Houston Pension Bill – As Passed

     As you have probably seen in media accounts, the Legislature has passed a bill making very substantial changes to the City of Houston’s pension systems.  The bill as passed was 260 pages and mind-numbingly complex.  When added to the existing statutory language, the Houston pension statutes will now run over 90,000 words, which in and of itself is absurd.
     The bill follows the general outline of what Turner proposed last October, but as the result of lobbying by the business community and grass roots activists, the Legislature made significant changes to Turner’s original proposal.  This is the first time that groups representing the taxpayers showed up in Austin to be heard on pension legislation.  In the past, local elected officials and the employee groups would make a deal and the Legislature would rubber stamp it.  That is not what happened this time.
Let me begin by emphasizing that while the final bill moves us in the direction of solving the City’s pension problems it is far from a permanent solution.  Many of the City’s claims about the virtues, like it will allow the City to pay off the pension debt in 30 years or it will save a million dollars a day, are patently false.  And other than the $1 billion in borrowed money, the bill actually allows the City put less money in the plans over the next 5-6 years.  Hardly a way to reduce the debt.
     So, the City will face another pension crisis.  The timing of that crisis depends in large measure on how the investments in the pension plans perform over the next few years.  If they continue to perform as they have in recent years (10-year average = 5.6%), that crisis will be sooner rather than later.
A detailed review of the bill is impossible here.  For those of you who want to take a deep dive, you can review the bill [here].  But here is the Cliff Notes version:
1.  Pension Cost Reductions for Infusion of Bond Proceeds – The only part of the new legislation that is likely to make any real difference in the City’s pension costs and debt are benefit reductions and increases to the employee contribution in the amount of about 15% or $2.6 billion.  It is important to emphasize that this reduction in pension liabilities is estimated because the actual amount of the savings is dependent on factors in the future, like interest rates.  Nonetheless, the savings are substantial and will bend the cost curve down in the future.
     The benefits reductions fall into two categories.
The police and municipal plans agreed to about $1.7 billion in cuts in exchange for the City’s agreement to infuse $1 billion from the issuance of pension bonds.  Some of you will recall that in the last mayoral campaign this was one of the scenarios I suggested as a tool to reduce the unfunded liability.  At the time, Turner was adamantly opposed, arguing, “You can’t solve debt with more debt.”  Fortunately, Turner changed his view.
     There are also benefit cuts and contribution increases totaling about $900 million for the fire fighters pension plan.  I have long criticized the fire fighters for being slow to accept that their benefit structure was unsustainable, but the changes to the fire fighter plan are deeply troubling to me.  Unlike the police and municipal plans, the fire fighters did not agree to the cuts in their benefits and will not get any bond money.
     Also, the cuts to the fire fighters’ benefits were dramatically more severe than those agreed to by the police and municipal plans.  The average benefit cut per member to the fire fighter benefits under Turner’s plan is about $150,000 compared to about $90,000 for police and $28,000 for municipal.
     There is no question that the benefits for fire fighters are the most generous benefits of the three plans and were badly in need of reform.  However, this plan does something that every candidate for mayor in 2015, including Turner, promised to never do – take away benefits that had been previously earned by our employees.  How many times did you hear all of us who ran for mayor declare “a deal is a deal” and promise that earned benefits would never, absent an agreement, be cut.  We, as a City, have now done just that and in doing so have clearly broken our word to the current and retired fire fighters.  That is not something that should be taken lightly or celebrated.
2.  Voter Approval of Pension Bonds.  One reform that was won by the business community and grass roots groups was the requirement that any new pension bonds must be approved by voters.  When the Legislature allowed cities to issue pension bonds in 2003, the legislation was silent on whether voter approval was required.  The Attorney General’s office has interpreted that silence (incorrectly I believe) to mean that voter approval is not required.  As a result, the City has already issued about $600 million in pension bonds without getting voter approval.
     That will no longer be the case.  The bill now requires the City to obtain voter approval before issuing any new bonds.  I have long said that pension bonds can be a tool to help manage our pension problems.  But like any tool, they can be used properly or they can be misused.  Voter approval is an important check to make sure any future pension bonds are not misused.
     You may recall that when taxpayer groups first insisted on a voting requirement on bonds, Turner declared it was a poison bill that would kill the bill.  But apparently after Turner saw polling that nearly 80% of Houstonians thought they should vote on any new bonds, the provision became less toxic.
