Detroit’s move to file for bankruptcy on July 18 is not a surprise. The city’s ongoing economic and fiscal problems are well-known. Two years ago, Mayor David Bing warned that without structural reforms to benefits, budget cuts, and other measures, Detroit would find itself without enough resources to meet debt and benefit liabilities, which the city estimates have reached $18 billion. Since 2011, Detroit’s deficit has grown from $45 million to $380 million. The city has been sustaining operations through borrowing since 2008.

Central to the crisis and ongoing legal battle, which will likely continue for several years, is the state-appointed financial manager’s warning that the only way out of this abyss is to cut pension benefits. Kevyn Orr suggested last week to Detroit’s unions that workers might have to switch to 401(K) plans and accept reduced benefits, among other measures. 

This announcement sent unions into motion. Orr rushed to file for bankruptcy on Thursday (instead of Friday) in order to block the unions from suing to prevent the move. (A judge has since blocked the filing, citing, of all things, the fact that it might displease President Obama.) The next step is to see how Michigan law will be applied to the proposal to reduce pension benefits. 

Detroit’s pension benefits suffer from the same embedded accounting errors being made in all public sector plans. Expected asset returns are used to calculate the value of pension liabilities, and then determine the annual funding amount. It’s the equivalent of re-calculating your monthly mortgage bill based on how much you think your investments will earn in the coming year. And that’s a big mistake. As economists point out, the two are independent in terms of their value. Not so in public pension accounting – and that’s where all the trouble begins. 

For years, public plans have been calculating the value of government-guaranteed (read: safe-and-default-free-like-a Treasury-bond) pension benefits with reference to risky asset returns. The problem is that this leads to systemic undercontribution, even when asset returns are meeting expectations. 

Pension shortfalls didn’t suddenly crop up in 2008; they were partially revealed by a dramatic market drop. I took a look at the actuarial reports for Detroit’s two pensions plans to discover just how different the shortfalls are between actuarial accounting and market-valuation pension accounting.

Using government assumptions – an 8 percent annual return on assets – to value plan liabilities, Detroit’s two main pension plans – the General Retirement System (GRS) and the Police and Firefighters Retirement System (PFRS) – are in good condition with a total unfunded liability of $634 million. The GRS has a funded ratio of 83 percent, and the PFRS a funded ratio of 99 percent.

Using market-valuation – that is, valuing these plans as though they are guaranteed to be paid, or as safe as a government bond – reveals the plans to be in critical shape. GRS has an unfunded liability of $5 billion and a funded ratio of 37 percent. The PFRS system has an unfunded liability of $4.7 billion and a funded ratio of 44 percent. Detroit’s total pension liabilities are many times larger than is recognized.

This in-the-weeds accounting detail is the reason for decades of poor choices that have made public plans look far healthier than they actually are. The consequence: Systems are running out of money and pushing these plans to a pay-go status. 

Guaranteed benefits are being valued as though they are risky. Michigan law protects accrued benefits for employees. Hence the reason for using the yield on Treasuries to value them. How that protection operates will have to be interpreted by a bankruptcy judge who will determine the outcome for pensioners, bondholders, and other creditors. For now, workers are assured that pensions will be paid out. Employees will also be paid.

As for health care benefits, which don’t enjoy the same legal protection as pensions according to the Washington Post, Detroit may take a page from Chicago Mayor Rahm Emmanuel. The president of the Retired Detroit Police and Firefighters Association expects health care benefits will be modified and retirees nudged towards buying insurance under Obamacare.