Author: The PLS Reporter/Friday, March 28, 2014/Categories: Features

By Jason Gottesman

It’s a rule as old as budgets themselves: Tough fiscal situations mean tough spending decisions. This year is no different. With the Commonwealth and school districts entering another tough budget year, debate over public pensions and how they relate to General Fund obligations has once again garnered center stage.

As announced in his 2014-2015 budget address, Gov. Tom Corbett has assumed coming fiscal year pension savings of $170 million for the state and $131 million for school districts in balancing his proposed budget.

To date, no pension reform legislation has been introduced following the governor’s budget address. Here’s a look at the most talked about pension reform concepts and where the debate might take any possible legislation as the June 30 budget deadline approaches.

How did Pennsylvania get here?

There are three main causes.

First, was the decade of underfunding of the pensions systems caused by Act 38 of 2002 and Act 40 of 2003.

According to a 2012 report on the pension crisis issued by the Office of the Budget, the combined effects of Act 38 of 2002 and Act 40 of 2003, by which the employer contributions were artificially suppressed, left the State Employee Retirement System (SERS) and the Public School Employee Retirement System (PSERS) underfunded by more than $5.9 billion. Act 40 had the added effect of freeing up General Fund dollars that were meant for pension obligations to be spent elsewhere in the budget, a pattern often repeated at the district level.

The second cause is benefit enhancements in Act 9 of 2001 whereby benefits were enhanced through a multiplier increase from two percent to 2.5 percent, to be applied retroactively. Legislators’ multiplier was increased from two percent to three percent. The retroactive change provided state and school district employees with a 25 percent pension increase from the Commonwealth and school districts without a corresponding employee contribution increase.

The third cause is the two major economic downturns affecting the investment markets. The first occurred in 2001 with the twin blows of the burst of the dotcom bubble and the 9/11 attacks. The second was in 2008 when the economy took a downturn into now what is called “The Great Recession.”

“Three causes, and they’re all actually pretty equally weighted,” argues Rep. Glen Grell (R-Cumberland).

The problem has left the Commonwealth in the current situation where public pensions are about 65-percent funded and have a $45 million to $50 million unfunded liability.

The first major attempt to get ahead of the current problem was seen in the oft-talked about Act 120 of 2010. Act 120 provided some budgetary relief by implementing annual rate collars limiting the amount of the increase in the employer contribution. It also had the effect of reducing the employee multiplier to pre-Act 9 levels and increasing the retirement age to 65 while also extending the vesting period from five to ten years. Act 120 also reformed the system by providing some shared risk whereby employee contributions will increase if actual investment returns fall below the assumed rate of return.

Despite Act 120’s existence, many argue that remaining budgetary pressures relating to pension obligations necessitate another fix.

“It’s the budget pressures,” Sen. John Blake (D-Lackawanna) noted about the need for some sort of pension reform. “At the end of the day it really comes down to the budget pressures.”

It was always believed by some members, however, that Act 120 was never meant to be a once and for always solution.

“When we passed Act 120, there were many of us on the Floor saying we know this isn’t a total solution to the problem, but given the politics of the time that was all we could achieve,” Rep. Grell said.

In February 2013, Gov. Corbett unveiled in his budget address a plan for renewed pension reform.

The concept outlined would have affected future employees and the future benefits of current employees.

Legislative plans offered in 2013 in conjunction with the governor’s budget address mostly dealt with mandating current and future employees move to a straight 401(a) defined contribution plan.

Senate Bill 922 by Sen. Mike Brubaker (R-Lancaster), House Bill 1350 by Rep. Chris Ross (R-Chester), and House Bills 1352 and 1353 by Rep. Warren Kampf (R-Chester) originally provided for this plan.

The Brubaker bill was amended in the Senate Finance Committee to provide for a defined contribution plan for future elected officials along with current elected officials to apply when reelected. The bill was further amended to remove the Pennsylvania State Police and corrections officers from the switch.

The straight defined contribution plan offered by Sen. Brubaker would be managed by SERS and PSERS and current employees would be given the option to voluntarily choose to join the plan. The contribution rates would be four percent on the employer side, with a 5.5 percent contribution for hazardous duty and 12.2 percent for State Police troopers. The employee contribution would be 7.5 percent for those enrolled in PSERS and 6.5 percent for those enrolled in SERS.

Senate Bill 922 cleared the Senate Finance Committee on June 19, 2013, and currently sits in the Senate Appropriations Committee. The Kampf bills are currently on the House tabled bill calendar. Rep. Ross’s bill sits in the House State Government Committee.

