There’s no silver bullet, and it will take the implementation of several steps to actually address problems in a meaningful way.
This is a guest post by Ryan Holeywell. This is the third post in a series on NLC’s public sector retirement initiative.
Cities are still struggling with soaring pension costs, and Houston, Texas – home to my organization, Rice University’s Kinder Institute for Urban Research – is among them. Mayor Sylvester Turner pegged Houston’s unfunded pension liability at $7.7 billion when he introduced a reform proposal on September 14, 2016.
Our newly-published report, “The Houston Pension Question,” explains how Houston can get its pension costs under control. But the solutions we highlight aren’t unique to Houston, and they can be considered by any city seeking to improve the stability of its pension system. Moreover, these options aren’t intended to be a specific policy prescription; instead, they’re more like a menu that Houston and other cities can choose from. Below are our six reform options:
1) Change investment assumptions associated with the pension plans
Since 1992, Houston’s plans have assumed a rate of return on its investments of 8 to 8.5 percent, even though they’ve earned less than that recently. Those shortfalls result in higher unfunded liabilities. In Houston’s case, we estimate that shortfall has contributed a combined $872 million to the city’s unfunded pension liability since 1992.
Plans nationwide are starting to respond to this pressure. Nationally, the assumed rate of return on investments dropped from an average of 8 to 7.6 percent from 2001 to 2015. In Houston, Mayor Turner has proposed using a 7 percent assumption. Every pension system should use investment projections that align with its recent financial performance.
2) Change funding methods
“Amortization” means paying off a liability through installments, as opposed to paying it off in one lump sum payment. Today Houston – and many other cities – use a “rolling amortization” schedule that effectively resets the clock on the annual pension payment schedule, ensuring the liability will never be fully paid.
Cities such as Phoenix and Baltimore have switched to “closed amortization” schedules, which commit to fully paying the unfunded liability within a set period of time, generally 20 to 30 years. Mayor Turner has proposed this reform in Houston. While the technique can help cities pay off the liability in a more timely fashion, it often increases the already-rising payments required of those cities.
3) Consider new funding sources
Because many of the steps needed to shrink the liability necessarily result in increased payments, cities may need to consider other funding sources. This might entail new or increased revenue, or it might mean diverting resources from other public uses.
In Houston, rescinding a voter-imposed revenue cap that has limited the city’s budget flexibility could result in an extra $40 to $60 million in annual revenue. Mayor Turner says he’ll ask voters to do this next year, though he hasn’t explicitly tied that strategy to pension reform.
Of course, increasing revenue or cutting services are steps that could be unpopular with taxpayers, and in some cases, state law may preclude local governments from increasing revenue.
4) Increase employee contributions
Employee payroll contributions are the norm in the public sector. We calculated that participants in the Houston municipal workers’ pension plan contributed 2.77 percent of their city income to their pensions. Nationally, participants in large local plans contribute 7.6 percent.
Several cities, including Phoenix, Jacksonville and Baltimore, have increased employee contributions as part of their pension reform efforts. We calculated that if Houston’s municipal workers contributed at the average level of public employees nationwide, by 2025, Houston would be saving $100 million annually.
But this reform comes at a cost, too: effectively, it reduces total employee compensation, making a city a less competitive employer. Mayor Turner has not included this reform option in his publicly-announced plans.
5) Switch to a defined contribution system or a “hybrid” defined benefit/defined contribution system for new hires
This can slow the growth of the pensions’ unfunded liability because it shifts financial risks from the employers to employees. The technique has been used in places such as San Diego and Fort Lauderdale.
While a defined contribution plan like a 401(k) can help stop future liabilities from mounting, it doesn’t erase previously-accrued liabilities. A defined contribution plan – in the absence of other steps – cannot immediately fix a pension system’s financial woes. For that reason, Mayor Turner said, he did not include this element in his Houston reform package.
6) Reduce benefits for current employees
Generally cities are legally prohibited from cutting benefits for current and former employees. They have some flexibility, however, with annual Cost of Living Adjustments (COLAs) and reforms to Deferred Retirement Option Plans (DROP), which allow retirees to claim pension benefits while continuing to work.
Mayor Turner says he’s worked with the city’s three pension systems to reduce the liability by about $2.5 billion, largely through negotiated cuts in these areas. But these reforms effectively reduce total employee compensation and may increase the likelihood that retirees could lack sufficient retirement income.
For cities considering pension reform, all of these options may be part of a solution, and all of them are painful. Taxpayers may have to pay higher taxes or enjoy fewer services. Retirees may face lower benefits. Current employees may face higher contributions, potentially coupled with reduced benefits.
Each city, its employees and taxpayers will have to figure out which combination of options will work best in their situation. There’s no silver bullet, and it will take the implementation of several steps to actually address pension system problems in a meaningful way.
About the author: Ryan Holeywell is the Senior Editor at Rice University’s Kinder Institute for Urban Research.