The city of Detroit recently filed the largest municipal bankruptcy in history.  One of the potential casualties of this situation will likely be retired city workers receiving pensions.  While pension payments are promises made by the employer, should the bankruptcy go through the city will be free to cut pension benefits as part of the restructuring of the city’s finances.  In light of this situation, how safe is your pension?

What is behind your pension? 

Your employer starts an investment fund that is designed to grow via investment returns and contributions from the employer to a level that will support the pension benefits you’ve earned based upon the plan’s benefits formula.  Pension benefits are typically earned by workers based on a formula that usually takes into account factors such as career earnings, years of service and perhaps other factors.  Each year an actuary calculates the amount that the employer must contribute to the pension plan in order to maintain an acceptable level of funding.

Sadly in far too many cases, especially in the public sector, we’ve seen employers under contribute to their pension plan causing severe underfunding.  In my home state of Illinois this is rampant and is a major part of our state’s ongoing pension crisis.  Certainly this was also a factor in Detroit’s case as well.

Let’s take a look at some of the issues with private employer pensions and those in the public sector.

Private employer pensions 

Pension plans offered by private employers (which I define as those employers who are not municipalities, state or federal government entities, etc.) are a liability of the company in much the same fashion are their accounts payable or a bank loan.  Failure to make good on these obligations can result in the bankruptcy of the firm.

Should a private employer be unable to make good on its pension obligation, in most cases the Pension Benefit Guarantee Corporation (PBGC), an independent governmental agency, will step and cover the pension obligations of the company up to its limits.  The maximum benefit they will guarantee depends upon the year in which the plan was terminated and your age among other factors.

For many workers the PBGC maximums will cover the pension payments promised via their employer’s plan.  Some highly paid retirees receiving large monthly pension payments might see their payments reduced once PBGC coverage kicks in.  A case in point occurred here in Chicago in 2005 when locally based United Airlines defaulted on its pension obligations and many retired pilots and other highly paid retirees saw their monthly benefits reduced by the PBGC.

Municipal and governmental pensions 

The issue for the retired Detroit workers is that municipal and governmental pensions have no backstop such as the PBGC.  Detroit will be the biggest test of the Chapter 9 municipal bankruptcy process but there is much speculation that current and future retirees will see cut on the order of 30%-40% or more in their monthly payments.

At the state level it is less clear to what extent that states such as Illinois would be able to reduce pension payments due the rules in place.

Steps to consider

If you are retired and drawing a pension there probably isn’t much that you can do.  One step to consider is taking your Social Security now if you are eligible and have been waiting to draw upon it until a later age to maximize your benefit.   You might also look at getting a part-time job or hanging out your shingle as a self-employed consultant if you have skills that are applicable to this route.

If you are approaching retirement and your pension plan offers the option to take a lump-sum benefit as an alternative to annuitizing this option might be even more attractive now.  As always you should look at all of the factors involved such as the financial stability of your employer, your other resources available in retirement, etc.  This might be a good time to engage the services of a fee-only financial planner who can help you evaluate your options.  While a lump-sum still needs to be managed in terms of the investments chosen and the timing of withdrawals, you do eliminate any issues surrounding future benefit reductions due to your employer encountering financial difficulties.  If you are offered an early retirement package you should give it serious consideration as well.

Younger workers should take this as a wake-up call and make sure they are saving for retirement especially if they are counting on a pension plan from their employer.  Many companies freeze their pension benefit which means that you will receive the benefit that you’ve earned but you won’t be accruing a larger benefit via increased earnings and years of service.  Take full advantage of defined contribution retirement plans such as a 401(k) or a 403(b).  Fund an IRA account.  Save and invest in taxable accounts.  Strive for financial independence as soon as possible.

Employees with a pension plan generally have a leg up in retirement.  The Detroit situation simply highlights the fact that nothing is set in stone.  At the end of the day we are all responsible for our own retirement, plan accordingly to the extent that you can.

For more background on this situation check out these two excellent pieces on the Market Watch site:

Detroit not alone; public pensions vulnerable

Will your pension disappear, post-Detroit?

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