Following discussions about transition costs and a renewed interest in other plans, much of the discussion has moved away from moving to a straight defined contribution plan.

Heading into the 2014-2015 budget cycle, three main plans are still standing. Here’s what they entail.

The Hybrid Plan

To those paying attention during the first few weeks of budgetary consideration following the governor’s budget address, the talk of a so-called “hybrid” pension plan is old hat. The name most closely tied to the plan is Rep. Mike Tobash (R-Schuylkill).

“I’ve been working in concert with other legislators, both members of the House and the Senate, and leadership has been really helpful and on board with moving the concept forward,” reports Rep. Tobash.

His hybrid plan would consist of a combination of a traditional defined benefit plan and a defined contribution plan. According to Rep. Tobash, the defined benefit plan would apply to the first $50,000 of income made by a state or public school employee with the rest going into a 401(a) public employee defined contribution plan.

“The concept here would be to offer an ample, adequate, attractive retirement benefit for new people coming into state employment that would be a combination of those things. Defined benefit, defined contribution, and Social Security would come together. Kind of a three-legged stool so to speak, to provide an adequate, ample retirement benefits for new people coming into the system,” he explained.

As to the $50,000 limit, Rep. Tobash said the amount is fluid, but makes sense. “That’s been one of the anchors of the plan,” he said. “I think it makes sense.” The number would also be indexed for inflation upward, but no more than one percent per year. “The plan does shift some of the risk away from the taxpayers, particularly for higher compensated employees of the Commonwealth.”

The defined benefit under the hybrid plan would, according to Rep. Tobash, provide guaranteed monthly income to the benefit holder, but would not be able to be accessed until the age of 65. Under the plan, the defined benefit would be capped at 25 years, beyond which the plan would be based on a straight 401(a) defined contribution amount.

Another key piece of the hybrid plan is that it involves an element of defined contribution from the very first dollar. “One percent of the employee deferral would go into the defined contribution to start to build that account early in people’s career and there would be a 50 cent match on that dollar from the Commonwealth. The idea is that the defined contribution does need to be a meaningful part of people’s retirement benefit, so we want to make sure to generate some account balance there so people look at that and realize this is a true element what [they’re] going to be able to depend on after retirement.”

One aspect previously not discussed relating to the hybrid plan is how it would address the current unfunded liability. “By nature, when you address the unfunded liability, that means you are paying more into the system,” explained Rep. Tobash. “The main premise of this plan is to develop savings to the Commonwealth and—by doing so—it gives you the opportunity to deal with…the unfunded liability and budgetary concerns.”

The hybrid plan is anticipated to save $7 billion over the 30-year period to the General Fund and $15 billion to the two pension systems. “Once you save the money you need to make a conscious decision as to how you are going to apply those savings and are they going to be throwing everything at the debt or realize there are other important programs we fund in the Commonwealth.”

Rep. Tobash anticipates the legislation will be ready for introduction within weeks and the amendment process will follow quickly after. “I think that there is a legislative fix that needs to be done here and I think that we vote a bill and then the question becomes how much of that is changing statute and how much of that is budgetary. Just like there’s a hybrid plan, I think we have to mix in to address the problem.”

The Cash Balance Plan

At the end of 2013, Rep. Grell introduced his pension reform plan, which has been termed a “cash balance plan.”

“The cash balance is considered a hybrid plan because it is part defined contribution and part defined benefit,” Rep. Grell explained.

According to the plan, employees would pay into the plan seven percent of their pay, with the employer making a contribution of four percent of salary. To encourage longer service in state government, if an employee has at least fifteen years of service the employer contribution would be raised to five percent.

As part of the plan, the money would be managed by SERS and PSERS, which allows for a guarantee of at least a four percent rate of return. Any additional return would be split equally between the employer and the employee. The plan would continue accruing value until the date of retirement, at which time it is converted into a per-month annuity assuring that pension-holders have income for the rest of their lives.

“That’s the part that’s like a defined benefit. It pays you out and you don’t run the risk as you do under a 401(k) of outliving your retirement income,” Rep. Grell stated.

Another part of Rep. Grell’s cash balance plan includes pension obligation bonds. “It’s really a misnomer though, it’s not really a pension obligation bond,” Rep. Grell explains. “A pension obligation bond would be if the pension fund goes out and borrows money at four percent and tries to earn seven percent on the money. That’s a pension obligation bond… What I’m proposing is that the General Fund would borrow up to $9 billion.”

According to Rep. Grell, borrowing that amount would make up for a decade of the state underfunding pension obligations to fill other budget line items. The bond obligation would be a taxable bond issue and provides capital into the funds where $6 billion of the $9 billion being invested into PSERS and the remaining $3 billion invested into SERS. “Whatever they earn on that money stays in the system. It doesn’t go to pay the bonds,” Rep. Grell said.