3.  The “Corridor.”  The third major component of the bill is a complex mechanism that is intended to limit the amount that the City will contribute to the pension plans in the future as a percentage of payroll, which has come to be known as the “corridor.”  As nearly as I have been able to determine, no other entity, public or private, anywhere in the country, has ever implemented anything like the corridor.  It is a completely untested and experimental model.
     It is also hideously complex and the provisions are ambiguous and in some cases internally inconsistent.  That, in my experience is a recipe for litigation and I suspect you will see plenty of that in the future.  You will also see the administrative costs for the plans, which are already too high, rise even more.
     The real flaw in the corridor mechanism however, assuming it is actually enforced, is that it primarily relies on future increases to employee contributions if the City’s contribution rises above the limit.  It is highly likely this will occur because the plans are unlikely to achieve the 7% investment target over the long run.  And a small miss on the investment return equates to very large increases in the employees’ contribution.  These increases will be so large at some point in the future it will not be feasible to enforce the corridor.  That is the event that will likely precipitate Houston’s next pension crisis.
4.  Phasing out Defined Benefit Plans.  The biggest disappointment with the bill is that there is no immediate phasing out of the defined benefit model.  The bill does include a safety net of sorts that provides that if any of the plans fall below a 65% funded level, they must move all new employees to a cash balance plan.  Cash balance plans have some elements of both defined benefit and defined contribution plans.  Unfortunately, the bill also includes extraordinarily long grace periods (four years for police and fire and ten years for municipal) which will likely make the provisions meaningless for all practical purposes.  In all likelihood, the City will see its next pension crisis long before the expiration of those grace periods.
     Nonetheless, the inclusion of this safety net is an important symbolic victory, because it is a concession that phasing out defined benefit plans is the real solution to the City’s pension problems.
5.  The Constitutional Question.  There is one issue outstanding that may make this entire effort for naught.  There is a provision in the Texas Constitution that grants the right to set actuarial assumptions to the pension boards.  Of course, the entire point of the corridor is to force the pension boards to share that power with the City and the bill establishes certain limitations on the pension boards’ discretion in setting the assumptions.  While there is certainly an argument to be made that the pension boards should not be exclusively vested with the power to set assumptions, that seems to be what the State Constitution provides.  The fire fighter pension board has already filed suit to declare the legislation unconstitutional.
     The other boards currently have no plans to sue, but may find they are forced to do so to avoid liability from their members.  Also, it is possible that any member of the plans could bring such a suit.  Of course, that litigation will take time to resolve.  If the City implements the plan and then it is declared unconstitutional several years from now, we will have a real mess on our hands.
     Notwithstanding Turner’s public confidence that the City will prevail in this litigation, the City legal staff was manic during the negotiations to get the fire fighter board to agree not to sue.   I make no prediction about the outcome on the merits, but certainly on its face, the legislation appears to violate the constitution.
     There is also another practical effect of the fire fighters’ lawsuit.  The Texas Attorney General must approve the issuance of any bonds by local governmental entities.  Generally, their policy is to not sign off on any bonds when there is any pending litigation.  Whether the Attorney General’s office would find this litigation affects the issuance of the pension bonds is an open question.  But generally, that office has been pretty conservative in making such determinations.
6.  Conclusion.  Shortly after Bill White was elected in 2003, he received the bombshell that the pension plans were underfunded by over $2 billion.  White undertook a series of reforms that reduced benefits and he issued pension bonds to shore up the plans.  But he left the defined benefit model in place.  A dozen years later, our pension debt had tripled.
     White’s reforms unquestionably reduced the future costs of the pension plans, but ultimately his incremental approach proved not to be a permanent solution.  Such is the case with this plan.  It too reduces the pension costs immediately, but instead of biting the bullet and beginning the phase-out of defined benefit plans, it relies on an untested and what will be proven to be unworkable mechanism to do what moving to defined contribution plans would have accomplished without the cost, complexity, litigation and uncertainty of this plan.   And as a result, Houston taxpayers and employees will suffer in the long run.
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Houston Gets Vote on Pension Bonds

