Pennsylvania Gov. Tom Wolf and top lawmakers – adversaries for more than two years – took a joint victory lap inside the State Capitol rotunda on Monday as Wolf signed a so-called pension-hybrid bill.
One day later, S&P Global Ratings sent a pointed message: The pension bill sounds nice. Now get your budget in order.
Wolf and the legislature are staring at a structural deficit of roughly $3 billion for fiscal 2018, or 9% of the governor’s proposed budget of roughly $32 billion. Wolf’s budget proposal highlights a $300 million pension contribution increase as a leading driver of the projected deficit.
Deadline is June 30.
The election-year compromise pension bill, aimed at curbing the commonwealth’s long-term pension liabilities, gives future state hires options that merge a traditional defined-benefit plan with a 401(k)-style defined contribution component.
Supporters called it a step toward diminishing long-term liabilities, and proof that Democrat Wolf and a Republican-controlled legislature are finally working together after two fractious years in Harrisburg that included passage of the fiscal 2016 spending plan nine months late.
“We can only hope that the cooperation evident in bringing the pension funding bill across the finish line continues into budget negotiations,” said Alan Schankel, a managing director at Janney Capital Markets in Philadelphia.
Opponents say immediate funding, not design change, is essential and that savings over 20 or 30 years will be irrelevant if nothing is done to start paying down spiraling debt that could blow up the state’s two major pension plans.
S&P called the credit implications negligible.
“While the bill represents a bipartisan effort to address the commonwealth's long-term liabilities, it does not address the state's acute budgetary stress,” S&P said. “The commonwealth's actions to structurally balance its budget and manage its liquidity position are more immediate credit concerns.”
S&P cited an analysis by the state’s nonpartisan Independent Fiscal Office that said pension costs for both of the state’s two major pension funds -- the State Employees Retirement System and the Pennsylvania School Employees Retirement System -- would still increase in the coming fiscal year, with no savings on a cash-flow or present-value basis until 2032.
The fiscal office projected $1.4 billion projected employer contribution savings over 30 years.
According to S&P, while the commonwealth's combined pension funded ratio of 52.8% is weaker than many states, it is higher than lower-rated peers. Pew Charitable Trusts identified Illinois, Kentucky and New Jersey with the lowest funded ratios, at 40%, 38% and 37%, respectively.
“Unlike other states such as New Jersey, Pennsylvania has taken steps to reach full actuarial-determined contribution [ADC] funding for both of its pension plans,” said S&P.
“While in our view funding full ADC is a strength relative to other credits, Pennsylvania's persistent structural imbalance demonstrates that it has not yet found a sustainable way to fund these costs.”
Richard Dreyfuss, a Hummelstown, Pa., actuary and an adjunct fellow at the Manhattan Institute for Policy Research, said S&P’s perspectives “underscore the view that an essential component of pension reform is one of effectively reconciling the long-overdue pension funding reforms with the overall state and local budget process.”
In Michigan, meanwhile, Gov. Rick Snyder and legislative leaders are finalizing a tentative hybrid deal for teachers and are trying to quickly push the bill through the legislature.
Coupled with a budget deal, the agreement, designed to lure new employees into a 401(k)-style defined contribution-only plan, would automatically enroll new school hires in a defined-contribution plan unless they choose a costlier pension benefit within 75 days.
The Michigan bill would also lower the assumed investment return to a 6% from 8%.
Data from the U.S. Census Bureau’s annual survey of public pensions showed that pension contributions from state and local governments increased by $8.5 billion, or 6.5% year-over-year, to $140.6 billion.
Pension contributions have come at the expense of higher education, according to Bank of America Merrill Lynch.
“The protections that pensions have in some states [both legally and through special-interest lobbying] has, in some instances, arguably granted them first liens on state revenues,” said BofA Merrill. “The general obligation pledge versus obligations to pensioners has been and will continue to be a litigated topic in the foreseeable future.
