Houston’s Pension Reform Package: Our Latest Analysis

Bill Fulton | @BillFultonVta | October 25, 2016

Image via flickr/Valerie Lawson.

Image via flickr/Valerie Lawson.

The numbers for Mayor Sylvester Turner’s pension reform plan generally add up, and the reforms generally move Houston in the right direction. In fact, this pension reform plan should be viewed by other cities as a national model, especially its risk-sharing aspect.

That’s the conclusion of a new analysis of the reform plan by the Kinder Institute for Urban Research and the Center for Retirement Research at Boston College. You can quibble with some things, and the whole plan is not without some risk. But generally speaking it is a strong move in the right direction.

All three Houston pension boards have now signed off on Mayor Sylvester Turner’s pension reform plan, and the City Council is scheduled to vote on it Wednesday. Assuming the council okays the deal, it will go to Austin for legislative action next year.

The deal is not significantly different than what Turner announced in September. But now we have more details about the overall numbers and the specifics about the pension reforms, the pension obligation bond, and the risk-sharing agreement or “corridor.”

In August, the Kinder Institute issued a report laying out options for reform. In September, after Turner’s initial press conference, the Kinder Institute issued a quick analysis. What follows is the result of our quick analysis of the new details issued over the last week.

The Deal and The Numbers

If you read our September blog post, you’ll remember that the deal went like this:

  • Assumed rates of return would drop from 8% or 8.5% to a more realistic 7% for all three pension systems.
  • Instead of using an open amortization period that resets every year, the city would use a closed 30-year amortization period.
  • These two changes, along with some other miscellaneous recalculations, meant the city’s unfunded liability is $7.8 billion.
  • The three pension boards would agree to then-unspecified reforms totaling around $2.6 billion, bringing the unfunded liability down to $5.2 billion.
  • The city would issue a $1 billion pension obligation bond, which would bring the total unfunded liability down to $4.2 billion, though the city would still have to pay off the bond.
  • The total annual cost — including the cost of paying off the bond — would be within the city’s current budgeted amount for pension payments.

It was a little hard to tell from the September information just whether and how the numbers added up. But as the table below shows, they actually do add up, assuming the 7% return on investment works out. Most specifically:

  • The city’s FY 17 budget assumes that the pension payment will be 33.2% of payroll, or about $416 million.
  • After accounting for changed assumptions and proposed reforms but before accounting for the pension bond, the FY 17 pension payment would be 30.3% of payroll, or about $420 million.
  • Accounting for the $1 billion pension bond – which will be applied to unfunded liability for both municipal employees and police – the FY 17 pension payment would be about $355 million, leaving $65 million to pay off the bond. This is sufficient to pay off a $1 billion bond at a 5% interest rate.

Reforms

The $2.6 billion in reforms comes entirely from increased employee contributions and changes to the COLA (Cost Of Living Adjustment) and DROP (Deferred Retirement Option Program).

Increased Employee Contributions

Police (10.25% of salary) and fire (10.5%) will now pay higher than the national average for public safety employees (9%). When measured against the “normal” cost – that is, the cost of benefits earned for each year of work – the police and fire contributions are right around the national average because Houston police officers and firefighters receive higher-than-average benefits.

Municipal employees will also pay higher contributions, including 8% for Group A (hired before 2008), 4% for Group B (hired before 2008), and 2% for Group D (hired after 2008). Group D employees currently pay no contributions but also receive much lower benefits.

The national average is currently 7.6% of salary for non-public safety employees and amounts to about half of the average normal cost. By comparison, Group D employees pay about half of the normal cost, Group B employees pay a bit more than half, and Group A employees pay almost all.

COLA Reforms

All three pension boards agreed to COLA reforms, but all the deals are different.

Most police retiree COLAs will be frozen for three years and then linked to social security COLAs but capped at 2.5%. This is a best practice, protecting retirees’ purchasing power while also protecting the city in the event of high inflation.

Firefighters will also take a three-year freeze and then receive COLAs linked to social security increases, but there is no cap. This could be a significant financial risk for the city if inflation ever increases dramatically.

Municipal employees will continue to receive a 1% COLA. If inflation in the future continues at around 2%, as it has for the past 20 years, retirees’ buying power will erode over time.

DROP Reforms

DROP is an option available to many city employees, especially those who have worked for the city for a long time. Employees leave the pension system while still working, meaning they begin receiving their pensions in addition to their salaries, and those pensions are then deposited into a DROP account on their behalf. When they leave the DROP system, the employees receive a lump sum and then begin collecting their pension directly. Only about 30% of large local government pension plans nationally have DROP programs.

