Are City Employee Pensions at Risk?
Pension systems in Dallas and Houston have been beat up by bad spending.
Public pension systems – funds that pay out retirement income to city employees, based on years of service and contributions made during employment – often face similar hurdles as people planning private retirement: Saving for tomorrow competes with spending that same money today. A city strained for resources may look to skimp on contributing to its employees' retirement funds, or even borrow from those funds to cover other priorities, just as an individual might pull money from an IRA before retirement, with plans to return that money later on. Retirement boards and their staff, entrusted with managing the funds and certain benefits, may fail to properly recognize problems or make critical decisions. When either occurs, city employees, retirees, and city taxpayers suffer losses.
Recently, that unfortunate cause and effect has played out in spectacular fashion up in Dallas, where city officials and those responsible for the city's fire and police retirement fund have done everything but fistfight over escalating pension problems. The Dallas Morning News has called the fallout "misery" – a system "on the verge of collapse within the next decade thanks to poor investments and unsustainable benefits." In 2015, City Council got an earful from police and fire retirement fund Executive Director Kelly Gottschalk, whose analysis showed that while contributions to the fund had gone up, those contributions had not kept pace with benefit increases. More important, however, were the extreme costs associated with a "side benefit," the Deferred Retirement Option Plan (DROP), which allowed members who could otherwise retire to keep working and save retirement checks in a high-interest savings account.
DROP, Gottschalk reported, had cost the system nearly $500 million, primarily due to excessive interest rates. Coupled with rotten investments that had ravaged the fund's portfolio, the program forced Gottschalk to lobby for a substantial reform of employee benefits. Otherwise, the nearly $10 billion fund would be insolvent within 15 years. Members rejected the proposal, amidst lawsuits from several retirees and one from the mayor, Mike Rawlings, who'd hoped to stop DROP's pricey bleeding.
Today, city leaders in Dallas appear stymied by the deep divisions over how to preserve the fund in a way that's fair yet keeps public safety staffing stable, even as the city faces lawsuits over benefits which would be most costly to lose. Three former mayors have expressed concern about the pension crisis causing a "$4 billion hit to the Dallas taxpayer." Together, they've formed a group called Taxpayers for a Fair Pension, which seeks a new system to give "equal governing authority" to taxpayers and system beneficiaries. In January, Dallas' City Council passed a resolution to encourage the system's board to take all lawful measures, including seeking judicial remedies, to "address this emergency situation," followed by calls in February to place the fund in receivership.
Dallas isn't the only Texas city facing serious pension issues. In Houston, the situation hasn't been as outright adversarial, but its far larger system reached a critical threshold in 2016 after years of chronic and publicly acknowledged underfunding. (Houston has nearly 44,000 workers and retirees in its three main retirement systems. Dallas can claim just under 10,000 in its police and fire system.) An analysis from Rice University's Kinder Institute indicated that pension debt for these three funds jumped from nonexistent in 2000 to nearly $4 billion in 2014. In 2015, a city audit threw the issue into focus just as Mayor Sylvester Turner was taking office.
Turner has been somewhat successful sidestepping any serious eruption by embracing the debt crisis and working with affected parties to forge a plan that shares the pain between city employees and citizens. Last October, he introduced a plan to reduce employee benefits, pay down debt in the short-term through a bond, and hold the city more accountable for future contributions, moves that will stabilize the retirement fund moving forward.
Such a plan requires legislative approval, but in October it received support from pension representatives and Houston City Council. Critics are concerned, though, that it trades one form of debt for another (the city is still paying off old pension obligation bonds), and firefighters have held back from fully supporting the plan.
Almost Impending Disaster
Both Dallas and Houston illustrate how management of traditionally structured public pensions can prove as political as it is financial, and sometimes pit state lawmakers, city council members, and city managers against employee groups and taxpayers in a struggle over how city dollars should be spent. To many, pensions represent a contract that's becoming increasingly rare in the modern workplace: a reward for loyalty and low wages for essential civic service most people don't want to do themselves: police, fire, and emergency medicine; trash collectors, utility workers, and health inspectors. To others, they are an outdated and expensive notion local governments can no longer afford.
That many cities face challenges funding pensions is no surprise. Markets have been volatile in recent years. A common practice of setting future earning estimates too high has resulted in many retirement systems overstating their ability to cover costs going forward. And new accounting rules have made the problems of underfunded cities more obvious.
Austin is not immune to these issues. A 2013 Pew report listed Austin among 37 cities for which pensions were underfunded at the close of the recent recession. Last December, financial analysts at Moody's named Austin as a city that suffers from high levels of unfunded pension liabilities (the amount of current and future benefits the city owes but could not cover if forced to pay today), sometimes called pension debt. Two of the city's three funds – those for police and city employees, including Austin-Travis County medics (there's a third for firefighters) – report funding ratios of less than 70%. If the city were tasked today with paying out its full lot of retirement benefits, these funds would fail to put up even seven-tenths the needed amount.
