A Pension Reform White Paper

8/14/2019 A Pension Reform White Paper

1/42

Retiring PennsylvaniasPension Challenge:

Eliminating the 2012-13Rate Spike

A Pension Reform White Paper

Commonwealth of PennsylvaniaGovernors Budget Office

Michael J. Masch, Secretary

June 5, 2008


2/42

Retiring Pennsylvanias Pension Challenge: Eliminating the 2012-13 Rate Spike 2

This Page Intentionally Left Blank


3/42


Contents

Executive Summary 5

1. Introduction to Pennsylvanias Pension Systems and Retiree Benefits 13

2. Defining Pennsylvanias Pension Challenge 21

3. Recent Investment Performance and Pension Legislation 24

4. Evaluating Three Proposed Changes to Pennsylvanias Pension Policies

That Do Not Solve the Pension Funding Problem 28

5. The Administrations Plan to Eliminate the FY2012-13 Rate Spike 34


4/42

EExx ee cc uu tt iivvee SS uu mm mm aa r r yy


5/42


Executive Summary

A. Pennsylvanias Pension Challenge

The Rate Spike A Huge Increase in Employer Contributions is Due in 2012-13 at the End of a 10-Year Loss-Postponement Period Established in 2003

In 2001 and 2002, in response to strong earnings performances and favorable fundedratios, the General Assembly passed Act 9 in 2001 and Act 38 in 2002 that enhancedretiree benefits, including an increase in the benefits multiplier from 2.0 percent to 2.5percent for most employees.

Coupled with stock market losses between 2001 and 2003, these benefit enhancementsthreatened to dramatically increase employer rates in the short term. As a result, theGeneral Assembly passed Act 40 of 2003 to change the projected payment schedule anddelay the onset of higher contributions. Pre-Act 9 gains and losses (in reality only gains)were amortized over 10 years, and post-Act 9 gains and losses (including all of the bearmarket losses) were amortized over 30 years.

This mismatch provided much-needed breathing room by postponing large increases inemployer contribution rates until Fiscal Year (FY) 2012-13, but as a result thecommonwealth for the last six years has not made progress in paying down the systemsunfunded liabilities.

For the Public School EmployeesRetirement System of Pennsylvania(PSERS), under current law and using thesystems annual earnings assumption (8.5percent per year), the commonwealthcontribution will increase from $340million in FY2011-12 to $728 million inFY2012-13 (114 percent). SchoolDistricts cost for retirement will spikeat the same rate, with the totalcontribution growing from $261 millionto $662 million (153 percent).

For the Pennsylvania State EmployeesRetirement System (SERS), againassuming 8.5 percent investment returnsbetween now and 2012, recentprojections indicate that it is possible that required 2012-13 contribution rates could besignificantly lower than forecast in previous actuarial valuations. But the latest

PROJECTED EMPLOYER CONTRIBUTIONS TOPSERS AND SERS UNDER CURRENT LAW:

ASSUMES 0% INVESTMENT RETURN FOR PSERS IN 2007-08 ANDFOR SERS IN 2008, THEN 8.5% RETURNS THEREAFTER

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Fiscal Year Ending

E m p

l o y e r

C o n

t r i b u

t i o n

( $ m

i l l i o n s )

PA Contribution to SERS ($ millions)PA Contribution to PSERS ($ millions)Schools Contrib. to PSERS ($ millions)


6/42


projections still indicate that the employer contribution will increase from $244 millionin FY2011-12 to $358 million in FY2012-13, a single-year increase of 47 percent.

Although investment returns have been remarkably strong over the long term for bothSERS and PSERS, there have been several periods of below-average returns lasting more

than one year. For SERS this occurred most recently in 1980-81 and 2001-02. Were asimilar dip to occur between now and 2013, the effect on commonwealth contributionrates would be disproportionately large due to the particularities of state law.

o For example, if PSERS experiences a single year of 0 percent returns in FY2007-08, commonwealth contributions will increase from $340 million to $944 millionin FY2012-13 (177 percent), while school employers contributions will increasefrom $261 million to $888 million (240 percent). 1

o Likewise, if SERS experiences just a single year of 0 percent returns in calendaryear 2008 and then returns to 8.5 percent investment returns thereafter, the

FY2012-13 rate spike challenge would transform from a $114 million (47percent) problem to a $377 million (155 percent) pension funding crisis.

The prudent course of action is to change the rules governing commonwealthcontributions now to reduce the chance of a rate spike.

If we do not take action soon, we may run out of time to fix the problem with anaffordable funding alternative that will moderate the rate spike.

Strong Recent Investment Performance and Pension Legislation Have Reducedthe Rate Spike, But Have Not Eliminated It

Despite investment losses earlier this decade, the earnings performance or funded ratiosof SERS and PSERS are not Pennsylvanias major pension challenges. Both systems haverecently announced strong investment returns: 22.9 percent for PSERS in FY2006-07and 17.2 percent for SERS in Calendar Year (CY) 2007. At the date of their lastactuarial valuation, SERS and PSERS were 97.1 percent and 85.8 percent funded,respectively.

After more than four years of top-decile investment returns, it is possible that FY2012-13 contribution rates could be significantly lower than previously forecast.

For SERS, the permanent 4.0 percent minimum contribution floor provided by Act 8 of 2007 has assisted in reducing the forecast FY2012-13 rate.

1 Footnote 5 on page 22 includes an explanation for the apparent discrepancy between the commonwealth andschool contribution rate increases.


7/42


The systems strong recent investment returns and recent legislative changes have beenfactored into the latest projections of the rate spike. While they reduce the magnitudeof the problem, they do not eliminate it.

Recent updated projections that the spike will be lower in FY2012-13 than was

previously expected could be quickly reversed if market conditions change andinvestment performance over the next few years ceases to be strong. The FY2012-13rate spike forecast is highly volatile and is subject to significant change based on thesystems investment returns each year.

Rate Floors Alone Will Not Eliminate the Rate Spike

PSERS

For PSERS, setting a minimum contribution rate floor equal to the current FY2007-08contribution level would prevent pension contributions from falling over the next fiveyears, but this action alone would have very little impact on the rate spike, becausethese extra contributions would be relatively small compared to the deferred losses thatbecome due in FY2012-13.

Conservatively assuming a single year of 0 percent returns in FY2007-08 and then 8.5percent returns thereafter, a rate floor equal to the current pension rate would reducethe forecast FY2012-13 rate only marginally from 15.2 percent under current law to14.6 percent if applied without more comprehensive reform. This 0.6 percent of

payroll reduction ($95 million) would be in return for combined (state + schools)contribution increases costing $1.13 billion vs. current law through FY2011-12.

SERS

Because SERS is closer to being fully funded than PSERS, rate floors alone do assist inreducing the projected rate spike, but only if investment performance continues to bestrong for the entire period through FY2012-13, an assumption that is too risky to bethe basis for state policy.

Proposals that seek to increase minimum contributions move pension funding policy inthe right direction, but they are not comprehensive enough on their own.


8/42


B. The Administrations Solution

The commonwealth should adopt a new policy to determine the annual pensioncontribution rate. The purpose of this change would be to:

Eliminate the projected FY2012-13 rate spike Limit sharp and significant annual increases or reductions in the employercontribution rate on an ongoing basis in an actuarially sound manner

Retain features of current law where possible, including current amortizationschedules and the five-year smoothing of actuarial gains and losses

Eliminating the Rate Spike

To insulate the commonwealth and school districts from a rate spike that will occur if investment performance lags between now and FY2012-13, the proposal would add to

current law:

1) A temporary, higher contribution rate floor for PSERS through FY2011-12 whichwould be set at the FY2007-08 rate, to prevent contributions from falling over thenext five years only to have to increase dramatically in FY2012-13. This floor willlessen the relative rate increase that will be faced by the commonwealth and schooldistricts in FY2012-13, and will produce additional revenues that will help to reducethe size of the rate spike.

2) A permanent, higher rate floor for both systems equal to the normal cost rate minus2 percent of payroll. The normal cost rate represents the full cost of pension benefits

accruing to current employees. SERS contributions will be phased in up to this newfloor through graduated rate increases, which are anticipated to be 0.5 percent of payroll per year for five years.

3) A method of maximum contribution rate increases based on the funded status of eachsystem, which will allow state and school district budgets to absorb the impact of higher contribution rates after FY2012-13 over several years (see table below)

Moderating severe spikes and valleys in the contribution schedule

To ensure that the commonwealth is protected from severe gains or losses, the policyadopts a permanent system of floors and collars that limits annual changes in thecontribution rate (either up or down).

