By Joseph Lichterman and Deepa Seetharaman

DETROIT (Reuters) - Detroit's emergency manager proposed freezing pension benefits for some current city workers starting in 2014 and will launch a two-month probe into the city's dysfunctional and error-prone handling of employee benefits.

A copy of Kevyn Orr's proposal was released by one of Detroit's two pension boards on Thursday, the same day the city's auditors posted a report that shed light on how Detroit overpaid benefits, including unemployment compensation for almost two years to 58 people who never worked for the city.

The report also raised the question of whether there was fraud in doling out some unemployment claims. The auditors' review of nearly two years of unemployment compensation claims found that 13 percent were likely fraudulent and another 36 percent were highly questionable and required investigation.

In his pension proposal, Orr, who was tapped by the state of Michigan in March to run its biggest city, would close the general retirement fund, which represents non-uniform city workers, to all future city workers and freeze it for current workers as of December 31. The city would replace the pensions with 401(a) and 457(b) retirement plans.

Tackling the city's pension overhang is a critical task for Orr, who is trying to restructure Detroit's $18.5 billion in debt and long-term liabilities after the city filed for the largest municipal bankruptcy in U.S. history on July 18.

The city's financial problems have eroded residents' quality of life. In a court order Thursday, U.S. Bankruptcy Judge Steven Rhodes wrote that he has heard "truly disturbing accounts of the consequences of the City's inability to provide basic services."

Detroit's two retirement funds are underfunded by $3.5 billion, with $2 billion of the liabilities coming from the General Retirement System, according to the actuarial firm Milliman, which has been hired by Orr.

The fund, which disagrees with Milliman's calculations, was not consulted on the proposed changes to retirement benefits, fund spokeswoman Tina Bassett said in a statement,

"We believe it is unseemly and disingenuous to present a proposal involving a new benefit structure that will affect the pensions of our members, beneficiaries and city employees not yet vested, without seeking our input, suggestions, knowledge and expertise," Bassett said.

The two retirement funds are the city's largest creditors and have filed objections to Detroit's bankruptcy filing. The city is still in the process of proving it is eligible to file the Chapter 9 bankruptcy petition, and Rhodes will begin hearings on the issue next month.

Part of Orr's strategy to address the city's problems is to overhaul the outdated method by which Detroit tracks and manages unemployment, pension and medical payments. Thursday's auditors' report offered an early look at those missteps, which will be examined further in the second report.

The initial probe found that the pension plans were overly invested in real estate while policies on what constituted overtime varied department by department. Managing healthcare benefits involved keeping track of more than 10,000 deduction codes.

The seven-person budget office was overwhelmed by the task of administering healthcare benefits for more than 30,000 active and retired city workers.

"It was found to be an extremely labor intensive process that lacks good documentation, uniformity of processes and it is prone to errors," the report said.

(Reporting by Joseph Lichterman and Deepa Seetharaman; Editing by Ken Wills)