COMMONWEALTH OF PENNSYLVANIA PENSION SYSTEMS. Ryan Genova, M. Ed.

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1 COMMONWEALTH OF PENNSYLVANIA PENSION SYSTEMS Ryan Genova, M. Ed. March

2 The State Employees Retirement System (SERS) and the Public School Employees Retirement System (PSERS) are funded through three constituents: 1) employer contributions, * 2) employee/member contributions, and 3) investment earnings. 1 At present, SERS and PSERS are offered a defined benefit (DB) pension plan. The amount per year upon retirement is determined by a fixed formula: 2 Multiplier (2.5% or 2.0%) X Years of Service (e.g., 30 years) X Final Average Salary 3 PSERS employer contributions are shared by the Commonwealth funded by taxes - and local school districts. Depending on the wealth of the district, the Commonwealth contributes a minimum of 50 percent of the total employer entity. For the fiscal year, the Commonwealth s projections are $1.5 billion in total, $677.4 million for SERS and $856.1 million for PSERS. More than 70% of the value of PSERS and SERS comes from investments by actuaries in the stock market. In 2001 and 2002, the pension system lost over $3 billion and $2.5 billion in market shortfalls, respectively. The greatest hit was a $32.2 billion loss in ($19.5 billion for PSERS and $12.7 billion for SERS) investments in 2008 resulting from the worldwide recession. 4 Pension market vulnerability was in part due to past legislation that either underfunded the system or overexerted the range of contributions through expansions to member benefits. Decisions made by General * Employers are to pay an Annual Required Contribution (ARC) made up of the cost of the current year s benefits in addition to an amortization payment to the Unfunded Actuarial Accrued Liability (UAAL). Pennsylvania is one of 33 states that are below the 80% funded liability threshold largely as a result of investment losses in 2008, according to the Pew Center s recent report. Assemblies allowed employer contribution rates to fall to 1.15% beginning in School district contributions and state contributions were short-sightedly lowered for budgetary freedom on behalf of both parties. The Commonwealth s contribution is funded by taxes; as such, more investment risk is placed on the taxpayer to make up for fewer inputs from school districts and state funding, and ultimately market losses. From 2002 to 2011, the vast majority of employees steadily contributed their share to the system. Employee members funded 19% of their own pensions from their paychecks, while employers contributed 10% of the total funding sources. For fiscal year , PSERS and SERS contributed nearly $1.4 billion. 6 Other decisions helped create farreaching debt. In 2001, following a robust expansion of Gross Domestic Product (GDP) and national wealth, the formulaic multiplier was raised from 2.0% to 2.5% through Act 9 s change to the basic benefit formula. Act 9 also lowered the vesting threshold from 10 years to 5 years, thereby increasing eligibility for membership. 7 Act 38 of 2002 was a frenetic response to large market losses in the last two quarters of The reform s eventual results were a decade of under-funding through a one year employer contribution holiday and overall lowered employer contribution rates. 9 Additionally, unfunded liability levels were increased by cost-of-living-adjustment (COLA). 10 Act 40 of 2003, again reactionary in nature, was implemented to ease fiscal burdens of rising employer contribution rates by delaying liability payments, though its impact was compromised by short-range decisions to increase basic education funding. With lower state and district contributions to the pension system, many school districts funneled their newfound budgetary increases into new programs and more employees. In 2

