Imagine working for decades and ending up with a reduced pension. This will happen to public employees in Detroit due to financial mismanagement and unreasonable expectations. A federal judge ruled that when Detroit declared bankruptcy pensions will be a part of the reorganization plans. It was thought that they were protected by the state constitution. The Judge ruled Federal bankruptcy law supersedes State law and pensions are fair game. How did this happen?
First, The city was over reliant on the auto industry. When that industry moved many jobs overseas, the tax based collapsed . The lesson here is never put all of your eggs in one basket. Taxes were supposed to be a source of future pension benefits. Simple math made this unsustainable. Too many retirees and not enough tax revenue.
Second, unrealistic promises were made. Often short sighted politicians will overpromise pension benefits in order to receive votes. They assume they will be long gone when the bill comes due. It is a win-win situation for the politician but a losing one for the taxpayer and pensioner.
Finally, unrealistic investment return assumptions are used. A conservative estimate on a pensions investment is about 6-7%. Often many pensions use much higher levels and that leads to a shortfall when these returns are missed. The reason for this is it allows workers to contribute less to their plans. In todays environment the estimated returns should be more conservative and workers contributions should be higher. Bonds are a key component of pension funds and interest rates are at historic lows. This is bad news for future returns on this asset and this should be factored into future returns which are used to pay pension obligations.
While the chance of your pension disappearing is almost non-existent, the probability of a reduced benefit in the future has increased. The way to prepare for this possibility is to save more in your individual retirement accounts. Federal or State laws have no powers to reduce or confiscate them …..yet.
