The End Game

As Detroit’s two public pension systems and Emergency Manager Kevyn Orr battle over funding levels and actuary analysis, the fate of millions of current and future municipal retirees across the nation hangs in the balance.

For nearly a quarter of a century as a trustee of the Detroit Police and Fire Retirement System, George Orzech has been the squeaky wheel that criticized questionable — and, at times, illegal — investments made from the $3.8 billion in pension fund.

Over the years, Orzech has railed against bad investments by his colleagues that squandered tens of millions of dollars from a fund that pays benefits to retired or disabled police and firefighters, along with their families. He denounced cozy relationships between pension trustees and businessmen (some of whom were indicted) that curried favors in exchange for investment dollars.

At times, Orzech clashed with city administration representatives on the board when he thought they were playing politics rather than working for retirees. More than once he pleaded for the federal government to investigate deals that did not pass his sniff test.

Now, as chairman of the police and fire pension board, and with a cadre of recently elected pension reformers, Orzech, a decorated Detroit Fire Department battalion chief, is fighting what he considers the most formidable foe the 72-year-old benefit fund has ever encountered: the city’s state-
appointed emergency manager, Kevyn Orr.

Orr maintains that the police and fire fund, when analyzed together with the separate General Retirement Fund established for other city employees, is the city’s largest creditor, with a combined claim against the city of $3.5 billion, out of the $18 billion in liabilities he says the city currently owes. He is threatening to take control of both pension funds, which have combined assets of more than $5 billion.

The legal tussle over the future of the funds could also define a continuing national debate among financial experts and actuaries over how to properly calculate the net worth of public pension funds and predict their ability to sustain payouts in current dollars to retirees well into the future.

Currently, the police and fire fund pays out $24 million in benefits every month to more than 8,400 retirees — the average annual payout per person is $30,000 (beneficiaries do not receive Social Security). How long the fund can make those payments is open to debate, considering the number of officers on active duty is roughly half that of the number of retirees.

Orzech and police and fire trustees acknowledge there have been serious problems with how the fund was administered in the past, but they insist it is now ably managed with the assistance of nationally respected investment teams.

They also say the police and fire fund is unfairly maligned by Orr and sensationalized by media reports that constantly harp on previous salacious stories of mismanagement and corruption dating back a decade, including the scandal-tainted administration of the disgraced former Mayor Kwame Kilpatrick.

The police and fire trustees realize that earlier, shaky real estate investments that cost the fund tens of millions of dollars, as well as first-class travel to exotic destinations by some trustees, have sullied the pension board’s reputation.

What’s more, a federal criminal investigation into city corruption returned an indictment last year for bribery against former city Treasurer Jeffrey Beasley, a Kilpatrick friend and fraternity brother. As treasurer, Beasley was an ex officio trustee on both pension boards.

Now Beasley, along with former police and fire trustee Paul Stewart, a 30-year police veteran and onetime vice president of the Detroit Police Officers Association, are awaiting trial on federal charges that they accepted thousands of dollars in cash, gifts, travel, and other favors from people doing business with the pension funds.

In addition, Ronald Zajac, who served as general counsel for both pension funds for 30 years, was indicted in March 2013 for conspiracy to commit wire fraud. Among other allegations, Zajac is accused of organizing a birthday party in 2007 at the Atheneum Hotel in Greektown, where he allegedly shook down investors doing business with the trust funds for thousands of dollars as birthday gifts for Beasley, Stewart, and former police and fire trustee Marty Bandemer (who was not named or charged in the indictments, but was later identified as having received money from Zajac).

Sean Neary, who like Orzech is a decorated firefighter and a member of the reform group on the board of trustees, says the board suspended Zajac in March 2012 after the indictment became public, and then fired him last November. “These events that prompted the Beasley indictments took place years ago and are certainly not happening now,” Neary says.

Attention by Subtraction

The trustees say another headache for their fund is that news reports sometimes lump the police and fire fund in with negative reports about Detroit’s general retirement system. A recent front-page story in the Detroit Free Press highlighted $1 billion in annual bonus payments, referred to as a “13th check,” made by the general retirement system to its retirees over the past 23 years. Subsequent reporting on the story failed to distinguish between the two systems, which Orzech attributes to sloppy journalism.

“Our operation is pretty transparent,” Orzech says. “The funding levels, all the operational procedures, the calculations, the annuities — all that stuff is very evident and open in our world. We are market-rate-driven and don’t have 13 checks. End of story.” (The fund did issue an annual 13th check from 1999-2001.)

The trustees say a major reason for some of the bad investment decisions by the board of trustees is its unwieldy composition of 16 members, half of whom are political appointees from city hall.

Six trustees are active-duty police and firefighters, three from each department. Two others are retired police and fire personnel. The City Council has one designated member, and seven other members are appointed by the mayor. 

“They, too, have skin in the game,” Neary says of a political reality that sometimes puts the city appointees at odds with the elected police and fire trustees.

In the case of the indicted Beasley, having the city treasurer as a trustee gives that member a disproportionate amount of clout on each board, Neary says.