Despite the bond, employer contributions would still need to be made.

“The most important thing to note in the borrowing piece is we are not creating new debt,” Rep. Grell said. The bond would merely take a portion of the existing soft debt in the unfunded liability, which has been argued to allow for political wrangling to avoid paying, and converting it to hard debt, an obligation which would need to be met each year. “It would take at least that piece of the debt out from this political situation,” he said.

The bond, according to Rep. Grell’s proposal, would be done over one to two years and would give $15 billion of savings over the 30-year amortization period. He believes this coupled with the cash balance portion saving $7 billion to $9 billion makes a substantial impact in the unfunded liability.

As a final piece, Rep. Grell’s plan deals with the remaining pension debt in a bargained-for exchange with current employees. The plan calls for existing employees to modify their option four right to take out the entire amount of self-made contributions to the fund and still receive a reduced monthly annuity from the employer contribution. “It’s not reduced enough,” Rep. Grell said of the current system. “If you leave your money into the fund, we’re going to assume we are going to earn 7.5 percent on that money because the assumed rate of return is 7.5 percent,” he said. “If you pull your money out [under the current system] we are only discounting your payment by four percent. We’re not saying we’re removing the lump sum option. All we’re saying is that if you pull your money out, we’re going to reduce it by the 7.5 percent to make it actuarially neutral.” The amount of savings from this piece is expected to reach around $13 billion.

The plan would also calculate the monthly benefit using a five-year final average salary, instead of the current three-year final average salary. “It has the effect of tamping down any spiking that employees do,” Rep. Grell stated. He said the savings from this move would equate to $6 billion.

Since current employees would be giving up something with the final piece, Rep. Grell’s plan provides consideration for those volunteering to make the change. For voluntarily choosing the change, Rep. Grell’s proposal would give a half-percent reduction in the employee contribution for the remainder of the employee’s career. “We completely eliminate the constitutional challenge,” Rep. Grell said of this piece of the plan.

So, why the cash balance plan?

“It’s comprehensive,” Rep. Grell argued. “It spreads the pain out among everybody. It doesn’t try to solve the problem on the backs of our future state and school district employees, as some plans do….It doesn’t try to solve our problem by borrowing our way out of it…and it doesn’t put the burden on current members. It puts a little bit on them and asks them to participate in shoring up their pension plan. There wasn’t one thing that caused this problem, so to try to solve it just by doing one thing doesn’t work and certainly doesn’t generate near the savings against the unfunded liability as my plan does.”

Senate Democratic Plan

In mid-March, the Senate Democratic Caucus unveiled its pension reform plan that follows the broad outline of Act 120 while providing short-term savings and long-term savings of $24 billion to the two systems and $7 billion to the taxpayers. The plan refinances the pension debt while also issuing pension obligation bonds to deal with the unfunded liability.

According to Sen. John Blake (D-Lackawanna), Democratic chairman of the Senate Finance Committee, the plan will accomplish goals of not increasing long-term pension debt, assure retirement security for state workers and school employees, assure no impairment of contract with current employees, and provide $600 million in relief to school district budgets and $1 billion in relief for the state budget over the next five years.

“Under Act 120 we did true reform, we did meaningful reform,” Sen. Blake explained, “the fact of the matter is, even with the adjustment that was made in Act 120 we did not deal effectively and finally with the true problem that had been growing over the last eleven years or twelve years of the unfunded liability.”

Sen. Blake said it was the failure of Act 120 to effectively deal with the unfunded liability that drove his caucus to draft its current proposal. A proposal that is in contrast to the hybrid plan, which would go so far as to adjust the funding collars for the employer contribution. He said taking an approach that immediately tackles the unfunded liability will send a better message to retirees and capital markets that the Commonwealth is serious about bringing down the debt.

As proposed, the caucus’s plan would issue $6 billion in pension obligation bonds for the Public School Employee Retirement System and $3 billion for the State Employee Retirement System.

Even though pension obligation bonds would have an immediate effect on drawing down the unfunded liability debt, it is no light matter. “We had to be prudent about how much we would take on and how hard we would make it in terms of the obligations, because the fact of the matter is, when you do pension obligation bonds it becomes a hard obligation. It is no longer flexible. It becomes a hard obligation to meet those debt service obligations and those covenants that are in the pension obligation bonds,” Sen. Blake noted.

“We felt it was time to really grind down that long term debt, we felt it was time to make it a hard obligation..., and save the taxpayers money in an interest rate environment that is favorable but might not remain favorable for that much longer.”

