Bill Fulton | @BillFultonVta | September 15, 2016
Sept. 21, 2016: This blog post has been revised to correct errors and include clarifications from Mayor Sylvester Turner’s office.
Houston Mayor Sylvester Turner says his newly announced pension reform package could solve the city’s pension liability challenge permanently.
Though he says he has the support of the police and municipal pension boards, the firefighters pension board is still holding out and did not attend the rollout of the plan at City Hall this week.
Turner is hoping to get formal approval of the deal from each of those three pension system boards, as well as city council, before he takes the package to the state legislature in Austin next year.
If he succeeds and gets buy-in from each of those entities, will the plan work?
Turner says his pension reform deal will simultaneously:
- Pay off billions of dollars of unfunded liability over a 30-year period without increasing the cost the city would otherwise bear.
- Use a lower, more realistic assumption about investment returns.
- Trim employee benefits only on the margins, as with COLA and DROP.
- Retain the defined benefit approach to city pensions.
- Avoid the need for higher taxes.
But will Turner’s deal really accomplish all of these goals at the same time?
The answer is that all these pieces more or less add up on paper, but they come with caveats. For it to all work:
- The system will have to be constructed in a bulletproof way, so the city doesn’t fall behind again.
- The stock market will have to grow consistently over time; and
- The city will have to make a very consistent financial commitment over a long period of time, which it hasn’t always done in the past.
Let’s unpack the deal piece by piece, using not only Turner’s deal points but also information contained in the Kinder Institute’s pension report released last month, with numbers prepared by the Boston College Center for Retirement Research.
Investment Return Assumptions: Down to 7 Percent
An important part of a well-funded pension system is hitting the target for investment returns. That didn’t happen when Houston’s pension systems assumed high investment returns during the Great Recession.
All three pension funds currently assume investment returns higher than the national average and higher than recent experience, as the Kinder Institute report noted. The firefighters plan assumed an 8.5 percent return, even though the fund’s return over the past 15 years has been 7.5 percent. The police and municipal employees plans assume 8 percent, even though their returns over the past 15 years have been between 6 percent and 6.5 percent.
Turner’s proposal calls for a 7 percent investment return target for all three funds, which is much more realistic but also has the effect of increasing the unfunded liability.
Total Unfunded Liability: $7.7 Billion
The city’s annual financial report estimated the unfunded liability at $5.6 billion in December 2015. (The Kinder Institute’s report used a figure of $3.9 billion, based on different accounting methods, primarily to allow us to track the growth of unfunded liability over time.)
Turner now estimates the unfunded liability at $7.7 billion, as of June 2016, with the lower investment return assumption accounting for the vast majority of that increase. This includes about $3 billion for municipal employees, $3.3 billion for police, and around $1.5 billion for firefighters. The unfunded liability for police increases the most under this calculation.
Concessions: $2.6 Billion
Remaining Unfunded Liability: $5.1 billion
Turner says the three pension funds have agreed to a total of $2.6 billion in concessions — $1.1 billion for police, $800 million for fire, and $700 million for municipal employees. This would bring the unfunded liability down to $5.1 billion.
The mayor did not announce specifics, saying that he is giving the pension funds flexibility over their own cuts. But most of the concessions will apparently come from reforms to the Cost Of Living Adjustment (COLA) and Deferred Retirement Option Program (DROP), which do in fact appear to hold the potential for savings of this scale.
Pension Obligation Bond: $1 Billion
Remaining Unfunded Liability: $4.1. Billion
Turner says the city will float $1 billion in Pension Obligation Bonds at an interest rate that he hopes will be around 3.4 percent. This could be one of the weak links in the deal.
Turner appears to be deducting this $1 billion from the remaining unfunded liability. That would bring unfunded liability down to around $4.1 billion, or about the same as the Kinder Institute calculated last month.
However, the city will still be responsible for paying the bonds off. A 30-year, $1 billion bond at 3.4 percent would require an annual payment of just over $50 million per year. The mayor has not specified publicly how he plans to pay off the bonds, though he has promised that the entire package will be revenue-neutral. In his press conference he mentioned the possibility of arbitrage profits – getting a return on investing the proceeds that is higher than the interest rate the city must pay — but he did not say he would use arbitrage profits to pay off the bonds.
The Kinder Institute’s analysis of the city’s previous pension bond issues found that the arbitrage was more or less a wash – the city has taken a minor loss on those bonds so far. Of course, those investment returns include the stock market decline during the Great Recession.
Amortization Period: 30 Years
The mayor proposed switching from an open amortization period to a 30-year closed amortization period.
The city currently uses an open amortization period, meaning that every year the remaining unfunded liability is re-set for 30 more years. This process backloads the unfunded liability and effectively ensures that it will never be paid off. A closed amortization scheduled ensures that the liability gets paid off in a specified period of time, just like a mortgage. The Kinder Institute report noted that most other cities that have undertaken pension reform, including Phoenix and San Diego, have switched to a closed amortization period.
