A recent Wall Street Journal article highlighted how the $4 trillion in total unfunded public pension debts of cities and states nationwide equals Germany’s economy. The WSJ figure below highlights how this massive sea of red ink means that there could be a tremendous burden on taxpayers as contributions rise or on public sector employees’ as funded ratios decline without major reforms.
In other words, public sector employees and taxpayers may soon be in a world of hurt because of decades of poorly managed and constructed defined-benefit pension plans.
The Teacher Retirement System of Texas, or TRS, recently lowered its assumed rate of return for its pension fund from 8 percent to 7.25 percent. The TRS figure below shows that the lower rate is more consistent with the average annual returns in the past 20 years of around 7 percent, but it remains well above the 5.8 percent average return in the last decade.
While some Texas teachers and unions worry about potential benefit cuts, teachers shouldn’t fret about changes to current benefits from the lowered assumed rate of return but rather note that the increased transparency helps better reflect longer-term solvency issues.
The lowered return indicates unfunded liabilities amount to a staggering $45 billion, pushing the funded ratio below 80 percent, which that some consider actuarially sound. However, if the funded ratio is below 100 percent, then some teachers are at risk of not receiving their retirement because of insufficient funds to pay them.
The goal of public pensions should always be a 100 percent funded ratio so teachers and taxpayers aren’t shortchanged.
To better fund teachers’ pensions, TRS has stated they will request more contributions from the Texas Legislature this upcoming session. These added contributions could come from current teachers or taxpayers through increased state or school district spending, but that’s up to legislators.
While Texas has historically had terrific credit ratings, it risks a downgrade if the Legislature doesn’t solve what could be a looming pension crisis. Total state unfunded pension liabilities now amount to more than $60 billion after the recent TRS decision. These unfunded liabilities, if not covered, will require more resources from teachers and taxpayers.
Lowering the rate of return to a more accurate assumption is a step in the right direction, but more reform is necessary.
To assure a 100 percent funded ratio, the Legislature should consider transitioning pension plans to cash balance plans. Or, to avoid getting back into the current situation from mismanagement of the portfolio over time, legislators should consider hybrid contribution plans or defined contribution, 401K-style, plans.
Traditional opponents of defined contribution plans say they cost more to the state, are less stable for retirees, and generate less returns over time. However, most of these are unfounded and those that are legitimate have solutions. A well-designed defined contribution plan can be even more beneficial to teachers so that they are in control of their retirement while practically eliminating the risk to taxpayers.
The looming debt crisis could hurt teachers and taxpayers if the can is continually kicked down the road. Before the can makes it off the cliff, legislators should act and reform the system.
Texas performs relatively well in measures of financial stability by ranking 16th nationwide in fiscal health and 2nd lowest in state debt per capita among the top 10 most populous states. These rankings along with historically high growth rates in economic output and population (see Chart 1) indicate that Texas has remained steadfast in having sound fiscal management.
However, a recent TPPF paper shows that there are increasingly troubling signs of fragility in the state’s fiscal position.
These signs of a rising burden of state liabilities (i.e., state debt and public pensions) could cost taxpayers billions of dollars without key reforms.
State debt outstanding, which is just the principal, amounted to $49.8 billion at the end of fiscal year (FY) 2016. While this amount is small compared with the $1.7 trillion economy, it has increased by 52.7 percent per capita since FY 2006 and is up to $1,790 owed per every man, woman, and child in Texas.
Debt outstanding tells only part of the story because the interest owed on this debt is also a taxpayer expense. Total debt service outstanding, which includes the principal and interest owed, is $80.8 billion, meaning every Texan owes roughly $3,000!
If these trends continue, they could jeopardize Texas’ AAA credit ratings by all three major credit rating agencies and raise the debt burden on taxpayers.
To reduce this concern, we recommend increasing debt transparency by requiring the following information on ballot propositions for voter approval of issuances of GO state debt: total debt service required to pay the proposed debt on time and in full and an estimate of the proposed debt’s influence on the average taxpayer’s taxes, as recommended for local debt.
