In the last few weeks, the City and two of its pension plans (Police & Fire) have issued their annual reports as of June 30 last year. The results are jaw-dropping.
According to the reports, all three plans had massive gains in their investment portfolios over their last fiscal year (July 1, 2020 – June 30, 2021). The firefighter and police plans reported gains of 34% and 32%, respectively. The municipal employee plan has not issued its annual report but the City’s report implies its return was ~34%.
To put the significance of these returns in perspective, if these gains prove to be durable, 70% of the City’s pension debt was wiped out in a single year.
The returns are large because the plans have moved well out on the risk curve. About 40-45% of their funds are invested in alternative investments such as hedge funds and private equity. The firefighter fund recently disclosed it has invested in cryptocurrencies. This is not unique to the Houston plans. Investing in such riskier assets has become increasing common for public pension plans as they have reached for higher yields to try and offset the demographic headwinds.
The returns reported by the City’s plans are somewhat higher than those generally reported by other plans last year but not hugely so. Pensions & Investments, a publication that tracks public pensions, surveyed 96 plans and found the average return last year was 27%.
One aspect that gives me some heartburn is that a large portion of the returns are coming from alternative investments, mostly private equity funds. For example, it appears that over half of the firefighter fund’s $1.34 billion in gains came from private equity.
Most alternative investments are not traded on public markets and therefore, their values are estimated. Nearly 30% of the police pension’s assets are ones for which there are “no significant observable market inputs.” The actual value of these types of assets is typically not known until the investment is liquidated, which may be many years in the future.
While there are certain standards and guidelines for valuations, they are still subjective and subject to potential overvaluation. Overvaluation may be a result of erroneous appraisals but it may also just be the result of frothy market conditions, as we saw in the dotcom boom/bust in the late 1990s and early 2000s. Charlie Munger, Berkshire-Hathaway co-chairman, recently said that he thinks the markets now are “crazier than the dotcom boom.”
Over time the plans’ returns have become increasingly volatile. Years in which there were outsized returns such as last year, have typically been followed by large losses and/or years of underperformance and even with this year’s outsized returns the long-term trend is still negative. Since June 30, the police pension plan, which is the only plan to publish interim investment results, only earned 3.6%, about half of the target to keep the plan fully funded.
Predictably, some city employees are already calling for a restoration of some of the benefits that had been reduced. But we have seen this movie before. The City got into this mess when benefits were dramatically raised late in the Brown administration on the theory that the plans were overfunded based on the dotcom stock market. But when the bubble burst, Houston taxpayers were left holding the bag. They were set back even more in the 2009 financial crisis when the plans lost 16-20% of their value.
That has resulted in the City steadily ratcheting up its contributions to the plans ever since. Last year the City contributed $413 million to the plans. Also, taxpayers have been saddled with $1.6 billion in bond debt which was contributed to the plan. The contributions last year were over 30% of the employees’ base pay and about one-third of all the property taxes collected by the City last year. Paying 30% for pension benefits puts incredible strain on the City’s budget and, of course, would be unthinkable in the private sector.
So, the inevitable fight coming based on these new valuations will be that City will want to start scaling back its contributions and the employees will want to raise benefits. But attempting to guess at the cost of future benefits and value of assets over the next four to five decades is a fool’s errand, especially when the plans have such large portfolios of the alternative assets,.
This is why I have long argued the City should get out of defined benefit plans, as the private sector did decades ago. And we are increasingly seeing in the public sector follow suit. The U.S. military went to a hybrid plan several years ago and Texas just did the same for new State employees last year. Most Texas municipal employees and all county employees have long had hybrid plans referred to as “cash balance” plans.
I have never supported changing benefits that have been promised to existing employees as the City did in 2017. A deal is a deal. But future generations of Houston taxpayers should not be asked to shoulder the investment risk for City employees. Otherwise, we are dooming future generations of taxpayers and city employees to the inevitable seesaw battle over the perception that the plans are either under or overfunded, while the reality is that we will never know whether they are or not.