Why Detroit’s bankruptcy spared retirees by Josh Gotbaum @FortuneMagazine December 4, 2014, 8:32 AM EST E-mail Tweet Facebook Google Plus Linkedin Share icons Recently it became clear that Detroit and Stockton, CA, will get out of bankruptcy without eliminating their pensions and that retirees’ benefits will not be cut very much, if at all. This surprised many people. Over the past decade, as the true costs of pension commitments have become clearer, many assumed that the inevitable end result of expensive pensions would be to eliminate them in bankruptcy. When Detroit and Stockton filed for bankruptcy, they assumed it was only a matter of time before retiree pensions came on the chopping block and retirees lost their pension plans. In practice, such a result is rare – and it’s likely to remain so. Here’s why. In order for society to work at all, commitments must be honored, whether they are to ‘love, honor and obey’ or to ‘pay you Tuesday for a hamburger today.’ Pension commitments especially require this: they are a commitment by an employer, who gets the benefit of years of work now, to pay for it in part after the employee retires. In this sense, retirement benefits are deferred compensation. Once the employee is gone, however, so is his or her leverage to demand that compensation. That’s why pension commitments, entirely appropriately, are safeguarded by law. Of course, the world changes and sometimes commitments cannot be kept. That’s why we have bankruptcy. Bankruptcy is a process by which people and organizations who cannot afford to keep their commitments can be relieved of some of them. But bankruptcy is not a ‘get out of jail free’ card. It’s a process under which people, businesses and local governments first show they really cannot keep their commitments and then work out a fair way to reduce them. That means that changes in bankruptcy must be both necessary and fair. (State government pensions are in a different situation, because the US Congress hasn’t chosen to legislate a bankruptcy process for states.) Although lawyers and philosophers have devoted thousands of pages to trying to define fairness, in practice, judges do what they’re supposed to do: make judgments. Everyone involved has interests. Many are important; some are crucial to their survival. Furthermore, each situation is different: Employee compensation – and former employee compensation – can be greater or lesser. Bondholders can be large financial institutions with the ability to take the risks involved, but they can also be individuals who are counting on bond income to fund their own retirements. At least as important is the fact that different institutions have different routes to recovery: Detroit had a ‘priceless’ art collection it could sell; most cities do not. In some instances, higher taxes are a possibility; in others, they are not. Some employees can afford to sacrifice a portion of future wages and benefits; others cannot. In all cases, there are dozens, even hundreds, of judgments about which activities can be cut back, and by how much. No judge has all of the knowledge that, ideally, they should have to make these judgments. They know this, and that’s why they encourage those affected by a bankruptcy to negotiate among themselves. In corporate bankruptcies, these negotiations have been undertaken repeatedly for decades, so there are established rules, practices, and precedents. In the public sector, there is much less such experience, but the goal is the same: try to reach agreements, not that necessarily make anyone happy, but with which most can live. Retirement benefits enter this complex calculus with several important arguments in their favor. First, retirees don’t have alternative sources of income. Unlike most of the financial institutions that hold municipal bonds, retirees cannot offset their losses in Detroit with earnings from other bonds. Neither, as a practical matter, are judges likely to force 75-year old retirees to re-enter the workforce. The second reason why retirement benefits are special is because they are employee benefits. Institutions, particularly distressed institutions, recognize that they need their employees to survive. Those employees usually feel a kinship, not a competition, with former employees. When American Airlines filed for bankruptcy, the airline was clear that it needed to reduce labor costs and proposed to do it in part by eliminating its pension plans. American’s unions, however, decided not to sacrifice their former members’ interests, and chose instead to make contract concessions in other ways. The bond between current and retired employees is by no means limited to members of a union or to the private sector. As a result, even cutting retirement benefits is legal and some cuts are clearly necessary, retiree benefit cuts are usually seen as unfair. Municipalities that need cuts to reorganize will end up looking elsewhere. Even though taxpayers (and editorial writers) may wish it, in most cases talk about public pension cuts will remain just talk. Josh Gotbaum is a Brookings Guest Scholar. Previously, he was Director of the Pension Benefit Guaranty Corp., which insures private pensions. He has worked with bankruptcy and restructuring processes for several decades.