Resolving the public pension "crisis".

• Author: Beermann, Jack M.
• Position: Public pensions in government bankruptcy

Introduction I. The Bankruptcy Hammer II. Pension Controversies in Michigan and Illinois III. Reform Is Coming: Who Should Pay? Conclusion INTRODUCTION

The public pension pigeons are coming home to roost. The high-profile bankruptcy filing by the City of Detroit, Michigan has brought to the fore the relationship between pension underfunding and the financial difficulties faced by an increasing number of American municipalities and states. The problem is likely to continue to grow with more municipalities finding it necessary to explore the bankruptcy option. It has even been suggested that states should be allowed to use bankruptcy to reduce their pension liabilities. (1) Trillions of dollars promised to millions of current and retired public employees are at stake.

Scholarship concerning the public pension crisis has focused on disagreements over actuarial calculations and the legal principles that constrain state and local pension reform. (2) While there is no doubt that pension liabilities are an important contributing factor to the fiscal difficulties of municipalities like Detroit, disagreement remains concerning the magnitude of the problem nationwide. On the fiscal side, some analysts contend that major reform is necessary to avert a widespread fiscal crisis, while others conclude that moderate change would be sufficient to resolve the fiscal difficulties faced by most public pension plans. (3) On the legal side, some analysts bemoan the straitjackets in which many public entities find themselves due to state law that severely limits pension reform, while others claim that there is sufficient legal flexibility to accommodate necessary reforms. (4) Little attention has been focused on the workers and retirees who are likely to suffer if their current or future payments are reduced substantially in order to restore their current or former employers to fiscal health.

In another comprehensive Article, The Public Pension Crisis, (5) I addressed many of the issues surrounding widespread underfunding of public pension liabilities at municipal and state levels in the United States. Although there is no question that many governmental units have fallen far short of actuarially sound contribution levels to their pension funds, I noted that there is significant disagreement over whether this underfunding presents a true fiscal crisis. While some analysts claim that many states and cities may be insolvent, others conclude that modest increases in pension contributions would resolve the problem. Further, in tight fiscal times, many state and local governments have cut payments to pension funds to balance the budget. (6)

I then explored in the prior Article whether public pension promises are excessive or abusive, and if so why governments would promise excessive pensions. (7) It turns out that this is controversial as well; some analysts conclude that overall compensation to public employees is significantly higher than compensation in the private sector, while others conclude that, if anything, public employees are underpaid and better pensions are part of a tradeoff involving lower salaries. (8) I noted that incumbent politicians often depend on government employees for political support, and even if only a small percentage of public employees are politically connected, favorable compensation including pensions would likely be provided to all employees if only to boost the fortunes of the small, favored group. (9) Further, underfunding pensions is a form of deficit spending under which current taxpayers enjoy services that are paid for by later taxpayers. I also illustrated that there are plenty of cases of abusive conduct in the public pension arena, but it is not clear whether the fact that there are some abuses means that the whole system should be viewed with suspicion.

I then looked at legal constraints on public pension reform under state and federal law. The weight of state constitutional law in many states is on the side of government employees and retirees. Many state constitutions contain provisions protecting pension rights that have been interpreted to prohibit significant reductions in pension promises to existing employees and retirees. State and local pension reform is also constrained by the Contract Clause of the United States Constitution, which prohibits state laws that impair the obligation of contracts. Recently, this provision has been interpreted to apply most strongly to states' efforts to breach their own contracts. Municipal bankruptcy under Chapter 9 of the Federal Bankruptcy Code (Chapter 9) may provide an avenue of pension reform for some insolvent municipalities. State governments cannot employ bankruptcy, but there is a chance that if a state decides to default on its pension obligations, the federal courts would be powerless to order a remedy. (10)

My Article concluded with a normative discussion of the plight of state employees and retirees. Unless one believes that the average state employee has been part of an abusive conspiracy to inflate pensions at taxpayers' expense, there is a strong normative case to be made for relief aimed at preserving pension rights. State employees accepted lower current pay in exchange for job security and favorable retirement promises, and for those who were not part of the federal Social Security system, their state or local pension may be their only source of retirement income. Even well-paid state and local government workers may have decided to accept government employment or remain in government employment when other opportunities arose in reliance on attractive pension promises. Public pensions constitute contractual compensation, not gratuities, and in the normal case there is a strong argument that government units should be required to live up to these promises.

This Essay is an effort to provoke discussion of the normative issues surrounding pension reform, mainly concerning how public employees and retirees should be treated. Should pension claimants be treated like any other unsecured creditor, or any other person who suffers when the regulatory background is altered, or is there a case for treating them as victims of a fiscal disaster beyond their control? Is pension reform just one more step in the evolution of the labor market that has made it much more difficult for lower-skilled workers to achieve a middle class lifestyle? If so, how should the law react? This Essay also discusses some of the fascinating federalism issues raised by the potential clash between state law protecting pension rights and federal bankruptcy standards. Should a federal bankruptcy court respect the decision of a state court that the use of federal bankruptcy to reduce pension obligations would violate state constitutional protection of pension rights? This federalism dispute may be the most interesting one in decades.

1. THE BANKRUPTCY HAMMER

   Recent developments, particularly the bankruptcies of Central Falls, Rhode Island, and Detroit, Michigan, should create unease over the fairness and utility of municipal bankruptcy. In the Central Falls bankruptcy, pension payments to existing retirees were cut by fifty-five percent, while municipal general obligation bondholders were paid in full. (11) This occurrence may be surprising, because pension claimants and general obligation bondholders are usually both unsecured creditors, normally entitled to the same level of compensation in bankruptcy. Full payment to bondholders was apparently justified by fear of the negative impact on the ability of Rhode Island municipalities to sell bonds in the future, referred to as the "contagion effect." (12) There was presumably no fear that the market for municipal employees would be adversely affected.

   One may wonder how the city could get away with treating one group of unsecured creditors better than another. Due to concern over the contagion effect, in the year before Central Falls filed its petition in bankruptcy, the Rhode Island legislature passed a statute granting general obligation bondholders a priority claim on city revenues, (13) basically elevating their legal status to secured creditors or at least priority unsecured creditors, above the claims of other unsecured creditors. From the point of view of the unsecured creditors left behind, this seems incredibly unfair, because it significantly reduced the funds available to pay the remaining unsecured claims. In effect, the legislation retroactively altered the priority among creditors, prejudicing some and privileging others. It could be viewed, in effect if not in law, as a fraudulent conveyance or illegal preference under which a substantial proportion of municipal revenue was placed beyond the reach of unsecured creditors, long after many of those creditors had extended credit to the municipality. However, Chapter 9 explicitly prohibits a bankruptcy court from interfering with the revenue and internal operation of the municipality, (14) so perhaps a bankruptcy court should respect state adjustments to priority.

   The legality of Rhode Island's strategy was never litigated in bankruptcy court. Rather, the entire process was subject to negotiation among the creditors. (15) Realizing that they were going to suffer serious reductions in their pension payments, the retired workers went along with the plan after they convinced the Rhode Island legislature to appropriate funds for a five-year cushion during which the cuts to their pensions would be substantially less than the ultimate goal of fifty-five percent. In actuality, pension holders may have been treated better than the city's other unsecured creditors (excepting bondholders). Other unsecured creditors may have lost more than fifty-five percent of the value of their claims. The city's other unsecured creditors apparently did not challenge what might have been viewed as relatively favorable treatment of pension recipients, perhaps because there was...