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John C. Goodman / Jul. 28, 2013

How Do Ponzi Schemes End?

What's the most important lesson to take away from the bankruptcy of Detroit? It's that when governments promise benefits they are unwilling to pay for, the system can very quickly come to resemble something designed by Bernie Madoff. ... Now here is something interesting -- did you know that it is illegal under federal law for a private corporation to do what Detroit did? ... So here is the obvious public policy question: why do we let cities and towns all across America do what is illegal for private companies to do?

What’s the most important lesson to take away from the bankruptcy of Detroit? It’s that when governments promise benefits they are unwilling to pay for, the system can very quickly come to resemble something designed by Bernie Madoff. Like many other cities around the country, Detroit promised police officers, firefighters, teachers and other public employees pension and post-retirement health care benefits, but was unwilling to set aside the money needed to fund those benefits.

The city attracted workers with a total compensation package that included current wages and future benefits. Since the future benefits were substantially unfunded, they can be paid only if future taxpayers pay them. But the future taxpayers never agreed to this deal. If they do pay, they will be paying for services delivered in the past. If they don’t pay, they won’t have to sacrifice any current city services.

So guess what? The future taxpayers have flown the coop. Louis Woodhill summarized the situation in a column for Forbes:

“Detroit’s bankruptcy filing lists about $18.25 billion worth of debt. This amounts to $26,838 for each person still living in Detroit, which is equal to an unsupportable 176% of annual per capita income. Slightly more than half of Detroit’s debts ($9.20 billion) represent the unfunded liabilities of the city’s retirement benefit plans, including both pensions and other post-employment benefits.”

Now here is something interesting – did you know that it is illegal under federal law for a private corporation to do what Detroit did? Any private company setting up a defined-benefit pension plan is required by law to fund that plan each and every year. Defined-benefit plans are plans that promise a specific pension benefit during the years of retirement, such as 60 percent of final pay. They are to be distinguished from defined-contribution plans, such as 401(k) plans, that are always funded because the employee is only entitled to whatever is in the account.

The only private companies with large unfunded pension benefits today are ones that were grandfathered years ago when the current pension regulations were put in place. No new pension plan can promise benefits and refuse to set aside funds to pay for those benefits. Moreover, every company that has a defined benefit pension plan is required to pay premiums to a national insurance fund administered by the Pension Benefit Guarantee Corporation (PBGC). Just in case something does go wrong, the PBGC will step in and pay the employees a minimum pension benefit.

So here is the obvious public policy question: why do we let cities and towns all across America do what is illegal for private companies to do? That the public sector has been irresponsible is patently obvious. In a study for the National Center for Policy Analysis, Andrew Rettenmaier and Courtney Collins discovered that when state and local retirement benefit programs are accounted for properly, they have a $3.1 trillion unfunded liability ? nearly three times the officially reported amount. Another estimate puts the total at $4.4 trillion for pensions alone.

As the unfunded liability for a city rises, it can fall into a death spiral. The city initially raises taxes to pay for its promises. In response, the private sector contracts as individuals and businesses move to less burdensome locales. The more people there are who leave, the higher the rates have to be. Meanwhile, the quality of the city services declines as more of the city’s revenues are used to pay for retirement benefits instead. That in turn encourages an even greater exodus of the people and businesses that form the tax base. As the Wall Street Journal explained:

“For years Detroit has been gutting services and sucking taxpayers dry to finance retirement and debt obligations. Nearly 70% of parks have been closed since 2008, and four in 10 street lights don’t work. The city has cut its police force by 40% in a decade. Response times are five times longer than the national average, and it has one of the highest violent crime rates in the country. Meanwhile, Detroit residents pay the highest property and income taxes in the state. Last year its business tax doubled. About 40% of revenues go toward retirement benefits and debt, much of which was issued in the last 10 years to finance pension contributions. Payments on $1.6 billion of pension-related certificates of participation consume nearly every dollar of property tax revenue.”

The lesson for the rest of us should be clear. It really doesn’t matter whether public employees are under-paid or over-paid. What matters is that city government pay for whatever they promise at the time the promise is made and do not try to shift those costs to future taxpayers.

Put differently, government at all levels (including the federal government) should have to play by the same rules that govern the private sector.

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