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.
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.
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?”
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.
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.