Last November, consultants at the Houston-based Arnold Foundation issued a lengthy report on the financial outlook of Austin's pension programs: "A Boomtown at Risk: Austin's Mounting Public Pension Debt." It conveyed a sense of urgency – almost impending disaster – citing pension debt across all three systems of $1.8 billion. The firefighter and police funds each represent about $1 billion in total pension obligations. The city employees' system is much larger at about $3.4 billion. The report's authors were especially troubled by Austin's rapid growth and the resulting expansion of its workforce. Between 2008 and 2015, the city's three retirement systems grew by about 573 active participants. Between 2003 and 2011, the report stated, the city shorted its employees' fund by roughly $170 million, based on a rule of thumb that cities should contribute enough to ensure they can reach full funding within 30 years. Austin's funds can currently reach full funding in 33 years or less. The report warned: "If Austin experiences an economic downturn in the future, it might not be able to keep up with its payments."
The foundation considered Austin's system lacking in how it estimated future earnings, pointing to assumed rates on returns of investment that it believed would prove unachievable. The three funds' rates ranged between 7.5% and 7.8% in 2016. "If the assumed rates of return were lowered to 6.5 percent for each plan," Paulina S. Diaz Aguirre and Josh McGee wrote, "the system's total debt would jump to $2.6 billion," which illustrates how over-optimistic projections can mask true funding requirements. The less a fund can expect to earn on investments, the more it needs to come up with in the form of contributions from employers and employees.
The report found specific fault with the city employees' retirement system's investment strategy, noting that 17% of its assets were invested in "hard-to-value, illiquid assets like real estate and alternatives," which could lead to serious trouble if returns aren't adequate. Eric Ralph, a financial adviser for City of Austin Employees' Retirement System (COAERS), corrected the report's characterization of the fund's investments in an interview with the Chronicle. For instance, its real estate investments, representing about 9% of the portfolio, are conservatively managed through Principal Global Investors and easily liquidated, he said. The foundation urged the city to consider replacing defined benefit plans – which provide benefits for life – with less costly options, and to lobby for local control of how plans get structured, something the foundation also recommended for Dallas and Houston. Doing so, the foundation's October report on Dallas read, "would give the city the authority to change the plan's governance structure and design, ensuring its long-term sustainability." But both reports are vague regarding how those changes would improve fund management.
The foundation also acknowledged that Austin's pension problems are not dire, and critics have since questioned the report's conclusions, saying it appeared to assume that defined benefit plans no longer hold a place in modern retirement systems. Ed Van Eenoo, the city's deputy CFO and a member of its employees' retirement board, told the Chronicle he thought the report "was written with a bent toward cities moving away from defined benefits plans and with a preference for defined contribution plans." And Pattie Featherston, executive director of the Austin Police Retirement System, issued a statement asserting that the foundation's "push" to eliminate public defined benefit plans in favor of other options was mired in "flawed myths about cost savings."
Whereas the report stated that the city's rapid growth could spell trouble for city pensions, Chris Hanson, executive director of COAERS, argued the effects of growth are actually opposite: In 2012, new hires began to incur a benefit reduction; when these workers retire, their benefits will be some 17% lower than that applied to workers hired prior to that year. The city also made adjustments to rules regarding cost of living adjustments (COLA); they now require the approval of Council and the city manager. (No COLAs have been granted to retirees since 2002.)
"Hiring the lower-cost new employees is actually better for us," said Hanson. "The sooner we get more group B people in than group A, the faster we'll get our amortization period down and our funded ratio up."
Shortly after the report's release, Hanson issued a statement in response: "COAERS and the City of Austin have a long, amicable history of working cooperatively to address pension issues. The existing governance structure has not been an obstacle to pension reform, nor has it limited the city's ability to make additional contributions to the fund."
A Series of Tough Decisions
State statute requires that retirement system boards for Austin's three funds include members of City Council, city management, active and retired employees, and at least one citizen trustee. (Dallas' board is comprised of only council members, employees, and retirees. In Houston, boards don't include common citizens.) The distinction is important. Citizens who are not system beneficiaries provide an independent taxpayer viewpoint, while representatives of city management are often more experienced in financial planning and management – and less often subject to political pressure. Statutes governing Austin's funds also allow employer contributions to be increased through a council vote and employee contributions through member votes. In contrast, Dallas' and Houston's funds require meet-and-confer agreements, city votes, or legislative action to make changes.
Robert Klausner, a legal adviser whose firm has worked with hundreds of pension systems across the country, said Austin provided "an example of what boards of trustees should do." In his eight years working with Austin Police's system, Klausner has been impressed with how members have acted on their own to identify costly features of benefits that could be problematic, making changes quickly and decisively. The police fund's board began making significant changes in 2014. "I give them a lot of credit for doing that," he said. He called the changes "tough decisions."
