The Houston Pension Question How the City’s Pension Liability Grew And the Options for Reform August 2016

Report requested by foundations Houston Endowment Brown Foundation Kinder Foundation Wortham Foundation

Information provided by: Houston Firefighters Relief and Retirement Fund Houston Municipal Employee Pension System Houston Police Officers Pension System Controllers Office, COH COH budget website

What This Report Does Clarify nature of Houston’s pension challenges Put pension challenge in greater budgetary context Put Houston challenge in national context Identify potential options for reform and explain pros/cons of each one Highlight experience of comparable U.S. cities that have undertaken pension reform

What This Report Does Not Do Make pension reform recommendations Assign blame for current situation Address question of local v. state control

City Budget Context $2.5 billion general fund 60% police and fire $2.6 billion enterprise funds Predominantly water, sewer, and utilities

City of Houston General Fund Revenue

City of Houston General Fund Expenditures

City of Houston Enterprise Funds

How Pensions Are Funded Payments From City Contributions From Members Investment Returns If contributions are insufficient and investment returns below expectations, additional funds may need to be found or else long- term liability will grow.

Key Terms Unfunded Liability (UAAL): The pension fund’s future liability minus its assets. ($1 billion - $800 million = $200 million) Funded Ratio: The pension fund’s assets divided by its future liability. ($800 million / $1 billion = 80%) Annual Required Contribution: The annual payment required to cover current costs and also bring down unfunded liability. Investment Rate of Return: The % return on the pension fund’s investment portfolio (i.e., 7%, 8%)

Change in Funded Ratios, All 3 Pension Systems,

ARC Payments As % of City Revenue (Using Census of Governments Data)

ARC Payments as % of City Revenue, Houston and other cities (Based on Census of Governments Data)

What is Driving Houston’s Costs? HMEPS financial issues are associated with unfunded liability (UAAL) HPOPS and HFRRF financial issues are associated with cost of current benefits

City and Member Contributions to Police and Fire Pension Funds, Compared to National Average

City and Member Contributions HMEPS, Compared to National Average

Houston Pension Benefits Generally on the “high side of normal” compared to national averages benefit reforms by HMEPS did make a difference. Though now closed to most new employees, DROP appears to be used by far more employees in Houston than elsewhere.

Overall patterns Optimistic assumptions about investment returns Annual Required Contribution has not been fully funded. Open-ended amortization period causes continuous increase in unfunded liability.

Growth in Unfunded Liability (UAAL), All 3 Pension Systems Combined

Unfunded Liability, 3 Pension Systems, (2013 for HFRRF)

Investment Returns Exceeded Expectations in 1990s Have Lagged Behind Expectations Since 2001

ARC Payments, All 3 Pension Systems,

Components of HMEPS unfunded liability (UAAL) growth,

Components of HPOPS unfunded liability (UAAL) growth

Components of HFRRF unfunded liability (UAAL) growth

Possible Approaches to Reform

Reform May Require Lowering the investment return assumptions Tightening amortization methods Increasing the Annual Required Contribution Finding either new revenue or savings to accommodate higher ARC

Stakeholders Who May Share Burden Taxpayers: Higher taxes (and/or revenue cap repeal) Citizens: Reduction in levels of city services (police, fire, others) Retirees: Lower benefits within legal parameters Current employees: Higher contributions Future employees: Reduced benefits

Options for Revenue and/or Savings Repeal revenue cap or find new source of revenue Divert funds from other budget categories Increase Employee contributions Reduce COLA Reform DROP Switch new hires to a defined contribution plan

Increase city contribution, either with new revenue or by cutting budget elsewhere Pros: Employer honors promises it has previously made to its workers. Cons: Today’s taxpayers make up the difference of previous generations’ failure to fund retirements.

Increase employee contributions Pros: Increasing employee contributions is a common way of reducing employer costs and avoiding many legal challenges associated with reducing benefits. Cons: Without a compensatory increase in wages, this amounts to a decrease in employee compensation and may eventually reduce the quality of worker a government can attract.

Reduce COLA and reform DROP Pros: May be the only benefit reduction that is legally available. Cons:. Again, a real decrease in compensation. A change to the COLA could mean that retiree income loses ground to inflation over time.

Switch new hires to a defined contribution or hybrid plan Pros: May be attractive to short-term or younger workers, since typical pensions are backloaded. Limits future uncertainty around retirement plan costs for employer. Cons: Does not address previous unfunded liability that has accumulated over time and takes a long time to show a real financial benefit for the employer.

Case Studies of Pension Reform From Comparable Large Cities Most cities that have undertaken reform have used at least some of these options

Case Study: Phoenix Switched to 20-year payoff of unfunded liabilities Increased employee contributions Limited pensionable compensation

Phoenix Reform Plan Over Time

Case Study: San Diego Switched 15-year payoff of non-police unfunded liabilities Reduced defined benefit for new public safety hires Switched other new hires to defined contribution

San Diego Reform Plan Over Time

Impact of Possible Reforms in Houston

3 Sets of Questions 1.What should the rate of return assumptions and amortization period be? 2.What should the Annual Required Contribution be? 3.Where should the city find additional money to pay a larger ARC?

Impact of Changed Rate of Return Assumptions on Unfunded Liability

Change in unfunded liability based on different investment return assumptions

Impact of Changed Amortization Period on ARC (using current rate of return assumptions)

ARC With 30-Year Amortization Period

ARC With 20-Year Amortization Period

Impact of Changed HMEPS Employee Contributions

Increasing HMEPS member contributions to national average would reduce ARC significantly over time – though employees would bear cost

Impact of COLA/ DROP changes (per Retirement Horizons Report) 1% COLA = would save $100 million annually now and go up over time. Freezing DROP credits at current levels = would also save $100 million annually but increase over time would not be as great. These estimates assume 8-8.5% discount rates. If the discount rates were reduced, both the unfunded liability and these savings would be higher.

Impact of Revenue Cap $58 million in FY 2016 Estimated: $44 million in FY 2017 Long-term impact depends heavily on growth in assessed value

Defined Contribution/Hybrid For New Employees No immediate impact Would eventually provide backstop to unfunded liability “bubble” Some evidence from elsewhere that younger current employees will choose a hybrid if given the option

Conclusion Current practices will cause unfunded liability to continue going up. In other cities, solution has involved significantly increased payments for 20+ years into the future. No one source of revenue or savings is likely to solve the problem, but a combination of options is likely necessary.

The Houston Pension Question How the City’s Pension Liability Grew And the Options for Reform August 2016