In addition to Orzech and Neary, the other elected trustees are Sgt. Matt Gnatek, a homicide detective; Mark Diaz, a police officer and head of the DPOA; police Commander James Moore; and Jeffery Pegg, a firefighter. Louis Sinagra, a retired police officer, was elected by police retirees and Michael Simon, a retired battalion chief with nearly 50 years on the force, was elected by the retirees of the fire department.

“The group is solid. We also have a new set of ethics rules in place that could have prevented some of the stuff that went on (in the past),” Orzech says. “There is only one thing on the (board’s) mind, and it’s the preservation of that fund. There is no game-playing there. They don’t tolerate any nonsense from the city. Since they have come onto the board, there hasn’t been any extra money to make new investments — so our attention is focused on the operation and preservation of whatever monies and investments we have. They have zero tolerance for shenanigans.”

Fait Accompli

Orzech says prior to an Aug. 23 meeting he arranged — but did not attend — between Orr’s team and financial and legal professionals from the police and fire fund, he was certain Orr, with the blessing of Gov. Rick Snyder, was orchestrating a takeover of both pension funds. “From everything I saw them do and say, I believed they wanted to just run us over and take control of the funds,” Orzech says.

But that meeting in August — the first face-to-face meeting of experts from both sides — tempered his view.

“We thought our people would be in there for about an hour, but it went on for nearly four hours,” he says. “I think we might have opened some eyes. It was the start of getting everyone on the same page. They said it was a good first meeting, they accepted where we are coming from, and now it will be interesting to see where it goes because we still believe our pension is constitutionally protected.”

The fire trustees say that not only is the police and fire fund in much better financial health than Orr has portrayed, the fund is off-limits because it is protected by the Michigan constitution — a position shared by state Attorney General Bill Schuette. The law says accrued invested benefits shall not be reduced or diminished. “You can’t get it any clearer than that,” Orzech says.  

Police and fire pension beneficiaries also have a niche that in other times might be seen as a disadvantage, but could provide a persuasive argument for the fund in bankruptcy court. “Police and fire people in America don’t get Social Security,” Orzech says. “That’s the way it was set up in the ’30s and ’40s, so the defined plan was supposed to give you $1,500 to $1,600 (per month) to cover for the Social Security you weren’t going to get.”

Judge Stephen Rhodes of the U.S. Bankruptcy Court had hearings scheduled in October to determine whether Orr could take the city into bankruptcy and, with it, the debate over the city’s commitment to future funding of the pension systems.

The pensions are not in bankruptcy; they are separate trusts and their existing funds are not bankruptcy assets and cannot be touched. The bankruptcy will determine how the city will handle unfunded liabilities and its commitment to future payments into the pensions.

“We’ve got widows, we’ve got children, orphans of guys that died in the line of duty, disabled people, we got older people in their 70s and 80s — they are not going to go out and find another job,” Neary says.

“We believe (Orr’s) plan is to modify benefits. They have already told us they want to stop the pension plans as they exist. They don’t want to pay into them anymore. They want to get out of the defined benefit business without consideration of the Social Security issue.”

Officials of both pension funds say Orr is using questionable analysis to come up with the $3.5 billion in underfunded liability figure. That figure came out of a review of the funds by the Milliman Group, a national actuary firm based in Seattle. The review, for which the city paid $350,000, concluded that the police and fire fund and the general retirement system were overly optimistic in predicting the rate of return on their investments.

Both funds, according to Milliman, are below the 80 percent funding level that, under the emergency manager law, could trigger a takeover. However, Orzech and other pension officials maintain that their actuaries, Gabriel, Roeder, Smith & Co. in Southfield, who have been validating the police and fire fund numbers for more than 70 years, tell a different story.

“Our number from the unfunded accrued liability is $147 million and our system is 96.1 percent funded, according to Gabriel Roeder,” Neary says. He adds that his reports on pension funds from across the state and the nation showed the Detroit police and fire fund in a very commanding position. “Our plan is ahead of the state employees’ plan, the teachers’ plan, and 20 other states in the country,” he points out. “We are the second or third best-funded pension plan in the country.”  

On the other hand, Detroit’s General Retirement System has acknowledged that its funding level is at 77 percent, with $829 million in unfunded liability. The Milliman consultants have pegged those numbers as a $2 billion shortfall, meaning it is 65 percent funded.

Nuts and Bolts

Pension funds depend on income generated by the investment of principal to make enough money to pay retirees. When the funds do not earn enough income or lose money, the entity sponsoring the plan — in this case, the city of Detroit — must make up the difference. Last year, for example, the city stopped making payments to both city funds. Soon after, the Wayne County Circuit Court ordered the city to pay the police and fire fund $51.9 million in back payments; it’s an order the city has ignored.

The trustees say a revived stock market and income from investments have buoyed the fund. “From June 30, 2012, to June 30, 2013, we started to plan for $3.15 billion to $3.56 billion or somewhere (close), and we wound up with $3.84 billion,” Orzech says. “That’s in addition to paying out $250 million in payments, and with the city not making its contributions.”    