Unlike the hybrid plan, the reform plan offered by the Senate Democrats would not provide for anything akin to a defined contribution plan. “There is a retirement security crisis prevailing throughout this nation right now,” Sen. Blake argued in support of keeping the defined benefit plan. “I think we need to be careful about an overhaul to the pension system that results in 15 or 20 or 30 years from now a bunch of retirees that are going to be on means tested programs funded by the state because they do not have sufficient retirement security.”

The caucus believes that if there is a move toward a defined contribution plan in any form, passive investment practices on behalf of pension holders and management fees will gobble up a majority of the earnings, depreciating the value of the retirement benefit and forcing retirees into taxpayer funded government programs earlier than in the current climate.

Other than debt refinancing and providing for pension obligation bonds, the plan offered by the Senate Democrats also addresses the so-called charter school pension double-dip where both PSERS and the Commonwealth pay for charter school employee pensions. According to Sen. Blake, the proposal offered by his caucus would alter the funding so that $65 million to $75 million will be saved in the current budget cycle.

Which one will it be?

“Where we move forward is obviously still being discussed,” said Jay Pagni, Gov. Corbett’s Press Secretary.

It’s hoped that everyone will coalesce around a plan and that plan will provide for long-term pension reform that does not kick the can down the road.

“There’s recognition by many of the experts as well as many in this building that a long term solution needs to happen to ensure the stability and the solvency of the plan for the future,” Pagni stated. “The governor has vowed—as have legislative leaders and other individuals that have introduced bills—not to kick the can down the road, but to balance any short term relief with long term reform.”

With an issue as politically charged as pensions, one might ask where the House Democratic Caucus stands on the pension reform plans.

“House Democrats are always open to new ideas to support more cost effective, more efficient government. Clearly. But Act 120 clearly has become the benchmark by which we compare other ideas that are out there,” said Miriam Fox, Democratic executive director of the House Appropriations Committee. “We ask ourselves every time we hear a new idea: Does it cost more than where we’re at now under Act 120? Does it save us money compared to where we’re at with Act 120? Does it increase the long term debt significantly? Those are really the three questions we ask ourselves each time we see something different or when we are evaluating ideas on our own.”

In the past, rather than proffer their own pension reform plan, House Democrats have advocated that revenue changes such as a severance tax on natural gas extracts, closing the Delaware Loophole, taxing smokeless tobacco and cigars should come before current obligations to state and school district employees are changed.

“If we could find a more cost-effective, more efficient way to do pensions that would save government money, certainly we would be open to that,” Fox said. “To date, we haven’t really seen anything that would offer significant savings.”

Asked if the caucus has seen anything better than Act 120 yet, Fox responded, “At this time, no.”

At the other end of the Capitol, Senate Republicans seem to be coalescing around the Tobash hybrid plan.

“We’ve been involved in the discussions,” noted Erik Arneson, spokesperson for Senate Majority Leader Dominic Pileggi (R-Delaware). “The plan being worked on—some sort of hybrid defined benefit-defined contribution—seems to have the best potential to get there this year…that’s the plan most likely to generate majority support in both chambers right now.”

Rep. Tobash plans to have his proposal in writing by mid-April.

Two caveats remain, however.

One is pension obligation bonds, a key element to two of the three plans still standing. However, despite arguments by Rep. Grell and Sen. Blake that moving the $9 billion away from soft debt and putting it on the Commonwealth’s books as hard debt would provide needed liquidity to the systems and show the bond market Pennsylvania is serious about paying down its pension obligation, not everyone is convinced they should be part of any long-term pension fix.

Additionally, pension obligation bonds are illegal under Act 120.

“They could possibly, maybe be part of the discussion, but that’s far from certain at this point,” Arneson noted.

The uncertainty of the Commonwealth’s ability to pay back pension obligation bonds based upon future interest rates and the uncertainty surrounding earnings on the bonds outpacing the expected earnings assumptions from pension investments are some of the noted detractors behind issuing pension obligations bonds.

The other caveat relates to State Troopers, state corrections officers, and other classes of employees who have received special treatment under the current pension plans and have asked to be exempted from any pension proposal that moves state employees to a defined contribution plan.

“Those groups of individuals are certainly in a different category for a number of different reasons…than your average state employee. So, it could very well be something that’s included in a final bill,” Arneson stated.

It appears there is not much appetite for a short-term plan, when long-term and meaningful reform is possible. Also, any legislative budget proposal from Republicans is likely to account for some pension savings, even if just as an initial placeholder.

There are 30 session days left until the June 30 budget deadline.