A few days ago, I received an unmarked envelope. Inside the envelope was a copy of the draft bill that the Turner administration is proposing to amend the police pension plan.
Because of the secrecy in which this process is shrouded, I am not certain that I have the most recent version. The mere fact this process is being carried on in this cloak-and-dagger fashion is shameful and, of course, very telling about the proponents’ confidence in this plan. Of course, we still do not have any of the financial data that backs up Turner’s claims about the plan.
You can review the police pension statute as it would be amended by this bill by clicking Article 6243g-4 – Police (w proposed changes). The comments in the margin are mine. Also, you can read my detailed analysis of the bill by clicking WEK Bill Summary.
But here are the highlights:
Not a Permanent Solution – At the outset, everyone should understand that Turner’s proposal is not a permanent solution to the City’s pension woes. It does, however (1) represents about a 14% cut in the City’s costs of the pension plans and (2) establishes a hideously complex mechanism that, if enforced in good faith, would limit the percentage of payroll the City must contribute to the pension. These improvements are not trivial, but neither are they an ultimate solution to our pension woes. As I have said many times, there is no pathway to real pension reform that does not entail phasing out our defined benefit plans.
However, if defined contribution plans for new employees were added to this plan and the “corridor” mechanism were tightened to be both effective and enforceable, especially restricting the issue of pension bonds, we would be much closer to a real solution.
Pension Debt Not Paid in 30 Years – Notwithstanding the Turner administration’s repeated promises that the plan would retire all of the City’s pension debt in 30 years, that is clearly not true. Any year in which the pension plans do not make the 7% investment goal – as they have not in three of the last five years – the losses for that year are added as an additional layer of debt that is amortized over thirty years from that loss. For example, if the plans miss their investment goal in 2037, 20 years from now, that ensuing debt would not be paid off until 2067!
No Vote or Restriction on Issuing Pension Bonds – Part of the Turner plan is to issue $1 billion of new pension bonds without voter approval. But worse, this bill imposes no restrictions on future pension bonds nor does it require voter approval. The bill has provisions that may require additional bonds to be taken into account when calculating the City contribution, but it also appears to allow the City to borrow its annual contribution each year.
Future COLAs (Cost of Living Adjustment) Tied to Investment Returns – This may be the most surprising, and potentially most impactful provision of the plan, both to taxpayers and retirees. In the term sheets, future COLAs were frozen for some retirees for three years and then tied to Social Security’s COLA adjustment. But in this bill the COLA is set to 5% below the pension plans’ investment return. Over the last ten years the plans have averaged about 5.5%. If that trend continues, this provision would virtually wipe out COLA adjustments for all retirees. While the current COLA provisions are unrealistic and need to reworked, this provision would dramatically impact older retirees, especially those who retired prior to the big run-up in pension benefits at the end of the Lee Brown administration.
Pension Debt will go Up, not Down – As we suspected from the term sheets, the bill adopts a repayment schedule that negatively amortizes the pension debt. If the City’s contribution hits the maximum allowed by the bill, which just about every expert predicts it will, the pension debt will go up an additional $1 billion. In addition, because of other factors (e.g. lag times, asset-smoothing, etc.), it is a virtual certainty that the pension debt will rise for the next decade or so, at least. We could easily wake up 10 years from now with several billion dollars more in pension debt than we have today.
No Consequences if “Corridor” is not Enforced – This may be the most serious concern I have about this bill. There is no consequence to the City if it elects not to enforce the corridor mechanism. The bill requires the pension plans to reduce benefits if the corridor maximum is reached. But the bill does not specify what happens if they refuse. The only remedy would be for the City to sue. First, do we really have confidence that an administration and City Council that accepts hundreds of thousands of dollars in campaign contributions from employee groups would really initiate such litigation? And even if they did, the complexity of the plan and the glacial pace at which our courts move would keep enforcement action in limbo for years. I think we have been in litigation over the drainage fee for seven years now and it still is not over.
Huge Loopholes in Bill – As you will see if you review my bill analysis, there are huge loopholes in the bill’s corridor mechanism. Whether these are intentional or just oversights, I cannot say. But if we are to go forward with the corridor mechanism, these problems in the draft bill must be addressed.
