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Others cities may cut pensions to deal with economic woes if allowed by federal bankruptcy court.
If the federal bankruptcy court sorting out Detroit's financial mess allows the city to cut pensions, other cities and states may try to take that route to deal with their lopsided liabilities, an investment manager whose company oversees $26 billion for endowments and pension plans warned on Monday.
Detroit Emergency Manager Kevyn Orr wants to reduce pension benefits for thousands of retired and current city employees. In its Chapter 9 bankruptcy filing, the city claimed $3.5 billion in underfunded pensions. That's nearly 20 percent of all of the city's total debts of $18.5 billion.
"Michigan has a law, which says, it's basically a general obligation of the city of Detroit to pay pensioners," Commonfund CEO Verne Sedlacek said on CNBC's "Squawk Box." His comments came days after Michigan Attorney General Bill Schuette said he's prepared to intervene to defend the state's pension protections against any impairments.
Last Wednesday, the U.S. bankruptcy judge overseeing the case suspended legal challenges from public employee unions and pension funds in Michigan state courts while he reviews the city's petition for protection from creditors. The judge did say that retirees have raised "very serious questions" in their complaints.
Sedlacek agreed: "If it appears that states, particularly localities, can get out of this large pension issue by declaring bankruptcy, we may see more bankruptcies."
While bankruptcy laws vary from state to state, he did point to a recent bankruptcy case from Central Falls, R.I. "The bond holders made all their money back—got all their money. The pensions took the hit."
In Detroit, the bankruptcy restructuring could take up to three years, Sedlacek predicted, which could put pensions in a bind. "The status is in court you don't make the payments," he added, saying that localities try to protect their cash during the process. "The bankruptcy court decides [how] to split up the dividend that comes out of it."
The pension problems facing Detroit are snapshot in a nationwide trend that has seen state pensions "almost $1 trillion in the hole," Sedlacek continued.
According to a new report by Wilshire Consulting, the recovery in the U.S. state pension system suffered a setback last year, as the huge funding shortfall in a large swath of state pensions swelled more than 20 percent, interrupting improvement in the two prior years.
The underfunding of 109 of the nation's state pension plans, which guarantee retirement for millions of public workers such as police, firefighters, and teachers, rose to $834 billion in 2012, the Wilshire report said.
"The financial crisis plus the challenges that particularly state and local governments have had with their own finances have resulted in continued underfunding of the pension plans," Sedlacek said.
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