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The Time to Fix Texas’s Public Pensions Is Now

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The Time to Fix Texas’s Public Pensions Is Now

Underfunded retirement plans for public workers jeopardize prosperity. Texas Rising 2016
Texas
Economy, finance, and budgets

Texas often gets hailed as a model of good fiscal management. A recent Moody’s analytics report, for example, rated the Lone Star State as the best prepared for the next recession among populous states. Yet despite its prudent reputation, the state faces at least one fiscal problem with the potential to damage its long-term economic health: underfunded public pensions.

The problem is especially evident on the local level. Many of Texas’s cities, including Dallas and Houston—the engines of the state’s economic growth over the last two decades—are now struggling with mounting public-pension debt; the expense of paying down that debt is beginning to cut into important services, such as public safety and road repairs.

Unless Texas takes steps to improve its pension outlook, its citizens could soon be paying much higher taxes, even as they receive fewer public services. Fortunately, the state’s public-pension challenge isn’t a crisis—yet. There’s still time to make reasonable, fair changes that would create sustainable retirement plans for future government workers, without jeopardizing prosperity.

Texas has slightly more than 300 public retirement systems. Of this number, 93 are pre-funded defined-benefit plans. The rest are either small, pay-as-you-go defined-benefit systems, in which governments pay pensions out of their annual budgets rather than pre-funding them; or defined-contribution plans, similar to private-sector 401(k)s. Most of the state’s defined-benefit plans provide an annual retirement benefit based on the number of years an employee works and that employee’s salary over his or her final few years on the job. Contributions made by public workers and their employers before the workers retire are supposed to cover the cost of promised benefits—that’s what pre-funded means. Pre-funding ensures that promised benefits can be paid when due, that they are fiscally sustainable, and that the costs of providing them are borne by the taxpayers and politicians who made the promises. But governments have proved less than diligent in holding up their end of the bargain.

Because retirement benefits get paid out over many years, governments must estimate how much money they should set aside today to cover future benefit payments. Determining the right contribution levels requires lots of guesswork, but crucial to the task is what is known as the “discount rate,” used to convert promised future benefit payments into a single dollar value today—referred to as a plan’s liabilities. Higher discount rates mean lower calculated liabilities, lower annual government contributions, and a greater reliance on investment earnings or on future taxes to pay for the benefits. Most plans use their expected investment rate of return to value pension liabilities.

According to the latest data from the Texas Pension Review Board, which I chair, the state’s public workers have earned retirement benefits worth roughly $303 billion. But this valuation rests on risky assumptions about future investment returns. The average asset-weighted discount rate used to value liabilities was 7.5 percent—that is, the typical Texas pension system’s investment must average a 7.5 percent return each year, or assets will fall short of promised benefit payments, triggering the need for additional taxpayer contributions to fill the gap. While returns may hit this target, it’s more likely that they will fall short. If returns over the next 30 years reach only, say, 5 percent, then the state’s current pension liabilities rise to more than $432 billion. That’s a lot of money, even for a big economy like Texas’s. To put the numbers in perspective, $303 billion is roughly 18 percent of Texas’s current gross state product; $432 billion is 26 percent.

The size of Texas’s pension liabilities is not necessarily problematic in itself. Other states have made larger pension commitments, and Texas certainly has the resources to follow through on its commitments. Yet as promised benefits grow relative to the size of the economy, even small misses on investment returns or on life expectancy can result in real budgetary woes.

Case in point: Texas is now dealing with the consequences of more than a decade of lower-than-expected investment returns and underpayment of benefit costs. Though in aggregate, Texas retirement plans remain nearly 80 percent funded, the state has piled up at least $67 billion—and potentially as much as $195 billion—in pension debt, owed to current and former public workers. Texas’s total pension debt now represents between 4 percent and 12 percent of gross state product. Servicing this debt has produced large pension-cost increases across the state.

 Graphs by Alberto Mena

Texas’s two largest statewide plans, the Teacher Retirement System (TRS) and the Employee Retirement System (ERS), are emblematic of the state’s pension-funding challenges. Together, these massive plans make up two-thirds of the state’s total retirement promises and 72 percent of its total pension debt. Leading up to the 2015 legislative session (the legislature meets only every other year), Texas officials acknowledged that neither plan had enough money coming in—indeed, both plans were expected to run out of funds within a few decades. The legislature proceeded to boost government and employee contributions to levels that they claimed would pay off the plans’ debt in 30 years or so.

