With over 27 million people covered by state and pension plans, the security of those plans is crucial to your clients and to America’s retirement readiness. As Detroit’s bankruptcy shows, these government pension plans that are supposed to supply retirees with guaranteed income might not be as secure as we thought.
In July 2013, the city of Detroit filed for Chapter 9 bankruptcy, making it the largest U.S. city to file for federal bankruptcy. The cause was roughly $18 billion of outstanding debt and liabilities, including roughly $650 million in underfunded municipal pension plans. There has been some debate about how underfunded Detroit’s $5 billion asset pension plan was at the time of bankruptcy. Estimates have ranged from around 15 percent to as much as 50 percent. Either way, the plan was severely underfunded. Approximately 30,000 working and retired plan participants found their retirement income in jeopardy. The underfunding of the plan was nothing new; it had been a problem for years. Just to keep the pension afloat, Detroit borrowed $1.4 billion in 2005 to meet its underfunded pension liabilities.
In July 2014, as part of the bankruptcy proceedings, retirees voted to cut pension checks by 4.5 percent and to eliminate cost-of-living adjustments. This was a significant reduction but one deemed necessary to prevent further loss to the pension system. While these negotiations and pension cuts help Detroit move closer to exiting bankruptcy, not everyone was happy with the decision, and a class-action lawsuit has been filed to stop the cuts.
The news gets worse. Detroit is not alone. Moody’s Investor Service estimates that U.S. states and localities have roughly $2 trillion in underfunded pension liabilities. There is a real concern as to which city, state or municipality will be the next Detroit. Will all these localities be able to meet their pension promises? If Detroit is any indication, the answer will be no. While it is more complicated to determine whether a state can reduce pension benefits due to underfunded liabilities in the same way Detroit has done – because states cannot file for Chapter 9 bankruptcy – it is clear that other cities and counties might follow suit.
A 4.5 percent reduction might not sound devastating. But when coupled with other potential retirement income changes – including giving up any inflation protection with cost-of-living adjustments – it could add up to a big problem for retirement security. Social Security remains the most common form of retirement income, followed next by employer-provided benefits. There are legitimate concerns regarding the funding status of Social Security as well. It is not far-fetched to imagine Social Security benefits reduced in the not-too-distant future. Under the status quo, Social Security will be able to make full benefit payments only until 2033, at which time there would be enough income from taxes to pay just 76 percent of expected benefits. When you consider how much your clients, especially those nearing retirement, might be relying on Social Security to fund a portion of their retirement income, this is a situation that bears closely watching. Reductions to Social Security coupled with permanent reductions in an individual’s state or local government pension plan could devastate your client’s financial security.
There is no doubt that the security of any client’s pension plan is an important consideration when planning for retirement. If you have a client eligible for a state or municipal pension, make sure you understand the funding situation of the pension plan. This could heavily influence your decision to recommend annuitizing the benefit, leaving money in the plan or taking a lump-sum distribution. I’d like to tell you that the art and science of retirement income is easy. As an expert advisor, you know better. Incorporating all of this into a comprehensive plan can be incredibly difficult to do. You’ll want to continue furthering your own education to be as prepared as possible, with a good understanding of the pension system and the latest techniques for mitigating retirement plan risk. If a plan is severely underfunded, it might be best to recommend withdrawing the money at retirement to avoid a Detroit-like situation.
Detroit is not alone. When it comes to retirement income planning, make sure your clients aren’t either.