pensions

Detroit bankruptcy ruling: We've been here before

December 4, 2013: 9:34 AM ET

The decision was regarded as a canary in the coal mine for cash-strapped municipalities looking to cut pension obligations, but that little birdie has already sung.

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FORTUNE -- Loyal former city employees facing the heart-wrenching decision: pay for food or medicine? Retirees living on a few hundreds dollars a month and disabled workers trying to find minimum-wage jobs.

This would be the reality if the Detroit bankruptcy moved forward and the city cut pension benefits for its city retirees, opponents of the city's Chapter 9 filing warned.

Judge Steven Rhodes, who is overseeing the case, was not moved. On Tuesday, in allowing the historic Detroit bankruptcy to move forward, Rhodes said that city retirees' pension benefits could be cut as part of a reorganization plan. "Pension benefits are a contractual obligation of a municipality and not entitled to any heightened protection in bankruptcy," Rhodes said.

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The ruling came as a surprise to onlookers, since the Michigan Constitution protects public pensions as a "contractual obligation" that cannot be "diminished or impaired." But federal bankruptcy law trumps state law, Rhodes said.

The decision was regarded as a canary in the coal mine for other cash-strapped municipalities looking to cut pension obligations, which were once thought to be untouchable.

But that little birdie has already sung, albeit on a much smaller scale.

In August 2011, with pension and retiree health care obligations totaling $79 million and annual revenue of $16 million, Central Falls, R.I. took the rare step of filing for Chapter 9 bankruptcy protection. It then did something even more unusual: It convinced its retired police and firefighters to agree to a reorganization plan that reduced their pensions and health care benefits. In September 2012, a bankruptcy judge approved a reorganization plan for the bankruptcy, which went into effect a month later.

The agreement was an unprecedented step at the time -- one that Detroit hopes its retirees will also take.

At a press conference Tuesday, Detroit emergency manager Kevyn Orr said that he and the city will "continue to try to work with both our unions and our creditors to reach consensual resolutions."

But while the underfunded pensions in Central Falls and Detroit are alike, the dissimilar figures behind them may lead the municipalities to different fates.

To start, the town of Central Falls -- population 16,000 -- would constitute just a neighborhood in Detroit -- population 700,000. Central Falls' $79 million pension funding shortfall is a sliver of the $3.5 billion in pension payments and $6 billion in health care benefits the Motor City owes. About 140 retirees signed on to the Central Falls bankruptcy agreement; Detroit's retirees number 23,000. Central Falls had planned to cut its pensions by 55%, but the state of Rhode Island pitched in money to soften that blow to 25% for the first five years. Proposed plans in Detroit, meanwhile, have awarded retirees as little as 16 cents on the dollar. It's not surprising, then, that while retirees in Central Falls voluntarily agreed to see their pensions slashed, Detroiters have fought tooth and nail all the way.

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Differences aside, the fact that city worker benefits cuts are again on the table only reflects the dire state of cities' retirement funds, which may force more municipalities to toe the painful pension-cut line. A Pew Center study released earlier this year found that the recession -- which shrank tax bases and walloped pension funds' investments -- left 61 cities -- the most populous one in each state plus all others with more than 500,000 people -- with a pension and health care funding gap of $217 billion. Charleston, W.Va.; Omaha; Portland, Ore.; and Providence had the most pressing shortfalls, with Charleston's funding crisis most acute of all. And on Tuesday, lawmakers in Illinois -- the state with the worst credit rating -- passed legislation that cut the pension packages of former and current state employees.

As pension crises grow increasingly desperate, the belief that these benefits are sacrosanct will likely fade. "Cutting pensions is not a good day for anyone, but it's a practical reality that negotiating these issues is -- in the long-term -- the best way for workers and retirees to get paid," says James Spiotto, a lawyer at Chapman and Cutler who tracks Chapter 9 filings. "If you're going to hold too tightly to your constitutional right that your pension can't be touched, the court is going to prove you wrong."

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