The systems will still calculate an actuarial rate each year, but changes in the actualcontribution rate (both up and down) would be limited to the increments shown in thetable below.


9/42


The collar is looser and the level of contribution increases higher the further eachsystems funded percentage is from 100 percent (fully funded). The proposed system isprudently asymmetrical in that decreases in the contribution rate occur more slowlywhen the funded percentage exceeds 100 percent than increases occur when the fundedpercentage is below 100 percent.

This asymmetry will supplement each systems assets during strong market periods,allowing the collar system to mitigate against a need for dramatic contribution increasesduring and after bear market periods.

If SERS/PSERS Funded Ratio is:Increase/Decrease This Years

Employer Contribution Rate byup to:

Less than 80% funded +1.25% of payroll 80% to less than 85% funded +1.00% of payroll 85% to less than 90% funded +0.75% of payroll 90% to less than 95% funded +0.50% of payroll

95% to less than 100% funded +0.25% of payroll 100% to less than 105% funded 0.00% of payroll 105% to less than 115% funded -0.50% of payroll

Greater than or equal to 115% funded -0.75% of payroll

Protecting system assets in periods of protracted market downturns

After significant market losses, the underlying assets and liabilities (and thus thecontribution rate needs) of SERS and PSERS may change faster than the collar systemcan adjust to. As such, the proposal adds an extra fail-safe increase to the contributionrate if the rate determined by the collars approach is not adequate to reach the actuarialrate in 10 years.

Retiring Pennsylvanias Pension Challenge

Through a system of minimum contribution floors and incremental adjustments to therate in both strong and weak investment periods, this white paper outlines how thecommonwealth and school districts can gradually absorb the impact of the rate spikeand pay down the systems unfunded liabilities.

In FY2012-13, the Budget Office projects that implementation of the proposed changeswould virtually eliminate the rate spike. Assuming one year of 0 percent returns forboth systems and then 8.5 percent thereafter, combined employer contributions toSERS and PSERS including contributions from Pennsylvanias 501 school districts


10/42


would increase by $150 million in 2012-13, a much more manageable, 12 percent single-year increase than the $1.61 billion, 190 percent single-year increase that would berequired under current law.

The administrations plan provides a pension funding solution that:

Provides greater security that the commonwealth and school districts will be able tomeet all future pension funding obligations;

Provides a plan that is actuarially sound; Creates a funding schedule that provides for incremental changes in contribution

amounts so that future state and school district budgets can gradually absorb the impactof higher pension contributions;

Makes contribution rate increases and decreases more predictable for thecommonwealth and its school districts, allowing them to identify and plan for changes inretirement costs sooner; and

Continues to provide benefits that are comparable to or better than those provided toother public employers and that allow for retirement with dignity.

PROJECTED EMPLOYER CONTRIBUTIONS TO PSERS AND SERS UNDER

ADMINISTRATION REFORM PLANASSUMES 0% RETURN FOR PSERS IN 2007-08 AND FOR SERS IN CY2008, THEN 8.5% THEREAFTER

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Fiscal Year Ending

E m p

l o y e r

C o n

t r i b u

t i o n

( $ m

i l l i o n s )



11/42


PROJECTED COMBINED EMPLOYER CONTRIBUTIONS TO PSERS AND SERS,COMMONWEALTH AND SCHOOL EMPLOYERS

($ millions)

Current Law 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20PA Contribution to PSERS ($ millions) $353 $318 $329 $340 $944 $1,178 $1,135 $1,136 $1,162 $1,189 $1,218 $1,248

Annual Change -10.0% 3.5% 3.5%177.2% 24.8% -3.7% 0.1% 2.3% 2.4% 2.4% 2.5%Sch Districts Contrib. to PSERS ($ millions) $245 $250 $256 $261 $888 $872 $820 $828 $840 $853 $867 $881

Annual Change 2.2% 2.3% 2.2%239.9% -1.8% -6.0% 1.0% 1.4% 1.6% 1.6% 1.7%PA Contribution to SERS ($ millions) $221 $228 $236 $244 $621 $657 $618 $639 $660 $682 $704 $727

Annual Change 3.2% 3.5% 3.4%154.5% 5.8% -5.9% 3.4% 3.3% 3.3% 3.2% 3.3%

Combined PA Contribution ($ millions) $574 $546 $565 $584 $1,565 $1,835 $1,753 $1,775 $1,822 $1,871 $1,922 $1,975 Annual Change -5.0% 3.5% 3.4%167.7% 17.3% -4.5% 1.3% 2.6% 2.7% 2.7% 2.8%

Reform Plan 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20PA Contribution to PSERS ($ millions) $466 $479 $496 $513 $573 $645 $715 $788 $865 $949 $1,039 $1,135

Annual Change 2.8% 3.5% 3.6%11.6% 12.6% 10.8% 10.2% 9.8% 9.6% 9.5% 9.3%Sch Districts Contrib. to PSERS ($ millions) $369 $377 $385 $394 $447 $494 $538 $586 $637 $693 $752 $815

Annual Change 2.2% 2.3% 2.3%13.3% 10.5% 9.1% 8.8% 8.8% 8.7% 8.5% 8.4%PA Contribution to SERS ($ millions) $249 $286 $325 $366 $404 $418 $444 $476 $508 $541 $576 $613

Annual Change 14.9% 13.6% 12.6%10.4% 3.5% 6.2% 7.2% 6.7% 6.5% 6.5% 6.4%

Combined PA Contribution ($ millions) $715 $765 $821 $879 $977 $1,063 $1,159 $1,264 $1,373 $1,490 $1,615 $1,748 Annual Change 7.0% 7.3% 7.2%11.1% 8.8% 9.0% 9.1% 8.7% 8.5% 8.4% 8.3%

Note: PSERS rates include health care premium and commonwealth contributions are adjusted for quarterly cash-flow timing.Includes 22.93% PSERS return as of 6/30/07 and 17.2% SERS return as of 12/31/2007. Assumes zero percent investment returnfor PSERS in FY2007-08 and for SERS in CY2008. Assumes 8.5% returns for both systems in all future years.


12/42

SS oo llvviinn gg tt hh ee RRaa tt ee SS pp iik k ee


13/42


1. Introduction to Pennsylvanias Pension Systems and RetireeBenefits

About PSERS

1.1 The Public School Employees Retirement System of Pennsylvania (PSERS) providesmonthly retirement, disability retirement, death benefits and a health insurancepremium assistance program to its members.

1.2 The System currently has 264,000 active members and 168,000 beneficiaries.Members are employees of the commonwealths 501 school districts as well as 233other school employers, which include charter schools, state colleges, communitycolleges and approved private schools.

1.3 PSERS defined benefit (DB) pension fund has three funding sources:

Employer contributions

Employee contributions

Investment earnings

1.4 Employer contributions are shared by the commonwealth and school employers.The commonwealth reimburses school employers slightly more than half the cost of providing retirement benefits for school employees, a ratio which will graduallyincrease over the next 20 years.

1.5 Each December, the PSERS Board determines the employer contribution rate basedon system experience, the current actuarial valuation and the advice of PSERSactuaries. The certified rate is the percentage of payroll that school employers arerequired to pay into the pension fund to accumulate assets to pay pension benefitsfor members when they retire.

1.6 Employees contribute between 5.25 percent and 7.50 percent of their salary to helpfund their retirement benefits, depending on the benefit level selected in 2001 andthe date hired. Absent legislation to the contrary, the employee rate does notchange from year to year, and employee rates for current employees cannot bechanged, even by statute, without employee consent.

1.7 Investment returns are the greatest contributor to the pension fund. Over the lastdecade, nearly 81 percent of the pension fund was funded by investment returns, 12percent by member contributions and 7 percent from school employers. As of December 31, 2007, PSERS had an investment portfolio of approximately $67.4billion.


14/42


About SERS

1.8 The Commonwealth of Pennsylvania State Employees Retirement System (SERS) has110,000 active members and 108,000 annuitants in 2007. Members are current andformer employees of the Commonwealth of Pennsylvania or one of its related

organizations.1.9 SERS is also a defined benefit fund and also has three funding sources:

Employer contributions

Employee contributions

Investment earnings

1.10 Each spring, the SERS Board determines the employer contribution rate based onsystem experience, the current actuarial valuation, and the advice of the systems

actuaries.

1.11 As with PSERS, investment returns are the greatest contributor to the SERS pensionfund. Over the last 10 years, nearly 85 percent of SERS pension fund was funded byinvestment returns, 9 percent by member contributions and 6 percent fromemployer contributions. At the date of the last valuation in December 2007, SERSassets were valued at $35.5 billion on a market value basis.

