Has Pennsylvania Turned a Corner on Pensions?

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PHILADELPHIA – Pennsylvania's many problems compelled John McGinnis to run for the state House of Representatives in 2012 as a disgruntled citizen.

Four years later, the state's struggles, notably with its pension funding, have made him more so.

"I'm now in my fourth year and I'm a very disgruntled citizen. That's where we are," McGinnis, an Altoona Republican and retired Penn State economics professor, said at a July 13 Philadelphia Area Municipal Analyst Society pension workshop.

McGinnis was speaking at law firm Ballard Spahr LLP to a room of bond analysts, lawyers and money managers just as perplexed about what to do about public pension funding, awareness of which has surged nationally in recent years and forced many municipal issuers to play budgetary whack-a-mole.

Approaches to the problem vary widely. Estimates of the total unfunded liability range from $1 trillion to $4 trillion. The choice of investment return assumptions accounts for the fluctuation, said Les Richmond, a vice president and actuary at bond insurer Build America Mutual.

According to a spring survey of 146 municipal analysts by PNC Capital Markets managing director Tom Kozlik, 93% cited public pensions – their funding levels and the issuance of pension obligation bonds – as the most important issue.

Pension obligations are also seen as crowding out important funding for other programs, notably infrastructure.

Speaking one day earlier at the Brookings Institution municipal finance conference in Washington, Adrienne Lu, senior associate with the American Cities Project at Pew Charitable Trusts, said budget crunches have forced choices between public safety and infrastructure and produced "disastrous results" in Flint, Mich., referring to the contamination of the water system with lead after a budget-driven change in water supply.

Some Oregon police departments unable to afford 24-hour patrols have even placed mannequins in police cars along roadsides, she said.

McGinnis is the author of "Future Forsaken: PennScam and the Demise of the Commonwealth" and a gadfly even within his own party around the state capitol in Harrisburg. He called Pennsylvania pensions "a bad system run by bad people."

His bill, House 900, would amortize Pennsylvania's public pension debt over 20 years instead of 30, with level dollar funding. It has been sitting in committee for more than a year. Estimates peg the commonwealth's pension bill at around $70 billion.

Still on the table for a fall session even more truncated than usual, given election-year campaigning, are discussions about funding and design changes to Pennsylvania's State Employees' Retirement System and the Public School Employees' Retirement System.

Funding defined benefit plans with a credible blueprint to eliminate the unfunded liability, he said, should precede design changes to the state's two major pension plans.

"I'm a fiscal conservative, but I believe this is one problem you solve by throwing money at it," he said.

McGinnis also stressed better management of the funds.

"I'll probably rankle some people, but believe in indexing. I believe we should give the money to Vanguard," he said.

McGinnis said Vanguard told two senators and him in November 2014 that it would charge two basis points, or $14 million at the time, and at less risk. SERS and PSERS, he said, each contract more than 250 money managers at a cost of roughly $700 million per year.

"That's a place where you can have some savings," he said.

Pennsylvania in early July passed a $31.5 billion budget for fiscal 2017 that included a $1.3 billion revenue package largely hinged on increases in tobacco and gambling taxes and fees, and a $200 million loan from a state medical malpractice insurance fund.

The new budget adds roughly $500 million for pension plan contributions – nearly double that of two years ago -- by eliminating collars, or reduced contributions, authorized under a 2010 law. Moody's Investors Service said July 15 that Pennsylvania was making "real progress on its path to funding its pensions."

Hummelstown, Pa., actuary Richard Dreyfuss said Moody's overstated Pennsylvania's progress.

"The reality is the unfunded liabilities of PSERS and SERS continue to increase, posing long-term financial risks to these pension systems," said Dreyfuss, an adjunct fellow with the free-market leaning Manhattan Institute for Policy Research.

"Rather than being content with a subjective political declaration of the amorphous term 'contributing 100% of the actuarially recommended contribution,' one should examine the understated liabilities, the overstated assets in PSERS and the excessively long amortization periods of both plans," said Dreyfuss, a retired Hershey Foods executive.

"As a result, [fiscal 2017] contribution levels remain deficient."

Villanova School of Business professor David Fiorenza sees this year's commitment as a beginning.

"Pennsylvania is making progress on the funding of the state's pension plans, albeit small but a start," he said. "It took a few different governors and several reports from Moody's to push the process. The downgrades in the bond status should stay stable for the next few years if positive reform starts this year."

Pennsylvania's unwieldy structure impeded effective overhaul, said Ballard Spahr partner Shannon Farmer.

"In Pennsylvania, every third person is in their own pension plan, which is a very unusual structure. It means pension reform in Pennsylvania is more difficult than it might be in other states."

According to her research, 48 states changed their pension systems from 2009 to 2014.

Most recently, Tennessee enacted for future hires a hybrid plan that combined traditional defined benefit and 401(k)-style defined contribution plans, while Kentucky introduced a cash-balance plan for employees hired after July 1, 2013. In addition, Oregon modified its defined benefit plan.

From 2009 to 2012, said Farmer, 30 states increased employee contributions; 33 enacted higher age and service requirements for new hires; 17 adopted longer periods for calculating the final average salary; 12 reduced the multiplier for certain classes of employees. Additionally, eight introduced defined contribution and/or hybrid programs and seven made the new plan the primary offering for future hires.

Municipal-level changes have also varied. In Detroit, where a bankruptcy court ruled that federal bankruptcy laws pre-empt state constitutional guarantees, retirees took reduced benefits under a settlement of the city's Chapter 9 case and active employees went into a new hybrid plan with the support of municipal unions.

"Detroit is a really fascinating thing when it comes to pensions. Detroit's pensions were not the cause of its bankruptcy, really," said Farmer. "But what comes out if it is that its retirees gave up a portion of their pension benefits. They took a shave."

While contractual impairment claims by states and cities may still be constitutional if courts deem them reasonable and vital to serve an important purpose, courts don't necessarily adhere to the public purpose claim, she said. They also recognize that the change cannot be more drastic than necessary.

In Illinois, whose unfunded liability is now close to $130 billion, the state Supreme Court in 2015 found that legislative efforts to reduce pension benefits of five state plans violated the state constitution's pension protection clause. The system was 41% funded at the time.

"The court looked back at the legislative history and various iterations of pension funding formulas that had been passed and said none of this was a surprise," said Farmer. "You made your own bed, now lie in it; that's basically the attitude of the court."

New Governmental Accounting Standards Board rules for accounting and financial reporting of public pensions should profoundly affect issuers' bottom lines, said GASB senior research manager Dean Mead.

"From my perspective, I think it's a much better measure of the liability than you were getting before," he told analysts. "And I think it is certainly a much more comparable number for looking at various governments and trying to get a gauge on the relative magnitude of their obligations.

"On the flip side -- I don't think it's bad news, it's just news that presents some challenges -- this is a big liability for most government that wasn't there on the face of the financial statements before, and there's nothing being dropped on the asset side to offset it."

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