Public Pensions & Politics

Reforming an Unsustainable System and

Managing “Generational Theft”

Richard C. Dreyfuss
Business Consultant and Actuary
Senior Fellow - The Commonwealth Foundation

Pennsylvania Business Council Education Foundation

Pennsylvania Competitiveness Council
Public Policy Seminar
May 3, 2011 – Camp Hill, PA
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.”
2
Three Factors Drive the Political
Institution of Public Pensions

1. Poor Benchmarking

2. Poor Risk Management Practices

3. Politics

3
#1 Poor Benchmarking
 Pennsylvania public pay and benefits are
typically benchmarked only within the public
sector rather than the entire PA marketplace

 Market trends in the private sector are directly

relevant to the public sector

 2010 Hewitt Survey: only 11 of 33 major PA

employers sponsor defined benefit plans
 All sponsor 401(k) plans with an average employer match of 72
cents per dollar and an average matched employee contribution
of 5.4 percent of pay.

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 Towers Watson Survey
Average DC Employer Cost - 5.77%
http://www.towerswatson.com/united-states/research/2106

Fortune 100 Companies - Trends in Retirement Plans

100%

90%

80%

70%

60%

50%
Traditional DB Plans
40%
Hybrid DB Plans
30% DC Plans

20%

10%

0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Traditional DB Plans 67 61 60 55 48 42 40 39 36 30 22 20 17
Hybrid DB Plans 7 13 14 18 24 30 30 29 25 23 26 25 26
DC Plans 26 26 26 27 28 28 30 32 39 47 52 55 58

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#2 Poor Risk Management Practices
 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.

 Little consistency in funding assumptions and funding

methods making comparisons most difficult.

 The Federal Pension Protection Act (PPA) of 2006

requires private sector DB plans funding based upon:
 Lower interest rate assumptions (an index: currently ~ 6%)
 Shorter amortization periods (generally 7 years)
6
. 2011 Wilshire Report on State Retirement Systems

“Funding Levels and Asset Allocations”

 None of the state retirement systems studied by
Wilshire Associates will be able to meet its actuarial
assumed rates of return over the next 10 years.
(Includes PSERS and SERS)

 Among 126 systems studied, the median plan will

return an estimated annualized 6.5% on assets over
the next 10 years, 1.5 percentage points short of the
median actuarial long-term assumed rate of 8%.

 Milliman's annual pensions study shows the average

equity allocation has fallen more than 15% over the
past three years.
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“Pension Magic” in Florida
(and elsewhere)

Orlando Sentinel – July 7, 2010

 "Warren Buffett would close down his shop and give his
money to the city of Orlando" if it could get 8 percent, says
Edward Siedle, a former federal securities lawyer and
president of Benchmark Financial Services in South Florida.

 Cities like Orlando have three choices, Siedle says.

1)"They can cut benefits, which is politically unacceptable”

2)"They can increase contributions from the employer and

employees, which is politically unacceptable.”

3)“The third choice is called magic. That's what public pension

funds across the country are doing, coming up with magic.”
#3 Politics
Pensions as political capital
 Pension Fund Surplus = Benefit Improvements
for Participants

 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

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PA Public Pension Recap
“In any collaboration between two groups who hold different
basic principles, it is the more irrational one who wins.”
 What good is an unprincipled bipartisan reform?

This helps explain the irrational pension legislation of

 Act 9 (2001) – 25%/50% increase in pensions
 Act 38 (2002) – Retiree pension COLA
 Act 40 (2003) – Deferring unaffordable costs to 2012 and
beyond
 Act 44 (2009) – City of Philadelphia & Municipal Pension
Non-reform
 Act 120 (2010) – PSERS & SERS Non-reform
(Generational Theft Bill)
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 Negative Implications of Act 120
Unacceptable Risks, Generational Theft, Non-Reform

During the next 30 years all this will be made worse if we:

1. Fail to earn the 8% annual assumed rate-of-return on the assets.

2. Revise the investment assumptions to reflect lower expectations.

(March 2011 action by PSERS reduced rate to 7.5% - this will
immediately increase the unfunded liabilities by $3.5B. Act 120
“savings” for PSERS over the next 30 years was estimated at $1.4B)

3. Once again defer scheduled contributions to “save” money

4. Once again “fresh start” or re-amortize the unfunded liability

5. Grant retirees an ad-hoc COLA, implement an early retirement

incentive or otherwise enhance current or future pension benefits
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HB 2497 Projection of PSERS Taxpayer
Contribution as Percentage of Payroll
(in FYE 2011, 1% pay =~$135M)