Conclusion – There are very significant issues with the changes to the City’s pension system that are proposed in this draft bill. But, if it were amended to address some of these issues, it would represent a real improvement in the current situation. The two most important changes to the plan are the addition of defined contribution plans for new employees and giving voters the right to approve pension bonds, and these points should be non-negotiable. Anyone not prepared to support these common-sense ideas is not serious about pension reform and certainly not a fiscal conservative.
The City and your pension plans’ management are leading you down a path that will seriously impact your pensions for years to come.
Defined benefit pension plans are a broken financial model. They were originally put in place in a time that most people only lived a few years after retirement and financial markets were much more stable. Neither of those conditions exist today. As a result, the costs of defined benefit plans have inexorably risen over the last several decades causing the private sector to almost completely abandon them.
Every new employee added to this broken model makes your pension plan weaker and your pension less secure.
This is not an opinion. It is just math.
The latest data from the City (which is still unrealistically optimistic) shows that the City would have to contribute over $8 billion just to pay the benefits that you have earned so far.
The proposed plan represents an average 12% cut in the benefits you thought you were going to get. Of course, this comes after City leaders repeatedly promised you they would honor all pension commitments. And trust me, these cuts will not be the last you see. In fact, this is just the beginning.
Automatic Future Benefit Cuts or Increased Contributions
The term sheets agreed to by your pension boards include automatic additional cuts if the City’s costs exceed the “corridor”. The term sheets specifically say that once the corridor is exceeded that the pensions will further cut the cost-of-living adjustments (COLA), extend retirement ages, and/or increase contributions.
Of course, no one can predict the future, but it is highly likely that the corridor limits will be exceeded sooner rather than later, as was suggested by Tuesday’s Houston Chronicle story. Many investment professionals question whether the new 7% return assumption is reasonable. Warren Buffet has said that pension plans should not be using anything above 6%. His company’s plan is based on 4.5%. Over the last two years your plans have averaged returns of less than 3%. Both the police and fire plans lost money last year.
You have been told that this plan provides certainty about your future benefits, when the exact opposite is true. And the plan is so complex it will undoubtedly result in years of litigation over how it is to be interpreted, if it ever passes.
Forget about Future Raises or Increasing Staff
The proposed plan sets the target contribution for the City at 32% of payroll. The upper limit is about 37%. How can the City possibly afford to hire new employees and pay them a decent salary when it must put up an additional 37% in a pension plan? And what do you think are the chances of existing employees getting any kind of respectable pay raises with a 37% add-on for pensions?
Practically speaking, you can also forget about there ever being two officers in a patrol car, the City ever building any new fire stations, or hiring enough building inspectors, or addressing any of the other hundreds of critical needs Houston is facing.
The Causes and The Cure
There are two reasons that the City is in this mess. The first is that the increases to pension benefits during the Lee Brown administration turned out to cost vastly more than was understood at the time. This is what is frequently referred to as the “legacy costs” and we must come up with a plan to deal with those costs.
But an equally important driver of the out-of-control costs is the City’s blind commitment to indefinitely continue defined benefit pension plans. The notion that we can hire people today and promise them a benefit based on their salary thirty years from now and have any idea what that is going to cost is absurd. If the City continues to cling to defined benefit pension plans, the City’s – and your pension plans’ – finances will continue to deteriorate.
The Right to Opt Out
In addition to other needed reforms, you should have the right to opt out of the existing pension plans and to put your money in your own retirement savings account. That may not be for everyone, but if you want out of the interminable controversy that has been and will be the history of these plans, you should have the right to do so and to take control of your future.
Property Tax Cap Will Not be Repealed
Many of your leaders are assuring you that some of the financial pressure on the City will be relieved if voters repeal the property tax cap that was passed in 2004. It is a fantasy. It is not going to happen. This issue has been polled extensively and over 70% of Houston voters oppose repealing the cap on property taxes. And with tax bills already skyrocketing, can you blame them?
