Fair warning: This post is going to get way off in the weeds of the complex math that defined benefit pension plans entail. So if you are a mathphobe you may want to skip to the next item in your inbox. Unfortunately, because defined benefit pension plans are such complicated financial arrangements, there is no way to fully understand their impact without getting into the weeds, so here goes.
The amount an employer needs to set aside to fully fund a defined benefit pension each year consists of two parts. The first is the estimated cost of the benefits earned by employees that year. This is referred to as the “normal cost” or “service cost.”
Of course that estimate is an educated guess at best. It is fundamentally unknowable how much money needs to be set aside today for an indeterminate benefit to be paid 30 years from now. We know from experience, however, that employers almost always underestimate this cost, which results in the plans becoming underfunded over time. This is equivalent to the employer borrowing money from the pension plan. It is debt, plain and simple.
That brings us to the second part of what the employer should be contributing to its pension plan. In addition to the current cost, the employer should be contributing something toward paying off its debt to the plan. But how much should that be?
To be considered “actuarially sound” the employer should be contributing enough to pay off the unfunded liability in 30 years or less. Most people would assume that if an employer were going to pay off the debt in 30 years, the employer would run an amortization schedule to see how much it would need to contribute to the plan each year to pay off the debt, exactly the same way your bank calculates your mortgage payment.
But that is not how amortizations are done in the bizarre world of pension accounting. Rather, pension plans normally calculate the amortization schedule to pay off the debt using something called the “level percentage of payroll method.” It is a complete scam.
This amortization method estimates the total payroll for the employer over the next 30 years and calculates what percentage of that total payroll the employer will have to contribute to pay off the pension debt. When you work through the math, this amortization schedule results in a negative amortization for about the first ten years (i.e. the debt increases for the first ten years) because the payments are dramatically back-end loaded.
I have learned that this is the amortization method the City intends to use in its proposed pension plan. So let’s see what that looks like.
For the purposes of this example, I am assuming that the concessions the pension plans have agreed to really reduce the pension debt by $2.5 billion, something that has yet to be demonstrated. I am also ignoring the debt service on the $1.6 billion of pension bonds that taxpayers will be saddled with if this plan goes through.
Making those assumptions, the City’s remaining pension debt would be $4.1 billion. Assuming the City’s payroll increases by 3% each year and assuming the pension plans earn 7% during the entire 30-year amortization period, the City will need to make an annual contribution of about 19% of payroll. This is what the amortization schedule would be.
As you can see, the overall pension debt remains above 2017 levels until 2031. More significantly, the payments begin low and then dramatically ramp up over the 30-year period, more than doubling. So if you are only going to be mayor, say until 2020 or even 2024, you don’t have worry too much about how to pay off the pension debt.
Here is what the numbers look like graphically:
Now let me add this caveat. This is a very simplified model of how this amortization method works. Very small changes in the assumptions make enormous differences in the outcome. For example, if the City’s payroll goes up by 5% annually, the payments are even more back-end loaded and the debt balloons to over $5 billion before it starts down. Also, other factors, like the inflation rate, can dramatically affect the future contributions and scheduled pay-down of the pension debt.
Of course, even the presumption that we can project what the City’s payroll will be over the next 30 years is absurd on its face in the first place.
But make no mistake. The only reason to use this squirrelly method to amortize the pension debt is to kick this can down the road to the next City administration.
Turner’s Pension “Plan”: The Good, the Bad and the Incredible
Sylvester Turner announced his pension “plan” last week. I put the word plan in quotes because the outline Turner delivered was so painfully sparse of details it is hard to even describe it as a plan. Turner also used the word “deal” although it was not at all clear who has agreed to the proposal or what terms had been agreed upon. Even many of the people standing with Turner at the press conference almost immediately began to hedge and distance themselves from some of his claims about the plan. Within minutes the Fire Fighter Union was tweeting out snarky comments.
I am at a loss to understand why so much of this plan must remain secret at this point. When pressed by reporters about the details for the $2.5 billion in supposed savings from benefit reductions, Turner said he would not reveal that information until the agreement was signed. Are not the taxpayers of Houston, who will ultimately be asked to pay for this plan, entitled to know the details now, before a final deal is reached?
In addition to Turner’s comments at the press conference, I have also been able to obtain notes from several sources who have had private briefings with Turner and his team. From the public comments yesterday and the information from the private briefings, I have been able to draw some broad outline of Turner’s plan. The elements of the plan fall into three categories: the good, the bad and the incredible.
