Lawmakers Tackle Long-Term Obligations BIG CHANGES TO THE STATE’S RETIREMENT SYSTEM ARE CREDIT POSITIVE

By Spencer Grubbs Published September 2021

Texas Comptroller Glenn Hegar has been calling attention to the growing costs of the state’s long-term financial obligations since he took office in 2015; in December 2016, he outlined concerns in a letter to state leaders. The Comptroller and credit-rating agencies alike warned that failure to address those obligations could jeopardize the state’s reputation, credit rating and overall financial health. This year, Texas lawmakers continued their efforts to heed those warnings.

During the regular legislative session that ended in May, the 87th Legislature advanced plans to pay down the spiraling costs of the state employee pension system, a move that is projected to be credit positive for the state.

This article on long-term obligations — the third since 2017 — primarily focuses on recent changes to state employee pension funding. It also provides brief updates on retirement and health care benefits for public school teachers, the state’s prepaid tuition plan and deferred maintenance for state-owned buildings.

State Employee Pension Funding

The Employees Retirement System (ERS) Plan currently serves about 395,000 active and retired public employees and their dependents. ERS Plan assets totaled $28.5 billion as of Aug. 31, 2020. However, the total amount needed to meet all future pension obligations on the books was $43.2 billion (Exhibit 1), a difference of $14.7 billion, which is the unfunded actuarial accrued liability (UAAL).

Exhibit 1: ACTUARIAL VALUATION RESULTS FOR ERS PLAN, AUG. 31, 2020

*Funding period: Estimates when a plan will become fully funded, based on current contribution rates and investment returns.
**Depletion year: The year in which a plan is projected to become insolvent.
Sources: ERS, 2020 Annual Comprehensive Financial Report (PDF); GRS, consulting actuaries, 2020 Actuarial Valuation Report (PDF)

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Gabriel, Roeder, Smith & Co. (GRS), a national actuarial and benefits consulting firm, determined that the financial outlook (PDF) for ERS was “very poor.” GRS projected that, based on the current state and employee contribution rates, the ERS plan would never have enough money to cover future obligations and would eventually be depleted.

The funding status of the ERS Plan has weakened, despite remedial actions taken by the Legislature since 2009, which included reducing benefits for new hires and increasing state and employee contribution rates. The plan’s funded ratio — an annual point-in-time measure of total assets divided by liabilities and expressed as a percentage — has declined from fiscal 2010 to fiscal 2020, with a steep drop occurring over the last year (Exhibit 2). GRS projected that the funded ratio would continue to shrink if the 87th Legislature did not “materially increase” contributions.

Exhibit 2: Historical and Future Projected Funded Ratios for ERS Plan, FY 2010-2025

Note: Reporting date is Aug. 31 of each fiscal year; projections are based on current contribution rates and a 7 percent investment return, among other assumptions.
Source: GRS, consulting actuaries, 2020 Actuarial Valuation Report, p. 33

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Pension Reform

In August 2020, projections indicated that the ERS Plan’s UAAL was on track to grow by $1.5 billion each biennium, or $2 million a day.

During the regular session, Texas lawmakers committed to paying down the plan’s UAAL and returning the plan to actuarial soundness. Their efforts culminated in the passage of Senate Bill (SB) 321, which launched the most comprehensive ERS pension reform package to date. Effective on Sept. 1, 2021, the bill has two key components: A requirement that the state pay down pension debt by a certain date and the inception of a new cash balance benefit retirement plan.

Legacy Payments

The Texas Pension Review Board, which oversees all public pension systems in Texas, recommends (PDF) that employer and employee contributions to a pension system be enough to eliminate its UAAL in 30 years or less; at present, the contributions to the ERS Plan fall short of this target.

SB 321 requires the state to make a payment to ERS each fiscal year that is “actuarially determined” to pay off its $14.7 billion UAAL by the end of fiscal 2054 — a funding period of 33 years. Before each legislative session, retirement actuaries will calculate the payment amounts — an estimated $510 million per fiscal year. These actuarially determined payments are in addition to the current state contribution rate of 10 percent of total payroll.

Cash Balance Benefit Plan

Another consequential element of Texas’ pension reform package is the cash balance benefit plan established as a new tier under the existing ERS retirement system (Exhibit 3). This reform affects only state employees hired on or after Sept. 1, 2022.

EXHIBIT 3: Central Components of the New Cash Balance Plan for Public Employees Hired on or After Sept. 1, 2022

The new cash balance plan under ERS is structured differently than the defined benefit (DB) pension plan for current employees. A cash balance plan diverges from a traditional DB plan largely because it “defines the promised [retirement] benefit in terms of a stated account balance,” according to the U.S. Department of Labor.

A member of the new ERS cash balance plan will receive a lifetime annuity with the annuity amount based on the accrued balance in the member’s account at retirement rather than a formula that incorporates the member’s highest salary and years of service. Cash balance annuity is dependent on the plan’s investment performance, whereas traditional DB annuity is guaranteed, regardless of investment performance.

