A recipe for real pension reform 1

Jim Pawelczyk, PhD2 Board of School Directors, State College Area School District State College, PA May 29, 2015

No sound bite explains or solves Pennsylvanias pension crisis. Thankfully, Harrisburgs perennial pension debates have taken on a more serious note. Perhaps sound policy decisions will trump the political posturing that has left the Pennsylvania School Employees Retirement System (PSERS) hamstrung.

PSERS many problems are well chronicled. They will impact public education and the economy for decades. What should the eventual reform package include? In my view, a complete solution needs to reflect the following realities:

1. Investment earnings comprise more than 70% of PSERS income. Using long-term historical performance or low risk assumptions for investment returns suggests that the PSERS unfunded liability approaches $60 billion, not the $40 billion that is commonly reported.

2. Two separate, but related, policy issues shape pension reform. First, the contractual responsibility to pensioners and employees must be paid. By 2020 over 70% of employer contributions will fund compensation for past service. Second, the cost of investment underperformance is largely borne by school districts and the Commonwealth. Employees enjoy little or none.

3. Current funding fails to meet actuarial need. Because underfunding was prolonged by legislation passed in 2002, 2003 and 2010, PSERS sells assets to make ever-increasing payments, choking off opportunities for investment. If this millennium has taught us anything, it is that deferring payments is not an option under any reform scenario. Otherwise, the unfunded liability will grow. The inescapable conclusion is that more capital is needed from higher contributions and/or new sources of revenue.

4. Practices such as spiking salaries in the last three years of employment and lump sum withdrawals further weaken PSERS by reducing capital to invest.

5. Most school districts have managed to pay their legislated share of PSERS contributions, (albeit passing them on to taxpayers in the form of higher property taxes). But Harrisburg has failed to identify enough recurring revenue to fund its portion of growing, and still woefully inadequate, pension contributions.

6. Because pension payments are calculated as a percentage of payroll rather than a level amount of dollars per year, most PSERS costs are back-loaded and still to come. For the State College

1 An abbreviated version of this article was published in the Centre Daily Times on May 29, 2015 2 The views expressed here are my own and do not necessarily reflect those of the State College Area School

District or the entire Board of School Directors.

Area School District, more than $220 million in pension costs remains to be paid over the next 20 years.

Pension reform must redistribute risk and recapitalize PSERS to actuarial soundness as quickly as possible. This means rethinking our fundamental philosophy of pension funding, and adjusting revenues and expenditures accordingly. Here are some changes I hope to see before June 30:

1. Revise the retirement system for new school employees using a cash balance pension plan more like the occupational pension system in the Netherlands (one of the worlds most respected). Funding should be built on the premise that each generation pays its own cost of retirement. A 401(k)-style defined contribution plan is based on a similar view.

2. Calculate payments on career average earnings rather than final three years of salary to reduce spiking, and continue Act 120s elimination of lump sum withdrawals at retirement.

3. Change future benefits for existing employees, which could include lowering the pension multiplier on future earnings. Pension payments for work already performed is deferred compensation and cannot be reduced.

4. Place responsibility where it belongs. Make school districts solely responsible for the employer normal cost, or annual premium, of their employees pensions, and make the Commonwealth solely responsible for existing and future unfunded liabilities.

5. End political tinkering with pension accounting, and require actuaries and fund managers to follow best practices recommended by the 2014 Society of Actuaries Blue Ribbon Panel. Reduce the amortization period from 24 years to 15-20 or less, shorten smoothing periods from 10 years to 5 or less, and standardize the assumed investment rate of return at realistic levels. Moodys, for example, has advocated for a more realistic 5.5% rate of return. These practices would more accurately mirror market and employment trends, and assure that revenues and expenditures match.

6. Combine revenue from a new natural gas severance tax, an increase in the personal income tax (including high value retirement income), and a new financial transaction tax to generate at least $1 billion per year for PSERS more than currently planned increases in employer contributions. This would preserve PSERS assets and move the system toward level payments.

7. Use neutral expertise, including the Commonwealths Independent Fiscal Office and the Public Employee Retirement Commission, to calculate funding needs and the value of active vs. passive asset management strategies.

Many of these ideas are found in Governor Wolfs proposal, Senate Bill 1, and pension reform bills such as House Bill 900, introduced by Representative John McGinnis. The pension crisis has bipartisan origins, and the solutions require bipartisan support.

The defined benefit "promise" was broken when employee benefits were increased without the approval of the school district employer and the taxpayer. Real pension reform will happen when we acknowledge the need for a comprehensive overhaul that completely funds a sustainable benefit, reduces the risk of investment underperformance, and allocates contributions more equitably. This summer, lets hope that the legislature commits to restoring PSERSs solvency for this generation and the next.

Some current and recent pension reform proposals can be found at http://www.pasbo.org/pension.