Articles, Research and Spotlights 

• How to Structure an Optional Defined Contribution Government Plan
• Texas Needs to Reexamine Law Restricting Firefighter Pension Reform
• Pensions a Large Part of California’s $500 Billion in Government Debt
• Budget Surpluses: A Chance to Reduce Pension Debt

News in Brief
Quotable Quotes on Pension Reform
Reason in the News
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research and Spotlights

Best Practices in Optional Defined Contribution Plans for Public Workers

Defined benefit (DB) pensions remain the most common retirement option for public workers. However, growing unfunded liabilities and evolving needs for employment flexibility are prompting governments to consider defined contribution (DC) plans like the private sector’s 401(k). One approach that has proven to be particularly effective for state and local governments is to offer an optional DC plan alongside the traditional DB benefit, giving new hires a choice to select the type of plan that best fits their expected career path. A new policy brief by Reason Foundation’s Zachary Christensen explores this approach, finding that providing employees with this option optimizes retirement for most public workers while also helping governments reduce pension-related debt. The brief provides actionable recommendations for policymakers, such as optimal contribution rates, default settings, and education strategies for new employees.
Policy Brief
Recorded Webinar

A Texas Law Governing Firefighter Pensions Is Straining City Budgets

The Texas Local Fire Fighters Retirement Act (TLFFRA) is the law that sets the rules for the management of city and county firefighter pensions in the Lone Star State. Reason Foundation’s Ryan Frost explains that while the purpose of TLFFRA is to protect the benefits of firefighters, aspects of the law create unreasonable pressures on local governments, tying the hands of policymakers at the expense of taxpayers. The law establishes rules for the makeup of pension governing boards that systematically prioritize the interests of firefighters over the government and taxpayers that will ultimately bear the brunt of any unexpected costs. It also requires the approval of firefighters for any reform to the benefits for new hires, which creates a nearly insurmountable barrier to necessary and prudent adjustments. Texas lawmakers should reexamine TLFFRA to enable essential reforms that balance fiscal responsibility with benefit security.

California’s State and Local Government Debt is Over $500 Billion

California’s combined state and local government debt now exceeds half a trillion dollars, with unfunded pension and healthcare liabilities as the main culprits, reports Reason Foundation’s Mariana Trujillo.  Pension debt alone has multiplied more than sevenfold in the past decade, putting immense pressure on city budgets across the state. Cities like San Bernardino and Scotts Valley are grappling with severe financial strain of increased pension costs, highlighting the urgent need for sustainable pension solutions.

States Should Use Budget Surpluses to Pay Down Public Pension Debt

Newly released fiscal survey reporting from the National Association of State Budget Officers (NASBO) gives a positive outlook for states over the next year. The report projects that many states will see budget surpluses in 2025 due to revenue growth and moderated spending. Reason Foundation’s Steve Vu articulates the opportunity many state governments will have, encouraging lawmakers to dedicate these potential windfalls toward paying down long-standing pension debt rather than using it to pay for new government programs.

News in Brief

Pooling Defined Contribution Plans

A recent issue brief by the American Academy of Actuaries discusses best practices for implementing collective defined contribution (CDC) plans, which feature fixed contribution rates but provide variable retirement benefits, adjusting based on investment outcomes and demographic factors. Unlike defined benefit (DB) plans, CDCs do not promise a specific benefit amount; instead, benefits fluctuate with the plan’s financial health, balancing the need for sustainable income with predictable contributions. Unlike defined contribution (DC) plans, CDCs pool fixed contributions from employees and employers into a single collective fund, allowing for the shared management of investment and longevity risk. This structure mitigates the need for additional contributions if assumptions fall short. Some governmental entities in the Netherlands, Canada, and the United Kingdom have replaced defined benefit plans with CDCs for new hires. However, under current U.S. law, CDC plans are not permitted by the Employee Retirement Income Security Act (ERISA), which generally requires either guaranteed benefits or individual accounts. The full brief is here. 

Pensions Pay Different Fees for the Same Financial Services 

A report from Nasdaq finds that public pension funds pay widely varying fees for identical passive index strategies. Analyzing the S&P 500, Russell 1000, Emerging Markets, and other index strategies, the report reveals significant fee discrepancies. The highest asset size tier (over $1 billion) saw the smallest dispersion in fees, while the lowest asset tier (below $50 million) had the greatest dispersion in fees paid. The report suggests many funds could achieve substantial savings without switching providers by leveraging peer benchmarking data to negotiate better terms. Limited pension investment fee transparency constrains negotiation potential and fiscal savings, but the report suggests using public benchmarking data could enable funds to optimize fees. The full report is here.

Quotable Quotes on Pension Reform 

“I don’t think there’s any question that many of the positions we hire…as well below the private market [in salary. …] We’ve always assumed people stayed in the public sector because of the good benefits, and I think we’re seeing that is deeply eroded.”
— Julie Kushner, Connecticut State Senator and co-chairwoman of the legislature’s Labor and Public Employees Committee, quoted in “CT retirement benefit debate looms large over next term,” Connecticut Mirror, Oct. 30, 2024.

“It’s the cost-of-living adjustment and the 3% compounding that’s driving the pension debt crazy, it’s not the pension itself.”
— Steven Reick, Illinois State Representative, quoted in “Panel discusses proposals to shore up Illinois’ unfunded pension liability,” The Center Square, Oct. 15, 2024.

Reason Foundation in the News

“When you’re making a decision like that—especially when you’re backtracking and you’re undoing a cost-saving reform that was done over a decade ago, you need to keep in mind that that’s going to pack in a lot of risk and that could turn south very quickly with a couple of bad years’ returns.”
— Zachary Christensen, Pension Integrity Project Managing Director testimony before Oklahoma State House Pension Committee, quoted in “Oklahoma pension changes may have been based on myth,” Oklahoma Council of Public Affairs, Nov. 4, 2024. 

“[Oklahoma’s full funding of its public employee pension] is an incredible accomplishment that should be acknowledged and protected. … Any change in the retirement benefit structure could revert or threaten this progress, and this is something that would have a tremendous effect on the fiscal health of this state and, again, the retirement security of your fellow employees.”
— Mariana Trujillo, Pension Integrity Project Policy Analyst testimony before Oklahoma State House Pension Committee, quoted in “Experts warn Oklahoma pension changes could harm state finances,” Oklahoma Council of Public Affairs, Oct. 10, 2024.

Data Highlight

Each month, we feature a pension-related chart or infographic created by our team of analysts. This month, we highlight Steve Vu’s analysis of surveyed state budget surplus funds, also known as “rainy day funds” or RDF. These growing reserves offer states a financial cushion against revenue volatility and economic downturns. As balances grow, states have an opportunity to allocate a portion of these funds toward paying down pension debt compounding at high interest rates, strengthening their long-term fiscal stability. Read the full analysis here.

The post Pension Reform News: How to structure an optional defined contribution government plan appeared first on Reason Foundation.

The Texas Local Fire Fighters Retirement Act (TLFFRA), in its current form, ties the hands of municipal governments, forcing them to resort to precarious financial strategies that offer only temporary respite. State legislative reform is urgently needed.

The structural flaws of the Texas Local Fire Fighters Retirement Act

The Texas Local Fire Fighters Retirement Act is a state law that governs retirement systems for firefighters employed by cities or other political subdivisions in Texas. These systems are managed by a board of trustees, which typically includes municipal representatives, firefighters, and additional appointed members. 

The TLFFRA gives each participating pension board the flexibility to design its retirement plan and determine benefit levels, eligibility criteria, and contribution rates, which are paid for by local tax dollars. The law requires regular actuarial evaluations to monitor the financial health of the pension systems and mandates the pension boards to adopt adjustments as needed to maintain fiscal balance.

Ironically, the structure of these pension boards has often led to significant imbalances. Take Midland, for example, where the seven-member pension board includes three active firefighters, the mayor (or a designee), and the city’s chief financial officer. The remaining two seats are chosen by a vote of these five members. As firefighters control three of those votes, they effectively hold the power to shape the board’s makeup. What should be a balanced board skews heavily in favor of firefighter interests, leaving the city with just two representatives advocating for taxpayer concerns despite the firefighters, in most cases, bearing zero responsibility to pay for unfunded liabilities.

In addition to unbalanced board representation, cities also have no authority to amend the pension benefits offered to new hires under TLFFRA. Any changes to the pension plan must be agreed and voted upon by the active firefighter membership. This structure inherently disincentivizes firefighters from agreeing to necessary benefit adjustments for future hires, as they bear no direct financial risk for their constitutionally protected benefits’ impact on county and city budgets. This lack of financial accountability among firefighters creates a cycle where pension promises remain generous while the means to fund them become increasingly strained. 

Simply put, firefighters design and run the firefighter pension system while taxpayers pay when it goes off the rails. 

TLFFRA sparks a rash of pension obligation bonds that rarely work

Pension obligation bonds (POBs) are not without risk and are a poor replacement for actual funding and benefit adjustments. These bonds are bets that the returns on invested funds will exceed the bonds’ interest costs. However, history has shown that this strategy can lead to disastrous outcomes if market conditions deteriorate. Cities like Stockton and San Bernardino in California experienced severe financial crises when their POB-funded pension strategies failed, leading to bankruptcy and immense taxpayer burdens.  

Today’s high-interest rate environment makes it a terrible time for Texas cities to pay off their unfunded pension liabilities with pension obligation bonds. If the investments underperform the interest rate of the borrowed funds or the market crashes, the returns will not cover the cost of the debt, leaving the issuer with even larger pension obligations.

Midland, Texas

Midland serves as a stark example of the detrimental effects of the Texas Local Fire Fighters Retirement Act. In recent years, Midland has seen its pension fund’s unfunded liabilities grow to $121 million due to the combined effects of lavish benefit promises and underperforming investments. As a result, the city needs to allocate more of its budget to cover pension costs, which limits its ability to fund other essential services. The city’s leaders are caught in a financial bind where raising taxes or cutting services are the only immediate options, both of which are politically and socially challenging.

The city’s firefighter pension fund crisis has escalated to the point where public safety costs consume over 50% of the city’s general fund budget. This immense financial pressure has forced Midland to seek emergency solutions to bridge its pension funding gap. Failure to properly address the issue will result in the pension system soon exhausting its assets, which will lead to costs triple or quadruple what they are today. 

Despite the mayor and city council’s efforts, the existing TLFFRA framework leaves them with limited options to control these escalating costs. Over the past three years, Midland has presented various solutions to its firefighters to address the pension fund shortfall, including multiplier changes, final average salary changes, removal of pension spiking, and contribution rate changes. Unfortunately, these proposals have been met with significant resistance, with firefighters rejecting nearly all of them apart from a small increase in contribution rates. This stalemate has worsened the financial crisis as the city cannot unilaterally implement changes to the pension plan under the current TLFFRA regulations. 

Irving, Texas

Irving’s issuance of an $86.3 million POB in 2021 reflects the desperate measures cities are resorting to under the TLFFRA. The decision to issue pension obligation bonds was driven by the need to stabilize the firefighter pension fund without resorting to drastic measures, such as slashing benefits or significantly increasing taxes. The plan sat at a funded ratio of 64%, just a couple of bad years of investment returns away from spiraling into insolvency. 

Longview, Texas

Longview has similarly issued pension obligation bonds to address its firefighter pension fund issues. In 2022, the city approved a $45.6 million bond to stabilize its Firemen’s Relief and Retirement Fund, which sat at just 41% funded. This move mirrors Irving’s approach and underscores the widespread reliance on risky financial instruments to manage pension liabilities under the TLFFRA. Longview took another step backward by also reducing the employer contribution rate to the plan, dropping from 19% to 12%.

Longview’s pension fund challenges, like its sister cities around Texas, were compounded by a history of underfunding and investment shortfalls. By issuing

POBs, the city aims to shore up its pension fund and reduce its unfunded liabilities on paper. However, this strategy does not address the underlying issues of pension plan design and governance that have led to the current financial predicament. The reliance on POBs is a stopgap measure that postpones the day of reckoning while exposing the city to even more financial risk if market conditions become unfavorable.