Cash balance benefit plans are not new, even in Texas. The Texas Municipal Retirement System, which administers retirement programs for nearly 900 cities in Texas, is the oldest cash balance plan (PDF) in the United States. The state of Kentucky, which had implemented a cash balance plan for its state employee retirement system in 2013, recently added a supplemental cash balance plan to its teacher retirement system. Other states with cash balance plans include California, Kansas and Nebraska.

Teacher Employee Pension and Health Care Funding

The Teacher Retirement System of Texas (TRS) — the sixth-largest U.S. public retirement system — administers a pension fund that currently serves about 1.7 million active and retired public school employees in Texas. As of Aug. 31, 2020, the total amount needed for TRS to meet all future pension obligations on the books was $218 billion, of which $50.6 billion represented UAAL (Exhibit 4).

EXHIBIT 4: Actuarial Valuation Results for TRS Plan, Aug. 31, 2020

*Funding period: Estimates when a plan will become fully funded, based on current contribution rates and investment returns.
Source: GRS, consulting actuaries, 2020 Actuarial Valuation Report

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The 86th Legislature in 2019 approved a six-year plan for TRS to phase in higher state, employee and employer (school district) contribution rates, aiming to address pension debt and achieve actuarial soundness (Exhibit 5). Beyond fiscal 2024, contribution rates are not expected to change.

EXHIBIT 5: State, Employee and Employer Contribution Rates for TRS, FY 2020-2025

Note: Each contribution rate is a percentage of the total employee payroll for that fiscal year.
Source: Teacher Retirement System of Texas

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In addition to providing retirement benefits, TRS administers two health care benefit programs, one for active public school employees and another for retired employees. The latter program — known as TRS-Care — covered nearly 220,000 retirees (PDF), dependents and surviving spouses and children as of Aug. 31, 2020.

TRS-Care largely is funded by state, employee and employer contributions, but it is considered a “pay-as-you-go” plan. The Legislature makes periodic appropriations, in addition to state contributions, to provide health benefits and reduce or sustain monthly premiums for plan members. The Legislature has made seven supplemental appropriations since fiscal 2010, the largest of which was $768 million in fiscal 2015.

TRS-Care is not a long-term obligation for the state alone because of the cost sharing and self-funding structure of the program. Legislative appropriations aid in closing the program’s ongoing funding gap and attempt to keep pace with health care expenses.

Texas Guaranteed Tuition Plan

The Texas Guaranteed Tuition Plan (PDF) (TGTP) is a prepaid tuition plan created in May 1995 and opened for enrollment in 1996. Texas voters approved a constitutional amendment in 1997 that guarantees the plan’s benefits with the full faith and credit of the state.

The TGTP stopped accepting new contracts when the Texas Legislature deregulated tuition in 2003 in anticipation of significantly higher tuition rates. In all, the plan sold 158,442 contracts prior to closure. As of Aug. 31, 2020, the plan still had 34,629 active contracts. The TGTP was replaced in 2008 by a new prepaid plan, the Texas Tuition Promise Fund.

The TGTP’s contract payments and investment earnings have not kept pace with the cost of tuition. As of Aug. 31, 2020, the plan had an estimated unfunded liability of $483.4 million and was projected to run out of cash in fiscal 2022.

The 87th Legislature appropriated $271 million to cover the TGTP’s projected cash deficit for the next biennium. The plan will require annual general revenue appropriations until 2039, when all contracts are expected to be fulfilled.

Deferred Maintenance for State Buildings

Deferred maintenance refers to the postponed maintenance of buildings, equipment and systems due to a lack of sufficient funding. Each year maintenance is postponed, costs rise due to further deterioration of known deficiencies, the accumulation of new problems and higher costs for repair and construction.

In 2020, deferred maintenance costs for state-owned or state-leased buildings totaled about $644 million (Exhibit 6). This point-in-time estimate, however, does not reflect cost increases or cost associated with needed repairs becoming emergencies.

EXHIBIT 6: State Deferred Maintenance Costs by Priority Level, 2020

Note: Table reflects state properties under Texas Facilities Commission management, which include properties for the Texas School for the Blind and Visually Impaired and the Texas School for the Deaf.
Source: Texas Facilities Commission, 2020 Master Facilities Plan Report

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The Texas Legislature appropriated $450 million from general revenue to the Texas Facilities Commission (TFC) for fiscal years 2016 to 2021 to reduce the state’s deferred maintenance backlog. In 2020, TFC, which manages owned and leased properties that support 97 state agencies, reported (PDF) that it had expended $200 million of the appropriated funds, in addition to executing more than $300 million in contracts for deferred maintenance projects.

Conclusion

Texas has enjoyed the highest credit ratings provided by major credit agencies, and taking care of long-term obligations is essential for maintaining the state’s good ratings.

“I have talked about our long-term liabilities for more than six years, and I’m thankful that the Legislature took much-needed action this year on ERS,” Comptroller Glenn Hegar says. “Our long-term obligations will only continue to grow if they’re not addressed, and that could mean larger program expenses in the future and even the potential for a downgrade in our credit ratings that could drive up the state’s borrowing costs. This legislative action is important to keeping our state on sound financial footing, which benefits all Texans.” FN

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