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The city of Houston’s pension funds are in financial trouble and pose a significant risk to the financial health of the city. The city’s latest Comprehensive Annual Financial Report (CAFR) for the year ended June 30, 2015, which reflects recent changes in the Governmental Accounting Standards Board (GASB) reporting rules, shows that the net pension liability (NPL) of the three Houston pension funds is $5.6 billion. The net pension liability is $0.6 billion for the Houston Firefighters’ Relief and Retirement Fund (HFRRF), $2.3 billion for the Houston Municipal Employees’ Pension System (HMEPS), and $2.7 billion for the Houston Police Officers' Pension System (HPOPS). In addition, Houston has issued over $600 million in pension obligation bonds and used the proceeds to reduce the unfunded liabilities of HMEPS and HPOPS, thus transferring $600 million in liability to the general fund. Including this debt, the total unfunded liability of providing pension benefits is $6.2 billion, which is likely an underestimate of the true outstanding liability given the assumptions underlying these estimates.
A number of actuarial assumptions are necessary to estimate pension costs, which underscores the substantial uncertainties in actuarial valuations. For example, the present value of future pension benefits (i.e., the value of the flow of payments over time at some specified date) is sensitive to the “discount rate” (i.e., the interest rate used to calculate the present value of future cash flows) that is assumed in the present value calculation. For example, the latest CAFR shows that if the discount rate for the three Houston pension funds is assumed to be 1 percentage point lower, then the net pension liability would increase from $5.6 billion to $7.4 billion. If the discount rate is assumed to be 1 percentage point higher, then the net pension liability would decrease from $5.6 billion to $4.1 billion. Given that the Houston pension funds are currently using a discount rate equal to the assumed rate of return of pension assets, a value ranging from 8 percent to 8.5 percent, it is almost certain that pension liabilities are underestimated (as discussed below, financial economics make a convincing case that assuming the discount rate is equal to the rate of return on assets is incorrect). In addition to discussing the basic framework and assumptions that make up an actuarial valuation, this paper is intended to shed light on the importance and uncertainty of various actuarial assumptions.
However, before continuing, it is worthwhile to briefly discuss how Houston’s three pension funds reached the current status over the past quarter-century. For HMEPS the actuarial determined contribution (ADC) was 6.2 percent of payroll in 1990, it increased to 9.3 percent of payroll from 1991 to 1993, and then rose steadily ending the decade at 9.8 percent of payroll in 1999. The ADC is the necessary contribution expressed as a percentage of payroll that must be made to keep or return the plan to a fully funded state given numerous actuarial assumptions. The plan was 93 percent funded in 1990, it fell to 79 percent funded in 1993, and then rebounded to 91 percent funded in 1999. The HMEPS actuarial valuation as of July 1, 1999 (Projection of Estimated Assets and Liabilities, p. 11), projected that the ADC would continue to increase to 14.1 percent by 2005. The actuarial report as of July 1, 2001, reported that the projection for the ADC had increased to 20.1 percent by 2006, at which time the pension plan would be only 76 percent funded. It is important to note that through fiscal year 2001 the city of Houston’s actual contribution had been roughly equal to the ADC, and thus was not the cause of the increase in the ADC or the unfunded liability. Instead, an increase in benefits that went into effect May 11, 2001, caused the increase in the ADC. The actuarial report as of July 1, 2001 (p. 9) shows the city contribution rate for fiscal year 2000 (9.5 percent) and breaks down the changes in the city contribution rate for fiscal year 2001. The changes included a 0.6 percent gain from a prior asset value increase, a loss of 0.6 percent from asset sources, a 0.1 percent gain from liability sources, a 0.7 percent gain from actuarial assumptions, and a 9.0 percent loss from the change in plan benefits. Thus, benefit changes were the cause of the ballooning ADC and unfunded liability in the HMEPS pension fund initially. Projections indicated the ADC would continue to increase significantly in the future to more than 50 percent of payroll (hereafter, the phrase of payroll is assumed to be understood in discussions of the ADC).
In 2004, the city and the pension fund entered the “Meet and Confer” process and agreed to the following provisions: the city agreed to contribute $300 million to the pension fund in 2005, the pension fund agreed to reduce rates of future benefit accruals (although at the same time the maximum benefit was increased from 80 to 90 percent, allowing current employees to benefit from the overly generous provisions enacted in 2001), the employee contribution rate was increased from 4 to 5 percent, and the city and pension fund agreed that contributions would be set by a schedule of payments rather than by the ADC (with all contribution levels below the ADC).
While the combination of these changes reduced the ADC significantly (from 53 percent in 2003 to 24.1 percent in 2005), the implied pension expense for municipal employees of 30.3 percent annually (the 24.1 percent contribution rate plus the 6.2 percent contribution for Social Security) was still unsustainable (assuming that all actuarial assumptions are met in the future). This led to another round of Meet and Confer and to additional changes in the HMEPS pension plan that were effective for employees hired after January 1, 2008. This round of changes reduced the benefit structure for new employees, made new employees noncontributory (i.e., it reduced employee contributions for new employees from 5 percent to zero), and set a schedule of payments for the city (with contribution levels all below the ADC). The change to the benefit structure and the decrease in employee contributions roughly offset, as shown in the HMEPS actuarial valuation as of July 1, 2007 (Table 6, p. 14), which notes that the change in benefits for new hires reduced the ADC by only 1.5 percent. However, these changes did reduce the normal costs (i.e., the costs of funding accrued annual pension benefits within each year) to roughly 6 percent of payroll for new employees based on current actuarial assumptions. The troubling aspect of the process is that Meet and Confer has allowed the city to contribute less than the ADC in every year from 2004 to 2015. Thus, the funded ratio declined to 58.1 percent by 2014 and the ADC remained high (27.4 percent in 2014).
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