Although state debt is a problem that must be addressed, the elephant in the room is state pensions.
Chart 2 shows the two largest state pension systems, Employees Retirement System (ERS) and Teachers Retirement System (TRS), with their estimated 8 percent annual return and the eight state debts with the highest computed compounded annual growth rates.
Volatile annual rates of return and fewer contributors paying for more beneficiaries are exhausting these defined-benefit (DB) plans. Assuming a less risky average 15-year Treasury rate of 2.3 percent compared with today’s 8 percent assumed return rate, Williams et al. estimate that unfunded liabilities for all of Texas’ state pensions of $360 billion ranks 3rd highest nationwide and of $13,120 per person ranks 14th lowest.
To alleviate this mounting state pension issue, we recommend changing these pension systems from DB plans to defined-contribution (DC) plans, whereby payments would be based on employee contributions and a defined government match with little to no transaction cost and the benefit of sustainability without higher taxes.
Finally, given the low computed compounded growth rates of state debt in Chart 2, we recommend that surpluses of state revenue be used to cut taxes before paying down state liabilities. This could be done by creating a budget-cutting tool called the Sales Tax Reduction (STaR) Fund or eliminating the state’s business margins tax. These tax cuts would help avoid leaving revenue unchanged for future spending.
Implementing ballot box transparency for state debt, converting public pensions to defined-contribution plans, and prioritizing state surpluses to cut taxes will help lower the burden of state liabilities on taxpayers.
Overview: Texas has a proven record of financial stability. Ranking 16th nationwide in fiscal health, 7th in lowest state debt per capita, and with historically high population growth rates accompanied by economic growth, these factors have kept Texas steadfast even during times of economic uncertainty. Relatively sound fiscal management has provided Texans a certain level of comfort, but increasingly evident signs of vulnerability are raising concerns about the state’s financial health.
This commentary originally appeared in Forbes on May 2, 2016.
Are American governments making promises that American taxpayers can’t keep? The answer may well be “yes” when it comes to public pensions.
Unfunded pension liabilities, or the difference between what’s been promised to future retirees and what’s actually on hand to provide for those benefits, have grown to absolutely epic proportions. This raises serious concerns about the sustainability of America’s retirement systems and its ability to make good on the promises made.
Last month, Moody’s Investor Services, one of the nation’s top credit rating agencies, estimated that federal unfunded pension liabilities (including civilian and military obligations) had risen to $3.5 trillion, or about 20% of GDP. In addition, Moody’s pegged state and local governments’ unfunded liabilities at roughly the same amount, bringing the total U.S. pension shortfall to 40% of GDP.
Making matters even worse, total U.S. unfunded liabilities that includes Social Security, Medicare and other debts top $100 trillion, according to the website usdebtclock.org.
Regardless, there’s an ocean of retirement-related red ink that, at some point, will have to be mopped up either through massive future tax increases, a substantial reduction in benefits, or some costly combination of the two.
Part of the reason that things have gotten so far out of hand is government’s penchant for hiding the ball. U.S. Congressman Devin Nunes echoed this frustration when he said: “It has been clear for years that many cities and states are critically underfunding their pension programmes and hiding the fiscal holes with accounting tricks.” Nunes filed legislation recently to help get a handle on the issue.
In Texas, the problems with public pensions are less pronounced but still serious.
The latest figures from the Pension Review Board (PRB), the state agency charged with overseeing Texas’ state and local retirement systems, show that among the 93 systems monitored by the agency, unfunded liabilities topped $60 billion as of February 2016. That’s a spike in pension debt of $2.7 billion since June 2015 and an increase of $7.7 billion compared with two years ago.
Digging further into the data reveals that the funded ratio—a measure of a plan’s current assets as a share of its liabilities—averaged 80% across all plans. It’s generally held that a funded ratio of 80% or more signifies a firm financial footing, something that Texas’ systems are right on the brink of surpassing.
