Detroit can Innovate!

By “Detroit”, I don’t mean the Big Three, I mean the actual city of Detroit.  It has some well-noted problems, not least of which that its ongoing collapse has devastated public finances.  One of the big targets in its bankruptcy proceedings has been the pensions for its current and retired workers, which are extremely generous – and considerably more than the average income of city residents whose taxes pay for them.  I was concerned that in the settlement of Detroit’s bankruptcy, the result would fall into one of two terrible extremes – either pensions would be completely looted, or the rest of the city government would be starved in order to prop up these unsustainable pensions.  Instead, Detroit is adopting an interesting “hybrid” plan (that does involve small cuts to current retirees).

Hybrid plans will include both elements of new and old-style retirement plans.  Detroit’s workers will still receive traditional defined-benefits plans, wherein the pension fund will invest money on their behalf and pay out once they retire.  However, they will bear most of the financial risk associated with changing returns to the pension fund’s assets.  It’s an intriguing plan, because it maintains attractive aspects of both types of plans.  Like a traditional plan, it guarantees that money is diverted to savings and provides a high level of confidence that retirement benefits will be there.  Like a defined-contribution plan (e.g., a 401(k)), it shifts most of the financial risk away from the taxpayer.  It also doesn’t suffer from the horrible drawback of relying on workers to manage the money themselves, which sounds nice but is a complete disaster in practice.

However, all of this will be moot if the growth of pension fund assets falls far short of projections.  The new plan assumes pension fund assets will grow at 6.5% a year, which is modest relative to benchmark returns the past few years but may prove difficult to reliably meet in practice.  It’s much better than the ludicrous 7.9% per year prediction that got the city into such trouble, but the issue with compounding interest is that a few bad years can destroy a long-run plan.  My suggestion here is to better align the incentives.  I’m sure that Detroit paid bright consultants good money to come up with this plan – how about paying them with a security linked to budget shortfalls?  If pension plan revenues come in below the bottom of their sensitivity analysis and Detroit needs to bail out the plan again, the consultants don’t get paid.  Maybe more public-sector consulting ought to work this way.

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