The Examiners: Mark J. Roe on Municipal Distress

As Detroit nears a crucial point in its restructuring, what lessons does the city’s historic bankruptcy offer troubled municipalities?

Detroit’s bankruptcy offers a cautionary tale for responsible municipal officials on how, and how not to, manage their budget. The pressure from pension obligations was a big factor in the Detroit bankruptcy.

The simple lesson focuses on how municipalities save up to pay pensions to their retired police, firefighters, and other municipal employees. The city sets aside funds for the future retirement payments and expects earnings from the investments to help pay the pensions.

But municipal pension managers tend to assume a greater future rate of return from the pension investments than has been, and is likely to be, realized.

High return assumptions might just be mistakes. But there’s reason to think that the mistakes are systematic, because politicians running cities get immediate benefits. They can make pension promises but need not come up with the cash to back those promises right away. That leaves the pensions adequately funded, but only on paper, and leaves more money on the table for political leaders to spend on other municipal activities or to keep taxes down. Municipal employees—a powerful constituency—can be promised much but don’t need to be paid immediately.

For politicians running for re-election, this is a good deal; the immediate constituencies are happy or happier. But problems may arise. Financial creditors, for example, may see the weakness and charge a higher interest rate than they otherwise would, if they fear that the municipality will not have enough funds to pay both pensioners and bondholders off at a later time.

Still, the problems from underfunding are off in the future, beyond the next election, and maybe beyond the politician’s career. Even for creditors demanding a higher interest rate, because of the underfunding of the city’s pensions, the higher interest payments over the life of a 20-year bond are mostly paid well after the next election.

The politician effectively makes a hidden promise to pay the pensions out of future taxpayers’ pockets, or at the expense of future services. The municipality might have to raise taxes in the future to pay both pension obligations and creditor obligations, but for politicians who aren’t looking far beyond the next election, that might not be a vivid cost. Future voters aren’t today’s voters.

Even if the Detroit bankruptcy now makes such issues vivid, Detroit is easy to dismiss as a problem that might have been solved with higher local taxes, and that only lacked viability because Detroit’s economic base—the auto industry—declined, leaving a declining population and an eroding tax base.

So, while there’s a lesson to be heard on more responsible funding assumptions, municipal leaders have good reason to turn a deaf ear to those preaching that lesson.

Mark Roe is a professor of law at Harvard Law School in Cambridge, Mass.