Summary of System Benefits

1.12 PSERS and SERS defined benefit plans guarantee eligible annuitants a monthly lifetimebenefit based on age, final average salary and years of credited service.

1.13 Commonwealth and school employees become vested in SERS and PSERS once theyhave attained five years of service. Accrued pension deductions and statutoryinterest are returned to employees who leave state or school service before reachingthe vesting requirement.

1.14 For vested members, PSERS permits normal retirement with an unreduced benefit atage 62 with one year of service, or at age 60 with at least 30 years of service, or at

any age with 35 years of service. SERS members are grouped into multiple differentclasses according to their employment, but Class AA employees (the largest group of members) can retire with an unreduced benefit at age 60 with 3 years of service, orat any age once 35 years of service are reached.

1.15 For the majority of PSERS and SERS members (class T-D and class AA respectively),annual retirement benefits are payable monthly and the maximum single life annuity is


15/42


calculated using the following formula. Final average salary is an average of the threehighest years of compensation.

Benefits Multiplier (2.5%)2 x Final Average Salary x Years of Credited Service

1.16

Early retirement is available to members under age 62 (PSERS) who have at least fiveyears of credited service. The monthly benefit is reduced based on the retirees age,gender and years of service. For retirees who are at least 55 with 25 years of service, a lower benefit reduction factor is used to calculate the monthly benefit.

1.17 Members who are unable to perform their work due to illness or disability may beeligible for a disability benefit. Eligible members must have at least five years of credited service and must provide documentation to a medical examiner that provesincapacity to perform their job duties.

1.18 In addition to providing a monthly benefit, PSERS and SERS also allow retirees to

withdraw all or part of their contributions and statutory interest at the time of retirement, and to take a corresponding reduction in the monthly payment so thatthe entire benefit is actuarially equivalent to the maximum single life annuity. Themonthly benefit is reduced according to how much the retiree elects to withdraw.

1.19 PSERS retirees, spouses and eligible dependents may also opt into coverage by thePSERS group health insurance plan. The Health Options Program (HOP) is avoluntary health benefits program funded by participant contributions. Enrolleeschoose from indemnity, fee-for-service and managed care plans, and in most casespremiums are deducted from the retirees monthly benefit.

1.20

The Premium Assistance program provides eligible Pennsylvania school retirees withup to $100 per month in non-taxable reimbursement to help pay for basic healthinsurance purchased from an approved plan, which can be either HOP or aPennsylvania school employer's plan. Retirees are eligible for premium assistance if they have at least 24.5 years of credited service regardless of age, or have at least 15years of credited service and terminated service on or after age 62, or are receiving adisability retirement benefit from PSERS.

The Impact on Retiree Benefits as a Result of Act 9 of 2001

1.21

After several years of above-average investment returns in the late 1990s, by 2001the systems had built up strong funded ratios. In 2000, the PSERS plan was super-funded with a ratio of assets to liabilities of 123.8 percent; in 2001, the funded ratiowas 114.4 percent. Likewise, SERS funded ratio was 132.4 percent in 2000 and116.3 percent in 2001.

2 For PSERS, a 2.0 percent benefits multiplier is applied to all purchased non-school service (such as out-of-state,maternity, non-intervening military and government). Similarly, SERS uses a 2.0 percent multiplier for purchase of non-state service.


16/42


1.22 Employer contribution rates were correspondingly low: just 1.09 percent for PSERSand 0 percent for SERS in FY2001-02.

1.23 Based on these improved circumstances, Act 9 of 2001 was enacted by the General

Assembly and significantly increased future liabilities by enhancing retirement benefits.1.24 New classes of service were created (Class T-D for PSERS and Classes AA and D-4

for SERS), and employees opting into the new classes became eligible for an increasedannuity of 2.5 percent of final average salary for all credited years of service (3percent of final average salary for members of class D-4).

1.25 To reflect the increased level of benefits, employee contributions were increasedstarting in January 2002 for all members opting into the new classes. For PSERS,member contribution rates were increased from 5.25 percent and 6.25 percent to6.5 percent and 7.5 percent, respectively. For SERS class AA members, contribution

rates were increased from 5.0 percent to 6.25 percent, and the class D-4 employeecontribution rate was set at 7.5 percent. No retroactive increases in employeecontributions were required for participation at the higher multiplier level. Theincreased multiplier and employee contribution rates were made mandatory for allemployees hired after June 30, 2001.

1.26 The monthly health benefit premium assistance contribution for PSERS increasedfrom $55 to $100 per month, and Act 9 also reduced the vesting period from 10 to 5years.

1.27 Act 9 also reduced the amortization period for the systems unfunded actuarial

accrued liabilities from 20 years to 10 years on a level dollar basis.

FIG 1.1: SUMMARY OF MAJOR BENEFIT CHANGES FROM ACT 9 OF 2001

Feature Pre-Act 9 Post-Act 9

Health Benefit PremiumAssistance (PSERS)

$55 per month $100 per month

Benefits Multiplier 2.0% 2.5%

Employee Contributions PSERS: 5.25% and 6.25%

SERS: 5.0% (mostemployees)

PSERS: 6.5% and 7.5%respectively

SERS: 6.25% (mostemployees)

Vesting Period 10 years 5 years

1.28 In 2002, Act 38 also improved retirement benefits by granting a Cost-of-Living-Adjustment (COLA) to retirees.


17/42


How Pennsylvania Benefits Compare with Other Statewide Plans

1.29 The Joint State Government Commission, a research arm of the General Assembly,issued a report in February 2004 called The Funding and Benefit Structure of thePennsylvania Statewide Retirement Systems: A Report with Recommendations.

1.30 The report compared qualifications, funding, and benefits of SERS and PSERS to thoseof 79 statewide state employee and public school employee defined benefitretirements systems in all 50 states.

1.31 According to the report, Largely because of a high benefit multiplier and the option towithdraw employee contributions at retirement, PSERS and SERS would appear to be among the more favorable statewide plans . Among the more generous features of PSERS andSERS retirement benefits were:

Benefits Multiplier: Of the 79 statewide systems that were compared to SERSand PSERS, only four retirement systems used a benefit multiplier higher than the2.5 percent used by the Pennsylvania systems, and only four other systems usedthe same multiplier.

Early Retirement Provisions: Both SERS and PSERS allow early retirementwith only five years of service. PSERS permits early retirement with a moregenerous reduction factor at age 55 with 25 years of service. According to thereport, The only system with as liberal an early retirement rule as the Pennsylvaniasystems use is Nevadas. Ten systems make no provision for early retirement .

Withdrawal Provisions: SERS and PSERS allow retirees to withdraw anamount equal to all employee contributions with accumulated interest at 4.0%

guaranteed and take a reduction in the monthly benefit so that the entire benefitis actuarially equivalent to the maximum single life annuity. Only two of the 79systems reviewed in the commission report allow such a withdrawal, while oneplan allows any actuarially equivalent option approved by the board and anotherallows withdrawal of half the benefit. Fourteen plans allow withdrawal of alimited term of the benefit, of which 12 establish a maximum period of threeyears.

Further, the current methodology used to calculate the early withdrawal amountresults in subsidized retirement benefits at the expense of the pension systemsfunds. Although both systems assume an 8.5 percent annual investment returnin their actuarial valuations, the present value of the withdrawal is calculatedusing a 4 percent interest rate. This increases the value of the withdrawalamount relative to the long-term earnings assumption of the systems.


18/42


FIG 1.1: PENNSYLVANIA STATEWIDE PENSION PLANS COMPARED WITHOTHER STATE PENSION PLANS 3

Feature PSERS SERS

Normal retirement Strict years of service

requirement; liberal mixedrequirement

Strict years of service and

mixed requirement; liberalage requirement

Early retirement Among the most liberalrequirements

Among the most liberalrequirements

Social Securitycoverage

Similar to most Similar to most

Employee contribution Among the highest forSocial Security coveredplans

Somewhat higher than most

Vesting period Same as most Same as mostBenefit multiplier Among the highest Among the highest

Final Average Salary(FAS) period

Same as most Same as most

Benefit limitation Same as most Same as most

Post-retirementincreases

Less favorable than most Less favorable than most

State income taxation More favorable than most More favorable than most

Withdrawal option Among the most favorable Among the most favorable

Benefit Adequacy

1.32 The commission also analyzed the adequacy of benefits provided for Class T-Dmembers of PSERS (96 percent of active PSERS members as of June 30, 2002) andClass AA members of SERS (94 percent of active SERS members as of December 31,2002). The report analyzed replacement ratios, which are defined as thepercentage of pre-retirement income needed to produce an equivalent standard of living post-retirement.

