By Hilary Russ and Deepa Seetharaman
DETROIT (Reuters) - Before Detroit filed for bankruptcy in July, a team of analysts working with emergency manager Kevyn Orr met three times with labor unions but couldn't agree on a critical number: whether Detroit's unfunded pension liability was five times larger than previously believed.
Weeks later, the bitter divide persists. Orr, appointed by Michigan Governor Rick Snyder to fix Detroit's finances, insists that his estimate of a $3.5 billion future shortfall for the city's two retirement systems is correct. The pension funds themselves have only reported a $644 million gap based on 2011 actuarial valuations.
The debate is heated because there is no one set way to measure an unfunded pension liability. Assumptions about returns on investments, expected life spans of retirees, smoothing investment gains and losses over time, and forecasted salary increases all play into the calculations.
"Everyone on our side suspects that Orr weighted things to the negative as much as he could," said Bill Wertheimer, an attorney for a group of current and retired Detroit city workers, who filed a lawsuit in July seeking to block a bankruptcy because it could lead to cuts in retirement benefits.
Orr rejects the notion that there is negotiating gamesmanship behind his number. "I hope they don't think it's a negotiating tactic," Orr told Reuters in an interview. "We put a number out there that we felt was accurate based upon the traditional measure that you use."
The dispute over the size of Detroit's pension shortfall is emerging as a key front in the battle over the city's pending bankruptcy filing. In a hearing scheduled for October 23, the city must prove it belongs in bankruptcy. Police, firefighters and municipal workers, and the pension funds they are paying into, are expected to argue Orr did not negotiate in good faith before seeking protection from creditors.
The jockeying over pension funding in Detroit comes as public retirement systems nationwide grapple with large funding gaps that are absorbing money needed for services like paving streets or paying teachers. The dispute over how to estimate the gap in pension funding also highlights a burgeoning debate about the methods used to calculate the size of America's public pension problem.
States like Illinois and California, and a host of cities, have struggled to come to terms with what their actual exposure might be. Moody's Investors Service has also pushed cities and states to take a starker look at the health of their retirement systems, even downgrading Chicago, Minneapolis and others whose pensions look worse in the ratings agency's view, based in part on rules brought in by accounting standards setters.
Last Friday, a federal judge in Detroit's bankruptcy case approved the creation of a creditors' committee of retired city workers to represent retirees during negotiations over several issues, including the size of any cut to pension benefits.
Detroit will need to determine the size of its pension gap as it seeks to overhaul its finances in the wake of its Chapter 9 bankruptcy filing in mid-July.
Orr has set an aggressive schedule, telling Reuters on Wednesday he expects Detroit to emerge from bankruptcy by the time his term as state-appointed emergency manager expires in October.
Bankruptcy experts say the pension dispute could prove to be one of the thorniest aspects of the city's restructuring and a potentially significant impediment to Orr's plans.
"If they don't even believe the numbers, this is going to be a very acrimonious and protracted negotiation," said John A. E. Pottow, a law professor at University of Michigan.
Robert Gordon, a partner with Clark Hill who represents the city's two pension funds, said he could envision his team working with the court-appointed retirees' committee. His group, which includes actuarial experts, also will join parallel talks with the city over how to calculate and tackle Detroit's pension overhang, Gordon said.
Orr spokesman Bill Nowling said the issue eventually will be heard in bankruptcy court. "We'll have to come to a target number of what the level of underfunding is so that we can then figure out what adjustments will be necessary to shore up the fund and to allow us to continue to pay benefits," he said.
Orr said the city knows its methodology will be subject to criticism in court from labor unions, retirees and other creditors. He has hired Seattle-based actuarial firm Milliman Inc to conduct an actuarial analysis of the pension funds.
"Whatever we do, we want to make sure it's substantiated on several different fronts because we know it's going to be contested, and we want to be able to say, 'Here's all the information,'" Orr said. "You can question the motivation, the judgment and the action. You can't question the facts."
But the unions say their facts tell another story. This spring, Detroit police, firefighters and other unionized retirees believed that their pension funds were relatively well-funded at more than 80 percent.
Data from the pension funds' actuaries, Gabriel, Roeder, Smith & Co., showed an unfunded liability of $644 million. Based on that same valuation, the gap was estimated to have grown to $977 million after fiscal 2012 to cover current and future benefit payments, according to Orr's June 14 proposal to creditors. That's still a far cry from $3.5 billion.
Mark Diaz, president of the Detroit Police Officers Association and vice chairman of the Detroit police and fire retirement system, said the gap between the city and pension fund estimates is not going away. "There's a significant breakdown there," he said.
Detroit's retirement systems calculate future assets based on the notion that their investments will return 8 percent annually over several decades. Many U.S. public employee pension funds use that projected rate of return.
Orr has declined to release details about his calculations. But his actuaries use a 7 percent rate of return on investments, calling it "more realistic" in part because the financial crisis and recession caused years of poor investment returns.
Important as the assumed rate of return may be, Orr's 1 percentage point reduction is not enough to explain the difference between his estimate and the one put forward by the pension funds, said Natalie Cohen, head of municipal research at Wells Fargo. A more thorough analysis will not be possible until Milliman's full report makes its methods public, she said.
"I don't think it's unbelievable," Alan Schankel, a managing director at Janney Capital Markets, said of Orr's estimate. "I would just like to see something behind it. It's important to get a little transparency here."
(Reporting by Hilary Russ in New York and Deepa Seetharaman in Detroit; Additional reporting by Bernie Woodall in Detroit; Editing by Martin Howell and Doina Chiacu)