The need for legislative reform

With the Texas Local Fire Fighters Retirement Act preventing reasonable solutions, many municipal governments are left with having to make poor decisions for their taxpayers, highlighting the need to reform this law. 

The Texas Legislature should consider amending the statutes governing firefighter pensions. Key reforms should include:

1. Allowing cities to adjust benefits for new hires: Municipalities need the flexibility to modify pension benefits for new hires to ensure long-term sustainability.
2. Increasing transparency and accountability: The Texas Pension Review Board has highlighted many issues with these TLFFRA plans, but has limited authority to force changes. 

Without these reforms, Texas cities will continue to face escalating public pension liabilities, jeopardizing their financial stability and burdening taxpayers. It is imperative for the legislature to act now to secure a sustainable future for both Texas cities and their firefighters.

The post A Texas law governing firefighter pensions is straining city budgets appeared first on Reason Foundation.

While the history of the Public Employees Retirement System ‎(PERS) and the origins of its $26 billion in unfunded pension obligations have been well covered, stakeholders have proposed few recommendations. It would be helpful for Mississippi stakeholders to examine how other states addressed similar public pension challenges, including reducing public pension debt and rising costs to taxpayers and making their pension plans more sustainable in the future.

North Dakota provided new hires with a new defined contribution retirement plan

Like the challenges Mississippi faces, the North Dakota Public Employees Retirement System‎ (NDPERS) would have continued to accrue unfunded liabilities in perpetuity without significant changes and additional funding. Maintaining statutory rates with incremental rate adjustments was insufficient, resulting in the contributions from workers and employers consistently being below what was required to properly fund the pension plan (also known as the actuarially determined contribution rate, or ADEC). In addition to its financial woes, the NDPERS defined benefit (DB) plan was also experiencing massive employee turnover, similar to what Mississippi PERS is seeing.

After a collective effort to identify and solve the problems facing NDPERS, state legislators penned North Dakota House Bill 1040, which addressed the longstanding issue of systematic underfunding by transitioning from fixed contribution rates to an actuarially determined contribution rate. 

Additionally, North Dakota’s legislation offered all future public employees a defined contribution (DC) retirement plan, which was projected to provide a greater retirement benefit for most employees without the risk of runaway costs and debt plaguing the defined benefit pension system. 

The state committed to paying off NDPERS’ existing $1.8 billion debt over 30 years, supplemented by additional cash infusions until the defined benefit plan reached 90% funding—meaning it has money to cover 90% of the pension benefits already promised to workers. 

Modeling forecasts estimated the bill would save the state $2 billion over 30 years compared to the status quo. The pension reform also promised improved retirement benefits for most newly hired employees, significant debt reduction, and eventual budget relief for North Dakota.

Arizona opened a new DC/hybrid choice system for public safety

The need to reform Arizona’s Public Safety Personnel Retirement System‎ (PSPRS) became urgent due to its declining financial health, which resulted in soaring annual pension costs for local governments and state agency employers. The pension system was burdening taxpayers with significant new, unexpected costs. The two primary factors contributing to PSPRS’s financial deterioration were its flawed permanent benefit increase (PBI) mechanism meant to serve as a cost-of-living adjustment (COLA), similar to the Mississippi PERS COLA, and underperforming investment returns that failed to meet overly optimistic expected rates of return.

The 2016 pension reform of Arizona’s PSPRS encompassed various elements affecting current workers, retirees, and future employees. The reform replaced the permanent benefit increase feature for current personnel and retirees with a pragmatic, pre-funded cost-of-living adjustment tied to inflation that protects fixed retirement benefits without adding unnecessary costs to taxpayers. 

To address the growing costs of PSPRS, Arizona’s public pension reform also introduced a new retirement plan design for new employees, offering a choice between a defined contribution plan and a defined benefit-defined contribution hybrid plan, alongside adjustments to pensionable pay caps, benefit multipliers, and retirement age eligibility. 

Arizona also implemented governance reforms, including changes in the PSPRS board composition and fiduciary standards to increase accountability and efficiency. 

Overall, Arizona’s public pension reform has already yielded significant savings for government agencies and taxpayers, reduced future pension liabilities, mitigated market risks, and provided more sustainable retirement options for public safety personnel.

Michigan opened a new DC/hybrid choice system for teachers

Like numerous other public pension systems across the United States, the Michigan Public School Employees’ Retirement System‎ (MPSERS) grappled with an overwhelming burden of unfunded liabilities and the anticipation of escalating contribution rates. The Michigan teachers’ plan was fully funded in 2000, but by the end of June 2016, the plan’s funded ratio had plummeted to below 60% and had a staggering $29.1 billion in unfunded liabilities. 

Various factors caused this pension debt, with two-thirds attributed to investments falling short of overly optimistic expectations over 15 years. Moreover, flawed actuarial assumptions, such as overestimating payroll growth, compounded the problem.  

In response, Michigan initiated a pension reform effort focused on addressing the needs of current and future members and reducing the state’s financial risks. 

The resulting public pension reform introduced an automatically enrolled defined contribution plan for future members with a minimum 4% employer contribution, extendable by up to 3% in matching contributions. Within four years of membership, teachers became fully vested in a 14% DC Plan, ensuring a robust retirement benefit. 

New hires also have the option to choose a hybrid plan within 75 days of employment. For active and retired members, measures like reducing the assumed rate of return to more realistic levels and moving to a contribution rate floor were also implemented to address potential market downturns and increase legislative accountability in funding obligations.

Texas public employees opened a new cash balance pension plan

Over the last two decades, the Employees Retirement System of Texas (ERS), which provides retirement benefits to most state public employees and sworn law enforcement personnel, has declined from full funding to holding $14.7 billion in unfunded pension obligations. 

By 2021, ERS was trending toward complete insolvency within the next 20 to 30 years in the absence of significant legislative changes. Overly optimistic investment return assumptions and underperforming investment returns resulted in over $8 billion in pension debt. Approximately $4.5 billion of this debt stemmed from the state government systematically underfunding its public pension systems through insufficient contribution rates. 

Moreover, a relatively small percentage of Texas workers—less than 14 percent of those hired under age 35—actually worked for the government long enough to receive a full, unreduced retirement benefit. A significant portion, 64 percent of Texas state workers, worked for the government for less than five years and didn’t even qualify for a pension.

Texas Senate Bill 321 employed two key strategies. Firstly, it revamped the retirement plan for newly hired workers by introducing a cash balance pension, reducing taxpayer financial risk over time by guaranteeing a return on investments instead of guaranteed lifetime income. The cash balance approach reflected the successful experiences of Texas’ municipal governments, which had used this type of plan to offer valuable retirement benefits without the compounding costs of pension debt for decades. 

Secondly, the Texas reform addressed funding and contribution policies to rectify two decades of structural underfunding, opting for an ADEC policy and committing supplemental appropriations. With improved funding policies, ERS is now on track to eliminate its debt and funding shortfalls.

The two-step approach of successful state pension reform efforts

Across the various public pension reform efforts mentioned above and pension and retirement plan designs that have emerged from other states over the last decade, a two-step approach has been the foundational organizing principle driving stakeholders to sustainable, long-term solutions. Mississippi should follow suit. 

First, Mississippi lawmakers must establish a plan to fully fund the constitutionally protected retirement benefits guaranteed to workers in the Public Employees Retirement System‎ (PERS), which includes nearly a quarter of Mississippi residents. Second, state lawmakers must create a path to retirement security for all future PERS members. 

Step 1: Establish a plan to tackle unfunded pension benefits as consistently and quickly as possible

The cost of providing PERS pension benefits has never been higher than it is today in the post-Great Recession (2007-2009) financial environment, and allowing PERS’ debt to continue growing will only add to the costs on government employers—and, thus, taxpayers. 

Successful pension reform efforts have limited the impact of rising costs by first focusing on setting the underfunded pension system on a prompt path to full funding through debt segmentation and committing to an actuarially determined contribution rate funding policy. 

Segmenting accrued unfunded liabilities from any gains or losses in future years allows policymakers to set the past debt on a direct and fiscally realistic course to being fully funded and prevents the need to revisit the issue in subsequent legislative sessions. 

Adopting more conservative payroll growth and investment assumptions and a responsible amortization policy for any emerging unfunded liabilities would ensure that the new pension debt accrued in a given year is paid off faster and more consistently. 

Committing to an ADEC funding policy to regulate contribution rates guarantees the funding goals are met regardless of market volatility.

Step 2: Create a path to retirement security for all participants 

In addition to the rising costs associated with the current PERS benefit, analysis of assumptions used by plan actuaries reveals that 81% of new workers (beginning work at age 25) leave before vesting in the plan with eight years of service. Employees who leave the plan before then are unable to receive a PERS benefit and must forfeit contributions their school or the state made on their behalf. For workers starting at the age of 25, 89% leave before 20 years of service, and only 9% remain in the system long enough to receive full pension benefits after 30 years of service. 

The fact is that very few employees entering public employment in Mississippi will take part in the full pension benefit as it is currently offered.

The examples above from North Dakota, Arizona, Michigan, and Texas addressed this issue by modernizing retirement plan design to serve more of their new hires. Although each state adopted unique plan designs, they all achieved the same goals. 

Mississippi policymakers should focus on this approach when considering a new retirement plan for new hires. From the perspective of serving public employees, a successful new tier provides a path to a financially secure retirement for all career and non-career members that is more attractive to the 21st-century employee. 

From taxpayers’ perspective, stabilizing contribution rates for near and long-term budgeting is essential. Reducing Mississippi’s public pension system’s exposure to financial risk and market volatility with responsible debt reduction policies would likely lead to higher contribution rates in the immediate term but will guarantee stakeholders that debt costs are not being passed on to future generations.

Although Mississippi lawmakers attempting to tackle the various challenges facing PERS might find themselves in unfamiliar waters, they should rest assured that those waters are not uncharted. Several other state legislatures have dedicated years to organizing and detailing successful public reform packages that Mississippi lawmakers can take the best of and use to guide how they address the state’s current challenges with PERS. 

The post Mississippi lawmakers can take the best from other successful state pension reforms appeared first on Reason Foundation.

Articles, Research & Spotlights 

• Flaws in proposed COLAs in Pennsylvania
• Warnings of issuing pension obligation bonds in Dallas
• Grading Ohio’s defined contribution plans for public workers
• Texas voters approve cost-of-living adjustment for retired teachers
• Michigan’s model for reducing pension debt in cities and counties
• Examination of the actuarial firms overseeing public pensions

News in Brief
Quotable Quotes on Pension Reform
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Pennsylvania’s Proposed Pension Bills Don’t Meet Best Practices for Cost-of-living Adjustments 

Three bills under consideration in the Pennsylvania legislature—Senate Bill 864, House Bill 1415, and HB 1416—would provide a one-time cost-of-living adjustment (COLA) to retired public workers. House Bill 1415 recently passed in the House and will be up for the Senate to consider. Reason Foundation’s Steven Gassenberger and Rod Crane explain that since a COLA benefit was not promised or funded in advance, the costs would be high and fall squarely on today’s taxpayers’ shoulders. They compare the three proposals with Reason’s best practices for COLA benefits, finding that they neither fund the cost-of-living adjustment efficiently nor tie them to inflation measurement. Pennsylvania’s main public pension plans are struggling to fund the benefits promised to workers and retirees. Both main state plans have less than 70% of the funds needed to fulfill promises, so policymakers should cautiously approach proposals to promise more benefits.

