Happy New Year from the City of Houston: We’re Insolvent!

     It has become standard bill of fare for the City of Houston to hold the release of its annual audit until sometime between Christmas and New Year’s Day, hoping that the awful news normally contained therein will go unnoticed by the local media, which it normally does.
     Holding true to form this year, the City dropped its audit for the fiscal year ended June 30, 2016 on the internet late in the day on Friday, December 30, notwithstanding that the auditors signed off on the report a month earlier on November 30.  You may recall that last year the City released its audit, which had been completed on December 2, at 4:00PM New Year’s Eve, which was also conveniently after the December 12 City run-off elections.
     The headline news from the report is that the City is now officially technically insolvent, that is, the City’s liabilities exceed its assets.  According to the report the deficit is a little under $100 million, although the real number is much larger (more on that in a moment).  The fact that the City was, for the first time in its history, insolvent was timely reported by the Chronicle.  [click here]  But unfortunately, the story also included the swill from Turner and our financial watch-dog turned lap-dog, Chris Brown, that the City going insolvent really was not that big of deal and that the solution to the City’s fiscal woes is to double down – for another 30 years — on the defined benefit pension system that got us into this mess.
     Turner was quoted as assuring everyone that the City had $2.5 billion of cash on hand, plenty to pay all its bills.  That is, of course, if you don’t count the $8 billion of pension bills the City has accumulated in the last fifteen years.  Nor does he mention that about 90% of that money is tied up in restricted accounts that are not available for regular expenses.
     There are hundreds of pages in the report, so there is much yet to be unpacked.  But here are some of the things that jumped out at me in the few days we have had to examine the reports.
     1. Are we insolvent by $100 million or $2 billion?  One of the more bizarre and deeply troubling aspects of these reports is that they continue to assume that our pension plans will earn an 8-8.5% rate of return indefinitely.  Of course, these assumptions are absurdly unrealistic.  Last year the plans, on average, lost about 2%.  It appears that the fire fighter plan assumption of 8.5% is the highest in the country and the only plan to continue to perpetuate this fantasy.  None of the other 10 largest cities in the country used a rate of 8% or higher in their most recent audits.  Even Turner has admitted as much by proposing lowering the rate to 7% in his new pension plan.  The police pension plan dropped its rate assumption last year to 7% and then arbitrarily raised it back this year to 8% notwithstanding it lost over 3% last year.
     The difference is not trivial.  Buried deep in the notes to the report is a schedule that shows the effect of lowering the plans’ assumption by a mere 1% on the city pension debt.  That small change balloons the pension debt from $6 billion to about $7.8 billion.  If the auditors had used Turner’s new numbers, the pension liability would have swollen to over $8 billion.  In other words, if the auditors had used the new assumptions proposed by Turner, the City would have been insolvent by over $2 billion instead of the $100 million it has officially reported.
     This kind of cherry-picking assumptions out of thin air allows the City to manipulate its audit results.  It is difficult to understand what the auditors were thinking about when they signed off on these absurd assumption.  Generally speaking, auditors are supposed refuse to issue a “clean opinion”if their client’s assumptions are patently unsupportable.  In their transmittal letter, the auditors specifically state: “Government Auditing Standards . . . require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.”  How is understating the amount of the City’s insolvency by 20-fold by using assumptions everyone agrees are not realistic not a “material misstatement” of the City’s financial condition?
     2. “Elite” Club of Bankrupts.  One of the City’s other favorite propaganda lines is to suggest that its financial woes are typical of other cities around the country.  Well, not so much.  I have looked at the latest financial reports for the 30 largest cities in the country.  While it is hard to compare the financial statements of one city to another, all must report their “net asset” position.  I have only found six others which are technically insolvent (New York, Chicago, Philadelphia, Jacksonville, Indianapolis, and Boston).  To be fair Baltimore has not issued an audit on the internet for over two years and is almost certainly insolvent.  Also, Dallas and El Paso will probably join the list when their reports are issued later this year as both are struggling with crippling pension debts as well.
     However, many other cities like Los Angeles, Charlotte, Seattle, Phoenix, San Antonio and San Francisco are still very much solvent notwithstanding their own pension issues.  So, while it is true that virtually every large city in the country today is struggling with financial issues to one degree or another, Houston’s predicament places it among those with the most grave fiscal challenges.
     3.  The Police Pension $676 Million Flip-Flop.  One truly amazing entry on the City’s books this year is a write-down, that is reduction, of the City’s debt to the police pension plan by $676 million due to “assumption changes.”  It appears that this is the result of police pension changing its investment assumption for 8% to 7% last year and then going back to 8% this year.
     Now just think about this for minute.  The amount that taxpayers supposedly owe just one of the pension funds changed by $676 million in one year purely on the whim of some nameless actuaries and a pension board which is mostly elected by the pension members.  By the way, that change is equal to more than half the property taxes collected by the City last year and about 15% of the total pension liability for that plan. And the taxpayers, rank-and-file police officers and even City Council had absolutely no say in the matter.
There cannot be a clearer example of the vagaries of the costs and debt associated with defined benefit pensions and the utter hubris that we can predict investment returns and demographics that will ultimately determine the true cost of these plans over the next 30 years.  This is why Turner’s plan to double down on defined benefit plans for another 30 years is such a dangerous idea.
     4.  Other Metrics
Here are a few other comparisons to the previous year noted in the report:
Total Revenues: Up 3.4%.
Total Expenses: Up 5.6%.
Amount Expenses exceeded Revenues: $288 million or 6%.
Increase in Total Debt: $820 million (larger than any bond issue ever approved by City voters).  Had it not been for the police pension’s flip-flop on its rate assumption, the increase would have been $1.5 billion.
Miles of Streets Resurfaced: Down by 42 (152 vs. 194, 28% decline).
Tons of asphalt used for pothole repairs: Down by 2,842 (13,130 vs 15,972, an 18% decline).
I expect to have more to say about the annual reports for the City and its pension plans after I have had more time to study them.  Till then . . . .

City’s New Pension Plan: The Good, the Bad and the Incredible

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.

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.

The Bad

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.

The Incredible

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.

Conclusion

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

City Sales Tax Slide Continues

City Sales Tax Slide Continues
The City of Houston got more bad news this week when the Texas Comptroller announced the City’s sales tax receipts for August were down again.  For the second month in this fiscal year (2016-17) the receipts were down by 4.5% compared to last August.  The sales tax for the first two months of the new fiscal year are the lowest since 2013.
The hope that the slide in sales tax collection was leveling off is now waning as we are beginning to see two years of year-over-year declines.  Also it is becoming increasingly doubtful that City’s budget projecting a 3% decline for this year will be sufficient.
This is a chart of the City’s sales tax collections for the last two years:
It is noteworthy that the trend line, which  had previously suggested that sales taxes bottomed out late last year, has turned negative based on the last two months’ data.
It is tempting to attribute the decline in sales taxes to the slump in the energy sector. But the fact that most of the cities in Houston’s suburbs saw considerably better sales tax receipts brings that explanation into question.  Here are the year-over-year results for some of the suburban cities.
Sugarland +4%
Bellaire +12%
Katy +8%
League City +8%
Pasadena -1%
Baytown +13%
This trend of the suburbs outperforming the City’s sales tax collections is likely the result of numerous factors, but it certainly appears that the exodus of companies out of the City is beginning to take a toll.