The DROP program is intended to incentivize a small number of valued employees to keep working even after their pension benefits have been maximized, but in Houston it has been used by the vast majority of employees, partly because they are permitted to stay in the program for a long time.

The typical allowable period to remain in a DROP program is five years, but police officers and firefighters in particular stay longer. Police officers will be permitted to stay in DROP for between 10 and 20 years, while firefighters will be able to stay in DROP for between 7 and 10 years. New municipal employees are not eligible for DROP.

For all three programs, DROP participants are guaranteed a minimum rate of return ranging from between 2.5% and 4% per year.

Shared Risk (The Corridor)

One of the most important features of the Houston reform plan is the shared risk or “corridor” concept. Under this concept, if investment returns are higher or lower than expected, negotiations will automatically be reopened between the city and the pension boards. Specifically, negotiations will be opened if the investment returns require an annual city payment of 5% or more above or below the expected payment. The negotiations must yield changes that will bring the payment back to +/- 5% within three years.

The proposed agreements contain excellent framing language, explaining that the normal market fluctuations should be managed by the city, but the city and employees must share the burden of unusual economic events either good or bad. Other cities and states should consider using this framing language.

The main goal, of course, is to ensure that if the investment returns are low, the combined contributions from the city and the employees do not underfund the pension system, as has happened in the past. More benefit cuts or employee contributions may be required. But as an inducement to accept this idea, the shared risk concept also requires a renegotiation if investment returns are higher than expected, opening the possibility of restoring benefits or paying unfunded liability down faster than expected.

The city’s plan does not specify what benefit cuts or increased employee contributions might go into effect as a result of the poor returns, only that negotiations are reopened. This is probably fine so long as the investment returns do not drop the pension funds below the corridor on a regular basis. If the investment consistently falls below 7%, it’s likely that the city and the pension boards will be in constant negotiation.

Pension Obligation Bond

A pension obligation bond has many benefits. Among other things it provides the city with flexibility in cash-flow and in scheduling future payments. As Boston College’s Jean-Pierre Aubry noted at our recent panel discussion on pensions, bonding the pension debt puts the debt in the hands of people who are making a business decision to acquire it (bond buyers) rather than the hands of plan participants who would rather not have unfunded pension liabilities.

The risk, of course, is that the city is floating a bond without generating any additional revenue to pay the bond. As stated above, the city should save enough money from pension reforms to cover the payment on a $1 billion floated at 5% — assuming the pension boards consistently hit the 7% return on their own investment funds.

Defined Contribution Plans

Both Mayor Turner and the pension boards have consistently rejected the idea of switching to defined contribution plans (i.e., 401K-type plans), rather than guaranteed pensions, for new employees and such a system is not part of the mayor’s plan. Turner has been consistently criticized by his 2015 runoff opponent, Bill King, for not supporting the defined contribution concept.

The upside of a defined contribution system is that it assures that the unfunded liability problem won’t get worse many years down the road, because the city is not responsible for covering the cost of a guaranteed pension if investment returns are low. But a defined contribution system would not help reduce the current unfunded liability and some critics say it can harm recruiting.


pension_chart

HMEPS = Houston Municipal Employees Pension System

HPOPS = Houston Police Officers Pension System

HFRRF = Houston Firefighters Retirement and Relief Fund (correct?)

“Budgeted Rate” = percentage of payroll required to make city’s FY 17 budget payment to pension funds.

“Budget” = amount required to make required to make city’s FY 17 budget payment to pension funds. Derived by multiplying budgeted rate by total payroll.

“8%/8.5% Rate” = percentage of payroll required to make city’s full required FY 17 budget payment to pension funds, using each pension board’s current assumption for annual investment returns (8% for HMEPS and HPOPS, 8.5% for HFRRF).

“8%/8.5% Contribution” = amount required to make city’s full required FY 17 budget payment to pension funds, using each pension board’s current assumption for annual investment returns (8% for HMEPS and HPOPS, 8.5% for HFRRF). Derived by multiplying 8%/8.5% rate by total payroll.

“7% Rate” =  percentage of payroll required to make city’s full required FY 17 budget payment to pension funds, using reform plans” assumption for annual investment returns (7% for all three systems).

“7% Contribution” = amount required to make city’s full required FY 17 budget payment to pension funds, using reform plans” assumption for annual investment returns (7% for all three systems). Derived by multiplying 7% rate by total payroll.

