CHICAGO The news from Detroit is enough to rattle anyone relying on a traditional pension: an unprecedented bankruptcy filing by a major U.S. city that opens the door to possible sharp cuts in benefits.
It's still far from clear that the courts will let Detroit slash pension benefits as part of its bankruptcy filing. But is the city's situation a harbinger of things to come for Americans relying on traditional defined benefit pensions?
The answers are important for millions of American workers and retirees. Although we hear constantly that pensions have gone the way of the dinosaur, in the public sector, 83 percent of workers still had access to a traditional pension plan in 2010, according to the U.S. Bureau of Labor Statistics.
And 35 percent of Fortune 1000 companies still sponsored active pension plans in 2011, though that figure is down sharply from 59 percent as recently as 2004, according to employee benefits consulting firm Towers Watson.
Most private-sector pensions are protected from plan failures by the Pension Benefit Guarantee Corporation (PBGC), the federally sponsored insurance backstop. If a plan is terminated due to bankruptcy, the PBGC has been known to take steps to stop companies from dumping their pension plans.
When PBGC does take over a plan, the majority of workers receive 100 percent of what they earned - but only up to the point of the plan's termination. PBGC payouts are capped by law, using a formula based on your age at the time the plan is terminated, and it is updated every calendar year.
For 2013, the maximum annual guaranteed benefit for a 65-year-old retiree is $57,500
PBGC protection isn't available for public sector pensions. It's rare to see governments attempt to use bankruptcy to restructure obligations. Although municipalities can use this maneuver in some instances, it is not an option for states, which are sovereign entities with taxing authority and constitutional requirements to balance budgets.
Moreover, many public sector pension plans are backed by state laws that guarantee benefits. The constitutions of seven states contain benefit guarantees, according to an analysis by the Center for Retirement Research at Boston College (CRR). Another 34 states have laws, or rely on judicial decisions, that treat pension benefit promises as contractual guarantees.
Michigan is one of the states with a constitutional guarantee. So, even if a bankruptcy court does allow Detroit to cut pension benefits, the matter would be far from settled. "It would be appealed almost immediately to the U.S. Supreme Court," says Hank Kim, executive director of the National Conference on Public Employee Retirement Systems. "It would set up a Constitutional crisis, with the Court asked to decide which is superior - federal bankruptcy law or a state constitution?"
But even if the courts decide that state laws govern situations such as Michigan's, that doesn't mean pensions are fully protected. For example, the Michigan constitution only guarantees benefits that have been already earned, or accrued. That means current retirees and those close to retirement should receive their full benefits, but younger workers could face cuts.
"If you're retired or close to it, you'd probably be OK," says Diane Oakley, executive director of the National Institute on Retirement Security. "If you're in your 20s or 30s, you'd be more likely to face cuts. But if you're that young, you're probably more worried about whether you have a job or not."
And in some states, the legal protections only apply to core benefits, leaving room for adjustments to future earned benefits on features. Many states already have increased employee contribution rates, tightened age and tenure requirements for benefits or reduced cost-of-living adjustments.
GAUGING PLAN HEALTH
If you're worried about a pension, the key figure to watch is your plan's funded status - that is, the percentage of assets on hand to pay promised benefits. Actuaries generally use 80 percent as a floor for safe funding levels. But the figures depend heavily on the assumptions by fund managers on their expected rate of return on portfolios over time. And those assumptions have become very controversial.
Most state and municipal pension funds assume a long-term rate of return around 8 percent, reflecting a portfolio invested in equities, bonds and alternative assets such as hedge funds. That number reflects the approach preferred by actuaries, and most funds have made or beat that number over the past 25 years, according to data from Callan Associates, an investment consulting firm.
Economists prefer a more conservative figure - a so-called "riskless rate of return" figure tied to bond rates, which is closer to 4 or 5 percent.
These investment assumptions matter - big time. A CRR review of 126 public plans found that they were 73 percent funded using the more optimistic 8 percent return assumption - but just 50 percent using a more conservative 5 percent figure.
Beyond the pension plan itself, Oakley says it is important to consider the health of the sponsor. "Detroit's plans are mature - they have more retired than active workers, and government is shrinking there because the population is shrinking. But if you're in a plan in a place where the population is pretty stable, and the plan is fairly well funded, your plan probably has enough flexibility to make whatever adjustments it needs to make to get by."
For more from Mark Miller, see link.reuters.com/qyk97s
(The writer is a Reuters columnist. The opinions expressed are his own.)
(Follow us @ReutersMoney or here. Editing by Lauren Young and Leslie Gevirtz)