When we look at troubled public pension plans in the U.S., we frequently see the same pattern: poor funding policies and faulty investment return assumptions that combine to drive growth in unfunded liabilities and volatility in the pension contribution rates paid by employers/taxpayers. A recent study by Rice University’s Kinder Institute for Urban Research details how these very factors have plagued the financial state of Houston’s public pensions. Without major reforms, the city’s unfunded pension liability and required contributions are expected to continue growing indefinitely.
The city of Houston has three major pension systems: the Houston Police Officers’ Pension System, the Houston Firefighters’ Relief and Retirement Fund, and the Houston Municipal Employees Pension System. The municipal plan covers the majority (63%) of the city employees.
In total, the city’s unfunded liability grew almost twentyfold from $212 million in 1992 to $3.9 billion in 2015, which represents about 76% of the city’s current total annual revenue. It should be noted that this $3.9 billion figure is an estimate under the old GASB standards; the unfunded pension debt would be $5.6 billion under the new GASB 68 standards that require using the market value of assets and a blended discount rate.
Among the three systems, the firefighter plan is the best funded with a 92% funded ratio, followed by the police plan with an 81% funded ratio. The municipal plan is in the worst shape with a funded ratio of only 54%, far below the national average of 74% in 2014. The funded status of the municipal plan has also consistently lagged behind the national average since 1992.
The city paid around $350 million into the three systems in 2015, falling short of the $400 million actuarially calculated contribution. The $400 million total payment is approximately 9% of the city’s revenue. This total actuarially required is up significantly over the 1995-2000 period, when annual city contributions to its pension systems totaled just 4% of revenue.
The city has fully funded the actuarially calculated contribution rate for the firefighters’ plan on a regular basis, but has failed to pay at least the full, required contribution for the Police Officers’ and Municipal Employees plans since 2003.
However, even if the total required contribution had been fully paid, it would not have stopped the unfunded liability from growing due to the open level percent amortization schedule that effectively refinances the pension debt every year and creates perpetual negative amortization (meaning that contributions are insufficient to even cover interest on the pension debt, much less pay down unfunded liabilities).
Where did the growing pension debt, and consequently the rising required employer contributions, come from? To answer that question, the study examines five factors that have driven the unfunded liability: contributions, investment returns, actuarial experience, benefit changes, and changes to assumptions and methods. The first two factors – unpaid contributions and underperforming investment returns – played the most important roles in widening the unfunded gap.
As previously noted, the city has not only failed to fully pay its required annual pension contributions, but it has also adopted an amortization schedule that renders the actuarially calculated employer contribution rate inadequate in the first place. By constantly resetting the amortization schedule and using a long amortization period, the open (rolling) level percent amortization schedule results in an employer contribution not large enough to cover the interest accrued on the unfunded debt, even if the required contribution is fully paid.
The second factor, investment returns, is directly linked to the return assumptions chosen by the pension systems. From 2001 to 2015, the actual returns of all the three pension funds (6.25% for the municipal plan, 6.4% for the police plan, and 7.5% for the firefighter plan) fell short of their respective return assumptions of 8%-8.5%, which are also higher than the 7.6% national average assumption. The high return assumptions also imply that the city’s unfunded liability is greatly undervalued. The study shows that if the average rates of returns over the last 15 years were used as the discount rates, the unfunded liability would rise to $6.4 billion, compared to the official $3.9 billion.
The Kinder Institute suggests that Houston’s pension plans should revise the return assumptions, choose a more appropriate amortization schedule (i.e. “closed” rather than “open”), and ultimately seek ways to increase the total amount of employer contributions into the system. The study offers four options for the city to reduce and/or control its pension debt:
- increasing employer contributions (by increasing taxes or cutting services),
- increasing employee contributions,
- reducing employee benefits (through reducing COLA and DROP benefits), and
- switching new hires to a defined contribution or hybrid plan.
While there are advantages for each of these, none of these options on their own is a complete solution. If Houston were able to adopt this whole schedule of reforms it would be very meaningful, but each of these also necessarily involve trade-offs with other city budgetary priorities.
Shortly after the Kinder Institute study came out, Houston Mayor Sylvester Turner announced a pension reform proposal that, if implemented, will immediately cut the city’s unfunded liability by $2.5 billion (as calculated by the city’s actuary). According the estimates from the plans, the proposed reform can reduce pension debt by $1.1 billion for the police plan, $802 million for the firefighter plan, and $700 million for the municipal plan. Most of the debt reduction comes from negotiated changes to COLA and DROP benefits, which is one of the options examined in the Kinder study. The reform package also sensibly reduces the assumed rates of return to 7% and adopts a 30-year closed amortization schedule in place of the current open one.
All of these measures are steps in the right direction, though other elements of the reform proposal are problematic. First, the proposal does not include an option to switch to a defined contribution plan, which would be a more structural solution to the city’s long-term pension problems. The proposal also includes plans to issue $1 billion in pension obligation bonds (POB), a practice that, according to an analysis quoted in the Kinder study, “has not paid off for the City of Houston” in the past. In fact, the invested bond proceeds from previous POB offerings are currently “worth $18 million less than the principal owed to bondholders.”
The details of the reforms are still being developed and will be presented to the governing bodies of the three pension plans, City Council and the state legislature for approval. So far, the proposal has received support from the police plan and the municipal plan, though the firefighter plan has not signed on yet. Given the size of Houston, the coming reforms, whether successful or not, can provide valuable lessons for other local and state governments.