What Detroit's Bankruptcy Means for Public Pensions Nationwide

Jeff Kowalsky, Bloomberg via Getty Images
When the city of Detroit sought bankruptcy protection this month, it marked the largest municipal bankruptcy filing in history, with huge implications for city taxpayers and creditors. As Detroit looks for ways to cut its outstanding debt from $11.5 billion down to $2 billion, current and former city employees could end up bearing much of the cost.

In his proposal to creditors, Detroit Emergency Manager Kevyn Orr (above, right) pointed to a shortfall of $3.5 billion in its pension funds. Arguing the need for "significant cuts in accrued, vested pension amounts for both active and currently retired persons," Orr will seek to reduce the amount Detroit has promised in pension payments for current employees as well as slashing pension-benefit checks for retirees.

A National Problem

Detroit is far from the only city facing severe pension problems. The biggest 61 cities in the U.S. had a combined employee-benefits shortfall of more than $217 billion, according to a report from the Pew Center on the States earlier this year. Of that amount, only $99 billion was attributable to pensions; the remaining $118 billion represented underfunded promises for health care benefits to retirees. Moreover, the most recent data available to the Pew Center was from 2009, with partial results from 2010 suggesting further widening of pension deficits. Although Washington, D.C., and New York City had fully funded pensions as of 2009, Chicago's funding level came in at only 52 percent, and Atlanta's pension was only funded at 60 percent.

For municipal employees and retirees around the country, there's a lot at stake in the Detroit bankruptcy proceedings. For decades, the idea that current and former workers have a contractual right to their benefits kept governments from making changes that affected past benefits, instead cutting benefits to new hires and dialing back the accrual of future benefits for existing employees.

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But the successful restructuring of pension obligations in Central Falls, R.I., where municipal retirees agreed to substantial pension cuts during the town's bankruptcy, shifted the way governments think about their pension obligations. As a result, city and state governments have been more aggressive in bargaining with workers, trying to cut pensions even before bankruptcy filings, and the bargaining position of those workers has been weakened by the erosion of the legal precedent that used to protect them.

A Lack of Protection

Public workers have two main disadvantages compared to their private-sector counterparts. When private companies fail, the Pension Benefit Guaranty Corporation steps in to provide benefits for employees and retirees. Although certain high-income workers who fall above the PBGC's maximum benefit amounts won't be receive full compensation, most rank-and-file workers get paid in full for their pension benefits. Unfortunately, the PBGC doesn't cover public employees.

In addition, for many municipal workers, city pension plans actually take the place of Social Security. Rather than having Social Security taxes withheld from their paychecks, those employees make contributions directly into pension plans. As a result, if their pension benefits are reduced, these workers lack a qualifying work history under which they can claim Social Security benefits.

A Balancing Act

Of course, some government pension plans have deservedly earned criticism from the public because of their lavish payouts. Episodes like the scandal in the city of Bell, Calif., which centered on large salaries for public officials that created even larger pension obligations under the state's retirement system, turned public opinion against government workers. Especially as more private employers have phased out traditional pensions entirely, the right to any pension payment has increasingly become the exception rather than the rule.

If Detroit is successful in cutting pension benefits for its employees, though, it could lead to similar cuts in cities throughout the country. And for municipal workers who are in or near retirement, and who have planned their futures based on those promises, the impact of those cuts could be devastating.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.

Retirement Tax Heaven (and Hell)
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What Detroit's Bankruptcy Means for Public Pensions Nationwide
Where you live can have a huge impact on your tax bill in ways that may surprise you. Some states are more tax-friendly for retirees than others -- particularly if you are living on a fixed income -- can have a big impact on how much you have left over to spend.

Click through our gallery to see which states qualify as "heaven" and which are "hell" for income tax, pension, social security benefits, sales tax and property tax.

Read Kiplinger's Article

Next: States With No Income Tax
Don't assume that a state with no income tax qualifies as a tax haven. High sales and property taxes can more than offset the absence of an income tax.

7 States With No Income Tax
South Dakota
(N.H. and Tenn. tax only dividend & interest income that exceeds certain limits.)
Next: Pensions - Tax Heavens
Only three states exempt virtually all retirement income (including public and private pension benefits, 401(k) and other retirement-plan distributions, and IRA withdrawals) from state income taxes.

3 Best States for Pensions

Next: Pensions - Tax Hells
Five states are particularly tough on retirees. Not only do they fully tax most pensions and other retirement income, but most of them also have fairly high top tax brackets.

5 Toughest States for Pensions
Rhode Island

Next: Social Security Benefits - Tax Heavens
36 states and the District of Columbia don't tax Social Security.

36 States That Are Heaven
Alabama, Alaska, Arizona, Arkansas, California, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Mississippi, Nevada, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, South Dakota, Tennessee, Texas, Virginia, Washington, Wisconsin and Wyoming
Next: Social Security Benefits - Tax Hells
The remaining 14 states tax Social Security benefits to some extent.

14 Tax Hells
Colorado, Connecticut, Iowa, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia. (Iowa will gradually phase out its Social Security tax by 2014, starting in 2008)

Next: Sales Taxes - Tax Heavens
These five states have no state sales taxes.

Top 5 States
New Hampshire

Next: Sales Taxes - Tax Hells
These five states each have a state sales tax of 7%, the highest in the nation.

5 Worst States
New Jersey
Rhode Island

Next: Property Taxes - Tax Heavens
Based on data from a 2006 Census Bureau survey and Tax Foundation calculations these are the five states with the lowest median real estate taxes.

5 Best States for Propert Taxes
West Virginia

Next: Property Taxes - Tax Hells
At the other end of the spectrum, these five states have the highest median real estate taxes. (from highest to lowest according to 2006 Census Bureau survey and Tax Foundation)

5 Worst States
New Jersey
New Hampshire
New York
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