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Can public school pensions be saved?1

Jim Pawelczyk, PhD2

Board of School Directors, State College Area School District

State College, PA

October 7, 2013

The causes of Pennsylvanias pension debacle are all too clear. Overpromised benefits,

underfunded programs, and underperforming investments have left the Commonwealth in a

$45 billion hole that grows deeper every day. The impact is staggering. Pennsylvanias

independent Fiscal Office calculates that by 2017, 10% of the states budget will be committed

to pension funding; thats more than $1000 per year for every Pennsylvania household. Fitchs,

Moodys and S&P have down rated the Commonwealths credit ratings because of pension

liabilities. For the State College Area School District, the pension bill is more than $275 million

over the next 30 years.

The ongoing collapse of the Pennsylvania School Employees Retirement System (PSERS) is an

unintended consequence of relief for school districts, also known as kicking the can down

the road. Despite its 7.9% rate of return last year, PSERS paid out $3.6 billion more than it

took in. Because school districts cannot increase their employer contributions more than the

politically motivated, actuarially groundless caps legislated by Act 120 of 2010, PSERS must sell

its assets to generate enough cash to meet its pension payments. Coupled with investment

losses that wiped out a decade of earnings, PSERS will remain in negative cash flow for the

foreseeable future. With fewer dollars to invest, its simply impossible for PSERS to earn its

way to health. Instead, PSERS is now fulfilling an old metaphor by eating its seed corn.

A new proposal percolating through the Pennsylvania House of Representatives presents a

suite of reforms that could help refloat the good ship PSERS. Representative Glen Grells three-

pronged approach provides funds to reduce the existing unfunded liability and controls future

growth in pension costs. Current retirees would not be affected.

Strategy onewould establish a new benefit plan for all future employees. Employees would

contribute 7% of income instead of the current minimum rate of 7.5%; employers, 4%. After 15

years of service, the employer contribution would increase to 5%. These funds would be

invested with a guaranteed return of 4%. If investment returns were better than 4%,

1 An abbreviated version of this article was published in the Centre Daily Timeson October 16, 2013

(http://www.centredaily.com/2013/10/16/3840194/jim-pawelczyk-can-public-school.html)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.

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employees would share half of the windfall. Upon retirement, the cash balance would be

converted to a fixed, monthly annuity.

This component of the Grell plan is a solid recommendation. A cash balance plan is a pension

that guarantees a reasonable retirement income for life. It does not, however, guarantee what

that amount will be until the time of retirement. With that said, employees will share the

benefit in times of plenty.

Strategy twowould recapitalize PSERS and the State Employees Retirement System with up to

$9 billion of new pension bond proceeds. It is a speculative strategy based on the idea that

the Commonwealth would make money if investment returns were higher than its payments on

the bonds, netting up to $6 billion in savings. Because of the economic downturn experienced

over the past five years, however, most borrowings of this type have lost more money than

theyve earned.

The key weakness to this strategy is losing the flexibility to adjust payment schedules, a

problem that Detroit is experiencing. So why do it? The motivation is simple: fast cash.

However, Boston Colleges Center for Retirement Research notes that those who are least able

to handle the risk are the ones that tend to issue pension bonds. Municipalities in California are

defaulting on their debt partly because of pension bond deals gone bad. Illinois, who issued

pension bonds in 2003 on the scale proposed by Representative Grell, remains the least funded

state pension system in the nation.

Strategy threeis designed to provide some revenue for pension bond payments with two

voluntary concessions from current employees: First, pension payments would be calculatedby averaging five instead of three highest years of salary in order to curb the practice of

spiking a persons salary during their final years of employment to generate a higher pension.

Second, about 90% of retirees choose to withdraw some portion of their contributions at

retirement, plus 4% interest, as a lump sum (Option 4). Sometimes referred to jokingly as

the Winnebago or Beach House option, its a convenient way for an employee to start their

retirement. In return, pension payments are reduced by 4%. However, the payment costs

more than the pension reduction that funds it, putting even more strain on the pension system.

Under the Grell plan, if future retirees opted to withdraw their contributions, then pension

payments would be reduced by 7% rather than 4%, making the lump sum payment morerevenue neutral.

Since public pensions in Pennsylvania are legally protected as deferred compensation, the key

to this strategy is that it is voluntary. To encourage participation by employees already in the

state pension systems, the Grell plan would offer an incentive; lowering employee

contributions by 0.5% of salary to provide more take home pay.

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Overall, the Grell plan has advantages and disadvantages. School districts pension

contributions would still increase by more than 50% by 2020, but the pension plateau would

decrease from 31% of payroll, or more than $10 million per year for the SCASD, to 26% of

payroll, reducing the Districts future pension payments by about $1.5 million per year.

Statewide, it would help fill in the unfunded liability, albeit by creating a new debt. Issuing $9billion in pension bonds would increase the Commonwealths annual debt service by more than

50% (roughly a half billion dollars per year), a liability that would be borne by our children for

decades. This part of the plan is a gamble; the risks are very real. If successful, the plan would

provide limited relief to school districts and help keep PSERS intact for current and future

employees. But if investment targets were not met, the Commonwealth could be painted into

the same fiscal corner as Detroit.

More information on PSERS can be found at http://www.psers.state.pa.us. The complete Grell plan can be

reviewed at:

http://www.legis.state.pa.us/cfdocs/Legis/CSM/showMemoPublic.cfm?chamber=H&SPick=20130&cosponId=1342

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