I am not predicting an imminent crisis or financial collapse of either the City or your pension plans. But if we do not reform the City’s finances and begin providing reliable services at reasonable tax rates, the City will suffer a long, slow decline, or hollowing out, like other great American cities that failed to tame this problem. And there will be a tipping point at which this becomes a crisis, just as it has in Dallas. That should concern you because your benefits are paid over the long term as well. If the City suffers financially, so will your pension plans.
We don’t know what all will be required to put the pension system on a sound footing and probably will not know for some years. But the most obvious change that should be made immediately is to convert new employees to defined contribution plans. This will not, by itself, solve the pension problems. But as the old saying goes, when you are in a hole stop digging.
Every city employee and retiree should not only be supporting defined contribution plans for new employees; they should be demanding it.
Many of you have been upset with me for the last several years because I kept raising the alarm about the condition of your plans. But I think if you look back at what I said and predicted about the City’s pensions, everything I told you or predicted was true or has come true. In contrast, all the assurances you repeatedly got from your pensions’ management and the City, that there were not any problems, has proved completely wrong.
And please do not ever lose track of the fact that there is a whole cottage industry of pension executives, Wall Street bankers, lobbyists, accountants, actuaries and others that make a very nice living off your pension. For example, why don’t you inquire about what the executive director of your pension plan is paid and compare that to your salary?
Last year, your plans paid $50 million in expenses. That is $50 million that could have gone to shore up your pension funds, but instead went into the pockets of bankers, pension bureaucrats and lobbyists, to name a few. They are petrified that their gravy train might end someday, which switching new employees to defined contribution plans would eventually do that. So, they will continue to spread misinformation about your plans, just like they have been doing for the last 20 years.
I, on the other hand, have zero financial interest in this issue one way or the other. My only interest is seeing that the City I love so dearly does not go the way of Detroit.
So, before you blindly follow your leadership and the City into yet another plan that is going to kick this can down the road until the current elected officials are out of office and your current leadership is retired, perhaps you should consider what is best for you. And believe me, that is not the continuation of defined benefit plans for new employees.
Any hopes that Houston’s sales tax decline was about to ease were dashed yesterday when the Texas Comptroller reported that the City’s sales tax receipts for December were down by 7.5% from last December. In the last ten years, Houston has only seen a 7% or greater decline in monthly sales tax nine times. Three of those have been in 2016.
The report is based on October sales and completes the first six months of the City’s fiscal year. Year-to-date collections are now off by 4.4%, which is the worst start for sales tax collections since 2013. Year-over-year collections have now declined for 16 consecutive months.
The last time the City saw a year-over-year increase was August, 2015. The trend line on collections has been in decline since October, 2012. This the longest period of depressed sales tax collection for as far back as I can find records.
It is time for the City to stop whistling past the graveyard and realize that it is in both cyclical and structural deficit and take action accordingly. It is certainly no time to be committing 50% of our property taxes for the next 30 years to pension contributions.
- There will be no transition, in the long or short term, to defined contribution plans. A transition to defined contribution plans for new employees is favored by 70% of Houstonians. Turner took it off the table because the employees would not agree to it. Exactly why our employees, most of whom do not live in the City, should have a say in what kind of retirement plan we, as taxpayers, offer to our new employees is beyond me.
- The plan will commit the City to spend $20-26 billion on pensions over the next 30 years.
- The City’s assumptions are based on the plans’ assets earning a return of 7% for the next 30 years, down from the old assumption of 8.5%. But in 2015, the plans earned less than 3%. They have not released their returns of this year. Rumor has it that they were less than 2015. The firefighters’ plan’s numbers were so bad this year it did not release the draft of the actuary report that was prepared.
- The employee groups’ leadership have tentatively agreed to about $2.5 billion of benefit cuts. This is about a 12% reduction. Various actuary groups are grinding away on whether the cuts actually add up to $2.5 billion, but my guess is that will be pretty close. It is less clear whether the rank and file in the employee groups are on board with their leadership’s agreement with Turner on these cuts.
