Texas Has a Problem With Its State Employee Pension Plan

By Anthony Randazzo and Jonathan Moody

The Texas Employees’ Retirement System (ERS) is in trouble.

The pension fund for Texas state agency employees only had 48 cents on the dollar for promised retiree benefits before COVID-19 struck, and weak investment returns due to the pandemic will make that number worse.[1] Adding to the challenge, there is a state constitutional cap on the amount money that the state can put into the pension system in any given year. The state is already at that threshold, meaning, absent an increase in employee contributions or a major overall change to ERS, the pension fund’s solvency will slowly erode.

Both active members of the retirement plan and retirees have cause for concern.

This was the message from Texas ERS executive director Porter Wilson at the end of August in testimony to the state legislature. Specifically, he told a House committee, “At this time, all three of the pension plans administered by ERS on behalf of the state are in funding distress and on a path to total fund depletion… altering contributions and/or benefits are the factors that have the most significant impact on reforming the struggling ERS pension plans.”

That kind of frank appraisal of distressed funded status is rare to hear from pension fund administrators. Which makes it stand out as a stark warning for all Texas ERS stakeholders to pay attention.

Coming into 2020, Texas ERS had a $30 billion funding shortfall.[2] The actuarial firm Gabriel, Roeder, Smith & Company (GRS), who works for the retirement system, forecast that the pension fund would have to generate 8% investment returns on average every year for the next 50 years — something that is as statistically improbable as a raging blizzard in Houston — just to maintain the current funding levels, never mind making progress toward full funding.

Unless there are fundamental changes for Texas ERS, the fund will likely run out of money some time between 2040 and 2060.

The exact date that Texas ERS would become insolvent under the current funding policies depends on the investment returns it actually can generate. The nearby chart is from a GRS report to the Texas ERS board last year highlighting the dire straits the pension plan is in.

If Texas ERS can average 7.5% returns on its investments (for which there is maybe a 1 in 4 chance) then the funds the plan has set aside could last in to the 2070s and all of today’s retirees would probably be okay. If there is another financial crisis, like in 2008 or the one we are currently experiencing, within the next 10 to 20 years, and investment returns only average 6% — a much more likely scenario — then money could run out as soon as the 2040s. This could affect both those just retiring now and active members in the system.

The long and short of this analysis is that Texas ERS is in trouble unless there is a serious change to the status quo.

What Can Be Done?

Texas is unlikely to let its state employees pension fund go insolvent. If the state were to allow for this, the state would still be on the hook for paying promised benefits. The state would then have to figure out a way to pay for pension benefits on a “pay as you go” basis — which would be significantly more expensive for taxpayers. Still, it is not clear when the state legislature will act or what they will do.

The path of least constitutional resistance is to raise employee contribution rates. The state constitution caps the amount of money that the state can put into Texas ERS at 10% of employee payroll. That is how much was being contributed as of 2019. Without an emergency declaration from the governor, the state can’t put in more money. But the constitution does not cap how much employees can be required to put into Texas ERS. Theoretically, this means the state could ask active employees to pay more into their pensions while not increasing the value of benefits. Such a move would effectively be a pay cut for state agency workers — ranging from legislative staff, department of transportation and education employees, to the state’s IT department.

Raising employee contributions is rarely politically popular, but in some cases it is reasonable to ask employees to put in additional money to ensure the security of their future benefits. In the case of Texas ERS, however, many will likely find increasing employee contributions unreasonable. State workers in Texas are already contributing the second highest amount for any state agency retirement system in the country where workers also contribute to Social Security. The nearby chart shows a distribution of the rates state workers pay into pension plans around the country (if they are also paying 6.2% of their pay into Social Security).

What Other Options for Texas TRS Exist?

A range of other ways to fix Texas ERS have been proposed.