Dallas Should Not Bet on Pension Obligation Bonds to Save Pension System

Responding to state requirements to be on track to fully fund the Dallas Police and Fire Pension System by 2055, a newly appointed city council committee is evaluating the possibility of issuing a pension obligation bond (POB) to reduce the plan’s $3 billion in unfunded liabilities. Reason’s Mariana Trujillo and Truong Bui warn that while this strategy may alleviate the city’s pension funding woes in the short term, it comes with more exposure to market losses. They explain that a POB differs from an interest refinance because it does not release the government of the original benefit obligation or any of its continued unexpected costs. They warn that POBs are more akin to leverage strategies that amplify investment risk.

Evaluation of Defined Contribution Plans Offered to Ohio Public Workers

When teachers and general government workers are hired in Ohio, they can choose between several retirement plan options. Among those available plans are the State Teachers Retirement System and Public Employee Retirement System defined contribution plans, which offer a flexible and modern approach to retirement savings. In these evaluations of the state’s two major defined contribution plans, Rod Crane and Rich Hiller apply Reason’s best practices to identify what Ohio’s plans do right and where there are opportunities for improvement.

Texas Voters Approve Cost-of-Living Adjustment for Retired Teachers

With 83% of the vote, Texas voters overwhelmingly approved a constitutional amendment granting the state legislature the authority to give retired teachers a one-time cost-of-living adjustment. Before the election, Reason’s Steven Gassenberger outlined how Prop. 9 will increase benefits and long-term liabilities of the Texas Teacher Retirement System, which holds $63 billion in unfunded liabilities. With these added benefits come more risks of unfunded liabilities if investments fall below the system’s assumed 7% return.

The Way Michigan’s Pension Reform Tackles Public Pension Debt Is a Model for Other States

In 2017, Michigan lawmakers took strides to improve the health of severely underfunded municipal pensions with the Protecting Local Government Retirement and Benefits Act 202. The initiative established detailed reporting and required corrective action from local plans that fell to funding below 60%. With transparency and funding expectations now well established, the legislature followed up with Act 166 in 2022, which offered state funding in the form of grants conditional on a local government’s continued adherence to a correction plan. Reason’s Mariana Trujillo illustrates how the combination of these strategies proved a powerful avenue for reforming Michigan’s public pension systems and reducing long-term costs for taxpayers in ways that are a model for other states grappling with municipal pension debt.

The Actuarial Firms Working with the Most Public Pension Plans and a Surge of Unfunded Liabilities

Public pension plans contract with actuaries to calculate and report funding projections and contribution requirements. According to Reason’s Thuy Nguyen examination of 209 major public pension plans, most of this work is being done by 32 actuarial firms. As of 2021, Gabriel, Roeder, Smith & Company (GRS) was the leader, overseeing public pension plans with an aggregate of over $1.5 trillion in actuarial accrued liabilities, followed by Cavanaugh Macdonald Consulting with $901 billion in total debt and Milliman with $791 billion in unfunded liabilities. Most actuarial firms added to the number of plans they consulted over the last five years. Since 2016, the Segal Group added eight new plans to their clientele, Cheiron Inc. added four, and Foster & Foster added two. 

News in Brief

Growing Allocations in Alternatives Pressures Plans to Improve Fee Reporting

A new report from the Pew Charitable Trust Public Sector Retirement Systems Project measures the proliferation of “alternatives” in pension investment portfolios and calls for more effective risk disclosures. According to the analysis, funds have doubled their allocation to riskier alternative investments, like private equity and hedge funds, over the past 15 years, leading to an aggregate 30% increase in investment fees as a percentage of total assets. The number of funds adhering to more robust disclosure practices has increased since 2016. Out of the 73 largest funds controlling 95% of all pension assets, there was a slight increase in those who made their investment policy statements available online, from 59 to 64. Further, there was a reduction in funds reporting only gross-of-fees investment performance, from 27 in 2016 to 18 in 2021. The full report can be found here. 

Incorporating Automatic Enrollment in Defined Contribution Plans Could Improve Retirement Outcomes

Incorporating automatic features in defined contribution (DC) plans, such as automatic enrollment and escalation, could significantly aid state and local government employees in mitigating longevity risks (the risk of outliving one’s retirement savings). A new report from MissionSquare Research Institute finds that although automatic enrollment has been adopted in 17 DC plans across states and the District of Columbia over the past 15 years, the use of automatic escalation remains notably sparse. This lack of adoption is attributed to various factors, including government officials’ reluctance to proceed without explicit statutory authority. The report advocates for integrating automatic escalation in DC plans to ensure public sector employees’ financial security in retirement. It offers case studies of states that have successfully applied this approach. The full report can be found here. 

Quotable Quotes on Pension Reform 

“When people started working for the school district or working for the state, there is nothing that says they’re going to get a COLA…The way that school districts pay for their bills are through school property taxes…So without a doubt, this would lead to a school district property tax increase.”

— Pennsylvania State Rep. Brad Roae (R-Crawford County) on proposals to give ad hoc COLA benefits, quoted in “Nearly 70K Pa. School, Government Retirees Have Had No COLA Increase in 21 Years,” Penn Live, Oct. 31, 2023

“It’s been said that we have an obligation to our retirees current and future…This will substantially weaken the pension fund for our future retirees.”

— Pennsylvania State Rep. Brett Miller (R-Lancaster County) on proposals to give ad hoc COLA benefits, quoted in “Nearly 70K Pa. School, Government Retirees Have Had No COLA Increase in 21 Years,” Penn Live, Oct. 31, 2023

Data Highlight

Each month, we feature a pension-related chart or infographic of interest generated by our team of analysts. This month, we are showcasing an analysis by Reason’s Thuy Nguyen that illustrates the size of pension liabilities managed by the largest actuarial firms. You can access the visualization and more information here.

The post Pension Reform News: Flaws in Pennsylvania proposal, voters approve increase in Texas, and more appeared first on Reason Foundation.

A pension obligation bond is a taxable municipal bond issued to pay off public pension debt. The proceeds are invested in the market in the hopes the investment returns are higher than the interest paid to borrow the money. The upside, commonly referred to as “arbitrage,” is set to enable pension funds to profit from the spread between the principal’s investment returns and the interest paid for borrowing it.     

The Myth of Debt Refinancing

A memorandum presented by the mayor’s committee cited the main concern with issuing a pension obligation bond (POB) as the “current interest rates.” Indeed, the current high-rate environment poses a significant threat to the profitability of pension bonds, but interest rate risk is just the first half of POB’s arbitrage spread risk. 

When pitched by underwriters, pension obligation bonds are often misrepresented as a means of “refinancing your debt.” It might sound like POBs are exchanging the assumed rate of return, the “interest” on their debt, for a lower fixed rate (bond yield). That is not the case. 

A pension obligation bond is a bet that by investing the money borrowed, a pension can make more than the interest they will need to pay. It is not like refinancing a mortgage; instead, it is analogous to taking out a second mortgage and investing the money on the stock market in hopes of making enough to use the net gains to pay off the original mortgage. 

A pension obligation bond is not an interest refinance or an interest swap; it is leverage. A swap would entail a complete exchange of cash flows on a fixed rate for a variable one. POBs do not release pensions from the compounding of the investment rate “interest” on their liabilities, the original mortgage. The variable investment return and market risk, therefore, is not forgone; it is amplified. 

Therefore, the risk is that interest rates will rise and investment returns won’t meet expectations. In practice, these bonds are a financial bet, a leverage on the investment portfolios, hoping to boost revenue to pay off unfunded liabilities. 

Financial leverage is a widespread practice across financial markets. It is not inherently irresponsible. It is commonly used by speculative and actively managed investment funds desiring to take on positions more prominent than their current assets allow, hoping to reach extraordinary gains—and willing to tolerate extraordinary losses. Leverage amplifies the size of one’s investment, implying POBs are not swapping but, in reality, increasing exposure to investment risk. 

The Funding Threat: The Inversion of Spreads

If the effective interest rate on the pension obligation bond is 5%, and a fund invests the lump sum proceeds raised expecting to earn a 7% return on investment, the spread of 7% – 5% = 2% is a novel profit that can aid in repaying the unfunded liability. Of course, the risk is if actual investment returns are lower than expected, say 4%, then the POB results in a loss of 4% – 5% = -1%, leading to an increase in costs and potentially the unfunded liability itself—an inversion of the spread. 

The higher the interest rate in the pension obligation bond, the lower the chance of the POB reducing costs—and the higher the chances of it leading to a reversal of spreads, causing an unintended increase in pension debt. 

Pension debt is, in itself, different from a mortgage or a car loan. Pension debt is an estimate. It is a very well-constructed guess, an estimation of how much pension funds would need today to cover promised retirement benefits fully. Even “paying off” the unfunded liabilities does not release its issuer from the liability itself. Reaching full funding status relies on all assumptions being met, enabling the plan to pay off the promised retirement benefits appropriately. This is a significant “if,” considering one of the main reasons American public pension funds grew underfunded for the past 20 years were deviations from actuarial and investment expectations. 

Funding Ratio Illusions

Pension obligation bonds can lead to a misleading improvement in the funding ratio. They are not factored in as “accrued liabilities,” the present value of retirement benefits, as they are not part of the fund’s owed retirement benefits. In parallel, the assets purchased with the bond proceeds are factored into the funding ratio. Therefore, assets purchased with a POB can appear to generate the impact a grant would have on the funding ratio, but make no mistake, the fund still owes back the bond principal and coupon. 

A pension’s funding ratio is the ratio of the plan’s assets to its liabilities (assets / accrued retirement liabilities = funding ratio). A value under 100% indicates that the projected value of the assets owned is not enough to cover the benefits promised; a value over 100% indicates the opposite: there are more assets than expected to be needed to cover the retirement obligations to members.  

POBs are a liability to the employer, in this case, the government. They are an additional liability—as the promised retirement benefits are still owed, but the bond payments are now also owed. The revenue raised through the bonds is converted into assets for the pension fund in the hopes the arbitrage rate of return the novel assets will yield is higher than the interest paid for the bonds, leading to a net gain in assets. 

With the proceeds from the bond issuance, funding ratios would immediately improve—not accounting for the obligation to pay back the amount borrowed through the bond eventually. 

Concern Is Consensus

The emission of POBs is widely cautioned by academics and analysts from a multitude of backgrounds. Reports from S&P Global, Pew Trust, and the Center for Retirement Research at Boston College have analyzed historical outcomes and raised pertinent concerns against their issuance.

The Government Finance Officers Association condemns the practice, declaring that “State and local governments should not issue POBs” and citing five main concerns:

• Spread Risk: “The invested POB proceeds might fail to earn more than the interest rate owed over the term of the bonds, leading to increased overall liabilities for the government.”
• A Robust Risk Management Operation: “POBs are complex instruments that carry considerable risk […], which must be intensively scrutinized as these embedded products can introduce counterparty risk, credit risk, and interest rate risk.”
• Opportunity Cost of Debt: “Issuing taxable debt to fund the pension liability increases the jurisdiction’s bonded debt burden and potentially uses up debt capacity that could be used for other purposes”.  
• Funding Cost Risk: “POBs are frequently structured in a manner that defers the principal payments or extends repayment over a period longer than the actuarial amortization period, thereby increasing the sponsor’s overall costs.”
• Credit Rating Risk: “Rating agencies may not view the proposed issuance of POBs as credit positive, particularly if the issuance is not part of a more comprehensive plan to address pension funding shortfalls.”

A Leveraged Bet

Pension obligation bonds pose a delicate spread that can reduce or increase a pension unit’s long-term costs depending on how the market unravels. It is a complex and highly speculative practice that does not replace the need for sound pension reform. A municipal bond issuance does not correct inappropriate state and employee contribution schemes or imprecise financial assumptions. The ruptures that created the unfunded liability remain—as convenient as it would be if they didn’t.

As stakeholders discuss viable proposals to address unfunded liabilities in Dallas, the speculative risk and funding nature of pension obligation bonds must be recognized. As correctly identified by the mayor’s ad hoc retirement committee, the spread-reversal risks of POBs are heightened in times of high interest rates with uncertain forecasts—escalating the risk of the bond leading to an increase, rather than a decrease, in the long-term costs of unfunded liabilities. The additional risk of investment returns not unraveling as expected and the illusory effect POBs have on funding ratios must also be recognized.