As you may have heard, the Texas Senate passed a bill yesterday which makes sweeping changes to the City of Houston’s pension systems.  I am still reviewing the language of the final bill and will have a summary for you in a day or two, but one very important provision requires that future pension bonds be subject to voter approval.

There has been a long-standing tradition in Texas that bonds repayable from property taxes, referred to as general obligation bonds, must be approved by voters.  In 1999, the Legislature formalized this tradition in Government Code 1251. 

When the Legislature authorized pension bonds in 2003, the legislation was silent on whether voter approval was required.  The Attorney General’s office has previously ruled that this silence on the voter approval allowed municipalities to issue bonds without voter approval.*  So, the roughly $1.5 billion in pension bonds that have been issued by Houston, Dallas and El Paso, have all been issued without voter approval.

Senator Huffman made an early commitment to include a vote on pension bonds in her bill.  Lt. Governor Dan Patrick and Senator Bettencourt both backed her up on the commitment.  Turner initially railed against the provision, insisting it was a poison pill, but in negotiations over the weekend, Turner folded and agreed to its inclusion.  Apparently the “poison” was not so lethal after all.

It is, however, unclear whether Houston taxpayers will get to weigh in on the initial $1 billion of bonds Turner intends to issue as part of the deal with the police and municipal plans for reduced benefits.  This is because unless the bill passes both houses of Legislature by a two-thirds majority it cannot become effective until September 1.  If it passes by a two-thirds majority, it becomes effective immediately on the Governor’s signature.  The Senate easily passed the measure by a two-thirds majority, but if the House does not, Turner would have a three-month window to try and rush through the bonds before the effective date.

While issuing the bonds before the effective date would be an incredible slap in the face of Houston taxpayers, I am not particularly troubled by this possibility.

Many of you will recall that during the campaign I advocated using pension bonds to get benefit concessions from the pension plans, but always said any such deal should be submitted to voters for approval.  Of course, during the campaign Turner was adamantly opposed to issuing pension bonds, but that is now the centerpiece of his pension plan.

The purpose of requiring voter approval for pension bonds, which are inherently risky financial instruments, is to ensure they are not misused.  But the deal Turner struck, $1 billion of pension bonds for roughly $2.5 billion in benefit concessions, is a on balance a reasonable one.  I would have preferred that they also be used to begin to phase out defined benefit plans, but there is some movement on that issue in the bill as well. 

Polling shows that while voters strongly feel they should have the right to approve pension bonds, a majority would approve this particular deal, especially when it is explained that City employees made benefits concessions in exchange for the cash infusion which will be made from the bonds. 

So, while I am philosophically opposed to issuing general obligation bonds without voter approval, I do not see any great harm if Turner issues the pension bonds before the effective date.  And if the House ends up adopting the Senate bill by a two-thirds majority, this loophole will not be available and a vote will be required.  Given the progress we have made on pensions generally in this new bill, if this proposition is submitted to voters I will support it.

Unfortunately, it looks like Houstonians will be the only municipal residents in Texas with the right to approve pension bonds.  A bill authored by Paul Bettencourt to requiring a vote on pension bonds statewide easily passed the Senate but appears to be going nowhere in the House.