3 many cases, the money that was to be used for unfunded liability relief was spent. 11 Further exacerbating the situation was a stark increase in heath care premium adjustments from $55 a month to $100 a month. 12 With two economic downturns between 2001 and 2010, the poor investment performance of market assets did not match the assumed 8.5% return, raising the employer normal costs, or recognized levels of contribution needed from employers. 13 Today the unfunded liability has become one of the most unmanageable and fastest growing obligations for the state, tripling from $400 million in 2006 to $1.5 billion in The goal of Act 120 of 2010 was to mitigate the burgeoning unfunded liability incurred by the Commonwealth by modifying the actuarial funding requirements of the pension systems. The plan allowed for the continuation of the defined benefit pension and reduced future costs for taxpayers and school districts by 60 percent, totaling $3 billion by Overall, the changes enforced by Act 120 will generate $33.1 billion in savings from benefit reductions by Act 120 s rate collars were to ease the burden of rising employer rates by artificially capping the increases each fiscal year from 2011 until PSERS and SERS had time required for vesting reversed from five years to ten years, their normal retirement ages increased to 65, and an increase in their qualifications for membership, all an effort to help relieve debt burdens. A 113% cap on benefits after retirement was imposed, and a shared risk provisional agreement between employees and employers was instituted to Moody s credit rating agency downgraded Pennsylvania s rating from Aa2 to Aa1 in part due to outstanding pension liabilities. States such as Pennsylvania rely on strong ratings to finance longterm initiatives. safeguard employer contributions against potential future recession periods. Act 120 additionally raised the employer contributions to 2.56%, up from a 1.15% rate since Act 120 affects only those public school employees who gain membership on or after July 1, Current members before this date are entirely unaffected and retain their benefits. In essence, yearly retirement benefits for new employees dropped by an averaged total of $9, Economic Impact Together, PSERS and SERS comprise 818,000 workers and retirees with more than $86 billion in assets under management. Approximately 90% of disbursements to retirees are spent in state and local economies, providing $4.6 billion and wages and salaries. State and local pension systems support nearly 100,000 jobs, and provide $1.2 billion in federal tax revenues and $636 million in state and local tax revenues. The National Institute on Retirement Security found that the income from pension disbursements supports: food services private hospitals real estate establishments physicians, dentists, and other healthy practitioners nursing and residential care facilities retail colleges, universities, and professional schools 18 Keystone Pension Report In the 2012 Keystone Pension Report, Pennsylvania s Secretary of the Budget Charles Zogby explains that while current proposed reforms offer no panacea to the 3

4 fiscal reality of the General Fund budget, the reforms offer an alternative to either fully funding pension obligations or making cuts to the core functions of government. He addresses the $41 billion in unfunded pension liability that the Commonwealth has incurred over the last decade, and the expectation of PSERS and SERS employer contribution rates to expand from the current 12.36% to 28.04% in FY According to the report, dollar amounts are projected to double every two years, totaling a rise of over 625% over the coming decade. Secretary Zogby iterates the need for funding in state government to finance public safety, police, health and human services, public education, and roads and bridges. The painted picture is a choice between the aforementioned programs and services and financing the Pennsylvania pension system, an assertion that both cannot coexist. The report concludes by outlining the negative consequences of inaction on the parts of taxpayers, new businesses, the Commonwealth s credit rating, and the pension debt itself. 19 Three omissions in the report alter perspectives by varying degrees. The report neglects the effect of the $1.18 billion cuts to funding in FY In regards to pensions, the 15% statewide decrease for PreK-12 made employer contributions by school districts extremely difficult to maintain without insolvency. 21 Secondly, new employees pay roughly 20% more into their own pension funds than they have historically paid in the past. Prior to 2001 s Act 9, new employees contributed 50.09%; after Act 9, that rate rose to 55.8%. Currently, employee contributions are over 70% of the total resources. 22 Thirdly, the current unfunded liability levels for existing employees and retirees must be paid off over time regardless of reforms to new employee pension systems. Pension system debts must be paid as an obligation of the Commonwealth, pursuant to 24 Pa.C.S (PSERS) and 71 Pa.C.S The Defined Contribution Proposal To remediate funding and budget deficits, Harrisburg s proposal is a reform to the basic pension plan. Beginning in 2015, new public employees would be forced into a defined contribution (DC) plan resembling a private sector 401(k). Instead of pooling resources and funding pensions with a group account, SERS and PSERS would have individual accounts maintained by professional managers. 24 A basic comparison between DB and DC plans is offered below: Comparison of Defined Benefit and Defined Contribution Retirement Plans Contributions Employee Employer Investments Defined Benefit (DB) Traditional Plans Employee contributions are mandatory and are set at a fixed rate. Contributions are set at a variable rate that is annually calculated by an actuary. Contributions for all employees are pooled, and invested by professional asset managers in a diversified Defined Contribution (DC) 401(k), 403(b), 457 Employee contributions are voluntary and the maximum amount annually deferred is limited and is based on age. The employer is not required to make contributions, however many employers choose to match their employees' contributions up to a certain percentage. Individual accounts for each employee; employees make all investment decisions themselves, and can choose 4

