Adjust Text Size

Why Detroit’s bankruptcy affects you

Written by William Cowie - 9 Comments

This post is from staff writer William Cowie.

If you had to pick a single city in the U.S. epitomizing America’s might as an industrial power, Detroit would be hard to beat. That’s right, the Detroit that just declared the largest municipal bankruptcy in American history.

If your first reaction was to shrug and say something like, “Too bad. Thank goodness it doesn’t involve us. Please pass the salt,” you would be one of many.

You would also be wrong.

What happened?

First off, don’t be misled by media headlines. They make it sound like someone is going to have to kiss $20 billion of debt goodbye. Wrong. No government body ever has enough money to repay lump sum debt, and nobody expects that to happen in this case.

It’s about payments, it’s always about payments. Every bankruptcy stems from a single problem: you’re unable to make your payments from your income. Here’s how that looks in Detroit:Revenue & expenditures in Detroit

Revenue & expenditures in Detroit

The picture clearly shows how the city’s revenues have declined, and how they have cut operating expenditures (blue) to try and live within their means. You can see the deficit every year as the green bar of revenue just doesn’t quite make it to the top.

To close that gap they borrow money. Every year that adds more debt and, of course, debt service. That’s why the purple band keeps growing, not shrinking. Same with the orange band: payments to retirees.

Haircuts

The solution to any bankruptcy of this kind is a trip to the barber. That’s right: “Instead of getting $100,000 a month in payment on what the city owes you, Mr. Bondholder, you will now please be happy to accept $90,000 per month.” That’s called a 10 percent haircut. Look, it won’t kill you, they say, and your option is getting nothing. That’s how business gets done on Wall Street. It’s been done hundreds of times and nobody has lost their job or gotten killed (presumably?). The key, though, is that everyone shares equally in the pain; no privileged parties get exempted from the barber shop party.

That’s where it gets a little messy. The purple band crowd wants to add the orange band to the line at the barbershop. At one level it makes some sense. Looking at the chart above, you can see that if the orange and purple bands each take a haircut of some level, total expenditures will also drop and the green columns of revenue will cover it all.

Haircuts may be fine for someone on Wall Street earning a quarter of a million dollars a year, and who’s not talking about his own money. It’s a different matter entirely for a bus driver or fireman whose means of living is on the line. No surprise, then, that all parties representing Detroit workers and retirees are screaming like banshees over the notion of taking a haircut.

Unfunded

Detroit is not the only government body faced with this problem, and it is about to be joined by many other bodies. Detroit’s pension liabilities were incurred at a time when everyone assumed the city would remain the same size or grow, providing ample resources to take care of those who spent their careers in the service of those who lived there. But, while America’s population doubled, Detroit’s fell by more than half. Population trends: Detroit vs U.S.

Population trends: Detroit vs U.S.

Now, who will pay for the pensions of retirees? Nobody disputes that they’re entitled to their pensions. But, at the same time, nobody can say who has to pay for them.

The key word in this drama is: unfunded.

What’s an unfunded pension? The answer is best seen in the opposite: a funded pension. That’s a chunk of money set aside and invested in stocks and bonds and things to yield enough interest that someone’s pension can be paid from the combination of interest and a gradual withdrawal of the principal.

An unfunded pension amounts to nothing more than a promise that runs something like this: “Hey, come and work for us. We’ll pay you $x for now and when you retire, we’ll continue paying you $y. We just assume there will be enough ratepayers (or customers in the case of a corporation) to keep paying you. We’re making this promise to you, but, really, that’s all it is. As long as we’re able to deliver on the promise, we’re good for it, but should the day arrive when we can’t, well, best of luck to ya.”

That last sentence is the one nobody ever spoke, mainly because nobody ever even thought it. That, of course, is because we never question the basic assumption underlying our promises: that “everything will keep growing like it has in the past.”

Warren Buffett made an observation in a different context: it’s when the tide goes out that you see who all was swimming naked. And any unfunded pension plan is an exercise in naked swimming.

Why is this important to you?

Detroit is a prototype for another, much bigger, unfunded pension liability we face: Social Security.

For decades the Federal Government has taken money from you under the guise that it’s money for your pension, which they call Social Security. The way it’s labeled and taxed (flat tax) makes it look and feel like they’re creating a funded pension for you. They’re not. And so their promise to you is like the one stated above: “As long as we can, we’ll pay you a pension every month. The amount is calculated from how much we took from your pay while you worked, but in reality it’s based on how much we can coerce from whomever is paying income taxes at the time. And, should the day arrive when there’s not enough money to pay your pension, then, well, sorry, you’re just going to have to go without.”

What will happen?