1.33 The report concludes that PSERS T-D and SERS AA general employees working forat least 30 years and retiring at age 65 will have sufficient pension benefits, in

3 Joint State Government Commission, The Funding and Benefit Structure of the Pennsylvania Statewide Retirement Systems: a Report with Recommendations. Harrisburg, PA, February 2004


19/42


combination with Social Security, to meet or exceed applicable replacement ratiotargets 4.

1.34 For the average employee, no additional retirement savings are needed to meet thetargets, although careful management of income is needed to offset the effects of

inflation.1.35 Further, under the economic assumptions used, because of the relatively high

benefits multiplier provided since Act 9 of 2001, the report notes that full-careeremployees may be able to maintain their pre-retirement standard of living afterretiring without post-retirement cost of living (COLA) increases.

Pennsylvania Post-Retirement Increases and Pending COLA Proposals

1.36 Pennsylvania has historically provided some degree of inflation protection for retirees

by enacting periodic ad hoc cost-of-living-adjustments (COLAs) to supplementtheir existing pension benefits. The provision of ad-hoc COLAs is consistent withthe practice in several other states. Since the first COLA in 1967, COLAs havegenerally been enacted in Pennsylvania in intervals of four or five years.

1.37 The last COLA for PSERS and SERS retirees was enacted in 2002. Consistent withprior practice, the Act 38-2002 COLA aimed to restore at least 50 percent of thelost purchasing power since the previous COLA in 1998.

1.38 Given the interval since the 2002 COLA, there are a number of bills proposingCOLAs for retired SERS and PSERS members pending in the General Assembly. At

this time, however, there are extenuating and compelling circumstances which mustbe taken into consideration.

1.39 House Bills 2084 and 2379 are the principal COLA bills pending in the GeneralAssembly. These bills would provide a supplemental post-retirement adjustmenteffective in 2008 for all members who retired before July 2, 2007, and thereforeincludes SERS classes AA and D-4 and PSERS class TD members who retired withthe enhanced benefit plan provided by Act 9 of 2001.

4 A national study on replacement ratios, which was developed by Aon Consulting in cooperation with Georgia

State University, concludes that a person can maintain the same standard of living after retirement as beforeretirement with a lower gross income. This is primarily because post-retirement reductions in tax liabilities,savings levels and work-related expenses effectively extend the buying power of the post-retirement dollar. Thestudy develops the replacement ratio targets against which SERS and PSERS post-retirement income is measured;these are the post-retirement income amounts that are estimated to be equal in value to as net pre-retirementincome amounts, and are expressed as the percentage of pre-retirement income that is required post-retirementto maintain the same standard of living.Aon Consulting. Replacement Ratio Study : A Measurement Tool for Retirement Planning . Chicago, IL, 2001 sourcedfrom Joint State Government Commission, The Funding and Benefit Structure of the Pennsylvania Statewide Retirement Systems: a Report with Recommendations. Harrisburg, PA, February 2004


20/42


1.40 The COLA benefit envisioned in House Bill 2084 would increase the accrued liabilityfor PSERS by an estimated $3.04 billion. The increase in SERS accrued liability wouldbe approximately 50 percent of PSERS, or $1.57 billion. The bill proposes that this$4.6 billion additional cost be amortized over 20 years on a level-dollar basis, ratherthan the 10 years that has been common funding practice for previous COLAs. As

with any long-term borrowing, extending the amortization period in this way reducesthe annual payment but increases the total cost to be paid down.

1.41 The actuarial analysis as reported by the Public Employee Retirement Commission(PERC) calculated the increase in employer contributions for PSERS from the COLAproposed in House Bill 2084 Printers Number 3689 to be 2.71 percent of payroll inFY2009-10, or $348 million per year for the next 20 years. The increased cost forSERS would be 2.90 of payroll, or $166 million per year. As a result, the combinedannual increase in employer contributions for both systems would be $514 millionper year for 20 years. This represents a total amortization of more than $10.3billion for this COLA alone.

1.42 This increase would be in addition to the sudden and substantial increase in theemployer contribution rate that will be paid by state and school employers to PSERSand SERS beginning in 2012-13, the reasons for which are outlined in detail in thefollowing section.

1.43 Although protection of purchasing power for retirees is common and desirablepractice for public-sector retirement plans, the Joint State Government Commissionreport notes that COLA protection of retirees is rare in the private sector.

1.44 In addition, COLAs must be considered in terms of the adequacy of existing benefits

as provided by the plan. The benefit multiplier provided by SERS and PSERS for classAA and TD retirees is higher than the accrual rate for almost every other statewidepension system in the United States.

1.45 Pennsylvanias first priority with respect to current retirees and active workers whoparticipate in our state retirement systems must be to find a way to avoid theFY2012-13 pension funding crisis, which threatens PSERS most acutely.Supplemental annuity increases should take into consideration the above-averagelevel of retirement benefits already being received by SERS and PSERS beneficiariesand should not be considered at all until the General Assembly has passed pensionfunding reform legislation that solves the FY2012-13 rate spike problem and

guarantees the solvency of both state pension systems.


21/42


22/42


FIG. 2.1: RATIO OF ASSETS TO LIABILITIES FORPENSION SYSTEMS IN NEIGHBORING STATES

Source: Public Fund Survey

State Pension System Funded Ratio

New York State & Local Police & Fire (2006) 105.2 New York State & Local ERS (2006) 104.1 Delaware State Employees (2007) 103.7 New York State Teachers (2006) 102.6 PENNSYLVANIA SERS (2007) 97.1 Ohio PERS (2005) 89.1 West Virginia PERS (2006) 86.8 PENNSYLVANIA PSERS (2007) 85.8 Ohio Teachers (2007) 82.2Ohio School Employees (2007) 80.8 Virginia Retirement System (2006) 80.8 Maryland Teachers (2007) 78.4 New Jersey Police & Fire (2006) 78.4 Ohio Police & Fire (2005) 78.4 New Jersey Teachers (2006) 78 New Jersey PERS (2006) 78 Maryland PERS (2007) 74.7 West Virginia Teachers (2006) 31.6 AVERAGE OF NEIGHBORING STATES 84.2

2.7 The major challenge facing Pennsylvanias pension systems is the requirement to fundthe projected dramatic single-year increase in employer contributions that isanticipated in FY2012-13.

2.8 Under current law, and assuming one year of 0 percent offsetting returns for bothsystems and then 8.5 percent returns thereafter (the systems current assumption),current projections forecast that commonwealth contributions to PSERS and SERSwill increase by at least $900 Million between FY2011-12 and FY2012-13. Schoolemployer contributions will also increase by more than $600 million. 5

2.9

This single-year, sharp increase in employer contributions to Pennsylvanias pensionsystems is known as the rate spike .

5 Pursuant to Act 29 of 1994, the commonwealth share of each years employer contribution to PSERS is paid tothe system on a one-quarter lag basis. Consequently only three-quarters of the sharply-increased FY2012-13contribution would be appropriated in budget year 2012-13. The final quarterly payment of the 2012-13commonwealth contribution will be made to PSERS in the first quarter of the 2013-14 budget year. Schoolemployer contributions to PSERS are not subject to this one-quarter lag provision.


23/42


2.10 This rate spike could have a devastating impact on the budgets of the commonwealthand the states 501 school districts in FY2012-13.

FIG. 2.2: PROJECTED EMPLOYER CONTRIBUTIONS TO PSERS AND SERSUnder current law, assuming one year of zero percent investment returns and 8.5 percent

thereafter, the latest projections forecast that commonwealth contributions to PSERS &SERS will increase by at least $900 Million between FY2011-12 and FY2012-13

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

$2,250

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Fiscal Year Ending

E m p

l o y e r

C o n

t r i b u

t i o n

( $ m

i l l i o n s )


2.11 The current funding rules are not the only pension funding policy the commonwealthcould adopt that is consistent with generally accepted actuarial policies and practices.Other approaches can reduce the spike in funding requirements in FY2012-13.

2.12 However, funding rules for SERS and PSERS are set by state statute, and legislativeaction is required to change them.


24/42


3. Recent Investment Performance and Pension LegislationHave Reduced the Rate Spike But Not Eliminated It

Investment Performance

3.1 Investment earnings are the greatest contributor to improving the funded status of the pension systems.

3.2 Both systems have experienced strong recent investment returns: PSERS 22.9 percent for fiscal year 2006-07 SERS 17.2 percent for calendar year 2007

3.3 Since the bear market of 2001-2002, both systems have generated five years of top-decile returns, mirroring the double-digit returns experienced in the late 1990s.