5 Amount of money in retirement Lifetime income Supplemental income portfolio of assets. The monthly benefit is determined by a set calculation, usually based on years of service and pay at the end of one s career. Payouts are provided as a monthly income stream that is guaranteed for the remainder of a retiree s life. Spousal protections, disability benefits, and cost of living adjustments are common. Courtesy of the House Appropriations Committee 25 from a range of investment options offered. The money available in retirement is simply the amount that one has accumulated in the savings plan, through contributions and investment earnings. Plans are not required to offer a lifetime income option, and typically pay out benefits as a one-time lump sum. Supplemental benefits are not applicable and generally not available. If provided, they require extra contributions to some structure outside the DC plan. The effects of the proposal and the putative reasons behind the proposal are dissociate, though interconnected, issues and discussed here in that order. Fewer liquid assets as retiring beneficiaries of the defined benefit plan shift funds from illiquid assets lowers the rate of return. A lower rate of return necessitates more employee and employer contributions as well. 26 According to the Keystone Research Center, a DC plan will concurrently expand the unfunded liability pool in part due to lower investment returns from safer assets, a byproduct of a defined benefit plan lacking contributions from new employees. 27 In layman s terms, by closing the original plan off to new employees, the number of new contributors decreases. Concurrently, an aggregate number of PSERS and SERS will retire and live - in some cases for decades - to receive their promised benefits. With a growing retired population and no new employees funding their pensions, the money going out of the asset pool will exceed the money entering into it. As a result, state and school districts will contribute more to PSERS and SERS benefits. 28 According to the Corbett administration s pension consultant, a similar situation has already played out in Florida, 29 and other examples and actuary estimates from California, Kansas, Minnesota, New Hampshire, Texas, Alaska, Michigan, West Virginia, Arizona, New York, Colorado, Nevada, Kentucky, Wisconsin and New Mexico indicate that switching plans expanded pension funding dilemmas in these cases. 30 The Pennsylvania State Education System (PSEA) reports that, alongside increased pension debts, increased costs to taxpayers, school districts, and the state, future new employees will garner 20% less than their predecessors under the new system. 31 Beyond reports on the public sectors inadequate pension shifts, defined contribution plans appear costly and ineffective in the private sector as well. According to the National Institute on Retirement Security (NIRS), Baby Boomers (born ) with private sector occupational DC plans are just as susceptible to lowered standards of living after retirement as those soon-to-be retirees with no retirement plan at all. The NIRS states, Americans with DB pension income are much more likely to achieve financial security in retirement than those without such pensions and return anywhere from 0.8% to 2.7% more per year than a DC plan. Nor are DC plans economically efficient: a recent analysis found that defined DC plans are becoming more and more common in the private sector. From 1975 to 2008, the percentage of private-sector employees with a DB plan went from 88% to 24%, respectively. 5

6 benefit plans are 46% less costly to deliver 32 ** than a DC structure. A litigious concern will likely play a part in the decision to shift plans. To pass his current proposal, Governor Corbett may violate areas of both the U.S. Constitution (Article 1, Section 10) and the Pennsylvania Constitution (Article 1, Section 17) stating that retirement benefits for PSERS and SERS are deferred compensation for years of service completed and are contractually binding for employers. 33 Pennsylvania s case laws have protected public retirement benefits from net detriment, an interpretation that includes reductions in earned benefits as well as future benefit accrual. PA Tax Breaks & Credits The situation may offer an alternative solution within the confines of the Pennsylvania bylaws and one of benefice to the Commonwealth, SERS and PSERS, and the overall budget. Recent governorships have been exponents of tax breaks for corporations. One might easily state that large corporations have a proclivity in American politics to sway legislative decisions in their favor, and Harrisburg is ostensibly susceptible to such influence. Amidst consistent public statements by the Corbett administration that money is tight in Pennsylvania, in March 2013 Pennsylvania legislators passed three bills that will further erode the budget. All three proposals support the wealthiest Pennsylvanians: The Senate Finance Committee created an addendum to the state inheritance tax allowing business owners to bestow business assets taxfree to their heirs. ** For more information on this topic, see The Shift from Defined Benefit to Defined Contribution Plans Implications for Asset Allocation and Risk Management, Broadbent, Palumbo, and Woodman. The House Finance Committee passed a bill exempting sales tax on private and corporate aircraft. The House Commerce Committee voted on a new tax credit for investors with a net worth of $1 million or an income greater than $200,000 a year. 34 The Pennsylvania Budget and Policy Center have documented $3.16 billion in annual budgetary losses that have been lawfully willed to tax credit programs, corporations, and large banks. A source of one of the largest annual losses dates back to 1998, a gradual phasing out of the capital stock and franchise tax (CSFT). In 2002 the CSFT rate was $7.24 per thousand; in 2012 the rate was $0.89 per thousand, amounting to $2.07 billion in state taxes for the decade. The CSFT change in FY is estimated to cost Pennsylvania s budget $201 million. 35 Corbett s latest proposal will include a decrease in the corporate net income tax (CNIT) from 9.99% to 6.99% between 2015 and PBPC estimates the CNIT Single Sales Forward losses to be $260 million annually, and the CNIT Net Operating Loss Carryforward to cost the state $339 million annually. The Coalition for Labor Engagement and Accountable Revenues (CLEAR) estimates $550 million in losses from the Delaware tax loophole. 36 More than 70% of companies that conduct business in Pennsylvania use Delaware-based P.O. boxes as headquarter addresses to avoid paying the Corporate Net Income Tax. 37 CLEAR additionally identified sources of roughly $1.04 billion in total revenue losses for Pennsylvania: $400 million in business tax breaks by adopting federal bonus depreciation rules $355 million to corporations by reducing the Capital Stock and Franchise Tax 6