Neary says their actuaries faithfully follow well-established and accepted accounting practices. “General accounting standards require that you have an assumed rate of return, or the amount your fund is supposed to make in that fiscal year,” Neary says. “Our number is at 8.0 percent, which is predominantly universal.”

Accountants and actuaries allow pension funds to average out gains and losses by “smoothing over” spikes and downturns in investments over a set period of time. Up until two years ago, the police and fire fund used a three-year period to smooth over those gains and losses. In 2011, however, the funds went to a seven-year smoothing period to help account for the substantial losses from the 2008-09 national recession.

“What Orr has done with the Milliman report, he has changed the (assumed rate of return from) 8.0 percent to 7.0 percent, and he’s changed the amortization from 30 years to 15 years,” Neary says. “When you plug Gabriel Roeder’s numbers into that formula, guess what? You are now at 78 percent (funded). You are no longer 96 percent funded. (Orr) has inflated the number by changing the formula of (the) assumed rate of return. All you have to do with these actuarial assumptions is change a couple of numbers and scare the hell out of everybody.”

According to The Wall Street Journal, the average anticipated return on investment for 126 public pension funds across the country, covering 85 percent of the market, is 7.8 percent a year. The average for most corporate pension funds is 8.0 percent.

The Journal recently reported that the state of Indiana and the District of Columbia lowered their expected return to less than 7.0 percent.

Although Orr pegs the Detroit funds’ return at 7.0 percent, Milliman’s report actually fixed that return rate at no more than 6.3 percent to 6.7 percent. Neither Orr nor the Milliman report explains how they came up with their numbers.

“If you read the Milliman report you see a term that has never been used before (in actuarial reporting), ‘our very rough preliminary estimates.’ What the hell is that? In the actuarial world, you can’t do that. It makes no sense,” Orzech says.

In an interview conducted at the end of August with The Detroit News, Orr promised that within a week he would release a report from a joint investigation by the city’s auditor and two inspector generals into allegations of waste and investment mismanagement within the pension funds, as well as their ability to meet long-term obligations to retirees.

He told the newspaper that if his investigation showed “overwhelming” evidence of such abuses he would “consider” taking control of the retirement systems. The investigative report, issued at the end of September, failed to find a smoking gun, according to Orr’s spokesman, Bill Nowling. While it uncovered apparent cases of fraudulent unemployment claims, it failed to find any new information about the pension funds.

As it stands, the fate of Detroit’s two pension funds amid the city’s Chapter 9 bankruptcy filing will very likely affect dozens of cities, states, counties, and school districts around the country where public pension shortfalls are said to run into the trillions of dollars.

Jeremy Gold, an actuary, economist, pension consultant, and author, has long maintained that his profession has been making fundamental errors in the rate pension funds will be paid out to retirees in the future. Over time, the errors have become the accepted norm in actuarial standards of practice and, as a result, pension funds look healthier than they really are.

In a recent interview on National Public Radio, Gold explained how he sees errors creeping into actuaries’ calculations on future payouts.

“When they do make these projections, they begin by looking at each retiree one at a time and say, ‘ What might this retiree be entitled to over the next 10, 20, 30, or 40 years?’ ” he said. “Those entitlements are then summed across all the retirees so that we have the total future entitlements year by year by year. And at that point, pretty much all actuaries agree. The next step, however, is where actuaries do not always agree. And that is, what discount rate should be applied to those future promises?”

Gold said if the discount rate is relatively high, then the value today is relatively low — but if the discount rate is low, the value today is high.

“Now the actuaries, for the most part, in public plans — including Detroit — have, for the last 15 years or so, been using an 8.0 percent discount rate. When they started doing that, interest rates on bonds were more or less in that range. Nowadays, Treasury bonds average about a 3.0 percent return,” he said.

With assumptions founded on the inflated discount rate, even cities that faithfully made their contributions each year are falling farther and farther behind, he said.

So as Orr and the pension funds’ trustees wrestle about what to do next, national experts on public pensions cannot seem to agree on a course going forward.

In a survey taken several years ago, the Society of Actuaries was alarmed to learn that public pension plans posed the most serious threat to their professional reputation.

They convened a task force to look further into the problem. The group last year suggested convening a blue ribbon panel composed of public policy persons to get a fresh perspective on pensions. The panel included Robert North, director of New York City’s five largest pension funds.

Public pension officials, however, cried foul and urged the Society of Actuaries to rework the panel and add more people who championed the status quo. Switching from the current methods of calculating pension fund assets and future payouts might cause confusion and volatility, they argued.

On the local front, Orzech and Neary say their group is ready to negotiate a restructuring or modification of their plan. “We have guys working on that right now. We want to be part of the solution. We want to work with Mr. Orr to come up with a solution,” Neary says. “Forty-four states have gone through this and restructured their plans and went to modified plans.”

While Neary says there is room to negotiate, he cautions there is an elephant in the room few want to address.

“There are close to 1,000 (police and fire) members that have their time in and can retire right now. They could be lining up at the door anytime and say, ‘Hey, I want my pension, I’m done,’ ” he says. “Most have more than 20 years of service and 148, like Orzech, have more than 30 years. What would happen to the city if you have 1,000 active employees leave within a two-week time span?” db