- In exchange for these benefit cuts, the City will issue $1 billion of pension bonds and give that money directly to the pensions. This will be the largest general obligation bond issuance in the City’s history and there will be no voter approval of these bonds.
- The target contribution for the City is approximately 32-33% of payroll. That is, of course, a staggering number compared to private industry. But the plan will allow that level to rise to 37-38%, which is supposed to be the maximum the City will ever have to contribute. But the details of how that limitation would work have not been disclosed or apparently even worked out with the employee groups.
- The repayment of the pension debt is back-end loaded so that the real fiscal pain is conveniently delayed for about eight years. I am sure that is just a coincidence.
Fair warning: This post is going to get way off in the weeds of the complex math that defined benefit pension plans entail. So if you are a mathphobe you may want to skip to the next item in your inbox. Unfortunately, because defined benefit pension plans are such complicated financial arrangements, there is no way to fully understand their impact without getting into the weeds, so here goes.
The amount an employer needs to set aside to fully fund a defined benefit pension each year consists of two parts. The first is the estimated cost of the benefits earned by employees that year. This is referred to as the “normal cost” or “service cost.”
Of course that estimate is an educated guess at best. It is fundamentally unknowable how much money needs to be set aside today for an indeterminate benefit to be paid 30 years from now. We know from experience, however, that employers almost always underestimate this cost, which results in the plans becoming underfunded over time. This is equivalent to the employer borrowing money from the pension plan. It is debt, plain and simple.
That brings us to the second part of what the employer should be contributing to its pension plan. In addition to the current cost, the employer should be contributing something toward paying off its debt to the plan. But how much should that be?
To be considered “actuarially sound” the employer should be contributing enough to pay off the unfunded liability in 30 years or less. Most people would assume that if an employer were going to pay off the debt in 30 years, the employer would run an amortization schedule to see how much it would need to contribute to the plan each year to pay off the debt, exactly the same way your bank calculates your mortgage payment.
But that is not how amortizations are done in the bizarre world of pension accounting. Rather, pension plans normally calculate the amortization schedule to pay off the debt using something called the “level percentage of payroll method.” It is a complete scam.
This amortization method estimates the total payroll for the employer over the next 30 years and calculates what percentage of that total payroll the employer will have to contribute to pay off the pension debt. When you work through the math, this amortization schedule results in a negative amortization for about the first ten years (i.e. the debt increases for the first ten years) because the payments are dramatically back-end loaded.
I have learned that this is the amortization method the City intends to use in its proposed pension plan. So let’s see what that looks like.
For the purposes of this example, I am assuming that the concessions the pension plans have agreed to really reduce the pension debt by $2.5 billion, something that has yet to be demonstrated. I am also ignoring the debt service on the $1.6 billion of pension bonds that taxpayers will be saddled with if this plan goes through.
Making those assumptions, the City’s remaining pension debt would be $4.1 billion. Assuming the City’s payroll increases by 3% each year and assuming the pension plans earn 7% during the entire 30-year amortization period, the City will need to make an annual contribution of about 19% of payroll. This is what the amortization schedule would be.
As you can see, the overall pension debt remains above 2017 levels until 2031. More significantly, the payments begin low and then dramatically ramp up over the 30-year period, more than doubling. So if you are only going to be mayor, say until 2020 or even 2024, you don’t have worry too much about how to pay off the pension debt.
Here is what the numbers look like graphically:
Now let me add this caveat. This is a very simplified model of how this amortization method works. Very small changes in the assumptions make enormous differences in the outcome. For example, if the City’s payroll goes up by 5% annually, the payments are even more back-end loaded and the debt balloons to over $5 billion before it starts down. Also, other factors, like the inflation rate, can dramatically affect the future contributions and scheduled pay-down of the pension debt.
Of course, even the presumption that we can project what the City’s payroll will be over the next 30 years is absurd on its face in the first place.
But make no mistake. The only reason to use this squirrelly method to amortize the pension debt is to kick this can down the road to the next City administration.
Many of you have asked me to put my periodic emails in a blog format. So here it is. Over the next several weeks I will be loading my past emails on this site and future emails will appear here at the same time they are sent to my contact list.