35.00%

30.00%

25.00%

20.00%

Prior Law
15.00%
Act 120

10.00%

5.00%

0.00%
2014

2031
2011
2012
2013

2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030

2032
2033
2034
2035
2036
2037
2038
2039
2040
2041
2042
2043
2044
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 100%

50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024

Current Law
2025
2026
2027
2028

HB2497
2029
2030
2031
PSERS Projection of Funded Ratio

2032
2033
Senate Amended 2034
2035
2036
2037
2038
2039
PSERS Projection of Funded Ratios

2040
2041
2042
2043
2044
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14
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
“paid-up” in the aggregate at retirement
 Achieving a 100% funded ratio
 Significant private sector pension funding reforms
occurred in 2006.

2. Costs must be predictable.

3. Costs must be affordable.

 4-7% of payroll (net of employee contributions)
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Five Step Statewide Pension Reform Plan
1. Establish a Unified Defined Contribution plan for new state and local
government workers, school employees, judges, and legislators
– Curtails open-ended liabilities; Eliminates long-term commitments
on behalf of taxpayers
– Removes politics from pensions

2. Prohibit pension obligation bonds or other post-employment benefit

(OPEB) bonds
– Prevents “generational theft” – deferment of liabilities

3. Mandate pension and OPEB liability management reforms for

current and any newly created liabilities.
– Achieve an annual employer cost of 4% to 7% of payroll with
standardized actuarial assumptions, shorter amortization periods,
all generally similar to PPA of 2006. Prohibit “fresh-starting”.
– Prohibit benefit improvements if this would result in a funded ratio
below 90%.
 Five Step Pension Reform Plan
4. Consider modifying unearned pension benefits (if legal and feasible)
– Reduced formula; Redefinition of eligible earnings; Increasing the
normal retirement age; Curtailing early retirement subsidies;
Eliminating COLAs and 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 steps 1,2,3,4 ≠ pension reform

 What good is budgeting 100% of an
actuarially deficient rate?
 Many in the state budget process are emphasizing the intent to fund
“the full actuarial contribution” for 2011-12 for PSERS and SERS.

 Quoting from the actuarial note accompanying Act 120:

 “However, it should be noted that the employer contribution collars (in
effect through 2015) represent a departure from the norms of actuarial
funding practice. The effect of the bill as amended would be to suppress
the employer contributions to both PSERS and SERS resulting in significant
underfunding of both retirement systems.”

 The PSERS FY 2011-12 budgeted rate is 8.00% + .65% (retiree

healthcare) = 8.65% of payroll or $1.2B. This plan has an unfunded
liability of $20B ($31B using the market value of assets). Annual
benefit additions are being earned at a rate of 8.12% payroll.

 SERS has an unfunded liability of $5.6B ($11.1B using market value).

In addition, a separate unfunded liability for state employees retiree
medical is estimated to be approximately $15B. 18
 State officials are pondering where to direct
a possible budget “surplus” of $78M?

 The concept of a budget “surplus” given the underfunding of

our long-term pension and retiree medical plans unsustainable
liabilities is counterintuitive at best.

 Sound public policy requires that we consider the long-run

effects and all people, not simply short-run effects and a few
people.

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 These unfunded liabilities impacts
Pennsylvania’s future competiveness
 A recent Deloitte Growth Enterprise Services survey of 527 executives
at mid-market companies (annual revenues of between $50 million
and $1 billion) found “tempered optimism” that the economic
recovery will continue.

 However, the survey also found significant concern over government

fiscal and regulatory policies.
 50 percent cited federal, state, and local debt as the greatest
obstacle to U.S. growth in the coming year.
 Lack of consumer confidence (39 percent)
 Rising health care costs (33 percent).
 High tax rates (30 percent).

http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_dges_Midmarketperspectives_042111.pdf
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 Final thoughts for Pension Reform

1. Deferring unsustainable pension liabilities does not make future

liabilities sustainable. Why is contributing less into already
underfunded plans considered “reform”?

2. We have over-leveraged our pension system. The challenge is to

finally restore proper funding while offsetting these increased costs
elsewhere within the state and local budgets without increasing
overall spending (or borrowing).

3. PA Municipal Pension Plans are a variation of this theme.

4. Retiree medical obligations are a parallel problem.

5. Given all this, what are the financial incentives to live, work, or invest
in Pennsylvania?

6. This debate is effectively one involving self-reliance while removing

politics from pensions, protecting the taxpayer and stopping
generational theft.
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