*  Some lawyers, including yours truly, think the AG’s office got it wrong on not requiring a vote on pension bonds in their initial review.   The AG concluded that at Govt Code §1251 (requiring a vote on GO bonds) and Local Gov’t Code §1.07 were in conflict and that therefore the savings clause in §1.07 controlled.  However, a careful reading of the two sections suggests the two provisions are not in conflict.  In that case, the voting requirement of §1251 should control.  Hopefully Paxton will take another look at this issue.

150 Financial Professionals & Executives Ask Legislature to Include Defined Contribution Plans for New City Employees

In the last few days we have heard more of the same old tired, debunked rhetoric from the Turner administration that the City cannot make the transition to defined contribution plans from the defined benefits plans that have driven it into insolvency.

Well, 150 of Houston’s top financial professionals and executives disagree.  They recently sent a letter to the Legislature asking it to include moving all new employees to defined contribution plans. [Click here to read letter.] *

These individuals represent some of the finest financial minds in our City.  The educational pedigrees include advanced degrees from universities such as Rice, Stanford, Harvard and Wharton, to name a few.  Combined they have over 4,000 years of financial experience in some of Houston’s leading financial institutions and professional practices.

It should be noted that their letter acknowledges that Turner’s plans represents a significant incremental improvement in the overall pension quagmire.  But they also conclude it does not go far enough in two critical regards.  First, they believe that all new employees should only be offered defined contributions plans and that the voters should approve the issuance of any pension bonds to provide a check on the imprudent use of those risky financial instruments.  These are hardly radical ideas.

The Turner administration has tried to make the case to the business community that his plan’s “corridor” eliminates the need to begin phasing out of the defined benefit systems.  But there are several reasons to be skeptical about the efficacy of the corridor.  First and foremost, it is hideously complex and its provisions are ambiguous.  In my experience, complexity and ambiguity normally leads to litigation.  But the truth is that no one knows how it might work because it has never been tried before.

But even if the plan works as advertised, its basic enforcement mechanism is to increase employee contributions if the plans do not make the new investment goal of 7% annually.  Even a small miss on the investment goal would subject the City employees to crippling contribution increases that could not possibly be enforced. To make matters worse, the fire fighters pension board’s attorney has opined that the corridor is unconstitutional and vowed to immediately file suit if it is enacted.  So it seems inevitable that we will be tied up in litigation for years, which will also mean that the bonds used to secure the benefit reductions will be as well.

Because of all of this complexity and uncertainty surrounding the corridor it is completely reasonable to provide for a back-up plan to control costs in the future, one that we know works.  And that back-up is to begin moving new employees to defined contribution plans.  We know that plan will ultimately work because the private sector has proved it works.

During the Senate negotiations on Turner’s plan, it was suggested that a “trigger” mechanism be added to force the conversion to defined contribution plans if the corridor did not work.  The suggestion was that if any of the plans fell below a 65% funding rate (a dangerously low level by anyone’s standard) new employees would automatically be put in defined contribution plans.  It was a reasonable compromise, but the Turner administration rejected it out of hand.

This should make everyone even more suspicious of the efficacy of the corridor.  If Turner is worried that the corridor will not even maintain a 65% funded ratio for the plans, he obviously has serious doubts it will work as he has claimed.

Everyone agrees that we need to deal with the Houston pension crisis in this session and not wait until 2019 to try again.  But Turner’s “it is my plan or nothing,” is a false dilemma.  There is no reason that his plan cannot be supplemented to add something we know works.

The Legislature should adopt Turner’s plan but (i) remove the fire fighters from the corridor to reduce the litigation risk, (ii) add a provision to phase out the old defined benefit plans with defined contribution plans for new employees, (iii) require voter approval on any new pension bonds and (iv) exempt older employees with lower benefits from the COLA elimination.  That would be real pension reform we could count on.


 

* Additional names added after this printing.