Unfortunately, the claim was based on the assumption that both plans would earn 8 percent investment returns from that point forward. Because 2015’s investment returns were close to zero (TRS earned –0.27 percent, while ERS earned 0.23 percent), and this year’s returns probably won’t be much better, the TRS and ERS plans will likely be in much worse shape when lawmakers reconvene in 2017. Thus, all that the 2015 legislature accomplished by modestly increasing contributions to the two systems was to push off by a little the expected date when the funds would run dry. Without greater taxpayer contributions or additional benefit changes, the plans are unsustainable.

While Texas’s two giant statewide systems received a lot of attention in the last legislative session, local systems will get more of the spotlight next year. Local budgets are smaller, generally don’t enjoy a lot of flexibility, and consist mostly of labor costs. Rising pension expenditures for localities can therefore cause serious budget crises—as many Texas cities are discovering.

Texas’s regulatory framework for managing local pensions is complicated and, in many instances, works poorly. First, though, consider some bright spots. Local governments can participate in two state retirement programs: the Texas County and District Retirement System (TDCRS); and the Texas Municipal Retirement System (TMRS). Both are “cash-balance” plans, a type of defined-benefit program in which the benefits are based on individual accounts. This model is easier to manage and understand than a traditional final-average-salary defined-benefit model and is also easier to bring back into balance, if necessary. That’s arguably a reason that the two plans have remained well funded. Currently, TCDRS and TMRS are 94 percent and 89 percent funded, respectively.

In addition to the two statewide systems, chapter 810 of the Texas Government Code and the Texas Local Fire Fighters Retirement Act (TLFFRA) authorize localities to set up and run retirement programs. Charter or “home-rule” cities can also establish plans. All these systems operate with very little state control. Local pension boards join with local government officials to determine how a plan will be structured, who will administer it, and what the benefits will be. On the whole, they, too, work pretty well.

Thirteen of Texas’s municipal retirement plans are tightly controlled by their own individual state statutes, and it’s with these plans that the real problems arise. Each of Texas’s large cities has at least one plan controlled by state statute; Houston and Austin have three apiece. Though several of the statutes provide some flexibility for changes to be made in the plans at the local level, most reforms require state legislative action—putting many lawmakers in the position of deciding the particulars of retiree compensation in cities that they do not represent. They can dictate the terms of the pension plan, in other words, but they aren’t the ones responsible for paying for it—that’s in the localities’ hands. This arrangement is an incentive for the state legislators to be generous to the point of irresponsibility in designing the plans, with little oversight over how they are managed. Even where these plans include local authority to make certain decisions, the plans’ management, boards, and members almost always wield more power in running them than do local officials or taxpayers. In a few cases, pension management and boards serve as both fiduciary—tasked with ensuring the financial viability of the system—and benefits negotiator. These roles often directly conflict.

Not surprisingly, many of the state-controlled local systems face pressing funding challenges. The pension debt owed to workers through the 13 systems makes up more than 56 percent of Texas’s total local pension debt. And in many of these jurisdictions, rising pension contributions to pay down debt are beginning to take a real bite out of annual operating budgets. In Austin, Dallas–Fort Worth, and Houston, the actuarially determined contributions for state-controlled plans range from one-sixth to nearly one-quarter of the cities’ general-fund revenues.

The Dallas Police and Fire Pension System is probably the most egregious example of mismanagement among these plans. Until quite recently, the plan’s executive director could virtually set its investment policy unimpeded by any other authority. (A variety of checks and balances are now being adopted.) He used that power to chase extremely high returns, moving more than 50 percent of the portfolio into risky and hard-to-value private equity, real-estate, and other real-asset investments—a strategy that quickly became an existential threat to the system’s viability.

In 2010, the Dallas Police and Fire plan reported that it was 82 percent funded; as recently as 2014, its official funded ratio was more than 75 percent. But since then, the plan has suffered large investment losses and more than $180 million in write-downs, due primarily to overvaluations in its real-estate portfolio. In a recent presentation before the Pension Review Board, the plan’s new executive director said that its current funded ratio had plummeted to just 46 percent.

As the system’s investments have struggled, Dallas’s pension debt has surged, as have the city’s taxpayer contributions to pay down that debt. Dallas’s statutory contribution to the Police and Fire plan is a flat 27.5 percent of payroll, but this is far below the actuarially determined contribution rate for 2015 of 42 percent and the even higher rate for 2016—a hard-to-believe 66 percent of payroll. Actual contributions cannot diverge so significantly from the true benefit costs for long. If Dallas stays on this path, the Police and Fire plan will run out of money by 2030. Any long-term fix will require shared sacrifice from the city and workers, but since the plan is state-controlled, any benefit or employer contribution-rate changes will require action from the Texas legislature.

