"The city has six fiscal years to make an impact and close the gap on the [pension] underfunding." Detroit finance director John Naglick said. "The reality is to find those kind of monies will cause some tradeoff in services."

DALLAS – Two years after exiting the biggest bankruptcy in municipal history, Detroit still faces challenges including an unexpected gap in pensions and the absence of a long-term economic plan that leaves the city vulnerable to further setbacks.

The city marked the anniversary of its exit from bankruptcy on Dec. 10. City leaders continue to hold the line on spending and, after registering a solid 2015, appear to have posted another positive year in 2016, although audited figures are not yet available.

"Frankly, there wasn't much room for the city to go but up," said Howard Cure, director of municipal bond research for Evercore Wealth Management. "For the city which is invested in autos, I am not sure if they are fully going to participate in an economic recovery or conversely just how vulnerable it is to an economic downturn."

The latest report filed on Nov. 29 from the Detroit Financial Review Commission, which provides oversight of city finances, estimates a general fund surplus of at least $41 million for fiscal 2016. The nine-member group, established under the so-called "Grand Bargain" legislation that drove the bankruptcy exit plan, is charged with ensuring that Detroit stays on course by reviewing borrowing, some contracts, and long-term fiscal plans.

The figures are based on budget projections as of Aug. 15. The city also expects to finish the fiscal year ending June 30 with a general fund surplus of about $30 million based on budget projections as of Nov. 16.

Still, worries remain in the forefront and the city’s rating remains deep in junk territory at B2 and B  from Moody’s Investors Service and  S&P Global Ratings, respectively.

"The city is doing the right things in the short-run, but this does not speak to sustainability," said Tom Schuette, co-head of Investment Research & Strategy at Gurtin Municipal Bond Management. "Large problems remain and some of the variables the city confronts, such as regional and national economic trends and demographic forces, are out of their control. We believe it is important to remember that Detroit is still dealing with a fiscal environment that allows little margin for error.

"Secondly, we believe the revenue assumptions in the city's recovery plan are aggressive, and that despite good years in 2015 and 2016, the city has little cushion to deal with another economic downturn or worsening tax collection rates," he added.

One of the most daunting challenges facing the city faces is how to pick up the tab for a pension deficit that caught the city by surprise.

Under the "grand bargain," which leveraged civic foundation support to form a relief package for the bankrupt city, Detroit reached settlements with its pensioners that left intact public safety monthly checks and imposed a 4.5% cut on general employees. Their cost-of-living increases were reduced or eliminated. Retiree health-care benefits were slashed by almost 90%, allowing the city to shed a $4 billion obligation.

At the time the pension plan was underfunded by more than $1.8 billion, and retirees would have been subject to a 27% reduction. The $816 million gained from the city's bankruptcy deal reduced the reduction in benefits to 4.5%.

"Even though they were able to make some cuts to pension payments – getting rid of the cost of living adjustment and making some cuts – when the city starts funding again their pension program in 2024 it looks like it will be more than they estimated in the original proposal," Cure said.

The city's plan of adjustment contemplated a 10-year period, from fiscal 2014 to fiscal 2023, when the city is only required to make a relatively small amount of pension contributions from its general fund.

Originally, in the City's plan of adjustment the amount to be paid by the city's general fund in fiscal 2024 was projected to be $111 million.

However, based on the city's actuaries at Gabriel Roeder, the 2015 actuarial valuation reports  released early in 2015, project the liability in fiscal 2024 and beyond at approximately $200 million. Gabriel Roeder, in arriving at its projection, used a thirty year amortization, with level principal payments and declining interest payments. The estimated liability in fiscal 2024 and beyond is likely to be even higher once the fiscal 2016 actuarial valuation reports are completed later this year because the earnings on investments were considerably lower than the assumed rate of return of 6.75%.

The city responded by planning to set aside $20 million from its fiscal year 2016 fund balance, $10 million from a fiscal 2016 budgeted contingency fund that was not utilized, and will include in its fiscal 2017 to fiscal 2020 four-year plan an additional $10 million per year than what was required in the POA. The commitment of the city, based on the planned set-asides, totaled $70 million more than required by the POA.

However, the sum may still be inadequate to meet the pension shortfall and it could impact the city's efforts on other fronts.

