Texas has a Balanced Budget Requirement, Except When it Doesn't

As is widely known, Texas has a balanced budget amendment and our legislators are required to pass a balanced budget. Our legislators are even now writing budget bills that will apply to the coming biennium, the two fiscal years from September 2021 – August 2023. However, forecasting future tax collections and even spending for the next two years is rather difficult. Imagine trying to write, today, your household budget, income and expenditures, over that same two year period and keeping your budget balanced!

In fact, Texas has debt - substantial debt. A large part of that debt is due to pension promises. Texas has four major statewide pension plans for state and local government workers. The largest is the Teachers Retirement System (TRS), and second largest is the Employee Retirement System (ERS).  These are both “traditional” pensions, or defined-benefit pensions, in which workers are promised certain pension benefits as determined by a formula and based on years of service and final pay. Here, employers and workers contribute to a pension fund during their working years that is managed by a pension fund that invests these contributions. Upon retirement, the now-retired former worker receives the promised pension payments for life.

Defined-benefit programs are difficult to manage. They require forecasting far into the future, much further than two years. A fully funded pension fund must collect and accumulate enough funds from contributions and investment earnings each year sufficient to pay the promised pension many years in the future. This requires forecasts of rates of return in financial markets, decisions about the mix of assets held by the pension fund, forecasts of when individual will retire, and what will be their future raises. It also requires forecasts of how long their participants will live.

State and local government defined-benefit pension plans are saddled with one other burden. The pensions follow accounting and financial reporting standards established by the Government Accounting Standards Board. These accounting rules are used to value future liabilities that are wrongheaded at best and that violate basic principles of finance. These rules provide procedures to calculate the current value of the future promises to pension plan participants, which are liabilities of the plan. These pension promises are relatively safe, almost never changed for current retirees and seldom changed for future retirees. It is rather amazing that government accounting rules allow states to value these promises at interest rates closer to high-risk securities such as stocks, rather than interest rates appropriate to their risk. The effect is to understate the liabilities of these pensions.

Pensions are underfunded if the value of their assets is less than the value of their liabilities. The two largest Texas pensions, TRS and ERS, report being underfunded by $82 billion in 2019. However, using a more correct discount rate, these pensions are underfunded by $147.5 billion. 

Why are these pensions underfunded? The simple answer is insufficient contributions, and overly optimistic forecasting, combined with accounting standards that allow under-reporting of liabilities. Pension funds accumulate from contributions from both employees and employers, along with investment returns. Contributions must cover the necessary funding that is not provided by investment returns. The other part of the issue is that workers are living longer, and longevity has increased more than expected, but our pension payout formula has not changed. Over time, our pension promises have unexpectedly increased in value slowly over time because we have kept the same formula for payouts but now these payouts occur, on average, over a longer period of time.

To put our underfunding into perspective, Texas collects about $60 billion annually in taxes, or about $120 billion over the biennium. To restore TRS and ERS to a situation of fully funded pensions would require $147.5 billion, an amount that far exceeds two years of ALL state tax collections. This is a serious debt.

So, does Texas have a balanced budget requirement? Yes, formally. But by not fully funding our pensions, we are borrowing, we are promising future payments that exceed what we have saved for making those payments. Where will that money come from to make up those future payments? Why, from taxpayers, of course. Make no mistake about it - our past legislators and oversight behavior has left Texas taxpayers are on the hook for those existing promises.  
Any move to address our state’s troubled pensions should consider two things. First, why kid ourselves as to the magnitude of the problem? The huge nature of the problem should be acknowledged by using an appropriate discount rate for calculating liabilities. Second, a move toward a cash value plan (e.g. Senate Bill 321) or defined contribution plan would at least stop the bleeding and help restore predictability to the cost of pension promises.

Posted: June 11, 2021 by Dennis W. Jansen