FIG. 3.1. PSERS AND SERS TEN-YEAR INVESTMENT PERFORMANCE

-15.0%

-10.0%

-5.0%0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

PSERS Investment Returns (Actuarial Valuation for Period Ending Jun 30)SERS Investment Returns (Actuarial Valuation for Period Ending Dec 31)

3.4 These investment returns reflect the remarkably strong long-term average annualearnings performance for both systems. For example, SERS 20-year average returnthrough December 31, 2007 was 11.5 percent per year when calculated as ageometric mean and 12.0 percent per year as an arithmetic mean.

3.5 Strong investment returns have reduced the forecast FY2012-13 contribution ratefor both systems. As shown in Figure 3.2., assuming 8.5 percent investment returnsin all years, the projected contribution for PSERS has been reduced from 27.7percent of payroll in the 2003 valuation, to 22.5 percent at the 2004 valuation, to18.74 percent in the 2006 valuation, to 11.23 percent in the 2007 valuation.


25/42


FIG. 3.2. CHANGES IN EMPLOYER CONTRIBUTION PROJECTIONS AS ARESULT OF STRONG INVESTMENT RETURNS PSERS

0%

5%

10%

15%

20%

25%

30%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Fiscal Year Beginning July 1

P e r c e n

t o

f P a y r o

l l

PSERS 2003Valuation

PSERS 2004Valuation

PSERS 2005Valuation

PSERS 2006Valuation

PSERS 2007

Valuation

3.6 For SERS, and assuming future supplemental annuities and 8.5 percent investmentreturns in all years, the projected rate spike has also been reduced significantly, from24.9 percent in the 2003 valuation to 8.5 in the 2007 valuation.

FIG. 3.3. CHANGES IN EMPLOYER CONTRIBUTION PROJECTIONS AS A

RESULT OF STRONG INVESTMENT RETURNS SERS

0%

5%

10%

15%

20%

25%

30%

2 00 4 2 00 5 2 00 6 2 00 7 2 00 8 2 00 9 2 01 0 2 011 2 01 2 2 01 3 2 01 4

Calendar Year

P e r c e n

t o

f P a y r o

l l

SERS 2003Valuation

SERS 2004Valuation

SERS 2005Valuation

SERS 2006Valuation

SERS 2007Valuation


26/42


Pension Legislation to Date

3.7 Since the problem of the rate spike became apparent, the General Assembly and theGovernor have enacted several pieces of legislation that have assisted in reducing theforecast FY2012-13 contribution rate.

3.8 For SERS, Act 8 of 2007 began to address the looming pension crisis by preventingcontributions from falling below a minimum rate of 4 percent. In the absence of thisreform, commonwealth contributions to SERS would have been halved in FY2007-08and gone to zero for four years thereafter, a step that would have exacerbated thelarge contribution rate increase due in FY2012-13.

3.9 Assuming no supplemental annuity increases (COLAs) before 2012-13, systemprojections show that by preventing contributions from falling below 4 percent, Act 8of 2007 reduced the FY2012-13 SERS contribution rate from 10.6 percent to 9.1percent. This reduction provides savings of approximately $90 million in FY2012-13.

3.10 However, despite the improved outlook due to strong recent investment returns andlegislative changes, the systems robust investment performance of recent years isnow being followed by a period of market weakness and uncertainty. As a result,projection models forecast at least a 177 percent increase in the commonwealthemployer contribution for PSERS between FY2011-12 and FY2012-13, and a 155percent increase for SERS in FY2012-13.

Complacency is Not a Responsible Option

3.11 Maintaining the pension contribution schedule required under current law wouldprovide the lowest impact on the state budget until FY2012-13.

3.12 Under current law, employer contributions for SERS could be held virtually static at4.0 percent between FY08-09 and FY11-12, and contribution rates to PSERS couldactually decrease from 7.13 percent currently to approximately 4.75 percentbetween FY2008-09 and FY2011-12.

Taxpayer resources could be invested in other state priorities over these years,such as economic development, roads and bridges, and public schools.

3.13 However, although long-term investment performance for both SERS and PSERS hasbeen remarkably strong (see 3.2-3.4), there have been occasional periods of below-average returns that coincide with weaker domestic and global investment markets.For SERS this occurred most recently in 1980-81 and 2001-02. Were a similar dip tooccur between now and 2012-13, the effect on contribution rates for thecommonwealth and its 501 school districts would be disproportionately large due tothe particularities of state law. As a result of current statutory methods for fundingour pension systems, just one or two years of lower-than-expected investmentperformance could return the spike to previously projected levels.


27/42


3.14 To reduce the risk that a period of below-average investment returns between nowand 2012-13 might increase the magnitude of the rate spike, the prudent course of action would be to change the law to create a more stable and predictable approachfor employer contributions.

3.15

If we make no changes to our pension funding policies, we could be faced with a full-blown pension crisis in FY2012-13, with no time to correct therate spike before the required increased contributions become due.

The Challenge is Well-Documented

3.16 Each year, members of the Pennsylvania General Assembly have proposed numerouspension funding bills, reflecting the interest in returning the pension systems to asustainable footing.

3.17 In February 2004, the Joint State Government Commission released an analysis of the

challenges facing PSERS and SERS in a study, The Funding and Benefit Structure of thePennsylvania Statewide Retirement Systems: a Report with Recommendations. This reportnoted that actuarial projections forecast sharply increasing employer contribution levels.The analysis made multiple recommendations to members of the General Assembly,including the investigation of alternative methods of adjusting contribution rates for investment returns.6

3.18 In September 2006, the Pennsylvania Auditor General released performance auditsfor each of the two pension systems. The audits found no fault with the systemsinvestment management but highlighted a future underfunding of the pension systemsdue to the causes noted earlier in this white paper. The Auditor Generals

Department urged the Boards, the Governor, and the General Assembly to work together to address this critical issue that will soon impact the SERS and PSERS retirement plans . 7 In the release accompanying the audits, the Auditor General observed that Now isthe time to act, to make sure that the states pension obligations do not escalate into afinancial crisis that threatens the economic competitiveness of Pennsylvania or the long-termprosperity of its residents. 8

3.19 The time to confront Pennsylvanias looming pension funding challenges is now. If the administration and General Assembly do not take action soon, we will run out of time to fix the problem and find a funding alternative that will moderate the ratespike.

6 The Funding and Benefit Structure of the Pennsylvania Statewide Retirement Systems: a Report with Recommendations, Joint State Government Commission, February 20047 A Special Performance Audit by the Pennsylvania Department of Auditor General, September 2006 http://www.auditorgen.state.pa.us/Reports/Performance/Special/SERSFinal.pdf 8 Auditor General Jack Wagner Urges General Assembly, Governor to Shore up Two Largest Public Pension Plans,Releases performance audit reports on SERS, PSERS. Harrisburg, PA. September 26, 2006http://www.auditorgen.state.pa.us/department/press/wagnerurgesgenassemblygovtoshoreuppublicpen.html


28/42


4. Evaluating Three Proposed Changes to PennsylvaniasPension Policies That Do Not Solve the Pension FundingProblem

Proposal 1: Shift from Defined Benefit to Defined Contribution

4.1 Some legislators and interested parties have suggested that the commonwealthspension funding problems could be solved by switching from the current definedbenefit pension plans to a defined contribution plan. The Rendell administrationanalyzed future funding requirements if new entrants to PSERS and SERS hired after

June 30, 2008 were to receive benefits through a defined contribution (DC) plan asopposed to the current defined benefit (DB) plans.

4.2 As a result of this analysis, the Rendell administration is not proposing the transition

from defined benefit to defined contribution retirement provision for eithercommonwealth or school employees, for the reasons presented below.

4.3 The commonwealths current employees could not be required toparticipate

Under state laws prohibiting the impairment of contracts, plan conversion could notbe unilaterally imposed on the states current employees it could only beintroduced for new employees hired after the effective date of the change. As aresult, it would be many years before any significant number of employees would beenrolled in a defined contribution plan.

4.4 Introducing a DC Plan will not reduce the systems current unfundedliabilities

SERS and PSERS face significant unfunded liabilities as the result of benefitimprovements approved prior to Governor Rendells taking office and lower-than-forecast stock market returns earlier this decade. A DC Plan will not reduce theseliabilities nor the 2012-13 rate spike in any meaningful way because the futurebenefits of existing DB members cannot be unilaterally rescinded.