Employees Likely to Face Massive Pension  Contribution Increases under Turner Plan

     The centerpiece of Turner’s pension proposal is its “corridor” mechanism which supposedly caps the amount the City will ever be required to contribute to the pension plans.  How the cap would actually work in reality is anybody’s guess.  It is a hideously complex, completely untested, experimental model, which has never been tried anyplace in the public or private sector as nearly as I can tell.
     But assuming it would be implemented as advertised, what would the effect on the City’s employees be?
     The proposal provides that if the City contribution exceeds the cap, the pension plans must decrease the cost-of-living adjustments (COLA), increase retirement ages and/or increase employee contributions.
     When you do the math, you find out that there is not much savings from further decreasing the COLAs or increasing the retirement age.  So, most of the adjustment will have to come from increasing the employees’ contributions.  The problem is that it will take huge increases in the employees’ contributions to make up even a small miss on the investment returns.
     The effect on the three plans is different.  Firefighters will be the most penalized.  The payroll for the fire department is roughly $300 million.  The firefighter pension fund has about $3.7 billion in assets.  If it misses the assumed rate by one percent (6% vs. 7%), that is $37 million that would have to be made up by an increase in employee contributions.  That means that the firefighters’ contributions would have to increase by 12.2% ($37 million/$300 million payroll).  The firefighters are already contributing about 10% toward their retirement, so this would take the required employee contribution to 22.2%.
     If you run the same calculation for the police plan you come up with 9.4%, which will take their employee contribution to 19.4%.  The effect on the municipal employee plan is not as great.  They would be looking at about an additional 4%.  One of the perverse outcomes of the corridor is that the better funded the plan, the harder the members of that plan are hit.
     If the investment returns are less than 6%, the increases in employee contributions would rise proportionately.   Keep in mind that the most recent 5-year average for the three plans is in the 5-6% range.
     Of course, requiring employees to contribute anything close to 20% is patently absurd and will never happen.  When we get to that point, and if the City were to actually attempt to enforce the increases, there would be mass resignations, strikes and, of course, more litigation.
     This is the fundamental flaw with Turner’s cap.  To claim that the City’s exposure is capped, it relies on a mechanism that will never be enforced because it is impractical.
     The timing of when employees will face higher contributions, and how high those increases will be, depends on how the plans do in the markets.  There are also a number of dampening features and trapdoors in the corridor language that will allow the City and plan administrators to manipulate the numbers to avoid hitting the cap, at least in the short term.
     But in the meantime, we are going to have to attempt to recruit and retain City employees with this sword of Damocles hanging over their heads.
     The corridor mechanism has been promoted as eliminating the need to begin the transition to defined contribution plans.  It does not.  There is no magic formula, no secret sauce.  The only real, long-term solution to Houston’s pension crisis to begin phasing out its defined benefit pension plans by moving new employees to defined contribution plans, just like 96% of the private sector has done.

Why Not Put New City Employees into Defined Contribution Pension Plans?

     According to a recent CNN survey, 96% of private sector employees have a defined contribution pension plan.  The private sector phased out defined benefit plans over the last several decades because it is impossible to predict what their ultimate cost will be.   They have proven to be particularly problematic in the public sector where elected officials, unions and pension boards have an incentive to understate the costs by jiggering the numbers – like assuming an 8.5% rate of return on pension assets.

     Predictably, that kind of chicanery eventually catches up with the pension plans and the entities sponsoring them.  One city after another that has played this game has found itself driven into insolvency and without sufficient revenues to provide basic municipal services.  Which, of course, is where Houston finds itself today.

     Turner has proposed a mechanism, the so-called “corridor”, to cap the growth of the City’s exposure to rising pension costs.  No other entity has ever adopted such a measure.  It is completely untested and experimental.  It is also hideously complex.  Complexity leads to ambiguity, which in turns leads to parties gaming the system and litigation.