"The city has six fiscal years to make an impact and close the gap on the [pension] underfunding. We don't want to create such a cliff in 2024 where there is a big budget shock," finance director John Naglick said in an interview. "The reality is to find those kind of monies over the next six fiscal years will cause some tradeoff in services."

In December, the city prepared an updated 10-year plan that replaces the one that was developed in its chapter 9 bankruptcy proceedings. The results from this updated plan will be one of the important tools used in conjunction with planning for meeting its legacy pension obligations. The new plan will include a bridge from the prior 10-year plan.

"The 10-year model will show the FRC that this incremental funding can be folded into the budget, but we aren't naïve it will also create some disruption in services to accommodate that," Naglick said. "Think of it as a master plan on how we are going to make this stable."

"Given investment performance and other adjustments since the actuarial estimates during bankruptcy, the city's pension expenses are likely to significantly outpace the original projections," Schuette said. "It is entirely possible that the city's fixed costs will revert back to levels seen pre-bankruptcy when they were consuming over 30% of revenues."

Detroit's general fund surplus is primarily due to underspending in personnel-related expenses due to a temporary delay in hiring and debt service relief achieved through a bond refunding last summer.

The refunding, which incorporated approximately $260 million of unlimited tax general obligation debt and $345 million of limited tax general obligation debt, achieved $60 million in savings. The refunding of the bonds is expected to reduce the city debt millage levy by approximately 1.24 mills per year for fiscal 2018 through fiscal 2021. The LTGO refunding provided some general fund debt service relief for fiscal 2017 through fiscal 2020 while still achieving a net present value savings of $34.1 million.

Naglick says that the city's August timing consumer $606 million bond refunding in hindsight was "near perfect timing considering what is happening in the muni markets right now," referring to the post presidential-election jump in interest rates.

Naglick said that with the summer refunding complete, the city is taking a look at all of its debt obligations to see if there is some need to bond even in light of the market movement.

The city has appointed First Southwest as its financial advisor and is conducting a request for proposals for an upcoming bond issuance that will be used to cover some of the costs related to adapting the design of a halfway-finished pro hockey arena to include the region's pro basketball franchise.

Naglick said that through Southwest, the city has received responses to its RFP from investment banks and is likely to refinance the $250 million of senior bonds early in the year. "We are going to be sorting through that as soon as the New Year starts," he said.

The city has agreed to contribute $34 million toward the cost for the redesign which will be funded through savings created by the refinancing of $250 million of 2014 bonds issued by the Detroit Development Authority. The bonds were originally issued through Bank of America Merrill Lynch in 2014 to finance the $650 million hockey arena during Detroit's historic bankruptcy. They are supported by tax increment financing revenues collected by the DDA.

The city will also be looking at a possible road funding bond issue on the back of changes in the state's formula for granting municipal governments funding for local roads. The state this year increased the gasoline tax by 7.3 cents and the diesel tax by 11.3 cents. The state also increased vehicle registration fees by 20%.

The increases are part of a roads package passed by state lawmakers and signed by Gov. Rick Snyder last year. The extra taxes and fees must go into the Michigan Transportation Fund, and are expected to generate $460 million a year for construction and repairs to deteriorating highways, roads and bridges across the state.

Naglick said that means additional funding flowing to the city for roads. "We are looking at whether it would make more sense to do a bond offering to accelerate infrastructure improvements instead of just taking incremental amount each year and putting in operating budget for these improvements," he said.

The last review from Moody's shifted what had been a positive outlook on the city's still junk rating to stable but said the city had shown some modest economic recovery. The rating agency affirmed the city's B2 issuer rating in July but shifted its outlook to stable based on what it called a very weak economic profile that make the city vulnerable to future downturns and population loss. "Sustained economic expansion and revenue growth are necessary for the city to meet its requirement to resume pension funding obligations in fiscal 2024," said Moody's.

Schuette said that demographics and foreclosures are also a nagging problem. The city's recovery is contingent on a certain amount of continued economic growth and a stabilization of their base.

"We have seen reports that 1 of every 6 properties in the city was given a tax foreclosure notice in 2015, and a rapid broad-based population recovery is unlikely," Schuette said.

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