7 $175 million in Education Improvement Tax Credit, including a $75 million tax credit expansion in the budget $74 million from an anachronistic sales tax that pre-dates computer-based accounting and saves businesses a 1% sales tax $45 million in other special interest tax breaks 38 PBPC has chronicled a series of reports on an impact drilling tax for Pennsylvania s natural gas production. In 2012 the drilling fee was restructured to one of the lowest rates in the country. Based on production data from the department of Environmental Protection, the organization estimates $387 million lost in potential revenues for the state between 2009 and CLEAR estimates an annual $247 million loss for the state from low drilling taxes. 39 Additionally, a flawed state funding formula for cyber and charter schools in Pennsylvania has cost public schools $175 million in funding. 40 The total cost of tax breaks for businesses after the passage of Act 40 of 2003 amounted to $6.8 billion. Funding shortfalls for PSERS and SERS combines to $5.9 billion. 41 In sum, revoking tax breaks and credits for businesses would allow the PA budget to balance with no cuts to pensions, public programs, or public services. Courtesy of the Pennsylvania Budget and Policy Center Privatization of PA Privatization has arguably proven merits in some arenas and, politically speaking, is a necessary antagonist to the left in avoiding an overly centralized, bureaucratized society, economy, and litigious system. The Economic Policy Institute has released a compilation of recent research illegitimating the claim that cutting taxes and services will attract businesses and jobs. 42 Further, the reports largely refute the idea that 7

8 tax cuts stimulate economic activity; in fact, reducing public services education, for example at the local and state level due to tax cuts can slow the economy and increase unemployment levels. According to EPI s research, businesses have a propensity to go where high-quality public services are offered. Taxes play very little into a business s costs about 0.8% of the total and decision making processes. 43 Education appears to be another exception to the merits of privatization, as the purported benefits are generally unfounded. Skyrocketing private higher education costs coupled with mediocre performances in charter schools a linchpin of the privatization movement have given rise to serious doubt regarding the plausibility of success in a privatized education system. Political Nepotism The forces behind legislative decisions are often multi-faceted, and for political soap opera fanatics, fascinating as they are entertaining. The aforementioned decisions and proposals have brought forth a deluge of press criticisms from nonpartisan sources such as The Pennsylvania Budget & Policy Center, the Keystone Research Center, the Education Law Center, The Coalition for Labor Engagement and Accountable Revenues, and the Pennsylvania State Education Association. Nevertheless, because much of governors campaigning is funded through the private sector, governors like Corbett often have a tough time denying the influence of corporations, particularly the natural gas industry. For more information on contributors to Governor Corbett s campaign, see Followthemoney.org s database online at: tate_contributors.phtml?s=pa&y=2010 Fourteen Marcellus Shale Advisory Commission members and several of their spouses contributed a combined total of $442,347 to Corbett's campaigns for attorney general (2004, 2008, 2010) and governor (2010). Most contributions to Gov. Corbett from Marcellus Shale Advisory Commission members came from either current or former oil and gas executives and lobbyists. In the 2010 election, donors from the oil and gas industry favored Tom Corbett by more than 10:1, giving his campaign $1.3 million while only contributing $130,300 to his opponent, Dan Onorato. Energy sector donors contributed a combined $768,438 to the legislators sitting on the House and Senate Environmental Resources & Energy committees. 44 Conclusion Poor legislative tinkering was unhelpful, though variables outside the state s locus of control contributed most significantly to the General Budget s current status. Perhaps the scale of the situation could have been lessened with acute foresight, though caveats are more easily written in retrospect. The alacrity with which state legislators have attempted to engineer consent from the public can be attributable to the importance of the issue. Pension systems directly or indirectly affect every Pennsylvanian; PSERS and SERS are in the most precarious position, though everyone stands to lose a hand on the grip of the law. The alternative, to be rejected, is an uninformed complacency allowing unenlightened self-interests to win out over common rights and citizen achievements. A significant pushback against political and corporate inertias will be a continued requisite 8

