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The slow road to state pension reform

Pennsylvania, like many other states, is facing a huge unfunded pension deficit in its defined benefit plans: a $70 billion shortfall in two large plans for teachers and other state employees. Unlike most states, Pennsylvania in early June passed — with widespread bipartisan support — major legislation "to get real meaningful pension reform," as Gov. Tom Wolf was quoted saying.

Indeed, the recent Pennsylvania law is a significant step in the right direction. However, the financial projections for the legislation show how long it takes, given the legal and political constraints, for this approach to pension reform to meaningfully reduce the burden on state budgets.

Here is the background. In 2001, Pennsylvania reported a $20 billion surplus in its two big defined benefit plans – the Public School Employees' Retirement System and the State Employees' Retirement System. But then state legislators boosted benefits for current state workers without increasing contributions to these plans, and even extended this giveaway to already retired public employees. In 2003, legislators compounded the state's funding challenge by taking a "pension holiday" — decreasing pension contributions to allocate revenue to other state priorities.

These actions contributed to a giant shortfall during the global financial crisis, when the value of the state's pension portfolios plummeted. In response, state legislators in 2010 reduced pension benefits — only for newly hired state workers — to pre-2001 levels. Nevertheless, because of growing obligations to current and retired workers, the state's contributions to its pension plans ballooned to $6 billion in the 2018 fiscal year from $1 billion in the 2011 fiscal year.

Similarly, the legislation applies only to teachers and other state employees hired in 2019 and thereafter (except for state police who will continue in the existing pension plan). Unless they opt out, these new employees will contribute 8.25% of their pay to a hybrid plan — with half of their retirement benefits coming from the state's traditional defined benefit program, and the other half from a new 401(a) plan. Alternatively, these new employees could choose the 401(a) plan for all their retirement benefits.

In addition, the legislation tightened some of the rules for the new employees in the defined benefit plans. As examples, the final salary for calculating benefits will be based on the five highest years of compensation, instead of three years; and new employees cannot get maximum benefits unless they begin withdrawals at age 67, rather than 65.

However, the legislation does not reduce the existing $70 billion deficit in the defined benefit plans for current and retired state workers. The Pennsylvania Legislature was not prepared to touch their benefit schedules because of political opposition from unions and potential suits. Some courts have declared that benefit formulas are protected for an employee's entire career, so they can never be reduced. Other courts have limited these protections to pension benefits already accrued, so they can be changed for future years of employment.

As a result, the projected decline in Pennsylvania's contributions to its retirement plans will be only $1.4 billion over the next 32 years.

Moreover, the number of new employees relative to the number of current and retired state workers will rise very gradually for two reasons. Pennsylvania is not on a hiring binge, and retired workers are living longer. Therefore, the state's pension contributions are projected to rise for the next 16 years before falling from 2035 to 2050.

Several legislators touted possible additional savings of up to $20 billion if the state's defined benefit plans fail to meet their investment targets of more than 7%. In that event, the state would share part of the risk of a pension shortfall with its new plan participants.

In short, the reform legislation will reduce by approximately half the investment risk of Pennsylvania's defined benefit plans after 2035, when new employees will constitute a large majority of the state's public workforce. However, until then, the state's contributions to its defined benefit plans will impose a substantial burden on the state budget and put financial pressure on other important public programs.

Although this compromise might be the best that could be accomplished in Pennsylvania due to legal and political constraints, it offers a slow road to state pension reform. To accelerate the pace of reform, state legislators would have to be politically willing and legally able to change the pension plans of current state employees in a more impactful manner — tightening the rules for retirement benefits to be earned in the future, while preserving those benefits already accrued.

Robert Pozen is a senior lecturer at MIT Sloan School of Management and non-resident senior fellow at The Brookings Institution. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.