Texas could drop billions of dollars into the pension fund by having the governor declare a state of emergency and use money from the state’s rainy day fund. This would have political challenges to say the least, and the state’s rainy day fund is likely going to be tapped to patch revenue shortfalls related to the COVID-19 recession. But even if the money were available, just dropping money into the status quo without fixing Texas ERS’s underlying problems (such as its overly optimistic investment assumptions) would likely just be delaying the inevitable.

The director of Texas ERS has suggested benefit cuts should be on the table. Cutting already earned benefits or current retiree benefits is almost certainly illegal and, if not, it would be immoral. Theoretically, the state might have some latitude to reduce the value of pension benefits earned in the future by telling active workers they will earn a lower multiplier for any future years of service. The ethics of such a move to cut benefit values, even if they are legal, would be murky at best. There certainly may be times where shared sacrifice is necessary to ensure a pension fund doesn’t run out of money and hurt everyone involved, but for a state the size of Texas with its relative wealth and capacity to raise revenue, it is far from obvious that Texas has reached a point where benefit cuts are necessary.

Creating a new retirement system for new workers — such as a guaranteed return plan (like Texas city and county workers have) or a defined contribution plan (like the option that University of Texas employees have) — is a common suggestion. Creating a new plan or a new option along side the current pension would likely have some upsides for recruiting employees who would prefer a more portable retirement benefit and/or reducing long-term investment risks for the state. But such a move would not address the existing $30 billion shortfall or ensure a funding increase to avoid future insolvency. All of this to say that there might be workforce related reasons to create and provide employees the option to opt into another kind of retirement plan alongside the current pension, but don’t count on it to solve the problems that pension debt is creating for Texas.

What to Do Next Year?

At a minimum, Texas ERS should be reducing its investment assumption to something that is more realistic and less likely to lead to unfunded liabilities. The board has already taken a first step in this direction — in May 2020 they voted to reduce the assumed rate of return from 7.5% to 7%. But even reaching that target has at best a 50/50 chance. A more realistic target for average annual investment returns would be closer to 6% than 7%. Doing so would translate to a higher measured value of unfunded liabilities, but it isn’t actually creating debt so much as offering a more accurate measure of the current funding shortfall for Texas ERS.[3] It is also important to note that reducing the investment assumption wouldn’t necessarily mean changing the actual investment portfolio, nor would it change the timeline for when Texas ERS might run out of money. What it would do is provide a clearer target for what policy changes are necessary to create a realistic path to stable funding.

The state may want to consider a large, comprehensive package of reforms that includes everything from the list above if there is sufficient support from all of ERS’s stakeholders.

The state may also want to delay this issue to the 2023 legislature, when the fiscal climate for Texas may have improved relative to this COVID-19 moment. But there should be a clear plan for fixing Texas ERS. A strong first step would be to create a commission that would be tasked with:

1. defining the purpose of offering retirement benefits for Texas state workers in the first place;
2. determining the best way to provide retirement benefits to workers going forward, irrespective of existing funding challenges; and then
3. a package of changes to funding policy, contribution rates, benefits, and revenues that all would work collectively — and in accordance with the objectives identified for Texas ERS in the first place — to ensure there will be long-term funding for promised benefits.

Sources and Notes

[1] See the Net Pension Liability data in Texas ERS’s 2019 actuarial valuation report, p. 33.

[2] This is the Net Pension Liability reported by Texas ERS using GASB 67 actuarial accounting standards. Using its own actuarial accounting preferences, Texas ERS reports a $12.45 billion market valued unfunded liability. While these accounting metrics differ meaningfully, both use the same measurement of available assets, and both methods suggest those assets will run dry in the next few decades.

[3] Specifically, lowering the discount rate further from 7% to 6% would mean an increase in the unfunded liability on an actuarial value of assets basis. But the GASB67 measured funding shortfall may not necessarily increase. The Net Pension Liability in the 2019 valuation report was measured using a 4.42% discount rate, based on GASB67 requirements for the use of a “Single Discount Rate” when a pension fund is forecast to become insolvent.