     Of course, you might want to ask yourself, if this is such a great plan, how come no one else has ever used it?  You would have to believe that the same financial geniuses that got Houston into this mess have suddenly become so brilliant that they have devised a solution no one else in the country has been smart enough to think of.  Excuse me if I am skeptical of that unlikely scenario.

     But the truth is that no one knows how well it will work, or if it will work at all.  I have previously expressed my doubts and reservations.  Others, like the Arnold Foundation’s Josh McGee, have a more favorable view of its potential benefits.  But I have not heard anyone, other than Turner and his surrogates, claim it is a permanent fix to our pension problems, because it clearly is not.

     If our goal is to limit, to define the taxpayers’ exposure to pension liabilities, we know how to do that.  We know how to do that because the private sector has already shown us the way — phasing out defined benefit plans in favor of defined contribution plans.  By the way, in addition to the private sector, other public sector organizations in our area, such as the Port of Houston and Metro, have already done this.

     The easiest, the fairest, and the least painful way to start the transition is stop offering new employees defined benefit plans.  It will take years to work out of the problem, but at least, we know there is an end someday.

     So, the question I have been asking for the last few weeks is this: Why not add phasing out the City’s defined benefit pension system in favor of defined contribution plans for new employees to Turner’s plan.  There is nothing that prevents us from doing both.  What is wrong with a belt and suspenders.

     The only answer I ever get is that the employees will not agree to that.  Huh?  Let me get this straight, 20,000 employees, over half of which do not live in the City, are dictating what kind of pension plan the other 2 million of us are going to offer to new employees!!  Are you kidding me?

     I completely support someone who came to work for the City being promised a defined benefit pension to demand they receive what they were promised.  But the employees have no right to veto taxpayers deciding to move new employees to defined contribution plans, something they favor by more than a 2-to-1 margin.

    So why would our elected officials bow to such an outlandish demand?  Well, as they say, follow the money.  The employee groups, along with the vendors that are feeding at the pension trough ($50 million last year), make very generous campaign contributions.  In the last City election, the “Workers’ Voice PAC”, which has a Washington, D.C. address, doled out over $300,000 alone.

     Of course, the ultimate irony is that a continuation of defined benefit plans is just as bad, if not worse, for the current employees as the taxpayers.  If Turner’s plan is implemented and really enforced, contributions from police officers and fire fighters are almost certain to rise to nearly 20% in a few years.  And COLAs, well, you can forget about those altogether.  What kind of luck do you think the City is going to have trying to hire new police officers when they tell recruits they have to contribute 20% of their salary to a pension that does not have a COLA?

     But, of course, it is the taxpayers who will, at the end of the day, be left holding the bag.  It is time for Houston taxpayers to take a stand and say, “NO MORE!”  If Turner wants to put his “corridor” in place, so be it.  But Houston taxpayers are entitled to a backstop in case the rosy promises we are hearing now end up being like the ones we heard about how the drainage fee was going to solve our flooding problem.

     We know that phasing out the defined benefit pension by switching new employees to defined contribution plans will absolutely make this problem go away, eventually.  So again, I ask the question, “Why not?”

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Houston Business Community Needs to Take Principled Stand on City’s Pension

I find it incredible that some elements of the Houston business community are still considering endorsing the pension “reform” plan that has been proposed by Turner.  Before getting too far off in the weeds on the details of the plan, let me pose five questions regarding this issue.
    1.  Do you think that the City should commit to maintaining defined benefit pension plans for the next 30 years, which will add tens of thousands of new employees to this broken financial model?
     2.  Do you think that the City should commit to 32%, and perhaps up to 37%, of its payroll to the pension system for the next 30 years?
     3.  Do you think that the City should commit 50% of the property taxes it will collect over the next 30 years to the pension system?
     4.  Do you think that the City should issue $1 billion of pension bonds, which will be the largest bond issue in the City’s history, without voter approval?
     5.  Do you think the City’s property tax cap should be repealed?
   If you disagree with any of these five propositions, then you should be opposed to Turner’s plan because each of them is a critical element of it.  While the property tax cap is not formally part of the plan, it is impossible to pay for it, even in the short-term, without the repeal of the cap and, of course, Turner has said that he intends to put the repeal on the ballot in November.
If you need more reasons to oppose the plan, consider the following:

     1.  Turner has claimed that there will be $2.5 billion in savings from the plan from benefit reductions and increases in employee contributions.  However, the City has refused to release the calculations from which these proposed savings were derived, notwithstanding the repeated requests to do so by third parties attempting to vet the plan.  From the limited information we have, most of those familiar with the plans have been unable to generate a number anywhere close to $2.5 billion.  Craig Mason, the City’s chief pension officer under Bill White, has flatly said the changes to the plan will not generate $2.5 billion in savings.

     2.  No drafts of the proposed legislation have been made public.  A secret draft of the legislation for the police has been circulated to some select organizations but not made available to the public.  Apparently some Houston residents are more important than others.  This week the City refused to release the draft of the police bill claiming it was exempt from the Open Records Act.  Of course, the mere fact that a “secret” draft is being circulated tells you all you really need to know about this process.   How can any organization or individual endorse the “plan” without the actual legislation being released to the public?

     3.  The only potentially redeeming feature of the plan is the so-called “corridor” which would limit the City’s contribution to 37% (as absurd as that level is).  According to the term sheets, once the contribution goes above 37% of payroll, the pension plans would either reduce benefits or increase employee contributions.  The problem is that the enforcement mechanism for even this minimal protection for the City has never been defined.  What exactly happens if the pension systems do not make the specified changes is anybody’s guess.  That kind of vagueness and the inherent complexity of such a mechanism virtually guarantees that the pension systems and the City will be in litigation for decades.

    4.  The plan uses a repayment schedule that negatively amortizes the pension debt for about the first six years.  Conveniently, the payments begin to dramatically ramp-up after the current administration will be out of office.  At the end of the 30-year period, the annual pension payments would be over $1 billion.

  Some have expressed the view that the current situation is so dire that any improvement is better than nothing and that since this is all Turner is willing to put on the table, the business community should support it.  Of course, it is remarkable that the business community now has so little influence that a mayor can now dictate terms to it.  But laying that embarrassment aside, a bad deal is not better than no deal.
    If there are no changes to the pension plans this session, the City’s payments will rise by about $200 million annually over the next two years.  That means the City will have to tighten its belt, which is not a bad thing.  And the higher payments will actually help shore up the plans’ financial condition.  But even more importantly, a little financial pain may pave the way for real reform in two years.  If Turner’s plan is adopted, real reform will be dead until the payments escalate beyond the City’s ability to cover them, probably ten years or so hence depending on whether the property tax cap is repealed.
    As many of you have heard me say repeatedly over the last ten years, there is no pathway to true reform of the pension system without a plan that phases out defined benefit plans.  Had the City started moving new employees to defined contribution plans ten years ago as many of us suggested, we would not be facing the crisis now before us.
    This plan, to the extent we can even discern what it really entails, is not true reform.  It is a complex shell game that does little more than kick the can down the road to the next administration.  It will make the City a financial cripple for the next 30 years and I believe will set off a downward spiral in City services that will hollow out Houston’s core much like we have seen in other cities.
     Houston’s business community failed our City by not being on top of this unfolding disaster over the last two decades.  Let’s not compound that omission by endorsing a plan that none of us would even vaguely consider for our own businesses.  It is frankly inconceivable to me that any serious business person or anyone who claims to be a fiscal conservative can even consider supporting this “plan”.
     It is time for our business community to make a principled stand and get our City back on the road to true fiscal responsibility.  That means some transition to defined contributions plans.  Anything short of that is not true reform and should be soundly rejected.

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.