SOLICITOR REPORT–PENNSYLVANIA PENSION REFORM
Senate Bill No.1 (the “Act”) will replace the current defined benefit pension plans under Act120 for state and public school employees (the “Current Plans”) with two hybrid plans and a defined contribution plan (the “Revised Plans”). As a result, Pennsylvania taxpayers should bear less risk for market performance of funds in the Revised Plans than the risk to which we are currently exposed with the adequacy and growth of funds in Current Plans. This means that Pennsylvania taxpayers might be obligated to fund less for the pensioner (other than State Police officers and correctional officers) of the Pennsylvania State Employees’ Retirement System (“SERS”) and the Public Schools Employees’ Retirement System (“PSERS”) following the application of the Revised Plans. The Act has been praised as an important step toward financial savings for state taxpayer. The Act has been criticized because it allows state and public school employees to continue to elect defined benefit plans and because it applies only to newly hired SERS and PSERS employees with no vested interest in the Current Plans.
It is important to understand the significance of risk shifting and cost savings. In a defined benefit (“DB”) plan, the retired employee takes a predetermined value based on employment compensation and career length; the employer is responsible to fund shortfalls due to insufficient contributions or poor market performance (unsuccessful investment) during the employee’s career. In a defined contribution (“DC”) plan, the retired employee takes a value based on contributions made to the plan and market performance (investment results) of those contributions; the employer bears no responsibility to enhance the actual retirement benefit without agreeing to contribute to the DC plan. The private employment sector 401k plan is a prevalent DC plan. The Act could bring to state government (and state taxpayers) the benefits that private employers have realized in their shifts from DB to DC plans over the last 25 years. The market collapse of 2007-2008 and resulting negative performance of retirement benefit funds is the type of risk that a DC plan would remove from state taxpayers.
The new DB/DC (“Hybrid”) plan into which PSERS employees would be enrolled if they make no election is as follows. For new PSERS employees, the employee would contribute toward the DB portion of the Hybrid 5.5% of current earnings with 10-year vesting and a benefit accrual rate of 1.25% of final average salary per year of service (presently 2%). The employer’s contribution to the DB portion is to assure the predetermined value is available to the retired PSERS employee notwithstanding the unknown investment success with the contributions. The employer contributes toward the DC portion of the Hybrid 2.25%with no liability for predetermined retirement value and the employee contributes 2.75%.
The new Hybrid plan that defaults to non-electing SERS employees is as follows. The employee would contribute toward the DB portion of the Hybrid 5% with 10-year vesting and a benefit accrual of 1.25% of final average salary per year of service; the employer is responsible to fund shortfalls due to insufficient contributions or poor market performance. Future SERS employees will be required to contribute 3.25% for the DC portion; the employer would contribute 2.25%but is not required to fund market and contribution inadequacies to a predetermined retirement value.
Newly hired PSERS and SERS employees seeking lower contribution rates for Hybrid plans must make an election and agreeto receive a lower multiplier for the accrual rate. PSERS employees would contribute 4.5% (not 5.5%) for the DB portion with 10-year vesting (and 3% (not 2.75%) for the DC portion) with an accrual on the DB portion of 1.00%(not 1.25%)of final average salary per year of service. SERS employees would contribute 4% (not 5%) for the DB portion with 10-year vesting (and 3.5% (not 3.25%) for the DC portion) with an accrual on the DB portion of 1%(not 1.25%) of final average salary per year of service. For both electing PSERS and SERS employees, the employer contributes 2% (not 2.25%) for the DC portion but for the DB portion of elected Hybrid plans, the employer must fund market and contribution inadequacies to the predetermined retirement value.
Both newly hired PSERS and SERS employees may elect a DC plan. The PSERS employee would contribute 7.5% and the employer would contribute 2%. Future SERS employees electing a DC plan would pay 7.5% with employer contribution of 3.5%. The vesting period for this DC plan and the DC portions of the default and elected Hybrid plans is 3years. The employer bears no responsibility for funding to a predetermined benefit. Employees electing the DC option might be those who do not plan to remain in state or school positions for the full 10-year vesting period of the DP plans.
Retirement ages will increase and the calculation of average salaries will be spread over more years for DB portions of the default and elected Hybrid plans. Retirement ages will change from 65years of age with 3years of credit service (or service years plus age equaling 92) to 67years with 3 years credit (or service years plus age equals 97). The final average salary would change from being determined over a 3-year period to being determined over a 5-year period.
The Act applies only to newly hired SERS and PSERS employees because it would be a confiscatory taking of value from present employees who have property rights in the Current Plans. To apply the Act to present employees would, if successful, result in a loss of benefits to them. This loss would occur because the employer has less market risk and liability(and the employees would likely receive less retirement benefits) under the Hybrid and full DC plans than under the present DB plans. The new plans will apply to SERS employees on January1, 2019 and to PSERS employees on July1, 2019.
Pennsylvania has an unfunded liability of $76billion for the current DB plans of SERS and PSERS employees. That liability will continue to increase as current employees retire with benefits under the Current Plans. The retirement of SERS and PSERS employees with Hybrid plans can be projected to occur beginning during the period 2029 (first year of vesting)through 2054(full retirement). The Commonwealth must address the employer’s liability for the predetermined values of the DB portions of those employees, but will not bear as much market risk under the Hybrid plans and no investment risk for the DC portion of the Revised Plans. Accordingly, real cost savings for the Hybrid plans will not occur for decades.
Cost savings for those Hybrid Plan employees would be greater if the predetermined values of the DB portions were reduced or if those DB portions were eliminated and the benefits under the Act were only DC plans as with the many private sector employees. The actual cost savings and liabilities are further discussed in an “Actuarial Note Transmittal” (the “Transmittal”) from the Pennsylvania Independent Fiscal Office for certain amendments incorporated into the Act. The Transmittal can be found at http://www.ifo.state.pa.us/download.cfm?file=/Resources/Documents/Actuarial/ACNSBIA0135 4A01558201703.pdf. According to the Transmittal, “[f]or [fiscal years] 2018-19 through 204950, the proposal is projected to reduce the employer contributions by $14 billion on a cash flow basis and $319 million on a present value basis.” Why then does the Act not provide only DC benefits? The Act arose in the legislative process with 4 caucuses and a Governor whose constituent interests vary as to retaining any DB plan. Those interests create compromise legislation in the political process.
The Governor signed the Act on June12, 2017 and it took effect immediately. In a press release on current session legislation, the Governor said, “Today is yet another demonstration that by working across party lines and branches of government, we can address important issues… And now, we can add one more success to that list [of legislation]–pension reform.” A prior pension reform bill in the last legislative session would have saved Pennsylvanians more money but was not enacted because of disparate interests of our elected officials. According to Senate Majority Leader Jake Corman (R-Centre), “What I’m going to say is [SB1]is what we can get two chambers to pass, and the governor to sign, and that’s the most important thing, because the other bills couldn’t, so therefore they don’t save anything.”
© 2017 Robert J. Hobaugh