Following what my Mother taught me, I will start with the good.
Lowering the Assumed Investment Rate
The City has finally admitted that the 8-8.5% projections for the pension plans’ investment returns are unrealistic and far above the assumption used by other pension plans. The new plan will assume a 7% return instead. This may still be too high, but, at least, it is more in line with the national average.
How much the pension plans earn from their investments is a critical component to the ultimate cost of the pension plans. Generally, about 70% of the funds to pay for pensions come from these earnings. So a relatively modest change in assumptions regarding plan earnings can make a very large difference in how much the plans are underfunded.
In our case — using a 7% assumed rate of return instead of the 8-8.5% the City previously used — the unfunded liability balloons from $5.5 billion to $7.7 billion. Adding the pension obligation bonds issued in the White administration raises the total pension-related debt now owed by the City to $8.3 billion. It is sobering to remember that the plans were fully funded as late as 2001 and disturbing to remember that less than a year ago the City was claiming it only owed $2.5 billion.
Plans Agree to Reduce Some Benefits
The other good news in the “plan” is that Turner says that all three pension plans have apparently recognized that the current level of benefits is unsustainable and that each has identified benefit reductions their members can live with. According to Turner, these changes will reduce the unfunded liability by approximately $2.5 billion. However, as I mentioned Turner specifically declined to detail these reductions in the press conference. In the private briefings, the Turner team has said these savings mostly come from reductions in the cost of living adjustments (“COLAs”) to pension payments and the deferred retirement option plan (“DROP”), which allows some employees during the last ten years of their employment with the City to collect both their salary and their pension as though they had retired. Apparently some other relatively minor changes have been discussed, such as the amount employees will contribute and retirement ages.
There certainly could be $2.5 billion in savings from just reducing the COLAS and the DROP, but without specifics about the changes there is no way to quantify what those savings might be. Still, the fact that the pension plans recognize that there are going to have to be some changes to the benefits is encouraging.
No Switch to Defined Contribution Plans.
The worst part of Turner’s plan is that he has taken any conversion from defined benefit (DB) to defined contribution (DC) plans off the table. In the news conference, Turner claimed that the City had studied switching to defined contribution plans and that they would cost more. This is complete nonsense.
Over the last several decades the private sector has almost completely abandoned defined benefit plans in favor of defined contribution plans for the simple reason that they are cheaper and because they allow the employer to control its costs. To suggest that our geniuses at City Hall have discovered something the entire private sector missed when it converted from DB to DC plans is ludicrous.
The reason defined benefit plans do not work is because they rely on our supposed ability to predict how much money we need to set aside today to pay benefits due decades from now. How much should be set aside depends on many financial and demographic factors. As I have previously noted, one of the most important of these is how much the pension plans will earn on their investments. We cannot predict interest rates next month, much less 30 or 40 years from now.
Also, in recent years all of the factors that affect the costs of a defined benefit plan have been trending higher. In particular, people are living longer and investment rates have been declining. The last two years have been particularly tough with respect to investment returns: All three of the City’s plans badly missed their targets, in fact.
The truth is we have no idea how much money we need to set aside today to ensure there will be sufficient funds to pay the benefit promised. Advocates for a continuation of the current system contend that they can calculate how much needs to be contributed each year. You will hear them refer to this as the “ARC”, which stands for the “annual required contribution” or the “actuarially required contribution.” It is a complete fraud. So much so, that the accounting rules that went into effect this year have completely eliminated the concept.
We simply have no ability to know what DB plans will cost taxpayers in the future. There is no certainty for taxpayers or City employees and hence no permanent solution to the City’s pension problem without a plan to eventually transition to defined contribution plans.
$1 Billion of New Pension Obligation Bonds.
One of the more disturbing features of Turner’s new plan is that he wants to issue $1 billion of new bonds. The proceeds will be transferred to the pension plans to reduce the unfunded liability. This, of course, does not increase or decrease the total pension debt, it merely changes the creditor from the pension plans to investor bondholders.
The idea of refinancing the pension debt is not, in and of itself, a bad one. Some of you may recall that I proposed refinancing the pension debt during the campaign, but only as part of a plan that would address long-term costs/liabilities by transitioning to DC plans.
But issuing new bonds to facilitate the continuation of the current, broken financial model is a terrible idea. At best, it is another temporary, albeit convenient, political fix that City taxpayers will be paying for over the next 30 years. Both the Government Finance Officers Association and the Society of Actuaries recommend against the issuance of pension obligation bonds.