POBs are not a refinancing of pension debt. They are a mechanism that enables funds to leverage the fiscal credibility of their municipalities to borrow and reinvest in the market to make an investment profit on the spread. Like taking on a second mortgage to invest in the stock market in hopes of making enough to pay off the original, pension obligation bonds are an additional liability of pension units—a speculative mechanism to increase a pension unit’s exposure to investment profits and losses.

The post Dallas should not bet on pension obligation bonds to save pension system appeared first on Reason Foundation.

Proposition 9 (2023) would amend the Texas Constitution by introducing a new section granting the Texas legislature the authority to enact laws allowing for cost-of-living adjustments and supplemental payments to eligible annuitants of the Teacher Retirement System of Texas (TRS).

In the 2023 legislative session, the Texas legislature passed Senate Bill 10, which outlined the process of appropriating and distributing this adjustment and additional payments to eligible retirees who retired before Dec. 31, 2021.

The amendment, now up for popular vote via Prop. 9, includes a temporary provision that mandates a one-time transfer of funds to the Teacher Retirement System of Texas to provide a cost-of-living adjustment, with strict limitations on the use of these funds. The temporary provision would expire on Sept. 1, 2025.

Texas voters will decide on the proposed constitutional amendment in the Nov. 7, 2023, election. Prop. 9 requires a simple majority of voter support to pass.

Fiscal Impact of Texas Prop. 9

The Texas Legislative Budget Board concluded that the proposed cost-of-living adjustment outlined in Senate Bill 10 and authorized by Prop. 9 would have no fiscal impact because the legislature funded a lump-sum payment of $3.35 billion to the TRS Pension Trust Fund from General Revenue for the state’s 2024 fiscal year. The payment was calculated by TRS actuaries using the current financial and demographic assumptions, including projected investment returns, and is meant to ensure that the issuance of the cost-of-living adjustment does not affect the actuarial soundness of the fund.

The Teacher Retirement System of Texas, however, currently has $63 billion in unfunded pension liabilities, according to administrators.  Because investment returns constitute a significant portion of the system’s annual revenue, the accuracy and timing of these investment returns will ultimately determine whether the lump sum payment is sufficient to prevent the fund from adding to its debt and becoming actuarially unsound.

Arguments in Favor of Prop. 9

Arguments in favor of Prop. 9 come from a variety of labor groups, advocates of public education, and representatives of retired personnel who frame the issue as reflective of Texas residents’ support for public educators, including, according to Ballotpedia, the Texas AFL-CIO, Raise Your Hand Texas, Texas Association of School Administrators, Texas Association of School Boards, Texas Elementary Principals and Supervisors Association, and more.

The Texas Retired Teachers Association (TRTA) notes that TRS retirees have not received cost-of-living adjustments since 2004. Opponents note retirees have received some one-time bonus checks issued in recent years instead of a COLA, but teachers’ advocates claim this method hurts retirees’ purchasing power since inflation occurs over time.

Unlike other public employees around the state, most retired educators in Texas do not participate in Social Security, making the TRS pension benefit their primary source of retirement income. The Texas affiliate of the American Federation of Teachers (Texas AFT), the state’s largest union of public sector educators, has mostly expressed support of Senate Bill 10 and Prop. 9.  Texas AFT materials point out that consumer prices have increased by almost 60% since 2004 and say Prop. 9 would support retirees who have not received an adjustment to their TRS annuity over that period to help them keep up with inflation.

After the the State Senate’s unanimous passage of SB 10, Texas Lt. Gov. Dan Patrick (R) said, “Texas retired educators have given so much for our students and for the future of Texas. It is only right that the state help give back to them.” Texas Gov. Greg Abbott signed SB 10 into law.

Arguments Against Prop. 9

Although no formal opposition was registered during the legislature’s consideration of Senate Bill 10 or Texas House Joint Resolution 2 (HJR 2, 2023) which placed the issue on the November ballot, there are three main concerns.

First, the state legislature’s ability to grant any cost-of-living adjustment to TRS participants is predicated on the pension system demonstrating that it will still be on a 30-year track to full funding after the COLA is implemented. Investment performance greatly influences the annual amounts needed to pay off TRS’ current $63 billion debt. Given that the lump-sum amount tied to Prop. 9 is based on plan assumptions, any short-term investment underperformance could cause TRS to exceed its 30-year amortization maximum, increase the system’s unfunded liabilities, necessitate more taxpayer-backed funding to cover the debt and make future COLAs less likely.

The second concern was most clearly on display in messages to members during the hearing of SB10 and HJR2, from Texas-AFT, who described legislators’ efforts as “not providing retirees with a ’COLA’ that reflects the actual increases in the cost-of-living.” Union members also raised concerns about the lack of structural changes to allow for ongoing COLA increases as inflation continues to rise.

Finally, with TRS and taxpayers responsible for $63 billion in unfunded pension benefits, some stakeholders voiced the imprudence of enhancing benefits in a structurally underfunded pension system. While other major pension systems like the Employees Retirement System of Texas (ERS) are funded based on dynamic rates set by plan actuaries that reflect the fund’s real-world experience, TRS contributions remain hard-coded in state statute and require legislation to adjust. Since investment returns comprise nearly two-thirds of all revenue flowing into public pension systems, and the amount appropriated to fund the Prop. 9 TRS COLA is based on the system’s 7% investment return assumption, having an unresponsive funding policy will make it more likely that the system will again exceed the state’s 30-year amortization limit and add to the $68 billion unfunded liability in down years.

Additional Discussion

In the fundamental sense, a cost-of-living adjustment is simply a feature of a defined-benefit pension plan that systematically increases annuity payments so retirees can maintain the value of their earned retirement benefits. As a feature of the benefit, COLAs are most effective when they are funded as part of the normal costs of the benefit and distributed according to specified conditions.

Despite teachers’ groups raising concerns over the impact of inflation on retirees, the COLA authorized in Prop. 9 does not reflect the actual inflation rate experienced by retirees and, thus, is not a true cost-of-living adjustment. Given that Texas enjoyed a budget surplus in 2023 that was the size of some smaller states’ entire budgets, the push by state leaders to use surplus funds to support retired educators came as no surprise. In 2019, the legislature considered a similar proposal but opted instead to issue an additional annuity payment to retirees, commonly referred to as a “13th check.” As even proponents of Prop. 9 have highlighted, granting a one-time benefit increase or issuing an extra annuity payment does not solve the long-term systemic challenge inflation poses to retirees. 

Unlike other similar pension funds around the country, the TRS benefit that members signed up for when they began working with their public employers has never included a guaranteed cost-of-living adjustment as part of the benefit. The TRS benefit is, at its core, a contractual agreement between the state and the employee. An educator works for the participating employer, and in exchange for meeting established tenure requirements, the employer provides a predetermined pension benefit established in state law, called a “defined benefit.” Thus, it is important to recognize that while TRS retirees may desire a cost-of-living adjustment, they are not owed one. If a COLA feature is not included as an element of the defined benefit, which is the case with Texas TRS, retirees are implicitly agreeing they are responsible for planning for inflation risks.

This is important because a defined benefit pension plan with a cost-of-living adjustment feature costs much more than one without a COLA feature, which usually translates into higher employer and employee contributions throughout an employee’s career. Any ad hoc increases to current benefits come with the associated risks of higher costs on future budgets and taxpayers. Essentially, a cost-of-living adjustment was never paid for by TRS retirees or their employers while they were working. As a result, Prop. 9 is effectively asking today’s taxpayers to cover an unplanned benefit increase for already retired teachers.

Lastly, none of the estimates circulated on the potential costs associated with the proposed cost-of-living adjustment include scenarios where investment returns come in lower than the Teacher Retirement System’s expected 7% rate of return. Any shortfall below this expected rate of investment return would increase the state’s $63 billion in unfunded pension liabilities, which would ultimately be passed on to future taxpayers.

The post Texas Proposition 9 (2023): Amends the state constitution to provide a cost-of-living adjustment to teachers appeared first on Reason Foundation.

Articles, Research & Spotlights 

News in Brief
Quotable Quotes on Pension Reform
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

State Pension Plans Match Record High $1.3 Trillion in Unfunded Liabilities

Reason Foundation’s Pension Integrity Project recently released its 2023 State Pension Tracker, which previews how state-run pension systems have fared over the past year. Many public pension plans won’t release official reports of their unfunded liabilities until late 2023 or early 2024, so this tool allows you to select different 2023 investment return rates to see how they would impact a state or plan’s funded ratios and debt. The latest year’s results are also presented alongside a 20-year funding history. Based on an estimated annual investment return of 7% for public pension plans, Reason Foundation forecasts the 118 state pension systems analyzed have $1.3 trillion in total unfunded liabilities at the end of the 2023 fiscal year. California, Illinois, New Jersey, and Texas have the most public pension debt, while Washington and New York are the only states projected to have surpluses. Kentucky and New Jersey are the states forecast to have funded ratios below 50%. Overall, these results suggest that most government pension systems still have a long path ahead to fulfill their retirement promises to teachers, police, firefighters, and other public workers, and policymakers should continue to explore reforms to do so.

Ohio Teacher Plan Offers Choice but Needs Reforms to Improve Resiliency

Ohio’s pension system for educators—the State Teacher Retirement System of Ohio (TRS)—is an innovative example of offering public teachers better options in retirement plans to help meet a wide range of potential career possibilities. New hires can choose between a traditional pension benefit, a defined contribution (DC), or a hybrid combining elements of both options. Like most other pension plans in the country, the defined benefit portion of TRS continues to face significant challenges with rising costs. Despite several previous positive pension reforms to manage runaway costs, Ohio TRS is still very vulnerable to market volatility. According to a Pension Integrity Project analysis, a single economic recession could easily pull TRS from achieving full funding, and policymakers should consider further improvements to funding policies.

Examining Calls to Bring Back Alaska’s Defined Benefit Pensions

A report from the National Institute on Retirement Security (NIRS) has added to calls to bring defined benefit pensions back for public workers in Alaska, which closed its pension plan to new workers in 2005. The analysis effectively illustrates the growing challenge of a more mobile workforce that nearly all public employers face today. Still, it does not prove that defined benefit pensions would turn the tide on this trend for Alaska. Reason’s Zachary Christensen and Jen Sidorova examine the NIRS findings and add context from several recent studies on the sentiments and patterns of public workers in Alaska and other states. Pensions, or any retirement plan type, are unlikely to solve the state’s ongoing recruitment and retention challenges, and policymakers should shift their thinking to focus on retirement plans that offer adequate benefits to all public workers, not just those who stay for decades.

Texas Legislature Should Prioritize TRS Reform in Special Session

Texas Gov. Greg Abbott called a special legislative session to focus on education policy, allowing lawmakers to address some lingering issues regarding student open enrollment and the state’s $63 billion in teacher pension debt. This Pension Integrity Project backgrounder shows the legislature has been structurally underfunding the Teacher Retirement System of Texas (TRS), and ignoring its growing debt will eventually require significant additional taxpayer dollars at both the state and local levels.

Connecticut’s Efforts to Reform Public Pensions May Add Long-Term Costs for Taxpayers

A recent reform of the Connecticut Municipal Employees Retirement System applies some cost-saving measures to relieve growing budget pressures but also makes changes that will add to the long-term costs for city and county employers. House Bill 6930 adjusts the system’s cost-of-living adjustment program and adds a deferred retirement option program, both of which could positively and negatively impact local budgets. Reason’s Ryan Frost identifies the most concerning change applied from the reform—extending the system’s amortization period from 17 to 25 years. This change may reduce annual costs upfront but will pass on significant long-term costs to future budgets.

