Detroit’s bankruptcy has meant that the city’s pensioners may receive less than what they expected. This has angered a lot of people and blame has been pointed in many directions. There are a lot of reasons why Detroit’s pension systems are in poor shape and there is plenty of blame to go around.

The most basic reason that pensions are underfunded in Detroit is simple: the city did not properly fund the system. During good times, the city oversold benefits and its assumptions have proven ineffective at keeping pensions funded during bad times.

A retirement system can offer generous pensions and weather bad markets if it uses accurate assumptions and good practices. Detroit did not.

Pension board members adopt a series of assumptions with advice from its selected actuaries. These assumptions are used to predict the amount of money necessary to set aside today to pay for the pensions earned by the employees working today. If gaps between what employees have earned and what the city has set aside develop, the assumptions are also used to estimate the amounts needed to catch up. 

In the Detroit General Retirement System, returns over the past seven years have been 3.9 percent, according to my calculations based on their financial statements. The assumed rate of return was 7.9 percent. The long-term discrepancy has meant that the system is underfunded. These unfunded liabilities will be paid off over 30 years. Since the average age of members in this system is 48, this is beyond the average longevity of current employees.

In the Detroit Police and Fire Retirement System, returns over the past seven years have been 4.6 percent. The assumed rate of return was 8 percent. Unfunded liabilities will be paid off over 29 years.

Another way of dealing with volatility has been to adopt gains and losses over a moving number of years. Detroit’s asset-smoothing assumptions go for seven years. With the substantial lags between when they perform and accept their actuarial valuations, they have only recently started realizing the losses from the 2009 recession, which will continue to weigh down asset values for the next few years.

It’s very important to get this right. The Michigan Constitution mandates it. The second part of Article IX, Section 24 states, “Financial benefits arising on account of service rendered in each fiscal year shall be funded during that year…” That is, when an employee earns a dollar’s worth of pension, his or her government employer needs to set aside enough money to pay for it. Depending on the assumptions, the government might only need to set aside a quarter today to pay for that dollar later, depending on when the employee starts collecting a pension, how long they expect to collect, and how much the government can get in returns on its savings.

Those returns, however, are volatile. The constitutional language does not stipulate that pensions should be funded unless a recession happens — it says that pensions should be funded as they are earned.

Managers, however, are hesitant to change estimates about the future, even when these assumptions have been shown to be ineffective. Doing so can make the gaps appear larger or require more cash to be put in the system. Given Detroit’s insolvency, these assumptions are unlikely to change even if they have been responsible for the gaps.

On top of assumptions that have underfunded the system, the city oversold during good times. The often-lamented 13th checks depleted down city funding just as optimistic assumptions ensured underfunding during bad times.

What separates Detroit from the other governments with underfunded pensions systems is its insolvency. Other governments generally have cash to pay their debts as they come due. Detroit does not. It’s in the situation that the 1963 constitutional provision was meant to avoid. In leading the systems to this point, pension board members failed in their basic duties.

Detroit’s retirement boards are comprised of mayoral and city council appointees plus some member-elected representatives. The boards have changed and there are new people on the city council. The smoothing and return assumptions, however, remain unchanged.

One way of dealing with this is to freeze and close the pension system, a reform Emergency Manager Kevyn Orr is pursuing. Defined-contribution plans do not require politicians to make bets on the future. By converting to one of these retirement systems, Orr wants to prevent this situation from developing again.

In 2012, Michigan legislators discussed closing the state-run school employee pension system and offering new employees participation in a defined contribution retirement system.

Those legislators decided against the move, citing alleged "transition costs" as the reason for not making the change. New work from Andrew Biggs at the American Enterprise Institute reiterates that these transition costs are illusory.

The transition costs policymakers refer to are changes in how unfunded liabilities are treated when closing a retirement system. In the piece, Biggs shows that the rules for pension accounting only guide how pensions are reported and do not mandate a pension funding policy. In any case, newly adopted pension accounting rules should clear up the confusion.

This point is also contained in the 2012 study, "Five Options for Addressing 'Transition Costs' When Closing the MPSERS Pension Plan." The study also showed how legislators could deal with transition costs even if they wanted to adopt the reporting requirement.

In other states, some have argued that pensions will also need to convert to more stable investments that offer lower returns as fewer employees are in the system. This would require more cash and are also referred to as a "transition cost." Biggs shows that this is based on a flawed belief that the current system mitigates investment risk. As he states, "A closed pension plan that takes less investment risk imposes smaller contingent liabilities on future generations, and so the total cost of the plan remains unchanged."

While transition costs are illusory, there are real savings from closing retirement systems. When Michigan closed its state employee retiree system in 1997, the state saved itself from racking up $2.3 billion to $4.3 billion in unfunded liabilities.

Michigan Sens. Mark Jansen, R-Gaines Township; Arlan Meekhof, R-West Olive; Pat Colbeck, R-Canton; Bruce Caswell, R-Hillsdale; Joe Hune, R-Hamburg; and Phil Pavlov, R-St. Clair, recently introduced a package of bills that will close the school employee pension plan. They should not let mythical transition costs prevent this reform.