A Comprehensive Proposal for Reforming Pennsylvanias Unsustainable Retirement Systems

Business Consultant and Actuary Senior Fellow - The Commonwealth Foundation Senior Fellow - The Manhattan Institute
PA House State Government & PA House Finance Committees August 14, 2012 Richard C. Dreyfuss

Managing Pension Liabilities

The Public Pension Crisis
August 18, 2006; Page A14

the fundamental problem is that public pensions are inherently political institutions. the current public pension system simply isn't sustainable in the long run.
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Three Factors Drive the Political Institution of Public Pensions

1) Poor Benchmarking 2) Poor Liability Management 3) Politics

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#1 Poor Benchmarking

Pennsylvania public pay and benefits are typically only benchmarked against public sector practices in other states versus considering market practices in the Pennsylvania private sector. Market trends in the private sector are directly relevant to the public sector.

2012 Hewitt/Aon Survey: Retirement Benefits

PA Companies Number of companies in survey 35 Number with Defined Benefit plans 9 or 26% Number of DB plans where benefits are 1 based upon highest average pay Number with 401(k) plans 35 Average employee contribution 5.2% matched percentage in 401(k) plan Average employer matching rate $.80 Average employer cost 4.13% to (Basic savings plan match to maximum 6.58% often discretionary) Number of companies offering some 18 or 51% retiree medical insurance coverage Number of companies where retiree 9 or 50% pays all US Companies 738 197 or 27% 74 738 5.4% $.81 4.17% to 6.14% 390 or 53% 206 or 53%
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Towers Watson Survey Average DC Employer Cost 4.77% to 7.67%

http://www.towerswatson.com/assets/pdf/mailings/TW-21621_July-Insider.pdf

Fortune 100 Companies - Trends in Retirement Plans

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Traditional DB Plans Hybrid DB Plans DC Plans 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Traditional DB Plans Hybrid DB Plans

DC Plans

64
8 28

59
13 28

58
14 28

53
18 29

47
23 30

40
29 31

37
29 34

36
28 36

33
24 43

29
21 50

22
23 55

20
20 60

17
20 63

13
17 70

#2

Poor Liability Management

Few absolute metrics defining the affordability or reasonableness of pension costs given the perpetual life of the government entity.

Entire defined-benefit (DB) funding system is based upon annual investment assumption in the 8% range recently revised to 7.5% for PSERS and SERS.
A 2011 Wilshire Associates study indicated none of the 126 state retirement systems (including PSERS and SERS) will be able to meet its actuarial assumed rates of return over the next 10 years. Likely return is estimated at 6.5%. A 2012, study by Welton Investment Corp yielded a composite forward expected annual return of 5.69% per annum for the next 7 to 10 years. The Federal Pension Protection Act (PPA) of 2006 requires private sector DB plans funding based upon: Lower investment rate assumptions (an index: currently ~ 6%) Shorter amortization periods for deficits (generally 7 years)
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#3 Politics
Pensions as political capital

Pension Fund Surplus = Political Capital & Benefit Improvements for Participants and/or Retirees Pension Fund Deficits = Underfunding by Taxpayers Maintaining or Improving Benefits = High Political Rate of Return

Reforming and Properly Funding Plans = Low Political Rate of Return

True Pension Reform Must Satisfy Three Basic Principles Using Realistic Funding Assumptions

1. Funding must be current.

Benefits should be funded as they are earned and paidup in the aggregate at retirement. Achieving a 100% funded ratio. Significant private sector pension funding reforms occurred in 2006. (Lower investment assumptions ~ 6%, funding periods <15 yrs., market value of assets) PSERS average age is 44.5. Avg. retirement age 60.9

2. Costs must be predictable. 3. Costs must be affordable.

4-7% of payroll (net of employee contributions)

Five Step Statewide Pension Reform Plan

1. Establish a single statewide Defined Contribution plan for all new state, school and local government employees with an annual employer cost of 4% to 7% of pay. No unfunded liabilities Eliminates long-term taxpayer commitments Removes politics from pensions 2. Prohibit pension obligation bonds or other post-employment benefit (OPEB) bonds on a statewide basis. This concept would also preclude other borrowing to finance benefit plans. Prevents generational theft deferment of liabilities 3. Adopt statewide funding reforms consistent with GASB 67 & 68. Shorter amortization periods, use of market value of assets Goal is an annual employer cost of 4% to 7% of payroll Prohibit benefit improvements if this would result in a funded ratio below 90% New GASB requirement requires unfunded liabilities to appear on balance sheets

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Five Step Pension Reform Plan

4. Modifying unearned pension benefits (as legally permitted) This includes increasing member contributions, reducing formula benefits, increasing the normal retirement age, curtailing early retirement subsidies Eliminating pension COLAs Revising Other Post-employment Benefits (OPEB) Statewide ban on Deferred Retirement Option Programs (DROPs) 5. Consider funding reforms only after prior steps are achieved Challenge is to do this without increasing taxes or through new borrowing

Omitting any steps comprehensive pension reform

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PA Non-Reform Reform Ideas

Reforms we dont need and cant afford
Item
Using pension obligation bonds or other borrowing strategies to finance the retirement benefit systems
An early retirement incentive plan

Detail
Issuing bonds to fund pension plan deficits

Why it is a problem
Increases risk to taxpayers with a certain incentive to increase pension benefits
Enhances already generous benefits. Long amortization periods. Only works if backfill rate is below 40%

Fresh start (reset) of any unfunded liability beyond the average remaining duration of active members. Other funding techniques which defer costs including assigning such costs to new employees. A new and reduced DB plan and/or an optional DC plan

Creates a new mortgage

Increases generational theft An easy political solution

Even a new DB will not escape the politics of public pensions. Consider PSERS and SERS - 10 years ago lessons of history. A new DB plan which where the accrued benefit is an account balance Same politics and funding problems associated with defined benefit plans

A new cash balance (hybrid) plan or a reduced set of new DB & DC plans

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A Half-Truth : The nature of transition costs in converting from DB to DC plans

GASB (the accounting requirement) currently stipulates that a closed DB plan needs to amortize unfunded liabilities on a level dollar basis and is silent on the duration. This higher near-term recognition of costs is referred to as the transition cost. Some DB plan apologists claim this required accounting treatment constitutes a funding mandate which should preclude consideration of major reform initiatives such as adopting a DC plan for new hires. Consider the mandate of funding the transition cost versus a frequently observed practice of otherwise not contributing the Annual Recommended Contribution. For additional information:
http://www.arnoldfoundation.org/news/foundation-debunks-myths-about-fixing-public-pensions

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