Calls for Public Pension Systems to Divest From Energy Sector Are Shortsighted

Some environmental advocacy groups claim that it is in public pension systems’ best interests to divest from the energy sector, arguing that if they had done so in 2013, the pension plans would be in better standing with investment returns today. However, as Reason’s Jordan Campbell indicates, this analysis and limited timeframe come with many caveats and should not be viewed as a reliable predictor of the future. The period between 2013 and 2022 included a significant drop in oil prices, so it is unsurprising that energy sector investments were a net drag on investment portfolios during that narrow snapshot. Campbell argues public pension systems should maintain long-term perspectives on risks and investments and their fiduciary duty to make investment decisions in the best financial interest of their members.

News in Brief

Increased Contributions, Not Returns, Have Driven Improvement in Pension Funding Levels 

A report from the Public Sector Retirement Systems project at The Pew Charitable Trusts examines recent trends in pension contributions and funding. In 2020, for the first time in nearly two decades, state pension plans collectively surpassed the requisite contribution levels needed to honor promised benefits, a landmark reached due to persistent increases in contributions from employers and employees. From 2007 to 2020, contributions from employers surged at an annual pace of 7%, leaping from $50 billion to $130 billion. Though exceptional investment returns in 2021 gave pension plan balance sheets a boost, the subsequent turmoil in financial markets led to a 6% to 8% estimated average loss on plan investments in fiscal year 2022, erasing much or all of the gains in 2021 and bringing plan funding close to pre-pandemic levels. The growth in plan contributions was the main driver for the improvements in state pension funding ratios. The full report can be found here.

Quotable Quotes on Pension Reform 

“No one would ever be excited about losing money, but I think it’s important to think about what happened in that year and to place this all in a little bit of context…So let’s go back into that year and think about all the things that we were all reading about—really high inflation, interest rates on the rise, commodities, a simmering war in the Ukraine—so it created a really volatile environment for investing in the world. And that’s the world in which we operate.”

— Oregon State Treasurer Tobias Read quoted in “Oregon’s public pension fund lost money last year. Taxpayers may be on the hook for it,” KGW8 Oregon, Oct. 12, 2023

Data Highlight

Each month, we feature a pension-related chart or infographic of interest generated by our team of analysts. This month, Reason’s Jordan Campbell created an interactive scatter plot of 2018-22 investment alphas organized by industry to examine recent impacts on public pension returns. Access the visualization here.

The post Pension Reform News: $1.3 trillion in state pension debt, shortsighted calls for divesting, and more appeared first on Reason Foundation.

Open Enrollment Goes Hand in Hand with Education Savings Accounts

• Open enrollment allows K-12 students to attend any public school with available seats, regardless of where they live.
• Data shows most families use open enrollment to attend public schools that are higher performing than their residentially assigned schools.
• Research from Arizona, Ohio, Colorado, and California finds public school districts, including small rural districts, use open enrollment to bolster enrollment, especially when facing declining local populations.
• Texas is one of 26 states that still allow public schools to charge tuition to transfer students. Some Texas districts currently charge transfer students up to $9,000 per year, putting those public schools out of reach for low- and middle-income families. Public schools should be tuition-free for all students, including transfer students.
• States such as Florida, Arizona, and Wisconsin have implemented transparency requirements so parents can easily find available spots and school districts can only reject students for legitimate reasons, like a lack of capacity.

$63 Billion in TRS Debt Squeezes Local Governments and School Districts

• According to the Teacher Retirement System of Texas (TRS), the market value of its current unfunded pension liabilities is more than $63 billion, a situation that is getting worse every year because of the way the legislature is structurally underfunding earned benefits.
• Unlike the Employees Retirement System of Texas after SB321 (2021), TRS contributions, post-SB12 (2019), are still set by law—not actuarially determined—and will be insufficient to keep up as the system adjusts outdated economic assumptions.
• Although plan actuaries claim that TRS will be fully funded in 2048, they caution this would only happen in the unlikely case that several dozen assumptions are met every year, including hitting a 7% annual investment return on assets—higher than the normal rate of return for public pension plans. 
• If investment returns do not consistently meet or exceed investment performance assumptions, TRS is guaranteed to slip further into debt without additional taxpayer dollars at both the state and local levels.

Texas special session on education: Prioritize open enrollment and TRS reforms

The post Texas legislature should prioritize open enrollment and TRS reform in special session appeared first on Reason Foundation.

Articles, Research & Spotlights 

• Reason Foundation’s State Pension Tracker
• Texas passes another pension reform 
• Public pensions’ risky entanglement with private equity
• Authority and control over public retirement plans
• Pension systems need more than additional funding

News in Brief
Quotable Quotes on Pension Reform
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Projecting and Tracking the Funding of State Pension Plans

With public pension systems starting to report investment returns for the fiscal year that ended June 2023, the funding outlook for state-run pensions is beginning to come into view. To contextualize these annual investment return results with the ongoing funding challenges state pension plans face, Reason Foundation’s Pension Integrity Project has developed the State Pension Tracker, an interactive tool giving users early projections on how 2023 investment returns will impact unfunded liabilities for each state and plan. Based on an estimated annual investment return of 7% for public pension plans, Reason Foundation forecasts the 118 state pension systems analyzed have $1.3 trillion in total unfunded liabilities at the end of the 2023 fiscal year. The states with the most pension debt at the end of 2023 are California ($245 billion in unfunded liabilities), Illinois ($144 billion), New Jersey ($100.6 billion), Texas ($88.8 billion), and Ohio ($68 billion). Calculations of public pension debt depend heavily on plans’ market returns, so the tool allows users to select their own return rates to see how that impacts the debt projections for a plan or state. An overview of the tool and its findings is here, and Reason’s interactive State Pension Tracker is here. As actual investment returns and unfunded liability figures are reported throughout the year, the tracker will be updated, making this a valuable tool for keeping tabs on the ongoing challenges states face in funding their public pension promises.

Texas Legislature Continues Bipartisan Push to Modernize Public Retirement Benefits

Following its landmark 2021 public pension reform, Texas has taken another step by securing another retirement plan offered to some public workers. Texas Senate Bill 1245, which passed unanimously this year, emulates 2021’s Senate Bill 321 by establishing a risk-reduced cash balance plan for newly hired judges. Now, the state’s judges will have the same retirement setup as the Employees Retirement System, (ERS), and most other state and local workers. Reason Foundation’s Steven Gassenberger examines how this new cash balance structure offers more flexible benefits and better serves the needs of the modern workforce while reducing the risks of runaway pension costs. He also outlines why state lawmakers must now direct their attention to the Teacher Retirement System of Texas, which has more than $51 billion in unfunded liabilities.

Why Public Pension Systems Invest in Private Equity, Even When They Shouldn’t 

With high levels of debt, many public pension plans face growing pressure to attain lofty investment returns, even as traditionally safe options like bonds continue to see weaker returns. Therefore, it is no surprise that pension fund managers are turning more to alternative options like private equity, which now accounts for more than 13% of public pension systems’ investment allocation. Reason’s Mariana Trujillo explains why the pressure to dive deeper into riskier investment options comes with several potential pitfalls for workers and taxpayers.

Examining the Control Governments Have Over Public Pension Plans

It is the responsibility of policymakers to reform underfunded and costly public retirement plans, but this can be a challenging and thankless endeavor. Pension reformers often face significant pushback from workers, retirees, and even the trustees and staff administering the plan. Reason’s Rod Crane emphasizes that the sole responsibility and authority to establish and administer public retirement plans rests with a government’s lawmakers. Crane says state and local governments are wise to consider the concerns of all stakeholders, but for the sake of the taxpayers they serve, governments must be careful not to abdicate their legal stewardship over these retirement plans.

Public Pension Systems Need to Reduce Debt and Modernize Design for Today’s Workforce

New research from the RAND Corporation has appropriately identified the ongoing problems of growing public pension debt, but the solution to this challenge needs to go beyond simply securing more government funding for these plans. Reason’s Richard Hiller notes that reforms to fix pension underfunding must address the causes of unfunded liabilities and the ways that public pensions have failed to adjust to the evolving needs of today’s workforce.

News in Brief

New Series Investigates Potential Solutions for Illinois’ Beleaguered Pensions

The Chicago Tribune’s opinion section has partnered with the Better Government Association on a five-part series that analyzes what has become one of Illinois’ most pernicious problems—the severe underfunding of its five pensions for public workers. The series examines the explosion of public pension costs that have created an annual bill that already takes up a quarter of the state’s annual budget and is projected to reach $19 billion, double the current cost, by 2045. The series highlights several failed attempts to right Illinois’ pensions and uncovers the massive consequences of further inaction. The author, David Greising, researches pension reforms that worked in other states, quoting Reason Foundation’s Leonard Gilroy on the importance of identifying sacrifices and detailing how Arizona’s pension reforms were agreed to by all impacted parties. The series also evaluates some of the solutions being proposed in Illinois, including calls to raise taxes, target funding levels below 100% (essentially conceding to pass on the costs of retirement promises to future generations), and risky pension obligation bonds. The entire public pension series by David Greising can be found here.

Report Discusses the Rise in Hybrid Plans to Balance Risk Exposure
The latest National Association of State Retirement Administrators Issue Brief explores the spectrum of hybrid retirement plan designs, splitting different levels of risk between employers and employees. The report comes as a growing number of pension systems have turned to defined benefit, defined contribution fusion plans to increase the long-term resilience of their plans. Public retirement plans are exposed to three main risks: investment risk, longevity risk, and inflation risk. These risks are borne by employees and/or employers, and each plan type balances these risks differently. The report shows how defined contribution plans place most retirement risk on the employee, while defined benefit plans put all risk upon the employer and taxpayers. This creates a plan design spectrum with varying degrees of risk-balancing along that axis. The full report can be found here.

Quotable Quotes on Pension Reform 

“Connecticut is one of the most indebted states per capita in the nation. Unfunded pension and retiree health care program obligations, coupled with outstanding bonded debt, totaled more than $88 billion entering 2023. And nearly $40 billion of the $88 billion was unfunded pension obligations. Even with the recent supplemental payments, pension obligations and other debts are expected to place significant pressure on state finances throughout the 2030s and possibly later. The $6.5 billion Connecticut must contribute this fiscal year to retirement programs or to make required payments on bonded debt will eat up nearly 30% of the entire General Fund.”

—State Budget Reporter Keith M. Phaneuf, “CT Poised to Take Another Huge Chunk Out of Pension Debt,” CT Mirror, Sept. 12, 2023.

Data Highlight

Each month, we feature a pension-related chart or infographic of interest generated by our team of analysts. This month, the Pension Integrity Project created an interactive dashboard that allows users to see the history and projected 2023 figures for the funding of state-sponsored pensions. Access the visualization here to see the latest state pension funding figures.

The post Pension Reform News: State pension debt forecast, risky public equity investments, and more appeared first on Reason Foundation.

Under the leadership of Sen. Joan Huffman (R-Houston) and Rep. Greg Bonnen (R-League City), Senate Bill 1245 (SB 1245) passed unanimously in the Senate and 144-1 in the House. The bipartisan bill signed by Texas Gov. Greg Abbott pays off $95 million of unfunded pension liabilities and opens a new cash balance retirement plan for all future judges. The plan is designed to offer strong retirement guarantees for the judges while avoiding additional unfunded pension liabilities moving forward.

During the 2021 legislative session, the Texas legislature took similar actions, passing Sen. Huffman’s Senate Bill 321 (SB 321) to align the retirement benefits offered to new Employees Retirement System of Texas (ERS) members with the retirement benefits long offered to most local government employees across the state. At the heart of SB 321 was addressing the ongoing runaway costs involved in the legacy pension plan, growing public pension debt, and a concern about the retirement security of today’s public employees, who more frequently move jobs and need mobile retirement options. ERS had $14.7 billion in public pension debt before the law was passed. SB 321’s pension reform opened a new cash balance retirement plan that future employees will use. This helps put the ERS’ existing unfunded liabilities on a path to be fully paid off over the next several decades.