“7% Rate w/Reforms” = percentage of payroll required to make city’s full required FY 17 budget payment to pension funds, using reform plans” assumption for annual investment returns (7% for all three systems) and subtracting the $2.5 billion in reforms contained in the reform plan.

“7% Contribution w/Reforms” = amount required to make city’s full required FY 17 budget payment to pension funds, using reform plans” assumption for annual investment returns (7% for all three systems) and subtracting the $2.5 billion in reforms contained in the reform plan. Derived by multiplying 7% rate w/reforms by total payroll.

“7% Rate w/Reforms and POB” = percentage of payroll required to make city’s full required FY 17 budget payment to pension funds, using reform plans” assumption for annual investment returns (7% for all three systems) and subtracting the $2.5 billion in reforms contained in the reform plan and a $1 billion Pension Obligation Bond.

“7% Contribution w/Reforms and POB” = amount required to make city’s full required FY 17 budget payment to pension funds, using reform plans” assumption for annual investment returns (7% for all three systems) and subtracting the $2.5 billion in reforms contained in the reform plan and a $1 billion Pension Obligation Bond.

“Total Payroll” = Total amount of city payroll expenses in FY 17 budget.

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Kinder Institute

6 Comments

  1. While I’m sure the usual anti-pension cranks will jump all over this deal soon enough, consider a few things about it. First, no new municipal employee has been eligible for a DROP benefit in 8 years, joining their police colleagues that gave up the benefit for new hires in 2004. The changes to the benefit drastically impact the remaining employees to the point where many will simply leave before these reforms are implemented, saving the city additional millions as previous cuts did under former mayor White.

    Them with regard to net rates of return by pension system investments, each system has averaged about 8% or more looking at the last ten years, that time frame including the largest market crash in history, so there is plenty of additional cushion added to the corridor plan compared to any other municipal plans like these across the country. I’d suggest the city establish some basic parameters regarding the first few rounds of cuts or increases to be handled by increased employee contributions but even applying a significant Beta coefficient to previous returns shows the deal appears sound. Those complaining about the total amount of unfunded liability are now displaying mock surprise over the escalation due to lowering the rate, a curious notion given they have gone on record previously addressing the need to lower the rate and how it would increase the debt.

    Before the loose cannons start in, the pension bonds discussed are more likely to cost closer to 3-3.5%, about half of the new expected rate of return, and they only partially cover what the city already owes employees for provided services, the municipal plan truly owed more than twice the $250 million they are getting and the police owed more as well, even before any interest would be factored in (the bulk of the existing unfunded liability is tied to the city under paying what was needed for many years). previous mayoral candidates like Bill King wanted to issue a great deal more than $1 billion in POB debt, with no provision for voter approval, when he ran for office last year but now has an issue with the diminished amount used as a part of the solution.

    As Councilman Martin points out, from a business standpoint, issuing POB for $1 billion in exchange for $2.5+ billion in employee concessions, and at a much lower rate at that, is simply good business, several state legislators holding a hearing in Houston during May practically demanding the city use such debt as part of the solution “or else”, the record of their comments is available for all to read. That the city will also save a significant amount by addressing the problem in a sensible manner according to the bond rating agencies, is just the icing on the cake, the Mayor’s stance to make the project revenue neutral a selling point to employees who are being asked to pay more, get less, and give up much of what was already legally owed by the city.

    If the current proposal passes as written, I predict the city will lose about 500 municipal workers in the first year and 800+ public safety workers, some who are already applying to other agencies before the rush. Any attempts by Paul Bettencourt or other fringe legislators trying to cater to his core constituency will likely fail, some minor tweaks likely but overall the plan passing through as demanded by the members of the state committee on pensions earlier this year. Folks who have run for office almost exclusively using pension problems as their one trick pony will fade away unless they can find another big ticket crisis to exploit, King is ready to switch gears to the storm surge proposals he favors, but as the folks from the Kinder Institute point out, for whatever flaws it has, the plan is largely sound.

  2. What a joke……….. that being the pensions and benefits promised Public Sector workers even AFTER all of these changes.

    What makes PUBLIC Sector workers so “special” that they deserve greater pensions and better benefits than the Private Sector taxpayers who pay for 80% to 90% of total Pension Plan costs? And who in the Private Sector gets any employer-sponsored retiree healthcare benefits any longer?

    No ….. Public Sector workers (in jobs with comparable risks and which require comparable education, experience, knowledge, and skills) are entitled to EQUAL total compensation (wages + pensions + benefits), but no more.

    And unless they earn demonstrably less in wages (for no less hrs/wk) there is ZERO 9yes (ZERO) justification for ANY greater pensions of better benefits.

