Houston Mayor Sylvester Turner may have found a way out of his city's unfunded pension pickle. Ismael Francisco/Cubadebate/AP

Houston owes its police, fire, and city workers about $7.8 billion, and it doesn’t exactly have the cash on hand. Their hard-fought solution could serve as a model for the rest of Texas, and the nation.

When Houston Mayor Sylvester Turner took office last year, he inherited a sweeping pension crisis. The city had an unfunded liability of $5.6 billion, a figure representing Houston’s obligations to its fire, police, and municipal pension systems.

Then it got worse: After he took office and got a closer look at the books, Turner saw the revised figure—$7.8 billion.

Pensions are the storm clouds on the horizon that threaten to wash out the so-called Texas Miracle, the wave of new jobs that kept the Lone Star State afloat through the Great Recession. Taken together, the four largest cities in Texas—Houston, Dallas, Austin, and San Antonio—owe more than $22 billion in pension shortfalls. Dallas and Houston rank second and fourth, respectively, on the list of cities nationwide with the largest unfunded pension liabilities, per a ranking by Moody’s. (At number one? Chicago.)

The road to pension crises is paved with good intentions. Officials in Houston and elsewhere tend to plan for funding pensions with sunny days in mind. When markets tank, the investments contributing to pension funds wither. And when the economy stumbles, cities sometimes withhold pension contributions to make up budget gaps. These effects add up over time, and correcting course usually involves contentious politics. Texas cities may have it worse than most because the local political climate is so hostile to tax revenues (even when Texas cities experience miraculous growth). Anywhere, though, officials and employees tend to kick the can down the road. It’s retirement, after all.

Admitting that you have a problem is the first step toward solving it; cities in Texas, whether they like it or not, are being forced to take that step.

Houston is further along than most. A proposal that the city will put before the Texas legislature this year would restructure the city’s obligations. The new dispensation would include benchmarks for bringing all parties back to the table to renegotiate terms, as necessary, until the unfunded liability is funded. It would also set a time period for meeting that obligation: a 30-year amortization schedule, something resembling a traditional home mortgage.

(City of Houston)

As Houston comes to grips with the severity of its pension crisis, the city’s 30-year plan may serve as a model for other cities in Texas—and beyond—that are struggling with similar anxieties.

“When I was sworn in, I spent a lot of time talking about shared sacrifice, which can lead to shared benefits,” says Turner. “What I said to employees was, ‘We will not balance the city’s books just on your backs.’”

Recognizing the depth of the problem, and which solutions won’t cut it

Houston has three civic pension systems—police, fire, and municipal employees—which are funded at ratios of 81 percent, 92 percent, and 54 percent, respectively. All three systems are different, and there isn’t a one-size-fits-all solution to funding them. But when Turner took office, all three pension systems had one feature in common: Each of the funds enjoyed established rates of return of 8 or 8.5 percent.

These rates were much higher than what those investment funds were in fact drawing. Over the short term, the funds were averaging returns closer to 3 or 4 percent. While the returns were higher over a 10-year period, they still weren’t meeting set expectations, introducing hidden shortfalls in the system.

One of Turner’s first steps toward pension reform was to ask the pension funds to lower their rates of return to a more plausible 7 percent. In lowering the discount rate used to estimate future investment returns of pension fund assets, the city added another $1.2 billion to its liability. The city further discovered about $500 million in unreported losses for the pensions, bringing the total unfunded liability to $7.8 billion. Progress!

“It’s better to deal with a more realistic number than to be dealing with a number that we all knew was not close to being accurate,” Turner says.

Then the city got to work developing a plan to meet its obligations. Part of that plan meant asking all three pensions to take a haircut.

“Because the unfunded liability turned out to be much higher than expected, we asked the employee groups to work with us to reduce that unfunded liability by as much as one-third from the first day that the pension reforms are approved,” Turner says.

After months of negotiations extending through last fall, all three pension systems agreed. Police adjusted their future benefits by $1 billion. The municipal and fire pensions adjusted their benefits by $700 million and $802 million, respectively. The cuts will largely take the form of scaled-back Cost of Living Adjustments (COLAs) and phased-out Deferred Retirement Options (DROPs). Among other things, that should mean that the most vulnerable pensioners won’t see cuts to their fundamental retirement savings.

City employees got something in return for agreeing to benefits cuts. The mayor’s plan fixed the amortization period for Houston’s unfunded liability at 30 years, replacing an open amortization period that changed from year to year. Under the plan, the city will issue $1 billion in pension obligation bonds, which will reduce Houston’s unfunded liability a bit further. Most importantly, Houston won’t be replacing pensions with 401(k) plans. “All three groups made it very clear to me from the beginning: They did not want a 401(k) plan,” Turner says. “They didn’t trust it.”

Employees have good reason to be wary of 401(k) plans, otherwise known as defined-contribution plans. As The Wall Street Journal reports, many of the financial and human-resources executives who helped ushered in 401(k) plans to preeminence as the nation’s favored system for retirement savings now have misgivings about defined-contribution plans; plenty of retirement experts agree that the near-total disappearance of pensions from the private sector since the 1980s has seriously damaged retirement security overall. Two recessions since 2000—which wiped out some of the market gains that made people so enthusiastic about 401(k) plans in the first place—plus low employee participation rates across the workforce have led to a pivot on defined-contribution plans.

Defined-benefit plans, on the other hand, remain popular among the now-small fraction of workers—largely city, state, and federal workers—who are still fortunate enough to be enrolled in them. But pensions aren’t worth a damn if the city has no money to pay out benefits. This week, S&P Global joined Fitch Ratings and Moody’s in downgrading the debt rating of Dallas over its unfunded pension obligations. Houston has seen its credit downgraded by Moody’s and S&P, too, and earlier this month, The Fiscal Times ranked the finances of Houston and Dallas as among the worst in the nation—primarily over pension liability.