The holistic approach outlined in SB 321, and carried over to the recent Senate Bill 1245, will save Texas taxpayers billions in the long run, primarily by reducing costly interest payments on public pension debt. Although only a couple of years have passed since SB 321 was implemented, the financial position of ERS has improved, and the feedback from ERS administrators has been very positive.

This latest move in SB 1245 to align the retirement plan for newly hired judges with that for state and local public employees demonstrates the bipartisan effort to improve the sustainability of the state’s retirement systems. Lawmakers must still address the largest major statewide pension system—the Teacher Retirement System of Texas (TRS), with its seemingly shrinking benefits and ever-growing unfunded liabilities. TRS currently has over $51 billion in public pension debt.

The restructuring of Texas’ statewide public pension systems began as an effort to address unexpected cost increases that were applying significant pressure on state and local government budgets. Also on policymakers’ minds were the needs of active and retired members who saw their take-home pay become stagnant or effectively reduced due to required pension contribution increases and inflation. Members and employers of the other cash balance retirement plans, like the Texas County and District Retirement System, TCDRS, and Texas Municipal Retirement System, TMRS, had long benefited from the guaranteed return on contributions provided by their public employers* and the increased portability of their retirement benefits. Future Judicial Retirement System of Texas Plan (JRS II) members will now enjoy those same benefits.

Texas legislators and public employers are responding to the evolving demographics of society and the changing landscape of how we work and retire. With increased life expectancies and a diverse and mobile workforce, it is essential to adapt public retirement systems to meet the needs of workers and taxpayers. Texas’ shift to a cash balance approach to retirement savings acknowledges these changes and helps ensure retirement benefits are sustainable for taxpayers and current and future generations of judges and public employees. By embracing the need for flexibility and adaptability in retirement planning, Texas is setting a forward-thinking example on public pension policy.

The Texas legislature deserves praise for passing multiple pension reforms that take meaningful steps to ensure the state’s largest debts are being reduced. But the state’s most intractable public pension challenge—addressing the Teacher Retirement System’s $51 billion of debt and unsustainable fiscal path—remains.  

Calls from TRS members for increased benefits may have never been louder. In April, members of the Texas chapter of the American Federation of Teachers described the $5 billion earmarked for cost-of-living increases to deal with inflation and TRS pension bonuses as “crumbs” and called on legislators to find a long-term solution to the unique challenges facing TRS and its members.

Hopefully, Texas lawmakers pursue another bipartisan approach that provides retirement solutions and mobility that benefit teachers, protects taxpayers from future public pension debt, and pays down the system’s massive existing debt.

*Correction: This piece originally referred to state contributions but has been changed to contributions provided by public employers to clarify local governments also make contributions to cash balance plans.

The post Texas legislature continues bipartisan push to modernize public retirement benefits appeared first on Reason Foundation.

Chair Capriglione and members of the committee:

Thank you for the opportunity to offer our perspective on House Bill 3495 (HB 3495), which would remove the cap on hedge funds in the Teacher Retirement System of Texas (TRS) investment portfolio.

My name is Steven Gassenberger, and I serve as a policy analyst based in Houston for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way.

HB 3495 (and its Senate companion Senate Bill 1246) includes several policy changes, including removing the 10% cap placed on hedge fund assets within the TRS investment portfolio, which is the focus of the following comments. Given that TRS already holds $52 billion in unfunded pension liabilities and relies on contribution rates that are politically, not actuarially, determined, we believe it is essential to contextualize the potential risks of the proposed investment class expansion based on our analysis of TRS data. Additionally, we highlight two opportunities to mitigate some of the dangers that HB 3495 and SB 1246 would introduce in a way that would also improve the TRS pension plan’s long-term resiliency and solvency.

TRS Investment at a Glance

• The TRS trust fund holds over $180 billion in assets, making it one of the largest investors in the world.
• TRS has $52 billion in unfunded pension liabilities owed to current and retired members.
• According to the latest TRS report, the system’s total hedge fund value exceeded $17 billion, with an additional $567 million in unfunded capital commitments.
• The fees paid from the TRS trust fund in Fiscal Year 2022 amounted to $1.3 billion, which included $43 million in management fees and $59 million in performance fees.
• TRS paid $744 million in management fees from returns and $1.4 billion in carried interest.

Hedge Funds Are Another Alternative Asset

Hedge funds and other alternative assets are investments that fall outside traditional cash, publicly-traded stocks, and bonds. These alternative assets are typically less transparent and bring higher financial costs and fees than more traditional equity and bond holdings. Commonly, alternative investments take the form of shares in limited partnerships, such as with hedge funds and private equity. As a government-backed pension fund worth over $180 billion, TRS is considered a major source of capital for alternative investment providers.

Why Would TRS Seek to Expand its Alternative Asset Holdings?

Like many of its national peers, TRS has adjusted its investment strategy in recent decades in response to the significant fluctuations in global interest rates, increased market volatility, economic recessions and other factors that made it increasingly difficult to maintain assumed investment returns of 8% and higher. Facing the challenge of maintaining high investment returns in an evolving environment, fund managers began moving away from safe fixed-income sources to more exotic—and often higher-risk—assets with increased potential upside.

Like many public systems around the country, TRS has pointed to alternatives like private equity and hedge funds as their highest-performing asset class over the last five years. With the system’s investment return assumption set at 7% and low-risk bonds yielding less than 4%, the TRS board now wants the option to move more of the TRS investment portfolio to high-risk/high-reward-style alternative assets. TRS has $52 billion in debt and hopes that the internal rate of return reported from alternatives will help the system avoid the need for higher contributions from the state government and its taxpayers. SB 1246 and HB 3495, in their current forms, would allow the TRS board to continue down this path of risk-taking, exposing more taxpayer and member contributions to private and opaque money managers. Today, TRS already holds a higher proportion of private assets than the average public pension system. Removing the cap on hedge funds would be the last limit the legislature has placed on TRS investments at a time when concerns about public money being used by private asset managers for political activism has never been more worrisome.

Concerns with Expanding Alternative Investments

Calling an investment safe implies a guarantee, which no investments can claim outright, but traditional fixed-income assets like U.S. Treasury bonds come close. Returns on bonds and large publicly-traded stocks are what sustained large public pension systems like TRS for generations without the need for supplemental infusions of public funds to close pension funding gaps.

Treasury bond rates were well above the TRS’ assumed rate of investment return until the mid-1990s, at which point U.S. Treasury bond rates began a long-term decline reaching levels far below the TRS assumed rate of investment return, prompting a “chase for yield” via an increasing reliance on alternative investments. TRS then began slowly drawing down its surplus, which totaled $2.1 billion in 2000.

TRS has historically assumed an investment return rate as high as 8% before lowering its assumption to 7.25% in 2018. The plan lowered the return assumption again in 2022 to the current 7%. With the experience of the last few decades, there is a concern that TRS is still depending on an outdated and artificially high investment return assumption, which may be a source of pressure to take undue investment risks in expensive and higher-risk alternatives.

Actively managed assets come with management, administrative, and performance fees that can drain hundreds of millions from the TRS trust fund. Such hefty fees are not inherently bad for TRS if they result in equally hefty returns for the fund, but just like other investments, there is no guarantee those extra fees will generate returns that exceed those gained by passively managed, much less expensive, and more transparently valued assets like index funds. 

Building on Senate Bill 1246 and House Bill 3495

Although alternative assets are not inherently harmful to public pension systems, they do introduce a significant level of risk. Hence, it is prudent for policymakers to install boundaries around investment decisions—like the current 10% cap on hedge funds—and provide increased oversight capabilities to the public.

Option #1 – Systematically Reduce the Need for Higher Investment Returns

Our first suggested course of action is to continue to systematically reduce the assumed rate of return (ARR) used by TRS actuaries from its current 7% set in 2022. The average assumed rate of return for state pension plans in the United States has fallen from over 8% in 2000 to an average of 6.9% today. New York State’s Common Fund—which manages assets for state and local civilian and public safety personnel in that state—lowered its assumed rate of return last year to 5.9%. The nation’s largest public pension fund, CalPERS, lowered its investment assumption to 6.8% in 2021, and internal advisors said they should target 6%.

Continuing to reduce the return rate assumption used by TRS would reduce the chances of adding more unfunded liabilities and unexpected costs in the future if the lower rate is combined with a modernized funding policy like the new actuarially determined rate that was implemented for the Texas Employees Retirement System (ERS) in 2021. It would also reduce the system’s reliance on the high-yield gambles it is taking in an effort to reduce its debt and fund the retirement promises already made to teachers.

Option #2 – Increase Investment Cost Reporting Details

Alternative assets usually involve higher costs. A 2018 report by the Pew Charitable Trusts found pension plans spend at least $2 billion a year on investment fees alone, and TRS is no exception to this trend. Despite efforts to reduce fees through increased in-house investment management, fees such as carried interest (i.e., performance fees) could be adding high unnecessary costs. Performance fees for private equity investments are typically far higher than the standard management fees for those assets, and most public pension funds—including TRS—do not publicly report those performance fees.

Improving transparency and financial reporting by adopting a robust Investment Cost Report would directly address the issue of opaque fee reporting. This would shine a light on the fees and other expenses TRS incurs while managing its portfolio. California’s teacher pension system, CalSTRS, offers a model in this regard, producing a report showing its investment costs by type and asset category. An example report can be found at resources.calstrs.com.

This report is designed to provide stakeholders with detailed fee data and trends for each asset class and investment strategy over a four-year period, opening the door for a detailed cost-effectiveness evaluation. Fees and expenses should be consistently monitored, and managers should be held accountable for the effectiveness of investments relative to the overall growth and resiliency of TRS.

Thank you for the opportunity to share our perspective on HB 3495 and SB 1246. We welcome any questions or information requests the committee members may have.

The post Comments on Texas House Bill 3495 and Senate Bill 1246 appeared first on Reason Foundation.

Chair Capriglione, committee members, thank you for the opportunity to offer our brief perspective on providing a new cash balance retirement benefit for future members of the Judicial Retirement System 2.

My name is Steven Gassenberger, and I serve as a policy analyst based in Houston for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way.

Our work in Texas includes actuarial modeling and technical analysis related to the state’s most recent and impactful pension reform, 2021’s SB 321, which is modernizing and strengthening the Texas Employees Retirement System (ERS) by placing new hires into a low-risk cash balance retirement plan designed to provide an attractive benefit, while also committing to fully paying off ERS’ $14 billion in unfunded liabilities over the coming decades.

Similarly, this year’s House Bill 3367 and its companion, SB 1245, would change the trajectory of the Judicial Retirement System 2 (JRS2, also managed by ERS) in a consistent and demonstrably positive direction. The proposed bills would provide a modern, low-risk cash balance retirement plan for new judges that offers a way to improve JRS2 while addressing the core issues causing today’s unfunded liabilities. From our perspective:

• JRS2 currently holds $95 million in unfunded liabilities and is projected to run out of assets in 46 years.
• HB 3367 and SB 1245 would not change retirement benefits or terms for today’s retirees or current judicial officers. It would only affect future hires.
• Cash balance retirement plans are designed to guarantee asset growth while providing a steady accrual rate, offering members portability, and ensuring retirement security.
• The proposed cash balance plan design follows the 2021 SB 321 reform for the wider ERS membership. The plan is similar to the Texas Municipal Retirement System and the Texas County and District Retirement Systems, both of which have long track records of affordably providing guaranteed retirement benefits.
• Cash balance plans have the advantage of managing the risk of runaway costs that often accompany traditional public pension systems like the Teachers Retirement System of Texas.  HB 3367 and SB1245 would slow the growth of Texas’ unfunded pension liabilities incurred for past service, giving the state the opportunity to start paying them down and ultimately returning JRS2 to full funding.

We commend Rep. Greg Bonnen and Sen. Joan Huffman, and other legislators for working to modernize and fully fund JRS2 in a meaningful way. Texas doesn’t allow structural deficits in its state budget, nor should it tolerate the equivalent of a structural budget deficit in its public pension funds. Adopting sound policies to help reduce public pension debt being passed on to future generations and tackling the important challenges facing the state’s public pension systems aligns with the long-term interests of Texas’ public workers, government employers, and taxpayers.