“Higher-ed funding on the other hand, does not enjoy the protections that many pensions do.”
Pennsylvania’s pension change will take effect for workers hired after Jan. 1, 2019 for SERS and July 1, 2019 for PSERS.
Those workers have the option to contribute 8.25% of their salary and split retirement benefits between a guaranteed pension and 401(k)-style investments.
A second option includes 7.5% salary contributions in return for a guaranteed pension base on 1% of their final average salary times years of service, supplemented by a 401(k)-style benefit.
The third option would be to participate in a full defined contribution plan.
The bill also increases the retirement age and changes the salary component of the pension benefit formula for these retirees. In addition, it calls for a review panel to examine and tweak the bill as needed.
“The hybrid in essence reduces the volatility of risk,” said pension expert James Spiotto, a managing director at Chapman Strategic Advisors in Chicago.
Pew Charitable Trusts backed the measure. In a letter to state lawmakers, Pew director Greg Mennis said it could save the commonwealth $5 billion to $20 billion over 30 years, depending upon investment performance.
Mennis cited projections by the Independent Fiscal Office of cash-flow savings of more than $1 billion and an improvement rate of more than $4 billion in fiscal position if the pension funds achieve their assumed rate of return on investments.
“I like it. It’s a solid reform,” said Schankel.
“It’s not going to change the stress on the pension systems for a while -- the old system's going to prevail -- but it’s an important measure. Fifteen or 20 years from now you're going to see signs of improvement.”
Pennsylvania has passed four other pension initiatives that have backfired to varying degrees -- notably, a 2001 bill backed by then-Gov. Tom Ridge that improved benefits by 25%, including retroactively. The commonwealth also underfunded its pension plans the previous few years, when returns were high.
The state's unfunded pension liability is estimated at up to $75 billion. Retiree Barry Shutt of Lower Paxton Township, Pa., displays a countdown clock outside the main cafeteria of the State Capitol in Harrisburg.
“I took some joking about the new pension bill shutting down my clock,” said Shutt.
Shutt, though, said the new bill is far from a solution. “OK, they took the first step," he said. "Now they have to start paying the bill and there’s no indication anybody wants to do that.”
Dreyfuss, citing a 131-page actuarial note that accompanied the bill, called the measure "unduly complicated and overengineered on the design side while it doesn’t grasp the funding problem.
“They had a chance to simplify things,” he added.
According to Dreyfuss, only three ways to reduce pension liabilities exist: cut benefits for existing retirees or those not yet retired, which is unconstitutional in Pennsylvania and politically volatile just about anywhere; achieve returns that exceed assumptions, which is highly unlikely; or pay it down.
The latter is especially tricky given budgetary strain. Democrats generally fear cuts to programs while Republicans don’t want to raise taxes.
Politics in Pennsylvania is especially divided. Democrat Wolf and the Republican-controlled legislature were several months late with the fiscal 2016 budget. In an election year, hybrid pensions marked a compromise that both sides could accept.
“People will say, ‘Is this enough? Should there be more?’ In the practical world, you live with what you can attain,” said Spiotto. “Every step toward reform is helpful and the types of steps Pennsylvania made are helpful.”
Change in Pennsylvania occurs slowly, said Villanova School of Business professor David Fiorenza.
“The pension-reform bill is a start in the right direction,” said Fiorenza, a former chief financial officer of Radnor Township, Pa.
Fiorenza, though, said exempting such personnel as State Police and judges effectively waters down the legislation. “The governor has put a Band-Aid on the situation instead of stopping the bleeding with a tourniquet.”
The review panel provides an effective safety net given the work-in-progress nature of plan adjustments, said Spiotto.
“It’s never a question of ‘I'll fix it and it will stay that way forever.’ You need something to review over X period of time.
“The devil is always in the details. As we know, legislation often needs to be modified. Fine-tuning is in the best interest of everyone. The simple approach might not be the most effective. If it’s complex, then you would need some periodic review.”