What's the most important lesson to take away from the bankruptcy of Detroit? It's that when governments promise benefits they are unwilling to pay for, the system can very quickly come to resemble something designed by Bernie Madoff. Like many other cities around the country, Detroit promised police officers, firefighters, teachers and other public employees pension and post-retirement health care benefits, but was unwilling to set aside the money needed to fund those benefits.
The city attracted workers with a total compensation package that included current wages and future benefits. Since the future benefits were substantially unfunded, they can be paid only if future taxpayers pay them. But the future taxpayers never agreed to this deal. If they do pay, they will be paying for services delivered in the past. If they don't pay, they won't have to sacrifice any current city services.
So guess what? The future taxpayers have flown the coop. Louis Woodhill summarized the situation in a column for Forbes:
"Detroit's bankruptcy filing lists about $18.25 billion worth of debt. This amounts to $26,838 for each person still living in Detroit, which is equal to an unsupportable 176% of annual per capita income. Slightly more than half of Detroit's debts ($9.20 billion) represent the unfunded liabilities of the city's retirement benefit plans, including both pensions and other post-employment benefits."
Now here is something interesting - did you know that it is illegal under federal law for a private corporation to do what Detroit did? Any private company setting up a defined-benefit pension plan is required by law to fund that plan each and every year. Defined-benefit plans are plans that promise a specific pension benefit during the years of retirement, such as 60 percent of final pay. They are to be distinguished from defined-contribution plans, such as 401(k) plans, that are always funded because the employee is only entitled to whatever is in the account.
The only private companies with large unfunded pension benefits today are ones that were grandfathered years ago when the current pension regulations were put in place. No new pension plan can promise benefits and refuse to set aside funds to pay for those benefits. Moreover, every company that has a defined benefit pension plan is required to pay premiums to a national insurance fund administered by the Pension Benefit Guarantee Corporation (PBGC). Just in case something does go wrong, the PBGC will step in and pay the employees a minimum pension benefit.
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