Thank you again for the opportunity to share our perspective on HB 3367. Please feel free to reach out if you have any questions or concerns.

The post Comments on Texas House Bill 3367 and Senate Bill 1245 appeared first on Reason Foundation.

Chairman Capriglione and members of the committee: 

Thank you for the opportunity to offer comments on Texas House Bill 3340 (HB 3340) and the need for a proper actuarial analysis of the proposed changes to Houston fire and police pension benefits. 

In 2017, policymakers took on a major effort to reform Houston’s underfunded and increasingly costly police and firefighter retirement funds. Ultimately, stakeholders achieved a resolution allowing the city to continue to provide pension benefits to its workers while managing the runaway costs that had plagued their budgets in the previous years. These reforms significantly improved the pension system’s funding, putting the city in a much more stable and manageable fiscal position. 

The proposed pension benefit increases in HB 3340 would roll back the delicate balance between cost and risk that the city has achieved and could resummon the same funding challenges that existed up to 2017.

HB 3340 would adjust when a member of the plan is allowed to retire and begin drawing a full benefit, which would have a major actuarial impact on the current system and directly roll back the changes made in 2017 that set the fund up to have its current funding success. 

Major pension benefit changes like this would significantly increase annual costs and demand serious long-term financial scrutiny to ensure that hard-won gains in solvency are not lost. To fully understand the impact of the changes proposed in the bill, policymakers need a full, 30-year actuarial analysis examining the cost implications on local property taxpayers using an array of different economic and market stress scenarios reflecting the types of real-world market volatility we’ve all experienced several times since 2000. 

HB 3340 has not been evaluated by an independent actuary to discern potential costs and risk exposure, nor have the proposed changes been stress tested to account for future market volatility and lower-than-expected investment returns. Both the static cost projections of the enhancements if all actuarial assumptions prove true each year and the quantifiable risk associated with missing those actuarial assumptions are crucial to properly understanding the size and scope of rolling back the 2017 reforms.

Since pension benefits are ironclad promises made to public workers, policymakers need to know what it may take to fulfill those promises in a wide range of situations, ideal or suboptimal. Before making a financial decision of this magnitude, Texas lawmakers should require the level of scrutiny that other governments have applied for similar proposals.

Take, for example, a bill recently passed in Washington state for its police and fire pension system. That pension system has been overfunded, meaning it has more assets than what actuaries calculate is needed at the time, since its inception in the mid-1970s through prudent risk analysis and funding design. Due to decades of wise policies and work, the plan created a side account to pay (in full) for future benefit increases. The first benefit increase was passed last year: a multiplier increase. 

The Office of the State Actuary’s fiscal note for that multiplier increase is an example of the level of detail that should be considered when adjusting a pension benefit. Washington state’s thorough fiscal note included an analysis of the following:

• The 25-year costs to the employer (and taxpayers);
• Analysis of the pension system’s funding trajectory going out 30 years;
• Stochastic modeling to assess how unexpected results under thousands of potential economic scenarios and outcomes would change costs and funding; 
• Probability analysis on the likelihood that contributions will exceed current rates;
• And sensitivity analysis on the bill’s projected effect on public workers’ retirement rates.

Members of the legislature, especially those concerned with the cities in Texas potentially needing to increase property taxes on locals to pay for proposals like HB 3340, must demand a similarly rigorous analysis so they can thoroughly evaluate the long-term risks and costs to taxpayers associated with HB 3340 before adding more benefit promises to an already underfunded retirement system. 

The 2017 pension reforms were a collaborative and informed effort involving many policymakers and stakeholders at both the local and state levels, and the product of that was a retirement infrastructure that properly balanced the needs of public safety workers, government employers, and taxpayers. State lawmakers employed a similar process in reforming the Texas Employees Retirement System (ERS), which is projected to save the state upwards of $16 billion over the next 30 years. To reap the benefits of these reforms, policymakers need to see them through and reject efforts to undermine them before they can achieve their long-term ends.

Unraveling the efforts from 2017 is likely to increase costs and risks to local property taxpayers and the city. The magnitude of these costs and risks are still unknown absent proper actuarial due diligence. Since Houston’s pension system has not yet reached its destination of full funding—having the money to pay for benefits already promised to workers and retirees—unrolling the 2017 reform could interrupt the progress achieved to date on a complicated long-term reform.

Thank you again for the opportunity to submit technical comments on HB 3340. We are happy to answer any questions the committee may have.

The post Proposed changes to Houston fire and police pension benefits require actuarial analysis appeared first on Reason Foundation.

With the challenge of inflation likely to continue to be at the forefront of all of the state’s major financial discussions when the Texas legislature reconvenes in January 2023, it is essential to understand how the state government determines the health of its public pension funds and how policymakers can protect public retirees from the degradation effects of inflation. 

How Texas defines “actuarially sound”  

In the Sept. 8 hearing, members of the Texas House Appropriations Committee explored the importance of being “actuarially sound” in response to the numerous calls by lawmakers and retired educators to follow up on 2019’s 13^th check by issuing more inflation relief to provide cost-of-living adjustments to retirees during the next legislative session.

Rep. Carl Sherman (D-Desoto) asked Teachers Retirement System of Texas (TRS) Executive Director Brian Guthrie about the health of the state’s largest public pension plan. In posing his question, Rep. Sherman focused on the term “actuarially sound” specifically. Guthrie noted that Texas currently defines “actuarially sound” as taking less than 31 years to amortize, or fully fund, every pension dollar earned by members of the pension plan. That definition is set in statute and applies to all the state’s major public pension systems.  You can watch Guthrie’s full response on being actuarially sound and the timeline for paying off the state’s unfunded liabilities below. 

What does a cost-of-living adjustment (COLA) for retirees have to do with a technical definition? 

This technical issue is on the minds of retirees because the Teacher Retirement System (TRS) of Texas and the legislature can only issue a cost-of-living adjustment or a 13th check if the pension fund is determined to be “actuarially sound.” As Guthrie noted, this is currently defined as the pension fund’s amortization period not exceeding 31 years.

With this year’s high inflation rates hitting retirees living on fixed incomes the hardest, it is not surprising that retiree groups and their allies are advocating for a cost-of-living adjustment in the next legislative session. But just as was the case in 2019, when the state legislature opted to issue a 13th check to make up for the past decade’s inflation instead of adding liabilities to the fund, giving a permanent cost-of-living benefit increase next session would attach future obligations to the state and taxpayer in perpetuity. These obligations should be fully prepaid to limit their impact on the long-term financial health of the pension system. If state policymakers want to address the issue once and for all, they should look at launching a new TRS tier for new hires that includes a predictable cost-of-living adjustment as a core benefit in retirement.

Did TRS suggest the state’s definition of “actuarially sound” is outdated? 

To be “actuarially sound” is less of a universal definition or number than a collection of policies reflecting short and intermediate timeframes. Policymakers would do well to listen to Teacher Retirement System’s Guthrie and talk to other actuaries and the Texas Pension Review Board about a more contemporary idea of how the state should judge the financial stability of its public pension systems. For example, Guthrie notes that other groups, including the Society of Actuaries, recommend public pension amortization periods be no longer than 15-to-20 years. Setting an amortization period and allowing rates to adjust—the policy the Employees Retirement Plan (ERS) recently adopted—is also more actuarially sound than the current TRS policy of setting rates and allowing amortization periods to adjust. 

Teacher Retirement System actuaries have now built the increased contributions from 2019’s pension reform, Senate Bill 12, into the plan’s funding valuation. The effect was a shorter amortization period calculation, from 87 years to 29 years, if TRS manages to do something it’s never done: meet all of its actuarial predictions, like investment returns and mortality rate, 100% accurately.

After the market turmoil in 2020 and then record-breaking investment returns in 2021, TRS actuaries are now reporting a 26-year calculation, which is about where the system stood in 2013. The impact of the 2022 investment year, likely well below the pension system’s long-term expectations, has yet to be reported. But the low-to-negative investment returns expected are bound to bring that amortization figure closer to, if not beyond, the 31-year mark.  

If retirees and budget managers want predictable inflation relief that protects the value of pension benefits in a financially prudent manner, updating the state’s definition of “actuarially sound” to align with the Society of Actuaries’ recommendations would be a good first step. 

The post Is Texas’ definition of an actuarially sound public pension system outdated?   appeared first on Reason Foundation.

It is understandable for state policymakers to want to push back against an environmental governance social investment (ESG) movement that they view as threatening to Texas’ oil and gas industry, but just as some progressive states are wrongly telling their public pension funds not to invest in specific sectors, Texas Senate Bill 13 threatens the cost-effective stewardship of taxpayer funds.

Texas SB 13 instructs the Comptroller to identify financial firms that are:

“…refusing to deal with, terminating business activities with, or otherwise taking any action that is intended to penalize, inflict economic harm on, or limit commercial relations with a company because the company … engages in the exploration, production, utilization, transportation, sale, or manufacturing of fossil fuel-based energy and does not commit or pledge to meet environmental standards beyond applicable federal and state law.”

The Comptroller’s list includes nine European companies and BlackRock, the world’s largest asset management firm. Disinvesting in BlackRock could impose special challenges for Texas pension funds because it is included in the Standard & Poor’s 500 stock index. Thus, in simple terms, any exchange-traded fund (ETF) or index fund that is based on the S&P 500 holds some shares in BlackRock.

Fortunately, SB 13 appears to provide some flexibility for state agencies that have exposure to blacklisted firms through indirect means—like holding them through mutual funds or ETFs. Specifically, SB 13 states:

A state governmental entity is not required to divest from any indirect holdings in actively or passively managed investment funds or private equity funds. The state governmental entity shall submit letters to the managers of each investment fund containing listed financial companies requesting that they remove those financial companies from the fund or create a similar actively or passively managed fund with indirect holdings devoid of listed financial companies.

So, according to the law’s text, a Texas pension fund or government agency can continue to hold an S&P 500 fund—as long as it asks the fund manager to drop BlackRock from its portfolio. It is doubtful that an S&P 500 fund would follow through and eject BlackRock for various reasons, including because it would introduce a tracking error—a divergence between the index fund’s performance and its underlying index.

Among the mutual funds on the Comptroller’s blocked list are six vehicles that invest in most S&P 500 stocks. Texas is targeting them because the state claims they explicitly exclude companies in the fossil fuel industry and those with low ESG scores. These blocked funds would also diverge from the S&P 500’s performance, but it is possible that ESG-focused investors holding these funds may be more likely to accept any discrepancy. It remains to be seen whether a fund provider could attract sufficient interest in an investment product that mostly tracks the S&P 500 while excluding ESG-oriented firms such as BlackRock.

The European firms on Texas’ blacklist include three institutions—BNP Paribas, Credit Suisse, and UBS—that rank among the 50 largest banks worldwide. The Texas Employees Retirement System or the Texas Teacher Retirement System may hold securities issued by these entities, but this cannot be readily confirmed because neither system publishes a detailed list of investments on their respective websites.

Although SB 13 is relatively clear that pension funds do not need to liquidate mutual funds that include the blacklisted companies, it is less clear whether the Texas pension funds can invest additional, new money in such vehicles going forward.

Most importantly, while the law includes provisions that try to reduce its impact on the state’s pension funds, Texas Senate Bill 13 sets a dangerous precedent for inserting politics and legislating into investment decisions.

It’s also part of a troubling bipartisan trend. In 2021, Maine passed a law requiring the state’s pension system to divest from fossil fuel investments.  And similar divestment bills have been proposed in Massachusetts, New York, and New Jersey.

State policymakers and legislators should not limit the flexibility of pension fund managers to maximize risk-adjusted returns. Public pension fund managers should focus on optimizing their portfolios on a risk/return basis, so the pension systems have funding to pay for pension benefits promised to workers.

