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Detroit manager seeks to freeze pension plan

Kevyn Orr
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Kevyn Orr

Detroit's emergency manager wants to freeze the city's pension system for public workers in light of mounting evidence that it was operated in an unsound manner for many years, contributing to the city's downfall.

The emergency manager, Kevyn Orr, issued on Thursday the preliminary results of a three-month investigation that identified questionable actions, including diversions of pooled money into individual accounts, excessive real estate investments that lost millions of dollars and "disconcerting administrative protocols" for the handling of health care and unemployment benefits. The investigation, conducted jointly by Detroit's independent auditor general and inspector general, was the first stage of a review that is continuing and expanding, investigators said.

Unfunded pensions and health care obligations are by far the biggest claims in Detroit's record-setting municipal bankruptcy. The city has about 33,000 workers and retirees who have been promised what human resources records call an "exceptional benefit package" to promote loyalty and reduce turnover.

(Read more: How broke is Detroit? It'll come down to number-crunching)

Mr. Orr said that the purpose of investigating the benefits now was "to help identify how the city can address its present financial crisis and, in the future, help determine the basis for and what, if any, actions that must be taken."

He also issued another order this week, demanding much more detailed information from the city's pension trustees about how the funds — one for general employees and the other for police and firefighters — were handled over the last 28 years. The order set a deadline of Oct. 11 for them to produce it.

Details of the proposed pension freeze were outlined separately, in a memo sent to Detroit's pension trustees several days ago. The memo said that the city's current defined-benefit pension plans would be closed to new members as of Dec. 31. City workers would stop building up their pensions as of that date but would remain entitled to the benefits they had accrued up until then.

That type of pension freeze is legal and fairly common in the private sector. But public employees' unions say that such a freeze would be illegal for their members because of state laws and constitutional provisions that cover government workers. Unions in Michigan are challenging Detroit's bankruptcy petition, and depending on the outcome, the case may answer the much-debated question of whether a federal bankruptcy judge can set aside such state constitutional provisions.

(Read more: Detroit bankruptcy could hit millions of retirees)

"What the unions, I believe, are saying, is, 'Does the authority to go into bankruptcy also include with it the authority to override that constitutional protection?' " said Paul Maco, former director of the Securities and Exchange Commission's Office of Municipal Securities, who is now with the firm of Bracewell & Giuliani in Washington. "There hasn't been a Chapter 9 case where the federal bankruptcy law was found to override the state constitutional law."

In a letter sent with their audit report, Detroit's auditor general and inspector general, Mark Lockridge and James Heath, said that they had started by looking at real estate investments because federal authorities were already investigating accusations of fraud in that area. That investigation has already produced indictments. They said they still planned to look at other investment classes. So far, they noted that both of the city's pension funds had exceeded the levels of real estate investment allowed under state law and had lost $144.8 million on them as of 2010.

Other areas where the investigators saw signs of trouble included the way overtime and other data were being factored into retirees' pension calculations, high-yielding bonuses that were added to current workers' individual accounts, and less-than-rigorous handling of health care billings. They said that nearly half of all the city's unemployment compensation claims over the last three years were either "likely fraudulent" or "highly questionable" and said they were escalating their review of those claims to a forensic investigation.

They also said that a five-year contract with a big managed care provider, signed late last year, might have to be redone because it was written in a way that seemed unlikely to save Detroit much money.

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Some of the records Mr. Orr demanded in his latest order seemed likely to support the two investigators' work. The order calls for the pension trustees to provide records showing how the city's two pension funds calculated "excess earnings" — a term they applied to investment gains in a given year that were greater than the average the trustees estimated the investments would earn over the long term. The trustees have said they put these "excess earnings" into a special reserve and used them to pay for year-end bonuses for retired city workers, called "13th checks."

The proposed pension freeze for Detroit would halt payments of nonpension benefits to both active workers and retirees. Nor would current retirees continue to receive yearly cost-of-living adjustments. Current city workers would be shifted into new defined-contribution plans, similar to 401(k) plans, which would comply with the requirements of the Internal Revenue Code, according to the memo.

The city's current approach, in which money is transferred from a pooled pension trust fund to a system of individual accounts, appears not to comply, risking the pension system's tax-qualified status. Pension funds are rarely stripped of their qualified status by the I.R.S., because all the contributions and investment earnings in such a case would immediately become taxable, a catastrophic event.

(Read more: Detroit spent billions extra from pensions)

The proposed pension freeze for Detroit would halt payments of nonpension benefits to both active workers and retirees. Nor would current retirees continue to receive yearly cost-of-living adjustments. Current city workers would be shifted into new defined-contribution plans, similar to 401(k) plans, which would comply with the requirements of the Internal Revenue Code, according to the memo.

The city's current approach, in which money is transferred from a pooled pension trust fund to a system of individual accounts, appears not to comply, risking the pension system's tax-qualified status. Pension funds are rarely stripped of their qualified status by the I.R.S., because all the contributions and investment earnings in such a case would immediately become taxable, a catastrophic event.

The proposed pension freeze would also have a deferred-compensation plan for people hired in the future; participants in the existing plan would not be eligible for that one.

Tina Bassett, a spokeswoman for the general pension trustees, said they opposed the pension freeze and saw it as a sign of bad faith on the part of the emergency manager's legal team.

"No one from the G.R.S. had any input into this proposal," she said in a written statement, referring to the General Retirement System. "We believe it is unseemly and disingenuous to present a proposal involving a new benefit structure that will affect the pensions of our members, beneficiaries and city employees not yet vested, without seeking our input, suggestions, knowledge and expertise."

—By Mary Williams Walsh of The New York Times

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