Dallas residents may have discovered over the past several months a financial crisis in their city related to the Dallas Police and Firefighters Pension. Few people really understand pension funding and how pension funding created this billion dollar shortfall for the city. The local news media in Dallas–Fort Worth, Texas has done a fairly good job of discussing current activities to try to resolve the financial crisis; but they have generally done a poor job explaining how pension funding caused this crisis. As a Dallas employment attorney with experience working with large pension plans I can delve into the mysterious web of pension funding. I worked with many of the nation’s largest private pensions through their run of funding problems following the 2008 financial market collapse and see the same problems with the Dallas Police and Firefighters Pension.
My discussion will focus on the actual funding issues rather than the administrative problems in Dallas–although I will touch on them. We’ll talk pension funding basics and then how that fit into this Dallas municipal pension. Then I’ll forecast the future of this funding problem for Dallas, Texas.
Pension Funding Basics in Texas
Pension funding lies at the intersection of life expectancy calculations and investment management. A defined benefit pension like the Dallas Police and Firefighters Pension promises a monthly benefit to retirees based upon a specified formula. The plan’s liability is the total of all payments the plan projects to pay to its present and future retirees based upon their life expectancy. As Dallas hires employees and the employees continue to work the plan’s liability grows. At the same time the plan satisfies part of its liability by paying benefits to retirees. The pension is in a constant state of paying retirees and accruing liability for future payments.
Pension plans are rarely fully funded; meaning they do not hold enough cash to pay all of its present and future liabilities right now. Instead pension plans hold an amount of money then invested so the investment returns pay the pension liabilities over time. If the investment returns do not satisfy the pension liability presently owed then the plan either pays out of the principal or the plan sponsor must pay more money into the plan. (In this case, Dallas tax dollars go to the plan or Dallas issues bonds to finance the pension.) It’s cheaper for the plan sponsor, Dallas, to put up some of the money early on and invest it because the investment returns externalizes the cost of benefits owed by the plan.
Think about it like this. You hire me as your employment attorney in Dallas, Texas and I do $10,000 of work for you. (We will discuss why I agree to delay payment in Part 2.) I agree to delay receipt of payment until one year from today. You could pay me $10,000 out of your pocket; however, a friend tells you if you’ll loan her $5,000 today she’ll give you $10,000 a year from now. If you loan her the money then you can cut your bill to me in half. Do you want to pay me $5,000 or $10,000? Obviously you want to reduce your costs. This is what pension plans do. They raise the $5,000 today and invest it so somebody else owes them the other $5,000.
So pension plans have these big piles of cash they need to invest. The amount of money in the Dallas pension, like most pensions, is so large that the plan can invest in more exotic investment instruments than common stock or bonds. They can invest in instruments that carry different types of risk. The instruments may be illiquid (not easily liquidated to cash if needed). They may not be as easily priced as punching in a ticker symbol on a broker’s website. There may not even be a definitive value for the investments. Plan administrators have to exercise diligence with investing the plan’s cash reserve.
Now you may ask: why invest Dallas pension funds in these unusual investments if they carry so many risks? Greater potential returns. Remember if the pension’s assets cannot cover its liabilities then Dallas, Texas either has to throw tax dollars at the pension or take out bonds to debt finance it. If an investment collapses or fails to deliver promised returns then the pension still owes all of its liabilities. Benefit payments must still go out. The more the plan externalizes its costs the less Dallas residents pay for police and fire protection. This creates a desire on the part of plan administration to choose risky investments, fail to thoroughly vet investments and to cover up investment failures.
The foundation of the Dallas, Texas pension funding crisis
To really understand the problem with the Dallas pension you have to understand the function of the pension. Most people consider pensions as an employment benefit gratuitously offered by the employer because the employer cares about the employee’s well-being. As an employment lawyer I know the existence of pensions is more complex. Pensions exist as a method to defer payment of compensation to employees. Instead of paying more wages today the employer can break up payment for today’s work by paying some as wages (and benefits) today and some as pension payments later. The employer gets the work today and then compensates the employee over time for that work. It makes the labor cheaper to the employer because the employer can externalize some of the cost by letting investment on the pension assets pay some of the benefits.