4.5 There is no intrinsic cost benefit from a DC Plan

To achieve long-term savings from a DC plan, the employer contribution rate mustbe set at a lower rate than the current DB plan normal cost rate. But this sameresult could be achieved simply by reducing the benefit level in the DB plan. For newhires, either a DB plan or a DC plan could set contribution levels at whatever benefitlevel is identified as affordable by the administration and the General Assembly. Thecommonwealth can reduce future pension costs in either a DB or DC scenario:There is no intrinsic plan design cost benefit from a DC plan.


29/42


FIG. 4.1: PROJECTED COMBINED EMPLOYER CONTRIBUTIONS TO PSERSFOR EXISTING MEMBERS AND TO A DC PLAN FOR NEW MEMBERS

A DC Plan would have no impact on the current forecast for the FY2012-13 employercontribution spike because pledged benefits for current members cannot be revoked

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

2 0 0 7

2 0 0 9

2 0 1 1

2 0 1 3

2 0 1 5

2 0 1 7

2 0 1 9

2 0 2 1

2 0 2 3

2 0 2 5

2 0 2 7

2 0 2 9

2 0 3 1

2 0 3 3

2 0 3 5


St at e+S ch o ol sC o nt rib uti o n st oPSERS

( $ M i l l i o n s )

PSERS DB Plan, Current LawPSERS DB for Existing Members; DC Plan for New Members

$0

$500

$1,000

$1,500

$2,000

$2,500

2007 2008 20092010 2011 2012 2013 2014 2015 201


S t a t e

+ S c h

o o l s

C o n

t r i b u

t i o n

t o P S E R S ( $ M i l l i o n s )

Area shown to Right

Employer contribution rate for the DC Plan is set to the employer normal cost rate for the current DB plan. Assumes 0%return in 2007-08 and 8.5% returns thereafter.

4.6 Conversion to a DC plan would shift considerable retirement risk toemployees

From time to time, the commonwealth has periodically provided assistance toretirees in the form of a Cost-of-Living-Adjustment (COLA). This would no longerbe the case with a DC plan. The level of retirement income available to retireeswould be completely dependent on their personal investment results. Unsuccessfulinvestment strategies and overall market downturns at critical periods could greatlydiminish the retirement income available to some retirees.

4.7 DB employer rates could be lower than comparable DC rates

Certain SERS employers currently offer both DB and DC plans, and the DC planscost them more. Employees of the State System of Higher Education (SSHE) andPenn State can choose their retirement plan. The two most popular choices areSERS and TIAA-CREF, which is a defined contribution plan. For the TIAA-CREFmembers, SSHE and Penn State must contribute 9.29 percent of salary per year [as of

January 2006]. This compares with the contribution rate for SERS of 4.0 percent in2006-07 and 2007-08. The SERS normal cost rate of 8.42 percent is also lower thanthe employer contributions for the comparable DC plans.


30/42


4.8 DC set-up and administrative costs can be high

According to data obtained by SERS, Californias estimated transition cost from a DBto a DC Plan was $7.6 billion. In Florida, it cost $86 million to set up an optional

private account plan, to which fewer than 5 percent of eligible employees chose toswitch.

DC administrative costs may also be much higher over the long term andadministrative charges are typically paid out of the participants' accounts, whichreduces investment returns.

4.9 DB plans provide a better mechanism to provide death and disabilitybenefits for uniformed employees

A DC plan made up of individual accounts is a weak mechanism to provide ancillary

benefits to members in high-risk occupations. Account balance plus investmentearnings may be an unsatisfactory benefit unless death and disability provisions arereplaced elsewhere.

Proposal 2: Make a Fresh Start on the Pension Systems Asset and LiabilityBases

4.10 SERS and PSERS strong recent investment performance have led some legislatorsand other interested parties to advocate for various Fresh Start proposals.

4.11 Fresh Start proposals would reduce the systems official unfunded liabilities bystatutorily resetting the credit base of each systems assets to recognize all of thesystems strong recent investment gains in a single year. Because SERS and PSERShave recorded consistent, above-average returns since 2003, a Fresh Start wouldimprove the systems funded position on paper, because their actuaries normallyrecognize each years investment gains and losses incrementally over five years. Thisfive-year smoothing method is commonly used in the public sector because itreduces the impact of investment volatility by recognizing on the books, in each year,only 20 percent of the investment gains and losses recorded in each of the prior fiveyears.

4.12 After Fresh-Starting the asset base at market value, the systems would slowlyphase back into the smoothing method over five years.

4.13 Assuming constant 8.5 percent annual investment returns (the systems currentassumption), a market value Fresh Start would maintain the commonwealthscontribution rates at similar levels to todays. Further, using an 8.5 percent returns


31/42


assumption, advocates can show that the forecast FY2012-13 rate spike could bedramatically reduced or even eliminated by this approach.

4.14 However, in the absence of any additional contribution rate protection (see section 5below), the systems five-year smoothing methodology is a critical means of insulatingPSERS and SERS $100 billion asset base from market volatility. As previously noted,average annualized long-term investment performance for both systems over the past10 years has been strong. However, there have also been occasional periods inwhich investment returns have been considerably below long-term averages. If investment performance suddenly deteriorates for whatever reason during the firstfive years after a Fresh Start, and if the systems are unable to achieve their 8.5percent annual earnings assumption for one or two years, SERS and PSERS assetbases will have no unrecognized gains on hand to help offset these losses.

4.15 Fresh Start advocates have proposed that some of the potential contribution ratevolatility in the first few years following the Fresh Start could be partially offsetthrough the use of a temporary collar on rate increases or decreases. However, theprimary objection to the Fresh Start is not that contributions could increase ordecrease too rapidly in the first few years depending on market performance(although that is a key concern). The key weakness in this approach is that if thesystems are unable to match their 8.5 percent annual return assumption for just oneor two of the first five years of the Fresh Start, they will have no unrealized gains tooffset these losses, and as a result, their funded status will deteriorate significantly.

4.16 Under the Fresh Start approach, a temporary downturn in the markets coulddramatically worsen the pension crisis in Pennsylvania: Not only would thecommonwealth have to prepare for and deal with much higher required contributionrates, but added to the mix would be a much-deteriorated funded ratio of assets toliabilities.

4.17 Pennsylvania is facing the looming FY2012-13 rate spike in part because of anactuarial mismatch that promised short-term relief from a long-term funding crisis.Enacting a new actuarial technique for the sole purpose of enhancing the fundingposition of PSERS and SERS on paper would bring with it the possibility of eventougher challenges in the future should the markets fail to match the systemsexpectations.

Proposal 3: Just Increase Minimum Contribution Floors -- WithoutAddressing Future Contribution Rate Challenges in Any Other Way

4.18 Increasing statutory contribution floors up to the normal cost rate has beenproposed by some legislators and other interested parties as the way to reduce theFY2012-13 rate spike.


32/42


4.19 For PSERS, a new minimum employer contribution rate equal to the currentcontribution level would prevent contributions from dropping in the next five years,but this action alone would have very little impact on the FY2012-13 rate spike.

Assuming a single year of 0 percent returns before the system returns to itslong-run 8.5 percent investment assumption, imposing this floor would costschool employers and the commonwealth $1.13 billion over the next four years,but would reduce the FY2012-13 combined contribution by just 0.67 percent of payroll (approximately $95 million).

4.20 With the new floor, the commonwealth would still be required to fund a single-yearincrease in employer contributions of $441 million, or 86 percent, between FY2011-12 and FY2012-13, and even this depends on investment performance returning tothe long-term earnings assumption of 8.5 percent for the entire period betweenFY2008-09 and FY2012-13.

4.21 Even with the new contributions floor, school employers would face a single-yearincrease of 115 percent between FY2011-12 and FY2012-13.

4.22 As a result, a new PSERS floor would not eliminate the threat of tax increases orsevere cuts in critical state and school district services in FY2012-13.

4.23 For SERS, an increase in the minimum employer contribution floor from 4 percent to5 percent (as proposed by Senate Bill 826) would require the commonwealth toincrease its contributions to the system by approximately $60 million per year forthe next four years.

The effectiveness of a new 5 percent floor in mitigating the rate spike dependson investment performance remaining strong for the entire period betweenFY2007-08 and FY2012-13.

4.24 Moreover, a permanent 5 percent floor for SERS would not provide an answer tothe other major challenge facing SERS funding, which is that current employercontributions are significantly below the normal cost rate. The normal cost rate isthe cost of the benefits accruing to active employees in the current year, and iscurrently 8.42 percent of payroll. This discrepancy between the cost of currentemployee retirement benefits and the actual contributions that are being made ontheir behalf means that each year SERS adds new unfunded liabilities that may need to

be paid by future Pennsylvania taxpayers and system annuitants.