Annual Payment and Unfunded Liability Payoff
Turner said he wants to maintain the current required pension payment from the city, which is about 32 percent of the city’s total payroll. For this year, that’s a little over $400 million. Of course, the dollar figure will go up over time as the city’s total payroll goes up.
A rough calculation for the Kinder Institute by the Center for Retirement Research suggests that the city can successfully pay off $4.1 billion in unfunded liability over 30 years by applying approximately 32 percent of total payroll, although the actual dollar figure will rise from around $400 million per year today to almost $1 billion annually 30 years from now. The actual percentage of total payroll for each of the three pension funds would be different, however.
In other words, Turner’s numbers appear to add up if:
- The city makes the required payment each year for 30 years;
- Investment returns of 7 percent are met every year for 30 years; and
- Pension bond payments are somehow coveredin a cost-neutral way.
Possible Shortfalls and the “Corridor”
If investment returns fall short of 7 percent, and/or the city fails to make the required pension payments, the city could wind up with an increasing unfunded liability once again. That’s one reason why Turner is proposing use of the “corridor” concept, which has been used with varying degrees of success in other cities and states.
Turner has not publicly announced many details of his “corridor” plan, but Finance Director Kelly Dow told me that it will be based on whether the required annual payment stays within a “corridor” above or below the expected percentage of payroll.
This is a little different than the typical corridor system, which is based on the funded ratio, not the annual payment. Under the “corridor” concept, a pension fund must remain in a small, well-funded “corridor” – usually between 90 percent and 110 percent of overall liability – or else remedial action must be taken.
If funding drops below a particular percentage of liabilities, more money must come from employee concessions, employee contributions or city payments; if funding goes above a ceiling, then money is available to pay down the liability faster or provide employees with additional benefits. In the Houston case, apparently, if investment returns were low and the city’s payment would required to exceed a certain level, that would trigger negotiations on changes to bring the city back within the corridor.
However, the system must be well-constructed or, critics say, it can simply serve as a vehicle for further underfunding.
For example, the state of Maryland switched to a corridor system in the early 2000s. But the law did not require the state to solve the problem immediately if funding fell below 90 percent. Rather, the state was required only to increase contributions by 20 percent over the previous year, even if that didn’t solve the problem immediately. The state underfunded the system from the beginning and eventually fell further beyond.
So, in order for the corridor idea to work, the city would have to be required to get back up to an appropriate level immediately so that it is not possible to fall further behind.
So far, the firefighters do not support the corridor concept, and it’s easy to understand why: Under current state law, they do not have any obligation to negotiate with the city under any circumstances, whereas the corridor idea might require them to come to the negotiating table if funding falls below a certain level.
Defined Contribution: Off the Table For Now
Turner specifically declined to use two other options identified by the Kinder Institute report, two of which would place additional burden on city employees. These are:
- A defined contribution system for new employees. Many cities have opted for 401k-style accounts, rather than guaranteed pensions, for new workers. Turner has always opposed such a change and reiterated his opposition yesterday.
- Tax or revenue increases. Although Turner did not propose any tax or revenue increases to fund this proposal, he did say he still plans to ask Houston’s voters to remove the city revenue cap in the November 2017 election. He suggested that the additional revenue could fund firefighter raises – so he may want to use the revenue cap election as a bargaining chip to get the firefighters to sign off on this deal.
Turner has not publicly addressed the question of whether he would entertain an increase in employee contributions, another option identified by the Kinder Institute report that is often used in pension reform. Police and firefighters contribute similar levels of their salary to their pensions as emergency workers nationwide. But Houston’s municipal employees contribute far less than their peers. Increased employee contributions may be one of the ways the pension boards hit their $2.6 billion target, or Turner may be holding this option in his back pocket in case the city falls out of the corridor at some point. In any event, he has not spoken about this option publicly.
How Turner’s Deal Will Play in Austin
One of the biggest challenges to any pension reform deal in Houston is the need for approval by the state legislature. Currently, state law allows the city to engage in “meet-and-confer” negotiations with police and municipal employees. But under state law, the firefighters pension board has no such obligation, which city officials believe impedes the city’s ability to manage the pension situation.
The question of who controls the firefighters pension system – Austin or Houston – has been controversial and divisive. Turner’s predecessor, Annise Parker, fought unsuccessfully to return control of the firefighter system to the city, and just last Friday the state Court of Appeals rejected the city’s argument that the current law is unconstitutional.
It would appear as though Turner – a crafty former legislator – is attempting to use the corridor idea as a way to break through this political gridlock in Austin. In fact, it seems likely that he is planning to give up some control over the police and municipal pensions as part of the deal.
Presumably, the legislation he is preparing will mandate that the city make the required annual payment every year for all three pension systems – something that has not always happened in the past. In exchange, the pension boards would have to agree to negotiate givebacks , but only if the pension boards’ funding drops below a certain level.
That’s a good deal for police and municipal employees, who would be guaranteed a certain city payment under state law, which they currently don’t have, and require them to negotiate only under certain circumstances. But it’s a bigger lift for the firefighters, who already get a guaranteed payment under state law and never have to negotiate with the city.