If you’re a Dallas mayor looking at a city with a crime problem that can’t raise police salaries to compete with other cities for qualified candidates but need qualified candidates and to retain staff then you might improve pension benefits as a way to increase compensation without having to pay it today. This is exactly what Dallas did.
DROP and the Dallas, Texas pension
One way Dallas improved the pension benefits was how it structured its DROP. DROP is deferred retirement option plan. Under the pension an officer or firefighter who met twenty years of service could retire and receive a full pension. DROP allows the employee to continue working for Dallas and receive pension payments which are credited to an account with the pension for the employee. When the employee retires he or she gets the pension benefit plus DROP. This allows Dallas to retain veteran officers and firefighters, thereby reducing its need to staff and train new officers and firefighters. It also allowed the plan to delay tangible payments from the pension. DROP accounts are credited with benefit payments but the pension plan retains the funds and continues to invest them. With benefit payments to DROP accounts only make on paper the plan could keep more money invested and try to obtain more returns.
To improve the attractiveness of DROP, the pension plan paid eight to ten percent guaranteed interest on DROP. (Later reduced to six percent.) Most cities in Texas do not pay interest on DROP or pay far less. This made the Dallas plan far more attractive. Now the Dallas pension has to gain returns to cover its currently due benefit payments, interest on bonds that financed the plan, the accruing but unpaid DROP funds and sizable interest on the accrued DROP funds.
If this seems like a high degree of risk then you’re reading this correctly. At the time–early to mid-2000s–investment returns were substantial. Real estate was a rocket and the stock market wasn’t far behind. It may have been possible to cover these liabilities if the markets continued to soar without retracting. We know that didn’t happen. But wait–add mismanagement to the mix.
How Dallas, Texas pension management blew it
In addition to voluntarily creating a swelling pension liability, the pension plan administration fell to a long string of mismanagement that exacerbated the problems created by the 2008 market collapse. Across several mayors it has been alleged that the mayor and Dallas city council failed to exercise proper oversight. This allowed the plan administrator at the time to run amok. He had a preference for real estate investments, allegedly, and made some bad investments. He reportedly oversold the investment returns and valued the investments at their purchase price without regard for changes in market value. The result of these alleged facts is a pension plan deeply underfunded with insufficient returns in illiquid investments while liabilities grew rapidly. Without clear knowledge that the pension was in financial crisis the situation could only continue to sink. By the time it became clear the pension had funding problems there was a race to withdraw DROP funds which created an immediate need for liquidity and a sudden depletion of capital.
In short: bad management, bad investments, bad plan design.
What will happen now to the Dallas, Texas pension
This is all bad news for Dallas. It’s bad news for the police and firefighters especially. Inevitably, as is always the case in these situations, the employees will bear the brunt of bad management. The employees put in the work in exchange for compensation and now Dallas doesn’t want to pay. (The people employed to manage the pension got theirs.) Dallas is in the process of trying to work out a resolution, most of which seems to involve the employees and retirees taking a pay cut. If Dallas cannot work it out on their own then the state government will have to step in. Likely to the same result. At least the employees have some help because they are public employees. The Texas Constitution gives due process rights to pension benefits accrued by public employees; but that does not mean Dallas cannot challenge it. (As it has in the past.)
It doesn’t get better for Dallas residents. As police and firefighters see compensation cut and feel the city doesn’t support them they will look elsewhere for work and Dallas will end up right back where it started fighting to keep qualified police and fire employees. Then expect crime to start to rise again in Dallas.
All this is not just a Dallas problem. Fort Worth has pension funding problems. Many Texas cities have ticking time bombs in their pensions with the same kind of investment problems.
Employee benefits attorneys in Texas for pension plan problems
If you work for a city in Texas with a pension plan facing funding problems then you should talk to an employee benefit attorney. If the plan administrator violates its duties under the plan or Texas law then you may have rights to pursue the city or plan administrator. You may be able to recover from the plan administrator for violating your rights under the plan. Employee benefit attorneys understand how pensions work and the laws regulating them. Contact a law firm that represents clients in employee benefit issues today to learn more about your rights.