It took several months to hammer out a deal, but Houston officials and employees agreed to reforms that balanced repayment terms with benefits adjustments. The city reduced its unfunded liability to roughly $4.2 billion (including the $1 billion in pension obligation bonds). Employees have greater guarantees about the terms of repayment.

However, mutual agreement is not the genius of Turner’s pension reform plan. The real trick is in defusing pensions as a political issue going forward.

Developing a “cost corridor” for defining benefits, now and later

Houston officials and employees might have been able to come to the table and agree on the city’s pension obligations for the next fiscal year. But the contribution rate will change the year after that, and the year after that, and the year after that. Every year is a new opportunity for one side or the other to hold out for more.

Houston’s way around that is the “cost corridor,” a kind of meta-scheme for deciding in the future what that contribution rate will be and how disputes will be resolved. The cost corridor depends on balance. When the city’s pension funds enjoy a good year on their investments, then the city’s contribution rate can go down. If the city’s pension funds suffer a bad year on their investments, the contribution rate needs to go up. So far, so good.

The cost corridor sets a mid-point for the city’s contribution rate, an actuarial sweet-spot that Houston aims to predict and achieve. The plan also sets high and low points, which serve as the corridor’s “rails.” If the city’s contribution rate moves more than 5 percent from the mid-point, one way or the other, it’s beyond the rails. “Everything comes down to the contribution rate,” says Kelly Dowe, finance director for the City of Houston and one of the plan’s chief architects. “That’s what defines what the city pays every single year.”

So if the city’s contribution rate for one of its pension funds rises to, say, 35 percent of payroll, when the target is 30 percent, then the city and the pension head back to the drawing board. If the city’s cost contribution goes over the high end of the corridor, then officials and employees agree on benefits cuts to bring the city’s contribution rate back into the cost corridor.

On the other hand, if Houston’s contribution rate falls to 25 percent—because times are good and investments are zippy—then the city agrees to adjust its amortization schedule to pay down its liability more aggressively. Funding its pension obligations faster than the 30-year period would bring Houston’s contribution rate back into the cost corridor. “There’s a very prescriptive list of things that are slightly different between the funds,” Dowe says. “[Houston] can shorten the amortization period. We can say that now the unfunded liability is going to be paid off in 29, not 30 years. Or we can move from a 7-percent investment rate of return to 6 percent. Those things that make the system stronger.”

Houston also plans to invest more than the midpoint in order to keep to its repayment reschedule. If the mid-point of the cost corridor for a pension system falls at a 27-percent contribution rate, for example, Houston will commit to 30 percent.

According to Dowe, the cost corridor will serve Houston even after the city meets its pension liability (by 2047, if not sooner). “Once we get a funding ratio of 100 percent, then we can start talking about changing benefits for the plan. It has to be a fully funded plan,” Dowe says. “If you’re 100 percent funded and below the bottom of the corridor, you can start the conversation about raising benefits. But that’s way out in the future.

Getting to ‘yes’ after years of ‘no’

The Turner administration’s cost corridor plan has the backing of all three pension systems. It’s also won over the Greater Houston Partnership, the city’s business alliance, as well as the Kinder Institute for Urban Research, the wonk shop at Rice University. The Baker Institute for Public Policy’s John Diamond, who has advocated for defined-contribution plans, nevertheless supports the cost corridor as “self-enforcing mechanism” for funding Houston’s pensions.

“Houston’s problem is that, under the current plan, when Houston has a problem, if they go to the three pension boards and say, ‘We need to fix an unfunded problem,’ the pensions board can just say no,” Diamond said during a panel conferred by the Texas Public Policy Foundation, a conservative think tank. “Then the political leaders can’t act.”

There is one lone hold-out on the Houston City Council: Mike Knox, a Houston police veteran with more than 15 years’ experience in the department. Knox insists that he does not oppose the mayor’s plan outright. He just wants to see specific figures before he is willing to sign off on it. “It’s all verbal,” Knox says. “I haven’t seen anything in writing from the mayor.”

Everyone in Houston, Knox adds, recognizes that something has to change, down to rank-and-file police officers. The status quo is unworkable.

For a cautionary example of what might come to pass if the Texas legislature doesn’t pass Houston’s plan during the session that opened this month, look to Dallas, where police and firefighters just rejected a $2.3 billion slate of benefit changes. Dallas is “walking the fan blades” of municipal bankruptcy, according to Mayor Michael Rawlings—who has reached out to Mayor Turner to see whether Houston’s cost corridor could work three hours north along I-45.

Turner says that the cost corridor itself won’t address Houston’s root financial problems. His next goal is to try to persuade Houstonians to lift the self-imposed revenue cap that they voted into place back in 2004. That cap has caused Houston to cut property tax rates multiple times since 2014, meaning lost revenues, meaning a challenge for funding the city’s obligations. Mayor Turner hopes to see the revenue cap go up for reconsideration on the ballot in November.

For now, the cost corridor is Houston’s best bet to make sure that the city meets its pension obligations now and in the future. The cost corridor may be Texas’s best bet, too. If it works for the cities facing the worst pension crises—namely Houston and Dallas—then it may work elsewhere, including Phoenix (#3 on Moody’s list) and Los Angeles (#5). A similar scheme of mandatory arbitration and regular benchmarks might even rescue the imperiled pensions of workers in economically hobbled Detroit (#7). There isn’t any precedent for what Houston is trying to do.

“It’s good old-fashioned Houston ingenuity,” Dowe says.

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