4.25 Because PSERS contribution obligations affect the financial stability of all of Pennsylvania's 501 school districts as well as the commonwealth itself, Pennsylvanianeeds a pension funding proposal that resolves the rate spike challenge for both thecommonwealth and our school districts.


33/42


4.26 Pennsylvania needs a pension reform plan that adequately addresses the relatively"short-term" problem of the contribution rate "spike" that is looming in FY2012-13for both SERS and PSERS, and also improves the long-term viability of Pennsylvania'stwo statewide pension systems so they are able to keep their promises to all of Pennsylvania public employees.


34/42


5. The Administrations Plan to Eliminate the FY2012-13 RateSpike

5.1 The Rendell administration proposes a comprehensive plan to effectively address thecommonwealth's looming pension challenges and realign the pension systems toachieve ongoing financial soundness.

5.2 The proposal calls for the commonwealth to adopt a new policy to determine theannual pension contribution rate for SERS and PSERS.

5.3 The purpose of this change would be to:

Eliminate the projected FY2012-13 rate spike;

Limit significant increases or reductions in the employer contribution rate on anongoing basis in an actuarially sound manner;

Make special provisions for protecting system assets in periods of protractedmarket downturns; and

Retain features of current law wherever possible, including current amortizationschedules and five-year smoothing of actuarial gains and losses no resetting(Fresh Start) of the unfunded liability.

Step One: Eliminate the FY2012-13 Rate Spike

5.4 The first component of the administrations plan will eliminate the forecast FY2012-13 contribution rate spike by making three reforms to the current approach tofunding the pension systems.

Prohibit contributions from falling any further before FY2012-13 :

In the absence of corrective short-term action, commonwealth and schoolemployer contribution rates for PSERS are actually now scheduled to decline forthe next several years before increasing severely in FY2012-13. To correct this,a higher contribution rate floor for PSERS should be set at the FY2007-08pension rate (6.44 percent) for the next four years through FY2011-12.

This increased rate will prevent contributions from falling over the next fiveyears only to have to increase dramatically in 2012-13. Although this action isinsufficient to prevent the spike on its own (see Chapter 4), the higher floorlessens the relative rate increase that will be faced by the commonwealth andschool districts in FY2012-13, and will produce additional revenues that will helpto reduce the size of the rate spike.


35/42


Gradually introduce a permanent contributions floor that is closer tothe normal cost rate:

A permanent, higher rate floor for both systems that is set at the normal costrate minus 2 percent of payroll should be gradually implemented. Becausecurrent SERS employer contribution rates are significantly below normal cost,contributions to that system will be phased-in up to this new floor throughgraduated rate increases, which are anticipated to be 0.5 percent of payroll peryear for five years.

The normal cost rate is the cost of the benefits accruing to active employees inthe current year, and is currently 8.42 percent of payroll for SERS and 6.68percent for PSERS. For PSERS, the current employer contribution rate of 6.44percent is close to the systems normal cost rate. But for SERS, there is a largediscrepancy between the cost of the retirement benefits that have beenpromised to employees and the actual contributions that are being made ontheir behalf each year. This discrepancy means that each year SERS adds new

unfunded liabilities that will need to be paid by future Pennsylvania taxpayers andsystem annuitants.

To address this discrepancy, the Rendell administrations proposal graduallyincreases SERS contributions over the next four years so that pension ratescould be no further than 2 percent of payroll from the normal cost rate.

Introduce a system of maximum contribution rate increases anddecreases:

Establishing a new system of maximum annual contribution rate changes basedon the funded status of each system will allow state and school district budgetsto absorb the impact of higher contribution rates after FY2012-13 gradually overa multi-year period (see below).

Step Two: Limit significant increases or reductions in the employer contributionrate on an ongoing basis in an actuarially sound manner

5.5 To ensure that the commonwealth is protected from severe peaks and valleys in thecontribution schedule on an ongoing basis, a permanent system of floors andcollars on contribution rates should be implemented to limit annual changes in thecontribution rate (either up or down).

5.6 The systems would still calculate an actuarial rate each year, but changes in the rate(both up and down) would be limited to the increments shown in the table below.

5.7 The collar is looser the further each systems funded percentage is from 100percent (fully funded), and the schedule is prudently asymmetrical in that decreases inthe contribution rate occur more slowly when the funded percentage exceeds 100percent than increases occur when the funded percentage is below 100 percent.


36/42


5.8 This asymmetry will supplement each systems assets during strongmarket periods, allowing the collar system to mitigate dramatic rateincreases during and after bear market periods.

If SERS/PSERS Funded Ratio is: Increase/Decrease this years

Employer Contribution Rate by up to:Less than 80% funded +1.25% of payroll

80% to less than 85% funded +1.00% of payroll 85% to less than 90% funded +0.75% of payroll 90% to less than 95% funded +0.50% of payroll

95% to less than 100% funded +0.25% of payroll 100% to less than 105% funded 0.00% of payroll 105% to less than 115% funded -0.50% of payroll

Greater than or equal to 115% funded -0.75% of payroll

5.9 If a plan is below 100 percent funded, the systems would certify their annualcontribution rate at the lesser of (1) the calculated actuarial rate or (2) the prioryears rate plus an increment that changes according to the degree to which thepension system is under-funded (per the table above)

5.10 If the system is greater than 100 percent funded, the rate would be the greater of (1)the actuarial rate or (2) the prior years rate minus an increment.

Example of the collars approachlimiting significant increases in the employer contribution rate

AssumptionsSuppose the employer contribution rate for a system in FY2014-15 is 7.8 percent. Prior to theFY2015-16 valuation, the pension system experiences a loss, decreasing the funded percentagefrom 100 percent in FY2014-15 to 89 percent in FY2015-16.

Suppose also that the normal cost rate is 8.0 percent, and an initial actuarial rate of 9.0 percenthas been calculated by the systems actuaries for FY2015-16.

Application of Collars approach to limit increases in the rate Based on the funded status of the system (89 percent), the collars approach outlined in the tableabove would generate a maximum increase in the employer contribution rate of 0.75 percent.

The 0.75 percent increment would be added to the prior years rate of 7.8 percent, generating anew employer rate for FY2015-16 of 8.55 percent.

In this case, the final rate is the lesser of the 9.0 percent initial actuarial rate and the 8.55percent rate calculated using the collars approach.

Contribution rates cannot fall below the normal cost rate (8.0 percent) minus 2.0 percent = 6.0percent, but the final employer rate in this case is sufficient because it is higher than this floor.


37/42


Example of the collars approachlimiting significant decreases in the employer contribution rate

AssumptionsSuppose that the employer contribution rate for a system in FY2017-18 is 8.9 percent. Prior to

the FY2018-19 valuation, the pension system experiences an actuarial gain, increasing thefunding percentage from 100 percent in FY2017-18 to 111 percent in FY2018-19.

Suppose also that the normal cost rate is 8.0 percent, and an initial actuarial rate of 7.5 percenthas been calculated by the systems actuaries for FY2018-19.

Application of Collars approach to limit reductions in the rate Based on the new funded status of the system (111 percent), the collars approach would limitthe decrease in the employer contribution rate to a maximum of 0.5 percent. The 0.5 percentincrement would be subtracted from the prior years rate of 8.9 percent, generating a newemployer rate for FY2018-19 of 8.4 percent.

In this case, the final rate is the greater of the 7.5 percent initial actuarial rate or the 8.4 percentrate calculated using the collars approach.

Contribution rates cannot fall below the normal cost rate (8.0 percent) minus 2.0 percent = 6.0percent, but the final employer rate is sufficient in this case because it is higher than the floor.

Step Three: Protect system assets in periods of protracted market downturns

5.11 Should a period of significant sustained market losses occur, there is a possibility thatthe underlying assets and liabilities (and thus the contribution rate needs) of SERS and

PSERS could change faster than the collar system can adjust to. While this is anunlikely scenario, the consequences would be serious and therefore provisionsshould be made to deal with it.

5.12 To insure that system assets are protected if a protracted market downturn occurs,a fail-safe provision should be implemented that will override the collars system incertain scenarios. The administrations proposal requires that annual increases in thecontribution rate must be at least sufficient to reach the actuarially-calculated ratewithin a maximum of 10 years.

5.13 Each year, after determining the initial actuarial rate, the systems actuaries will also

calculate whether the initial rate should be overridden by a larger increase in theemployer contribution rate.

