The bankruptcy of the city of Detroit has turned the spotlight on the fate of thousands of current and former city workers whose pensions and health benefits are now potentially at risk of disappearing. Yet many Americans don't understand the full importance of the loss of those pension benefits, as they erroneously believe that Social Security will step in to provide at least a baseline level of subsistence income for workers affected by Detroit's bankruptcy.
Unfortunately, many public sector employees don't have Social Security standing behind them. That stands in stark contrast to what many private workers receive, like the much-ballyhooed benefits that Detroit-area automakers Ford (NYSE:F) and General Motors (NYSE:GM) offer some of their employees, who could get both lucrative private pension payments and potential Social Security benefits down the road. Unlike them, many city and state employees only have their pensions as support -- pensions that could now be in jeopardy from Detroit's bankruptcy filing.
Looking at Social Security history
To understand why Social Security doesn't help all state and local employees, you have to go back to the origins of the Social Security program. At its inception, Social Security didn't cover any state and local government employees, as the idea was that Social Security was supposed to be a supplemental income program and that government employees who already had access to public retirement pension programs didn't need a further backstop.
Since then, laws have changed that allow states to voluntarily enter Social Security under what's known as Section 218 agreements. Moreover, federal law in 1991 began to protect public employees of state and local governments that weren't members of a public pension system.
Even with those opportunities, many state and local employees still aren't part of Social Security. The benefit of that is that unlike private employees, they don't have 6.2% of their wages withheld to cover Social Security taxes. But the downside is that they also aren't entitled to Social Security benefits based on their earnings record as a government employee, and they sometimes also have benefits that they've earned during past private employment reduced.
How Social Security takes benefits away
In particular, two provisions affect benefits of government workers who've previously had private-sector employment subject to Social Security. The Windfall Elimination Provision involves using a modified formula to determine your benefits, resulting in a benefit amount that is lower than you would receive under the normal formula. The idea is that because Social Security benefits are tiered to return a higher percentage of income to low-wage workers, those with substantial government service often end up resembling workers with low income levels, thereby getting a disproportionately large Social Security benefit in addition to pension payments. The formula the Social Security Administration uses essentially takes away the low-income advantage of Social Security, reducing benefits by as much as half even for those with more than 20 years of non-government service, subject only to maximum reduction restrictions.
The other provision creates a Government Pension Offset that affects spousal and survivor benefits. This offset is a lot simpler to understand: If you worked in a government job that wasn't covered by Social Security but are entitled to benefits under your spouse's work history, then the amount of your Social Security payment will be cut by two-thirds of whatever you receive from your government pension.
Both of these provisions have more detailed rules that create exceptions in certain cases. Still, they explain why so many of the workers involved in the Detroit bankruptcy might not have Social Security to fall back on if their pensions are cut.
The Detroit debacle
Of course, it remains to be seen whether Detroit workers will actually suffer pension reductions, and legal wrangling over benefits could continue for years. If they do, though, one other problem they face is that unlike private employers, government entities aren't eligible to have pensions insured by the Pension Benefit Guaranty Corporation. In the past, the PBGC has protected workers of US Airways (NYSE: LCC), United Continental's (NASDAQ:UAL) United Airlines, and many other formerly bankrupt corporations whose workers had benefits cut.
What all of this makes clear is just how high the stakes are in the bankruptcy proceeding, both for Detroit and for public-sector workers around the country. If benefits are cut, it could set a dangerous precedent that other cities across the nation could follow. For those who lack a previous work history covered by Social Security, an adverse finding from the bankruptcy court could leave them completely on their own to salvage their retirement prospects.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.