Looking at these plans’ amortization periods also hints at trouble. The PRB’s guidelines for actuarial soundness recommend that a plan’s amortization period ideally range between 15 and 25 years. However, 56 of the 93 plans exceeded that target as of February 2016.
Over a longer time horizon, it’s evident that fewer plans are able to achieve the recommended amortization period. A 2014 PRB report compares the financials of Texas’ 93 monitored plans in 2000 and 2013. The report finds that in 2000 roughly 46%, or 43 of the 93 plans, had amortization periods at or above 25 years. By 2013, however, that figure had grown to 65%, or 60 of the 93 plans.
On a more local level, the city of Houston—which is the largest city in Texas and the fourth biggest in the nation—is seeing its finances wrecked because of public pension problems. Its three major municipal systems, including the Houston Municipal Employees Pension System ($1.8 billion owed), the Houston Police Officers Pension System ($1.2 billion owed) and the Houston Firefighter’s Relief and Retirement Fund ($532 million owed), have unfunded liabilities totaling $3.5 billion. And thanks to a sweetheart setup, the city is limited on what it can do to bring down the swell of debt.
Recognizing Houston’s pension problems, Moody’s downgraded the city’s credit rating in March, citing “large unfunded pension liabilities (among the highest in the nation)” as one of core concerns. Shortly thereafter, Standard & Poor’s followed suit and dinged Houston’s credit rating citing: “the city’s large unfunded pension liability that has been exacerbated by what we consider optimistic rate of return assumptions and a history of lower-than-actuarially determined contributions…”
Be it from a statewide perspective or more locally, Texas’ public pension systems are clearly not headed in the appropriate direction. A course correction is needed before the problem metastasizes into something much, much worse.
At the core of the pension problem, both nationally and in Texas, is a fundamentally flawed system—the defined benefit (DB) system. DB-style pension plans promise current and future retirees a lifetime of monthly income, but do so without knowing whether the money will be in the fund.
These types of pension plans suffer from two major deficiencies: generational accounting and excessive expected rates of return.
The first is the issue of fewer people contributing to the pot of retirement benefits compared with the rapid pace of baby boomers receiving benefits that’s often more than what they contributed. Put another way, there are fewer dollars available for retirees. This is a huge burden on DB-style plans.
Another issue is the fact that many plans assume unrealistically high rates of return—like an 8.5% return expected annually by the Houston firefighters fund or an 8% yield assumed by Houston’s other two major pension plans. Houston is certainly not the only U.S. city guilty of being too bullish on future returns. This is a nationwide problem that’s leaving a wider gap in financial solvency over time. Moreover, many plan managers have invested in risky assets to achieve these returns that could come to bite them later.
For taxpayers and retirees, it’s imperative that substantive reforms are put in place. This starts with eliminating DB-style plans and transitioning to a more secure retirement option like defined contribution (DC) plans.
DC-style plans resemble 401(k)s in the private sector and the optional retirement programs (ORP) available for higher education employees in Texas. These DC-style plans put the power of an individual’s future in their own hands instead of depending on the good fortune of government-directed DB-style plans. DC-style plans are portable and sustainable over the long term as they are based on the contributions of retirees and a defined government match.
With DC-style plans, retirees will finally have the opportunity to determine how much risk they are willing to take. They also reduce the risk that the government will default on their retirement or fund those losses with dollars from taxpayers who never intended to use these pensions. By giving retirees more freedom on how to best provide for their family, they will be in a much better position to prosper.
Because of their efficiency, simplicity and fully funded nature, the private sector moved primarily to DC-style plans long ago. For the sake of taxpayers and retirees dependent on government pensions, it’s time for all governments to move to these types of plans as well.
With trillions of dollars in pension problems at the federal level and tens of billions of dollars in Texas, lawmakers at the federal, state and local levels must make changes now.
Specifically, they should transition all new employees and those interested into DC-style plans.If not, our kids and grandkids will be saddled with pension debt and forced into a future of higher taxes and broken promises that could have been avoided.
Vance Ginn, Ph.D.