February 26, 2021

A Cautionary Tale of Pension “Reform”

A Cautionary Tale of Pension “Reform”

The state of Texas maintains a pension system for its employees (including state elected officials) known as the Texas Employment Retirement System (“ERS”).  It is a large plan with nearly 400,000 members and  manages nearly $30 billion in assets.  It is a traditional defined-benefit plan.

In 2015, the Texas Legislature was faced with a financial crisis at ERS.  In less than a decade, the unfunded liability had ballooned about $1 billion to nearly $8 billion.  ERS projected that its fund would be completely depleted by 2064, while still owing billions in pension benefits.

The Legislature’s “solution” to the problem was to throw money at the problem.  The state raised the on-going contributions from the members and the state from 7.2% to 9.5%.  However, the state also gave its employees a raise to cover the cost of their increased contribution.

The plan has resulted in the state putting about $200 million more per year into the plan and paying its employees about another $200 million for them to contribute.  The plan made no changes to the benefits, specifically retaining the defined-benefit structure.

The plan was heralded by members of the Legislature and employee groups as a huge success.  The Texas Public Employees Association gushed in its post-session newsletter to its members that:

“The history books will look back at this legislative session as one of the most important for state employees and retirees, as lawmakers passed legislation to preserve the Employees Retirement System (ERS) pension fund.  This is a tremendous achievement for the state . . . Lawmakers shored up the ERS pension fund, which has a $7.5 billion unfunded liability, and they did so without enacting changes to the plan’s benefits or structure or placing a burden on active state employees.  A 2.5 percent across-the-board pay raise offsets the increased employee pension contribution rate . . . By restoring the ERS pension fund to actuarial soundness, the Legislature has opened the door to future consideration of a cost-of-living adjustment or 13th check for retirees.”

So, how did the 2015 reform work out?  Here is what the outside actuaries recently wrote about ERS’s condition in their annual report:

“The current financial outlook for ERS is very poor. . . the currently scheduled contributions are not expected to accumulate sufficient assets in order to pay all of the currently scheduled benefits when due . . . there is a strong possibility that ERS will become insolvent in a 30-40-year timeframe . . . Contributions must materially increase in the next legislative session to secure the benefits for current members.”

As their chart below shows, the actuaries project that if the plan has the same investment performance as it has experienced over the last 20 years, it will run out of money in 2047.

Actuarial Valuation Report, December, 2020, Slide 10

The unfunded liability has nearly doubled since 2015 and the plan has gone from 75% funded to 66%.  The actuaries project that the unfunded liability will grow to $19 billion by 2025 and the funded rate will drop to 61%.

Actuarial Valuation Report, December, 2020, p. 32

So, what went wrong?  First, ERS assumed it would earn 8% on its assets in 2015.  It lowered the assumption to 7.5% in 2017 and then to 7% last year.  And it is still not even making that, notwithstanding the incredible bull market we have had over the last few years.  Warren Buffet, the world’s most successful investor, believes pension plans should use 5% as an investment assumption.

Small differences in investment returns may not seem like a big deal, but they are.  A note in ERS’s most recent audit concluded that a 1% miss on the investment assumption increased the pension liability by over $10 billion. (See 2020 Comprehensive Financial Report, p. 69, Figure 16.)

And so, what is ERS’s proposed solution to the new crisis?  More taxpayer funding, of course.  It projects that funding will have to go from the current 19.5% contributed by the state and its employees to just over 26%.  That is not chump change.  ERS is projecting it will require almost an additional billion dollars annually to reach that funding level.

There is an interesting twist to the ERS request.  The Texas constitution limits the state’s contribution to ERS to 10% of the employees’ compensation.  The state can only exceed that limit if the governor declares an emergency, which, to date, he has not done.

The ERS is not recommending any changes to its benefit structure and it is silent on how that increased contribution would be shared between the state and employees.

The ERS presentation requesting additional funding ends with this dire warning:

Actuarial Valuation Report, December, 2020, Slide 24

Doing nothing?  Since the 2015 reform, taxpayers have put over $3.5 billion dollars into ERS.  That is about two billion more than if the state had left its contributions at the pre-2015 level and not given the across-the-board pay increase to cover higher employee contributions.  That is two billion dollars over the last five years that was not available to fund schools, infrastructure, improvements in mental health services, or, God forbid, reduce taxes.  Now ERS is proposing to add an additional $1 billion per year . . . forever.

The bottom line is this: Defined-benefit plans do not work in the demographic and market conditions that exist today.  Defined-benefit plans became popular at a time when interest rates were high and life expectancies after retirement were short.  Those conditions no longer exist, and they are not coming back. For years, defined-benefit plans have been disguising their true costs by making unrealistic investment assumptions.

The private sector figured out decades ago that traditional defined-benefit plans do not work and phased them out.  Today defined-benefit plans almost exclusively exist in the public sector.

I do not believe in changing benefits employees have already earned, like Houston’s pension “reform” did.  A deal is a deal, and we should honor commitments that have been made to people whose services we have used.  But it is utter insanity and generationally irresponsible to continue to add new employees to plans based on a flawed financial model. Texas should bail out ERS, because that is the promise we made to the employees.  But at the same time, the Legislature should move all new employees into a defined-contribution plan as the private sector did decades ago and Governor Abbott should refuse to declare an emergency to allow the funding to increase over the 10% Constitutional level unless it does.  If not, I can assure we will be back here in a few years watching this same movie all over again.

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