    Private Sector Taxpayers have been financially “mugged” by the insatiable greed of the Public Sector Unions/workers for FAR too long.

    • I’m a public employee pensioner and will address your questions:

      1. We aren’t “special”. Our pension/benefits are comparable to those in financially sound private companies that kept their pension agreements [unfortunately, many companies underfunded their pensions and then, in bankruptcy, raided the remaining pension funds, leaving their pensioners penniless. Perhaps you would like City of Houston(COH) to go into bankruptcy, devastating your property values and your way of life?].

      2. Public sector workers (in jobs with comparable risks and which require comparable education, experience, knowledge, and skills) receive _less_, not more, compensation than those in the private sector. This was explicitly stated to me and all other HMEPS workers as part of our COH orientation. We were told that, while we were paid less, in compensation the City of Houston, its pension fund and its benefits would steadfastly remain in good financial condition, unlike many private firms. The promise was that, while the City paid a lower salary for our work, the benefits would always be there.

      3. Taxpayers elected COH politicians who made promises out of both sides of their mouths for decades. You reap what you sow. Screwing pensioners out of their livelihood when they are weakest and approaching end-of-life is the lowest of the low.

      For decades Houston’s taxpayers have foolishly not paid attention to city politics. They have allowed politicians to underfund pension funds and use tax money unwisely. If the chickens are coming home to roost, the COH taxpayers has no one to blame but themselves.

      As for the pensioner, the State of Texas has for decades seen how cities try to screw pensioners. So they put into effect laws that require cities to fund pensions properly. But Houston hasn’t been obeying the law. Yes, they’re underfunding the pensions so they can keep taxes lower! That’s why these pension changes must be voted on by the State. It is likely that the state will reject them, as they should.

      When the COH makes a contract, it should keep it. When COH agree to build and fund a pension, that pension is not a piggy bank or overspending fund for COH. Do not screw thousands of workers who gave up better pay for decades in order to get a decent pension at their end of life. If I had know how diligently politicians would try to mine the pension “goldmine”, I would have never worked for COH. I could have made plenty of money elsewhere. I thought COH would keep their word, but city leaders never quit trying to screw pensioners. It’s like the American Indian vs US government – the Indians never got a fair deal.

      And what’s he problem with paying taxes anyway? To live in a city you pay city rates. Paying taxes on a well-managed city budget is one of the best ways to maintain and ensure that your property values increase. But for God’s sake, pay attention to COH politics and hold leaders accountable!

      If you don’t want to pay taxes, then become a “Mountain Man” and move to Montana. Live on a mountaintop w/o roads, sewer, water, hospitals, stores, and cellphones. Or maybe you want Houston to go the way of Detroit? You can

      – kill your property values,
      – call 911 and get nothing, not even a dial tone,
      – Burn your own trash,
      – Run your own septic system,
      – Run your own electric generator,
      – Buy a satellite cellphone (no other option – no other service available),
      – Drive to Dallas once a month to stock up on flour, sugar, beans and batteries.

  3. The vast bulk of pension costs are paid for by investment returns and employee contributions. Plus, existing studies that control for all factors show public sector employees are paid LESS for comparable positions when education requirements and experience are factored in.

  4. [This is the third time I’ve posted this. ]

    This article fails to mention the draconian cuts in spousal survivor benefits proposed in the Houston Pension reform package. These severly cut pension benefits for retirees’ widows and widowers.

    The most recent issue of the HMEPS Pension Press newsletter ( http://www.hmeps.org/assets/hmeps_newsletter_dec_2016.pdf ) states those proposed changes, which I quote below:

    “For active participants and retirees who die on or after July 1, 2017, the spousal survivor benefit percentage will change from 100% to 80%…”

    and

    “For defereed participants (not yet receiving a pension benefit) who die on or after July 1, 2017, the spousal survivor benefit percentage will change from the current 100% to 50%, payable at the participant’s eligibility date…”

    from
    http://www.hmeps.org/assets/hmeps_newsletter_dec_2016.pdf

  5. Houston Firefighters Relief and Retirement Fund have NOT agreed to the proposed pension reform deal that The Mayor has proposed. The mechanism called the “Corridor Plan” has not been explained fully of how it works. It is untested, unproven, and experimental in nature. There is no other Pension plan that has used it. Therefore, there is no history of results to have comparisons to. A risky deal that The Pension Board for the firefighters will not sign off on if it is not communicated exactly how it works and they have not seen the full document yet and the Mayor is not negotiating in good faith.

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