Houston faces a similar, though somewhat less severe, situation. Like most of Texas’s plans, Houston’s retirement systems for firefighters, police, and municipal workers were all fully funded at the turn of the millennium. In 2001, the legislature, at the city’s urging, hiked benefits for all three plans, with some of the increases taking effect retroactively. Overnight, pension liabilities exploded by more than $1 billion, and annual pension contributions skyrocketed. The city expressed shock at the huge cost increases, claiming that it had received incorrect information from actuarial advisors.

Beginning in 2004, Houston, working together with the police and municipal plans, implemented benefit changes that rolled back some of the 2001 increases and put in place much less generous benefits for new workers (the firefighters’ plan has thus far refused to make any changes). At the same time, though, the city took a number of actions that reduced its annual contributions well below the actuarially determined amount, and that meant yet more pension debt. According to Houston’s latest annual financial report, the city has accumulated nearly $6 billion in pension debt and pension obligation bonds. Actuarially determined contributions for the three Houston plans have risen from 6.7 percent of general-fund revenue in 2001 to nearly 20 percent today.

Pension costs became a major campaign issue in Houston’s recent mayoral election. Newly elected Sylvester Turner confronts a $160 million budget gap in his first full year in office; rising retirement costs are a major contributor. Mayor Turner has publicly committed to stabilizing those costs, but, as in Dallas, any long-term solution requires action from the Texas legislature.

To tackle these problems, Texas should do much more to hold governments accountable for their retirement promises; it should also simplify pension regulations by giving municipalities local control of their retirement systems. Many of the elements of such a solution are already in place. Texas is already a state leader in pension oversight and reporting, thanks to the Pension Review Board, a unique state agency with a mandate to assess the actuarial soundness of Texas’s retirement systems and determine whether they comply with state law. The board, though, has a limited set of enforcement tools, and state law allows a wide range of funding practices.

Encouragingly, Texas has recently strengthened its role in holding local governments accountable for paying their retirement promises. Under the Funding Soundness Restoration Act (FSR), if annual government payments to a pension plan aren’t projected to pay off the plan’s accumulated pension debt in less than 40 years, then the system’s leadership and sponsoring government must work together to come up with a way to pay off the pension debt in the required amount of time. Yet while the FSR improves accountability, it doesn’t go nearly far enough—here, too, a meaningful enforcement mechanism is needed. Adequate pension funding should be nonnegotiable. The state should establish minimum funding standards for defined-benefit plans and legal guardrails that enable a pension system to control common benefit elements, such as cost-of-living adjustments, that can swiftly drive up costs. Otherwise, the state should allow local jurisdictions to negotiate and implement their plans locally.

State-mandated minimum-funding standards could follow the recommendations of the Society of Actuaries Blue Ribbon Panel for Pension Plan Funding and the current practices of TDCRS and TMRS, the two big statewide systems for local governments. The essential elements of a good funding policy are fairly straightforward: pension debt should be paid off in no more than 20 years, and governments should not be able perpetually to refinance their debt. The discount rates used to value pension liabilities should be much lower than they are today, and they should be tethered to interest rates, as they are for private-sector retirement plans. Adopting responsible funding practices will also require a substantial increase in annual pension contributions. Finding the funds to cover these additional payments will be tough for many governments, but the alternative of doing little or nothing will just lead to harder trade-offs down the road, putting worker benefits at risk and threatening essential public services.

Texas governments should also consider moving new workers to better-designed retirement programs. Individual-account-based plans can be crafted to help all workers reach secure retirements, while putting a lid on governments’ ability to accumulate crippling pension debts. Putting new workers in easier-to-manage plans will not solve the funding problems caused by legacy retirement promises, but it would put Texas governments on the path to a more sustainable future.

For too long, Texas has failed to hold its governments accountable for making responsible retirement payments and has let them make risky investment bets that will end up costing more in the future. The state’s pension debt keeps increasing and is putting workers and taxpayers at risk. If political leaders ignore this problem, many Texas cities could face the kind of financial turmoil currently plaguing Chicago, where adequate pension contributions would consume more than 50 percent of the city’s general fund. Now is the time to act.

Photo by Marcio Silva/iStock

Texas Rising 2016

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