5.14 If the initial rate increase identified by the collars system is less than one-tenth of thedifference between the prior years rate and the current year target rate (theactuarially-calculated rate), then the systems would increase the final employer rateabove the limits specified in the collars table, such that the annual increase is no lessthan one-tenth of the difference between the target rate and the prior year's rate.


38/42


Fail-Safe Adjustment:An example of the employer rate calculation

following a market downturn

AssumptionsSuppose that the final employer contribution rate in FY2019-20 is 7.0 percent. A seriousmarket downturn leads the systems actuaries to calculate a FY2020-21 initial actuarial rate of 12.0 percent. Suppose also that the system is 96 percent funded.

Application of Collars approach Based on the funded status of the system (96 percent), the collars approach outlined in the tablewould generate a maximum increase in the employer contribution rate of 0.25 percent.

Before taking into account the fail-safe provision, this would generate a preliminary employercontribution rate of 7.25 percent (0.25 percent greater than the rate in FY2019-20).

However, because the initial, calculated actuarial rate for FY2020-21 (12.0 percent) is greaterthan this preliminary employer rate (7.25 percent), a fail-safe adjustment may need to be appliedin order to safeguard system assets.

Application of Fail-Safe Provision To assess whether any fail-safe adjustment is needed, the systems would first calculate by howmuch the new actuarial rate exceeds the prior years final employer rate.

In this case, this initial actuarial rate for FY2020-21 (12.0 percent) minus last year's employerrate (7.0 percent) is 5.0 percent.

In order to reach the actuarially calculated rate within ten years, the systems would thencalculate one-tenth of this difference. In this case, the difference is 0.5 percent. The finalemployer rate must be increased by at least this amount over the prior years rate in order tomeet the fail-safe requirement.

In this case, the collars approach would only increase the employer rate by 0.25 percent overthe prior year. Therefore, an additional 0.25 percent contribution is also needed as a fail-safeadjustment, in order to reach the 0.5 percent increase that is required.

Therefore, the final employer contribution for FY2020-21 would be 7.5 percent (not 7.25percent), a rate of increases that if continued would expect to reach the actuarial rate within 10years.


39/42


Step Four: Retain features of current law wherever possible no resetting of thesystems calculated unfunded liabilities

5.15 The administrations pension proposal does not make any changes in determining theamortization rate. The systems would not undergo another Fresh Start and would

therefore retain current law amortization schedules. The proposal also retains five-year smoothing of actuarial gains and losses in determining actuarial value.

5.16 Any new benefit enhancements or ad hoc COLAs enacted by the General Assemblywould be funded over a ten-year period with level dollar payments. Amortizationpayments for any newly enacted benefits and COLAs would be added to thecontributions calculated through the floors and collars system outlined in thissection.

5.17 Future actuarial gains and losses would continue to be amortized using level dollarfunding.

FIG 5. 1. COMPARISON OF PROPOSED FUNDING POLICIES VERSUSCURRENT LAW

Feature Current Law Proposed Reform

PensionContributionRate

Actuarial Rate with a minimumemployer rate contributions floor

Actuarial Rate with collar limits and anenhanced minimum floor

Actuarial Rate Normal Cost plus Amortizationof Unfunded Liability

Normal Cost plus Amortization of Unfunded Liability

Amortization of UnfundedLiability andfuture changes

Level Dollar payments remainconstant during the amortizationperiod, thereby decreasing as apercent of payroll

Retains Level Dollar Amortization percurrent law

Assets used todetermineUnfundedLiability

Actuarial Value of Investments asset gains/losses are phased-inover a five-year period.

Retain Actuarial Valuation of Investments

Rate Smoothing Use of Actuarial Value of Investments helps smoothinvestment gains and losses overa five-year period.

An incremental rate will be determinedeach year based on the funded status of the system. This increment will determinethe allowable increase in the rate if theplan is underfunded or the allowabledecrease if the plan is overfunded from theprior years pension rate. The incrementsincrease or decrease the further thefunded percentage is from 100 percent.


40/42


The impact of this plan on future pension obligations

5.18 The administrations pension reform plan would address both the FY2012-13 ratespike and the need to manage future pension system liabilities.

5.19 The changes proposed in this section deliver a funding schedule that provides forincremental changes in contribution amounts so that future state budgets cangradually absorb the impact of higher pension contributions. This provides greatersecurity that the commonwealth and school districts can meet all future pensionfunding obligations.

FIG. 5.2: PROJECTED EMPLOYER CONTRIBUTIONS TO PSERSASSUMES 0 PERCENT RETURN IN FY2007-08 AND 8.5 PERCENT RETURNS THEREAFTER

Through a system of minimum contribution floors and incremental adjustments to the ratein both strong and weak investment periods, the commonwealth will be able to graduallyabsorb the impact of the rate spike and pay down the systems unfunded liabilities.

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

$2,250

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Fiscal Year Ending

C o m

b i n e d s t a t e a n

d s c

h o o

l s c o n t r

i b u t i o n

( $ m

i l l i o n s )

Current Law Adminstration's Funding Plan


41/42


42/42

5.20 The funding strategy outlined in this white paper meets the challenges facing the

commonwealths two statewide public pension systems head on. Theadministrations pension funding plan offers a solution that:

Provides greater security that the commonwealth and school districts will beable to meet all future pension funding obligations, for both current and future

retirees; Takes prudent steps to insulate the commonwealth and school districts from a

rate spike that will occur if investment performance lags; Provides a plan that is actuarially sound; Creates a funding schedule that provides for incremental changes in contribution

amounts (both up and down), allowing future state and school district budgets togradually absorb the impact of higher pension contributions;

Makes contribution rate increases and decreases more predictable for thecommonwealth and its school districts, allowing them to identify and plan for

changes in retirement costs sooner; and Continues to provide benefits that are comparable to other public employers

and that allow for retirement with dignity.

FIG 5.5: PROJECTED COMBINED EMPLOYER CONTRIBUTIONS TO PSERSAND SERS, COMMONWEALTH AND SCHOOL EMPLOYERS ($ millions)

Current Law 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20PA Contribution to PSERS ($ millions) $353 $318 $329 $340 $944 $1,178 $1,135 $1,136 $1,162 $1,189 $1,218 $1,248

Annual Change -10.0% 3.5% 3.5%177.2% 24.8% -3.7% 0.1% 2.3% 2.4% 2.4% 2.5%Sch Districts Contrib. to PSERS ($ millions) $245 $250 $256 $261 $888 $872 $820 $828 $840 $853 $867 $881

Annual Change 2.2% 2.3% 2.2%239.9% -1.8% -6.0% 1.0% 1.4% 1.6% 1.6% 1.7%

PA Contribution to SERS ($ millions) $221 $228 $236 $244 $621 $657 $618 $639 $660 $682 $704 $727 Annual Change 3.2% 3.5% 3.4%154.5% 5.8% -5.9% 3.4% 3.3% 3.3% 3.2% 3.3%

Combined PA Contribution ($ millions) $574 $546 $565 $584 $1,565 $1,835 $1,753 $1,775 $1,822 $1,871 $1,922 $1,975 Annual Change -5.0% 3.5% 3.4%167.7% 17.3% -4.5% 1.3% 2.6% 2.7% 2.7% 2.8%

Reform Plan 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20PA Contribution to PSERS ($ millions) $466 $479 $496 $513 $573 $645 $715 $788 $865 $949 $1,039 $1,135

Annual Change 2.8% 3.5% 3.6%11.6% 12.6% 10.8% 10.2% 9.8% 9.6% 9.5% 9.3%Sch Districts Contrib. to PSERS ($ millions) $369 $377 $385 $394 $447 $494 $538 $586 $637 $693 $752 $815

Annual Change 2.2% 2.3% 2.3%13.3%

10.5% 9.1% 8.8% 8.8% 8.7% 8.5% 8.4%PA Contribution to SERS ($ millions) $249 $286 $325 $366 $404 $418 $444 $476 $508 $541 $576 $613

Annual Change 14.9% 13.6% 12.6%10.4% 3.5% 6.2% 7.2% 6.7% 6.5% 6.5% 6.4%

Combined PA Contribution ($ millions) $715 $765 $821 $879 $977 $1,063 $1,159 $1,264 $1,373 $1,490 $1,615 $1,748 Annual Change 7.0% 7.3% 7.2%11.1% 8.8% 9.0% 9.1% 8.7% 8.5% 8.4% 8.3%

Note: PSERS rates include health care premium and commonwealth contributions are adjusted for quarterly cash-flow timing.

A Pension Reform White Paper

Documents

Transcript of A Pension Reform White Paper