.

Based on what I’ve read so far there is no chance the bondholders will suffer as much as the pensioners… especially since the federal judge ruled that federal bankruptcy laws trump the Michigan state constitution and collective bargaining agreements. And who are the bondholders? In some cases they are pension funds… but in most cases they are high rollers: the 1% or perhaps the top 20%. They are people who could arguably afford a “haircut” more than the disabled firefighter who gets $2800 per month. A pension spokesman said it best:

Bruce Babiarz, a spokesman for the Detroit Police and Fire Retirement System, was blunt in his assessment. “This is one of the strongest protected pension obligations in the country here in Michigan,” he said. “If this ruling is upheld, this is the canary in a coal mine for protected pension benefits across the country. They’re gone.”

And not just for firefighters… It is not difficult to imagine several governors and mayors looking at their budgets and demanding wage, benefit and pension cuts in order to “avoid bankruptcy” and many “reform” politicians using Detroit as a “lesson” in the efforts to advocate the abandonment of defined benefit pensions. And the voters? As noted above and in my earlier “Broken Covenants” post, they are on board with any wage and benefit cuts because they’ve likely encountered them already in their workplace. The bondholders? They’re the ones signing on to the ALEC agenda to make sure that bondholder primacy, like shareholder primacy, continues.

What’s the lesson in Detroit? When the house of cards falls, it’s better to be a bondholder than a pensioner.

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