There is no easy answer. Detroit’s pensioners say they’re entitled to receive what they were promised. However, what if there’s not enough money to pay for those promises made in an earlier time when things were different? Blood from turnips is one picture (i.e., nothing), but blood in the streets is another. Sound a little dramatic? Those who are old enough will remember a time, not so long ago, when riots, looting and bloodshed, in America, made the nightly news almost every night. The issues were different: first race, then a war, but people feeling betrayed taking to the streets to destroy property and shed blood, here in this civilized country, is not as far-fetched as it may seem.

What should you do?

1. Understand whether any promises of pensions made to you are funded or unfunded.

2. Question whether those who made unfunded promises to you will be able to deliver. You cannot blindly stake your financial future on any promises made by corporations or governments, because they may not be able (or even around) to deliver on them.

3. Save and invest. You may think it’s too late and it may not be enough. But it will be more than you might get from “them.” And for sure it’s more than if you do nothing. The earlier you start, the better.

4. Become proactive. If your promises were made by a corporation and they have a pension plan, get on the board or committee overseeing those investments. Yes, it takes time and yes, there will be politics. But if you’re involved you may be able to affect the outcome, instead of being a blindsided victim of something that could have been done better. If it’s a government body, get involved with that, too.

The reason politicians get away with lining their own pockets is because voters let them. Whenever and wherever voters get involved, things always start going their way.

How funded, or unfunded, is your future?

Published on July 24th, 2013 - 9 Comments
Filed under: Retirement

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

Related articles...

» Bankruptcy Filings are on the Rise
» Bankruptcy Deadline Looming
» United Airlines Bankruptcy: Don’t Believe Everything You Read
» Effect of Foreclosure, Short Sale, and Bankruptcy on Your Credit Score
» Buyer Beware: Sharper Image Gift Card Restrictions
» Bankruptcy and Marriage – Should You Marry Someone Who Went Bankrupt?
» Carnivals – Week of 05/22/06
» Thoughts on Kodak, Bankruptcy, and Investing

Was this article useful? Please sign up to receive our content via e-mail:

You will receive only the daily updates, and can unsubscribe at anytime.

9 Responses to “Why Detroit’s bankruptcy affects you”

  1. 1
    Personal Loans In Delhi Says:

    This by far is the best “for laymen” analysis of the Detroit muck.

    The debt trap and it’s many ramifications held me from the first para to the last.

    I am a more informed citizen then yesterday :) Thanks for devoting time to write this.

  2. 2
    Stephen Says:

    I did a pretty loose calculation of my social security using this formula. I’m about midlife as far as my working years, so I make a rough assumption that my current weekly social security contribution is going to be the average of my lifetime weekly contribution.

    ((current weekly contribution * 52) * 50 years working) / estimated per year social security benefits

    What does that equal? 4 years.

    What does that tell me? The only way this system works is if a significant number of contributors never collect or collect for only a very short time, the number of contributors continually increases, or the fund realizes returns on investment; or some combination thereof.

  3. 3
    William Cowie Says:

    Stephen: no, the system depends much more on what current taxpayers are putting in, and how that relates to what’s going out. The system worked great when there were more people paying than drawing out. As the baby boomers retire, there will be more people drawing out than the remaining folks paying in. That’s when the unfunded nature of social security will be evident…

  4. 4
    Stephen Says:

    That many? Wow!

    I see the numbers are already pretty high. Over 50 million beneficiaries and under 150 million employed.

    http://www.ssa.gov/policy/docs....._snapshot/
    http://www.bls.gov/news.release/pdf/empsit.pdf

    Both are data for June 2013. The system is already really out of whack.

  5. 5
    Stephen Says:

    It just occurs to me how incredibly out of whack it already is:

    The average contribution of three people is expected to cover the average benefits of one. 3:1?

  6. 6
    Loan Modification Help Center Says:

    Wow very informative and insightful.

  7. 7
    Lois Gerber, RN, MPH Says:

    Important information for anyone. Some pundits write Baltimore and Los Angeles and other cities are in deep debt, too.

    The bottom line is to pay attention to your future financial health.

  8. 8
    BG Says:

    If your retirement plan is based on others paying for your retirement (ie: pensions), then don’t be surprised when that plan doesn’t work out for you.

  9. 9
    BIll Says:

    Not just detroit..most of the cities are in a similar kind of situation..as some one rightly pointed out in the above comments it is advisable to take care of ur financial health..

Leave a Reply

Disclaimer...
Because rates and offers from advertisers shown on this website change frequently, please visit referenced sites for current information. This website may be compensated by companies mentioned through advertising, affiliate programs or otherwise.

FiveCentNickel User Survey