9 of the public and the Commonwealth, both in the coming months and beyond. Endnotes: 1 An Introduction to Your PSERS Defined Benefit Plan, Pennsylvania State Education Association. January What do Corbett s Pension Reforms Mean? The Sentinel, February 10, Frequently Asked Questions about Pensions, National Institute on Retirement Security. 4 A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December Gov. Corbett Targets Public School Employees Pensions, Bill Hileman, Pittsburgh Federation of Teachers. 6 What happened? Why are Pennsylvania s pension costs to increase so dramatically? Pennsylvania State Education Association. November Gov. Corbett Targets Public School Employees Pensions, Bill Hileman, Pittsburgh Federation of Teachers. 8 A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December The Keystone Pension Report: A Discussion of Structural Reform and Relief to Pennsylvania s Retirement System for Long Term Sustainability, Charles Zogby, Office of the Budget. Fall Gov. Corbett Targets Public School Employees Pensions, Bill Hileman, Pittsburgh Federation of Teachers. 11 The Keystone Pension Report: A Discussion of Structural Reform and Relief to Pennsylvania s Retirement System for Long Term Sustainability, Charles Zogby, Office of the Budget. Fall Gov. Corbett Targets Public School Employees Pensions, Bill Hileman, Pittsburgh Federation of Teachers. 13 A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December Understanding State Pension Systems, Joe Markosek. House Appropriations Committee. January Pennsylvania Pensions, Keystone Research Center. March Synopsis of Pension Reform Legislation: Act 120 of 2010 (House Bill Number 2497, Printer s Number 4476). 17 Synopsis of Pension Reform Legislation: Act 120 of 2010 (House Bill Number 2497, Printer s Number 4476). 18 Understanding State Pension Systems, Joe Markosek. House Appropriations Committee. January The Keystone Pension Report: A Discussion of Structural Reform and Relief to Pennsylvania s Retirement System for Long Term Sustainability, Charles Zogby, Office of the Budget. Fall Key Facts about Governor Corbett s Education Budget for Education Law Center. 21 A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December Understanding State Pension Systems, Joe Markosek. House Appropriations Committee. January Digging a Deeper Pension Hole: Transitioning to Defined Contribution Plan Brings Higher Pension Debt and Taxpayer Costs, Stephen Herzenberg, Keystone Research Center. February Understanding State Pension Systems, Joe Markosek. House Appropriations Committee. January Digging a Deeper Pension Hole: Transitioning to Defined Contribution Plan Brings Higher Pension Debt and Taxpayer Costs, Stephen Herzenberg, Keystone Research Center. February Digging a Deeper Pension Hole: Transitioning to Defined Contribution Plan Brings Higher Pension Debt and Taxpayer Costs, Stephen Herzenberg, Keystone Research Center. February Digging a Deeper Pension Hole: Transitioning to Defined Contribution Plan Brings Higher Pension Debt and Taxpayer Costs, Stephen Herzenberg, Keystone Research Center. February , Study Reflecting the Impact of Closing the Florida Retirement System Defined Benefit Plan to New Members Effective January 1, 2014, Milliman, Inc. February Digging a Deeper Pension Hole: Transitioning to Defined Contribution Plan Brings Higher Pension Debt and Taxpayer Costs, Stephen Herzenberg, Keystone Research Center. February A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December Frequently Asked Questions about Pensions, National Institute on Retirement Security. 33 Pennsylvania Pensions, Keystone Research Center. March

10 34 Three New Tax Breaks Will Cost PA Schools and Services, Third and State. March 20 th, Found online at: 35 $3 Billion Bill for Corporate Tax Cuts in Pennsylvania Budget and Policy Center. March A Better Way for PA: Restoring Pennsylvania s Fiscal Health through Fairness, Efficiency, and Innovation. Coalition for Labor Engagement and Accountable Revenues. 37 Geoffrey Goes to Delaware, Pennsylvania State Education Association. March A Better Way for PA: Restoring Pennsylvania s Fiscal Health through Fairness, Efficiency, and Innovation. Coalition for Labor Engagement and Accountable Revenues. 39 $3 Billion Bill for Corporate Tax Cuts in Pennsylvania Budget and Policy Center. March A Better Way for PA: Restoring Pennsylvania s Fiscal Health through Fairness, Efficiency, and Innovation. Coalition for Labor Engagement and Accountable Revenues. 41 A Critique of the Corbett Administration s Keystone Pension Report, Pennsylvania State Education Association. December Rethinking Growth Strategies: How State and Local Taxes and Services Affect Economic Development. Robert Lynch, Economic Policy Institute Names in the News: Pennsylvania's Marcellus Shale Advisory Commission. Kevin McNellis, Followthemoney.org, July 28, Found online at: 10