Detroit Bankruptcy and Important Lessons

The bankruptcy filing by the City of Detroit is the culmination of decades of decline. As a wealth management firm based in suburban Detroit, with clients in metro Detroit and nationwide, we hope this difficult step is the beginning of a process that will have long term benefits. What can be learned from it?

Pensions

For the retirees of the City, the future of their retirement benefits is now unknown. These benefits will be subject to litigation and the outcome of the bankruptcy process. As I’m not an attorney, I can’t provide a legal opinion. From a financial standpoint, as these are segregated pension assets, it would be reasonable for future benefits to be actuarially recalculated based on the existing assets, not practically eliminated. However, that is far from what may occur. (See my disclosure below)

Nationally, the pension benefit issue could have dramatic implications. If the bankruptcy courts determine that these pension benefits can be drastically reduced, it could set a wide-ranging precedent for other municipalities throughout the country. Thus, this is a major legal issue.

A national problem

This should be a wake-up call for voters/citizens and leaders of other organizations (the Federal government, state governments and other municipalities, companies and non-profits that provide retirement and health care benefits). Many entities of all types have huge unfunded pension obligations and are not taking steps to reduce them. They continue to kick these liabilities down the road. Leaders from Washington to local governments need to be realistic about their investment assumptions and figure out how to balance their budgets. For more on this topic, see the excellent article, “Detroit, tip of pension liability iceberg” by the Guardian’s financial journalist Heidi Moore.

This is an urgent need. Politicians can no longer put off resolving tough issues. We as citizens need to realize that if we are not going to pay more in taxes, then our governments must reduce the benefits and services that we receive. Washington needs to take steps such as addressing social security benefits (reducing them for the wealthiest Americans?). Congress has to find a way to make logical but difficult political decisions. The pain of these choices must be shared. It is time to close post offices in many remote areas and reduce Saturday mail delivery. We cannot continue to have our cake and eat it too.

Small actions today can result in pay significant long term benefits. Change can be difficult and unwanted, but change can also eventually be good. If these issues are not addressed, there will be future crises and bankruptcies like the City of Detroit’s, in other parts of the country.

Municipal bond investors

The action by Detroit may have negative ramifications for municipal bonds throughout the entire State of Michigan, and possibly beyond. The lesson: muni bond investors should invest in a much more diversified manner, not just primarily in one state. All too often, residents of one state concentrate their muni bond holdings in their state of residence, for the state tax exemption.

We have recommended to our clients to invest in municipal bonds across the country, so they are diversified by states and localities, not just in their state of residence. Detroit’s bankruptcy shows that municipal bankruptcies are possible, and depending on how the courts handle the pension liability issue, the risk of other bankruptcies may be more likely in the future.

As with so many aspects of investing, diversification is vital. Broadly diversifying a portfolio of municipal bonds across states is even more important now. Will investors review their portfolio and make the needed changes?

Disclosure: My stepfather is a City of Detroit retiree and recipient of Detroit pension benefits.

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