The Makings of Pennsylvania's Pension Funding Crisis
Gov. Tom Corbett and his allies in the state Legislature have introduced controversial legislation to reform the pension systems for state employees and public school teachers.
The sponsors say the bills make necessary cuts to reduce the state’s massive liability problem. Unions argue that the measures are illegal because they cut current workers’ future benefits.
To get a handle on how Pennsylvania’s two public pensions ended up in their current funding crisis, one has to look more than a decade into the past.
A Big Commitment
It started in the spring of 2001. The Clinton years had just ended, the U.S. economy was on a roll, and September 11 was supposed to be just another Tuesday.
At that point, Pennsylvania’s pension funds for public employees were not just healthy – they were robust.
“Our system was about 123 percent fully funded, which means we had 23 percent more than all the liabilities on the books at a certain point in time,” said Jeff Clay, who’s been at the helm of the Public School Employees Retirement System for nearly 10 years.
In May, with the pensions flush with cash, the state Legislature passed Act 9 of 2001. Clay said in short, this bill raised benefits for public employees by about 25 percent in exchange for an increase to employee contributions.
Not only did Act 9 increase future benefits, but also it worked retroactively for then-current employees, instantly giving a major boost to the benefits they’d already earned. The state’s pension investments and the bigger employee contributions were predicted to cover the costs.
But a few months later, something went very wrong.
The First Recession of the 2000s
“We know what happened on September 11 of 2001. What that did was send a shockwave through the financial markets,” said Jay Pagni of the Governor’s Budget Office.
He said the ensuing financial mess led to a steep decline in investment returns for the state’s two pension systems.
Suddenly, just a few months after committing to much larger pension payouts, the state couldn’t rely on its investments to bring in the cash for employees’ retirements. When that happens, the employer — in this case the commonwealth — must make up the difference.
That was a problem for Pennsylvania. Feeling fiscal pressure of its own, the state couldn’t afford to cover the underperforming investments. In 2002 and 2003, the Legislature put constraints on the government’s maximum share of pension funding with Act 38 and Act 40.
Pagni said legislators were hoping to pay less in anticipation of a market turnaround, which did happen to a degree, but it wasn’t enough.
“You’re artificially underfunding the system," Pagni said. "Your market returns aren’t keeping up with expectations, and you’ve increased benefits. You’re creating the perfect storm, if you will, for a pension crisis."
On a line graph, the Public School Employees Retirement System took a sled ride down a pretty steep hill. The PSERS went from 123 percent funded in 2000 to an 81 percent funding level six years later. Its little sister, the State Employees Retirement System, went along for the ride as well.
The Great Recession Delivers a Knock-Out Punch
Things got better for a few years mid-decade, but the Great Recession of 2009 brought funding levels low again. That prompted the Legislature to pass Act 120 of 2010.
“Act 120 really took a lot of statesmen on both sides of the aisle to come together and say, ‘OK, if we do this, it will pay off the unfunded liability and secure retirement for generations of public employees to come,’” said Mike Crossey, union president of the Pennsylvania State Education Association.
Act 120 did a lot of things to save money: It reduced new employees’ benefits to pre-2001 levels; it increased the retirement age to 65; it set a schedule to increase the state’s pension contributions; and it required employees to increase their contributions if the plans’ investment returns were low — a practice known as “shared risk”.
Where Are We Now?
The public schools pension system is currently funded 69 percent, while the state employees system is at just 59 percent — both below where they were at the worst of the Great Recession.
Corbett’s office has introduced legislation to reform the pension systems in three ways. First, it changes new employees’ benefits to a defined contribution plan. Secondly, it slows down the yearly increase to the state’s contributions. Lastly, and perhaps most contentiously, the governor’s plan reduces the future benefits of current employees.
Not only would the new employees' 401(k)-style plan arguably lead to eventual underfunding of the system, but teachers union president Mike Crossey also argued it violates the state constitution (Article 1, Section 17) to break the contract of current state employees by lowering their benefits.
“Anybody that has a contract with their employer, in the middle of the contract, you can’t change it,” Crossey said. "That just shocks me, that this governor who used to be the (state) Attorney General is so willing to violate state law."
On the other hand, Corbett argues that the reform package is not only legal, but also necessary to avoid budget cuts elsewhere due to higher pension payments.
“The process of the law that is out there has been based on retroactivity to the benefits," Corbett said. "What we’re doing here is prospective activity to the benefits. There is a maxim … out there that you have to look, in some cases, for the benefit of the greater good of the greater state.”
In fact, the administration incorporated the projected savings of the governor’s pension reform plan into his budget proposal for the fiscal year beginning July 1.
Where Do We Need to Be?
At what level should the state’s two pension systems be funded? Public school employees pension director Jeff Clay said the system doesn’t necessarily need to be at 100 percent funding, as long as you’re aiming for that goal.
“We achieved that back in the late '90s; I think it was '96-'97," Clay said. "We started in 1917, so from 1917 to that '97 time frame, we were not at 100 percent funding, which is OK, because the system was being funded correctly."
Clay said that means all three "legs of the stool" were carrying their own weight – that is, the investments, the employee contributions and the state. He says the artificially suppressed state payments of the 2000s brought about the unhealthy funding levels.
“With the governor’s proposal, the underfunding continues, and if the governor’s proposal was in place, it would actually aggravate that slightly,” Clay said. He said in any case, the funding levels will continue to drop before they can begin to improve.
With unions, Democrats and some Republicans staunchly opposed to the governor’s pension reform proposals, the administration has its work cut out to garner enough support in the Legislature to pass the overhaul before the budget is due June 30.
For its part, the teachers union said the state should instead stick with the reforms made in 2010 and make up for rising state pension payments with the closure of business tax loopholes.