35% of Payroll
Turner has said that the new plan will include a limit on the City’s contribution to pension plans in the future. This is a good idea. However, there are two problems. First the limit that is being discussed is 35% of payroll. This is absurd on its face. How many private employers do you know that contribute 35% of a person’s pay to a retirement plan? Harris County contributes 13% to its employees’ plan. And worse, under Turner’s plan, the City would have to contribute this amount for the next 30 years! How are we ever going to be able to hire new police officers and pay them a decent salary when we are committed to putting 35% of their pay into a pension plan?
The second problem is that it is unclear what will happen when the necessary contributions exceed 35% which they undoubtedly will, probably within the next few years. What is the enforcement mechanism?
Repeal of Property Tax Cap
Without a doubt the worst part of this plan is that Turner is coupling it with a repeal of the property tax cap. He said he would ask voters to repeal the cap next November.
Make no mistake, a repeal of the property tax cap means that your property taxes will go up. And as will be clear from the analysis below, Turner’s “math” cannot work without the largest tax increase in the City’s history.
When it comes down to the bottom line, pension math is actually quite simple. If a plan is underfunded the only way to remedy the shortfall is to add more money (increase the assets) or reduce the benefits (decreasing the liability for future payments). There is no magic or alchemy that can avoid this basic equation.
Of the roughly $8 billion of pension debt the City has accumulated, Turner’s plan would eliminate about a quarter of it by reducing benefits. Exactly how the other three-quarters would be eliminated is something of a mystery.
Turner says that his plan will amortize the remaining debt over 30 years without increasing the amount the City is contributing. That is mathematically impossible.
The City’s annual contribution to the pension is divided into two parts. The first part is the cost of benefits that its employees earned that year. This is referred to as the “Service Cost” or the “Normal Cost.” In addition to this amount, the City is supposed to contribute enough to pay off any underfunding in 30 years.
The City is currently contributing about $400 million each year to the plans. A little less than half of that goes to pay for the current cost. That only leaves a little over $200 million each year to pay down the accumulated pension debt.
Even if the benefit reductions really cut the pension debt down to $6 billion as Turner claims, you cannot service $6 billion in debt over any time frame, much less 30 years, with $200 million per year. Just the interest on this debt will run well over $300 million per year. So it is impossible to pay back the $6 billion in debt without dramatic increases to the City’s contributions at some point.
And that brings us back to your property taxes. Property taxes are the only revenue source over which the City has any substantial degree of control. And so the only way the City will be able to pay for the ramped-up contributions to the plans that will be needed in the future is to increase property taxes.
And the increases will not be small. If City were to amortize the $6 billion in debt with level payments over 30 years, it would require annual payments of nearly $500 million. Added to annual current cost means a contribution of nearly $700 million each, or $300 million more than the City is currently contributing. It would take a 30% increase in the tax rate to pay for this increase in contributions.
And that assumes that the proposed benefit reductions actually add up to a $2.5 billion reduction in the pension debt and that the plans earn 7% on their investments indefinitely into the future and that there are not significant increases in life expectancy over the next 30 years. In other words, there is plenty that could go wrong and necessitate even larger contributions to the plans and ever larger tax increases. State Sen. Paul Bettencourt has estimated that it will take a 50% tax increase to pay for a continuation of the City’s current defined benefit system.
I commend Turner for attempting to take on the pension issue. It is a difficult, in fact nearly intractable, problem. He will be criticized from all quarters regardless what he does. But that does not mean that Houstonians should blindly line up to support a bad proposal. And from what I can discern at this point, this is a bad proposal. It cuts benefits and throws the City even deeper into debt, but promises no permanent solution to the problem.
Our City is at a critical juncture. We know what happens to cities that overtax and under serve their citizens. We have seen it in Detroit, Chicago and many others. The City is already losing some of its largest taxpayers and the overwhelming majority of the growth in the region is occurring outside the City limits. And unfortunately this is not the only challenge the City is facing. We will likely be looking a very large increase in water and sewer rates in the near future due to being out of compliance with the Clean Water Act.
We cannot afford to kick the can down the road again on the pension crisis we are facing. If we do not get this reform done this time and get it right, the City may well be on a fiscal trajectory from which there is no recovery.
City Sales Tax Slide Continues
Many of you have asked me to put my periodic emails in a blog format. So here it is. Over the next several weeks I will be loading my past emails on this site and future emails will appear here at the same time they are sent to my contact list.