Among those changes were significant alterations to the police system's DROP program. The board voted to stop paying interest on DROP accounts, and to begin charging fees on new accounts. At the same time, it extended from five to seven years the maximum length of time an individual can participate. Changes to the DROP and other benefit programs were largely intended to make the programs "cost-neutral," according to Tim Atkinson, a recently retired APD detective and board chair of the Austin Police Retirement System. Rather than costing the system money, the updates ensure that the system at least breaks even, he said. Atkinson reported in a 2016 member newsletter that the board saved the system $18 million and cut its amortization period by almost seven years as a result of the various changes.
Board leadership and officers (both active and retired) have supported the necessary changes. Andrew Romero, an APRS board member since 2014 and a vice president of the Austin Police Association, said officers have shown a willingness to accept reduced benefits in order to better preserve the system. "To me, what that says is the members support making good decisions that lead to the long-term health of the fund," he said.
For the city's much larger city employees' retirement system – which manages pension for about 15,300 employees – changes have been underway since at least 2011. Van Eenoo told the Chronicle that Austin "is not exactly where we want to be" but noted that the city has been proactive in addressing policies that need adjustment.
"I think we are taking all the right steps to make sure these plans are sustainable in the future," he said, adding that actuarial indications show the city will arrive at the healthier financial status it seeks in the next 10-15 years. Van Eenoo said that losses associated with the 2008 recession, not poor fund management, drove the need to revise projections. "We have created a second-tier lower-cost plan for new employees ... and increased contributions to the fund so it remains stable and sustainable into the future," Van Eenoo said. "The city had the wherewithal and the foresight to do what needed to be done to keep the fund sustainable. I'm not sure that every city would do that."
Not Fixing What's Not Broken
At the state level, efforts to give cities more control over their own public pensions have been percolating around the Capitol since 2015's legislative session and may be gaining momentum in the current session. Two bills in particular aim to give more power to local governments and taxpayers. Senate Bill 152, sponsored by Sen. Paul Bettencourt, R-Houston, would let cities eliminate defined benefit plans for state-created retirement systems in favor of defined contribution plans, a switch that is strongly opposed by public safety and municipal workers but which Bettencourt sees as necessary. He told the Chronicle that defined benefit plans "are simply not viable long-term in the 21st century the way they are structured," both because they are costing taxpayers too dearly, and because in most cases they represent benefits for government workers that are "astoundingly high" compared to what is available to private sector workers. One catch with converting to a defined contribution plan is that those covered by the old plan must continue to receive their lifetime benefits, even as new contributions are not funding the plan, creating significant financial stresses in the short-term. SB 151, also by Bettencourt, would require voter approval to issue any obligation bond to fund pension obligations.
There's also House Bill 43, filed by state Rep. Dan Flynn, R-Canton, which only applies to Houston, and essentially serves as a placeholder for Mayor Turner's proposed reform plan for which he needs legislative approval. Neither it nor the substitute is expected to change the city's defined benefits structure.
As controversial for some as the bills, however, is the composition of the state's Pension Review Board, and its current chair, Josh McGee, the Arnold Foundation VP who co-authored "A Boomtown at Risk" and who was appointed to the PRB in 2015 by Gov. Greg Abbott. The Austin American-Statesman reported in December 2015, shortly after McGee took the chairmanship, that a dozen labor groups called on Gov. Abbott to rescind the appointment. In that story, Tim Lee, who presides over the Texas Retired Teachers Association, called it "shocking" – "the worst possible choice to be chairman." Charley Wilkison, executive director of the Combined Law Enforcement Associations of Texas, a statewide police union, said McGee's presence amounted to "a serious threat to the livelihood of officers who sacrifice so much for the people of Texas."
Whether this move foreshadows a state-sanctioned effort to push locals away from defined benefit plans remains to be seen. But the issue is likely to come up in McGee's confirmation hearing (he wasn't confirmed in 2015 because the Lege wasn't in session). Sen. Kirk Watson, D-Austin, vice chair of the Senate Committee on Nominations, told the Chronicle that he will "seriously consider any allegation of a conflict of interest" as he weighs whether to recommend McGee's nomination to the full Senate.
The decision to stick with defined benefit plans locally is rooted in the idea that Austin's pension system is not in need of major repair. As the troubles unfolding in Dallas and Houston continue to fuel proposals for reform, key stakeholders in Austin have yet to be convinced. "I see no need to fix what isn't broken here," said Watson. He lauded Austin for taking "significant steps" to improve the condition of its pension funds and for the degree of cooperation between "City Hall and employee groups."
Hanson agrees. He used to preside over the PRB, and emphasized the importance of looking at the complete picture in Austin, rather than fixating on specific measures. What's important, he said, is a fund's trajectory. The long-term trend in Austin points toward improvement, one driven largely by the reduced benefits new hires will receive. After the Arnold Foundation report came out, he got calls from retirees "worrying they weren't going to get their checks." He's been telling those retirees since then that their benefits are secure.