The post Texas dangerously inserts politics into pension investing appeared first on Reason Foundation.

The interactive map below shows the funded ratios for state-managed public pension systems from 2001 to 2022. A funded ratio is calculated by dividing the value of a pension plan’s assets by the projected amount needed to cover the retirement benefits already promised to workers. The funded ratio values for 2022 are projections based on a -6% investment return. 

Year-to-year changes in investment returns and funded ratios tend to grab attention, but longer-range trends give a better perspective of the overall health of public pension systems.

In 2001, only one state, West Virginia, had an aggregated funded ratio of less than 60%. By the end of 2021, four states—Illinois, Kentucky, New Jersey, and Connecticut—had aggregate funded ratios below 60%.

If investment returns are -6% or worse in the 2022 fiscal year, Reason Foundation’s analysis shows South Carolina would be the fifth state with a funded ratio below 60%. 

Over the same period, 2001 to 2021, the number of states with state-managed pensions with funded ratios above 90% fell from 33 to 20. If all plans return a -6% investment return assumption for 2022, Reason Foundation projects the number of states that have funded levels above 90% would shrink from 20 to six.  The six states with funded levels that would still be above 90% after -6% returns for 2022: Delaware, Nebraska, New York, South Dakota, Washington, and Wisconsin. 

Importantly, the -6% investment return assumption for the 2022 fiscal year used in this map may be too optimistic for some public pension plans. The S&P 500 lost 12% of its value over the 2022 fiscal year from July 1, 2021, to June 30, 2022. Vanguard’s VBIAX, which mimics a typical 60/40 stock-bond portfolio, was down 15% for the fiscal 2022 year ending in June 30, 2022. Thus, given the condition of financial markets this year, the public pension plans with fiscal years that ended in June 2022 are likely to report negative returns for the 2022 fiscal year.  

Another useful long-term trend to look at are the unfunded liabilities of state-run pension plans. Whereas a pension system’s funded ratio takes the ratio of assets to liabilities, unfunded liabilities are the actual difference between the pension plan’s assets and liabilities. Unfunded liabilities can be conceptualized as the pension benefits already promised to workers that are not currently funded by the plan. Again, the values for the 2022 unfunded liabilities map are a projection using an investment return of -6%. 

The five states with the largest unfunded liabilities are California, Illinois, New Jersey, Pennsylvania, and Texas. In fiscal year 2021, the unfunded liabilities of those states totaled $434 billion and would jump to $620 billion in 2022 with a -6% return.  

For more information on the unfunded liabilities and funded ratios of state-run pensions, please visit Reason’s 2022 Public Pension Forecaster.

Notes

ⁱ The state-funded ratios in this map were generated by aggregating (for state-managed plans) the market value of plan assets and actuarially accrued liabilities. Prior to 2002, Montana and North Carolina reported data every two years, therefore for 2001 figures from 2002 are used. Figures for Washington state do not include Plan 1, an older plan that is not as well funded.

ⁱⁱ The discount rate applied to plan liabilities will impact the funded ratio of a plan. Therefore, the map above can be best thought of as a snapshot of state-funded ratios based on plan assumptions by year. Overly optimistic assumptions about a pension plan’s investment returns will result in artificially high-funded states. Conversely, pulling assumptions downward, while prudent, will result in a worse-looking funded ratio over the short term.

ⁱⁱⁱ In addition to projections for fiscal 2022, some public pension plans in 29 states have yet to report their complete fiscal 2021 figures and therefore include a projection estimate for 2021 as well. Thus, 2021 projections were used for at least one plan in the following states: Alabama, Alaska, Arkansas, California, Colorado, Georgia, Hawaii, Illinois, Kansas, Louisiana, Massachusetts, Michigan, Missouri, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oregon, Pennsylvania, Texas, Tennessee, Utah, Virginia, Washington, West Virginia, Wisconsin, and Wyoming.

The post Projecting the funded ratios of state-managed pension plans appeared first on Reason Foundation.

Based on a -6% return for fiscal 2022, the aggregate unfunded liability of state-run public pension plans will be $1.3 trillion, up from $783 billion in 2021, the Pension Integrity Project finds. With a -6% return in 2022, the aggregate funded ratio for these state pension plans would fall from 85% funded in 2021 to 75% funded in 2022. 

The 2022 Public Pension Forecaster below allows you to preview changes in public pension system funding measurements for major state-run pension plans. It allows you to select any potential 2022 investment return rate to see how the returns would impact the unfunded liabilities and funded status of these state pension plans on a market value of assets basis.

The nation’s largest public pension system, the California Public Employees’ Retirement System (CalPERS), provides a good example of how much one bad year of investment returns can significantly impact unfunded liabilities, public employees, and taxpayers.

If CalPERS’ investment returns come in at -6% for 2022, the system’s unfunded liabilities will increase from $101 billion in 2021 to $159 billion in 2022, a debt that would equal $4,057 for every Californian. Its funded ratio will drop from 82.5% in 2021 to 73.6% in 2022, meaning state employers will have less than three-quarters of the assets needed to pay for pensions already promised to workers. 

Similarly, the Teacher Retirement System of Texas (TRS) reported $26 billion in unfunded liabilities in 2021. If TRS posts annual returns of -6% for the fiscal year 2022, its unfunded liabilities will jump to $40 billion, and its funded ratio will drop to 83.4%. The unfunded liability per capita is estimated to be $1,338. 

The table below displays the estimated unfunded liabilities and the funded ratios for each state if their public pension systems report -6% or -12% returns for 2022. 

Estimated Changes to State Pension Unfunded Liabilties, Funded Ratios

The first three quarters of the 2022 fiscal year clocked in at 0%, 3.2%, and -3.4% for public pensions, according to Milliman. The S&P 500 is down more than 20% since January, suggesting that the fourth quarter results will be more bad news for pension investments.

Considering the average pension plan bases its ability to fund promised benefits on averaging 7% annual investment returns over the long term, plan managers are preparing for significant growth in unfunded liabilities, and a major step back in funding from 2021. 

The significant levels of volatility and funding challenges pension plans are experiencing right now support the Pension Integrity Project’s position last year that most state and local government pensions are still in need of reform, despite the strong investment returns and funding improvements in 2021. Unfortunately, many observers mistook a single good year of returns—granted a historic one—as a sign of stabilization in what was a bumpy couple of decades for public pension funding. On the contrary, this year’s returns, as well as the growing signs of a possible recession, lend credence to the belief that public pension systems should lower their return expectations and view investment markets as less predictable and more volatile. 

State pension plans, in aggregate, have struggled to reduce unfunded liabilities to below $1 trillion ever since the Great Recession, seeing this number climb to nearly $1.4 trillion in 2020. Great results from 2021 seemed to finally break this barrier, with the year’s historically positive investment returns reducing state pension debt to about $783 billion. Now, state-run pension plans will again see unfunded liabilities jump back over $1 trillion, assuming final 2022 results end up at or below 0%. 

It is important not to read too much into one year of investment results when it comes to long-term investing. But during this time of economic volatility, policymakers and stakeholders should recognize that many of the problems that kept public pension systems significantly underfunded for multiple decades still exist. And many pension plans are nearly as vulnerable to financial shocks as they were in the past.

Going forward, state and local leaders should continue to seek out ways to address and minimize these risks, making their public retirement systems more resilient to an uncertain future. 

Webinar on using the 2022 Public Pension Forecaster:

The post Unfunded public pension liabilities are forecast to rise to $1.3 trillion in 2022 appeared first on Reason Foundation.

The turbulence across financial markets to this point in 2022, with virtually all U.S. companies in the S&P 500 index in the red, means TRS will likely be among the public pension plans missing annual investment return targets this year. Just as strong, double-digit investment returns in 2021 greatly enhanced TRS’ funded status, this year’s investment losses are expected to lower the plan’s funding level.  

This dramatic up and down following the COVID-19 pandemic illustrates the folly of reading too much into pension funding measurements based on a single year of reported returns. Prudent public pension plan managers need to maintain a longer perspective and continue lowering investment return assumptions to accurately reflect what most market prognosticators expect to see over the next 10-to-15 years. 

Maintaining an overly optimistic investment return assumption is costly. Doing so raises the risk of significant growth in pension funds’ unfunded liabilities, which historically tend to spiral into colossal costs for taxpayers and take decades to remedy.

The Teachers Retirement System of Texas is a perfect example of this. The plan has accrued $47.6 billion in pension debt since 2002, and most of it, around $25 billion, came from investment returns falling below the plan’s assumptions (displayed in Figure 1 as “Underperforming Investments”). The primary contributor to this was TRS maintaining an unrealistic 8.0% rate of return assumption until 2018, well past the time most other pension plans had started adjusting their return rate targets downward in reaction to a lower yield return environment on financial markets. Policymakers’ failure to be nimble with return assumptions ended up contributing to the system’s current funding challenges, and it would be wise to not repeat that mistake. 

Figure 1. The Causes of the Texas TRS Pension Debt (Cumulative 2002-2021) 

It is critical for Texas policymakers to consider improving the TRS contribution policy by changing “statutorily-set” to “actuarially determined” rates. As the Pension Integrity Project has covered, annual contributions capped by statutory rates have generated significant funding challenges for the system. Since 2004, contributions have routinely fallen below the interest accrued on TRS’ unfunded liability that year (a situation called negative amortization). This has led to the Teachers Retirement System falling further behind in its ability to pay for promised obligations.  

An adjustment of the assumed rate of return down to 7.0% means the plan will recalculate pension debt upwards in 2023, but will also be better positioned to avoid future debt growth over the longer run. The forecast in Figure 2 compares the growth of TRS’ unfunded liabilities under three scenarios: 

1. Returns meet TRS assumptions;

2. TRS experiences two major recessions over the next 30 years;

3. And, TRS makes actuarially determined contributions (also using the two-recession scenario).

With this actuarial modeling of the system, it is clear that statutorily limited contributions will continue to pose funding risks for TRS that will be borne by Texas taxpayers. A proposed 7.0% assumed return will readjust 2023 unfunded liabilities upwards by $6.5 billion, but the plan will suffer fewer investment losses over the next 30 years when the plan inevitably experiences returns that diverge from expectations. TRS’ unfunded liabilities will remain elevated under the rigid statutorily-set contributions. If, however, TRS was to transition to Actuarially Determined Employer Contributions (ADEC) each year, then even by recognizing higher 2023 debt (under a 7.0% assumption) TRS could shave billions off its unfunded liabilities by 2052 ($74.7 billion down from $81.3 billion with current 7.25% assumption).  

Figure 2. Texas TRS Stress Testing: Unfunded Liabilities (2021-2052) 

The lower return target should improve TRS’ ability to withstand turbulent market periods like we are seeing today.  

A switch to an actuarial (or ADEC) contribution policy is what lawmakers did with the state’s other major pension plan—the Employees Retirement System of Texas (ERS)—just last year in a landmark pension reform. Unlike rigid contributions set in statute, actuarial contributions adjust and respond according to needs. This means that in situations of volatile market conditions (as tested and confirmed in the analysis above) contributions adjust automatically to ensure that the state’s unfunded obligations do not get out of control. This change in the ERS contribution policy is projected to save state taxpayers billions in long-term costs, and now would be a good time to consider similar reforms to how the state funds TRS. 

Seeing the obvious reduction in funding risks through actuarial modeling, it is clear that lowering the Teachers Retirement System’s assumed rate of return is a step in the right direction to safeguard the pensions for the state’s teachers. In addition to heeding the advice of the pension system’s actuaries, Texas policymakers should also consider addressing the rigid statutory contribution policies, which currently prevent Texas from meaningfully cutting down existing unfunded liabilities and curbing future pension debt. At a time when market results appear to be extremely unpredictable and volatile, the state’s teachers and taxpayers need to ensure that TRS is positioned to weather whatever storms may come.  

The post The Teacher Retirement System of Texas needs to adjust its investment return assumptions  appeared first on Reason Foundation.