Philadelphia pension funding strategy gets an affirmation
An outside analysis says Philadelphia is on a sustainable path toward paying down its pension debt over the next decade even if returns fall short of expectations.
The Pew Charitable Trusts stress test analysis of Philadelphia’s retirement showed that pension system would weather various economic conditions if the city continues its path of increasing employee contributions coupled with increased support from the general fund and sales tax revenue. City officials said the Pew analysis shows that its multi-pronged approach to get the pension system up to an 80% funding level by 2029 is on track.
“While there is still work to do, we think that the Pew report validates what we are trying to do in strengthening the pension fund,” said Philadelphia Director of Finance Rob Dubow. “It also emphasizes that we need to keep doing what we’re doing to get to 80 percent [funding] and ultimately 100 percent.”
Since assuming office in 2016, Mayor Jim Kenney’s administration has focused on the city’s pension system, which is now 46.8% funded with $4.4 billion in liabilities. Dubow said the city’s near-term goal is to have a 62.7% funding level by the end of the city’s current five-year plan in fiscal 2024 and be up to the high 60s or low 70s in 2026.
Philadelphia’s pension burden coupled with spending uncertainty related to plans for increased school district spending contributed to the city’s general obligation bonds getting downgraded one notch last year by S&P Global Ratings to A from A-plus. The S&P rating is on par with Moody’s Investors Service, which rates Philadelphia debt at A2 and one notch above Fitch Ratings’ A-minus mark.
Philadelphia’s road map for an 80% pension funding level over the next decade is predicated on the city paying at least the state-required minimum municipal obligation which Dubow estimates will total more than $8.7 billion between 2018 and 2029. The Pew report noted that contributions to Philadelphia’s pension system have risen “substantially” to $783 million in 2018 from $553 million in 2014.
"The cost to the city is likely to remain high for years to come," Pew's report said. "This means that contributions to the pension fund will continue to crowd out spending on other budget priorities."
Pew analyst Greg Mennis said that while the city’s higher contribution rate creates budgetary challenges, the strategy provides protection from future investment underperformance.
“The city has created a path to get to fully funded status,” Mennis said. “The city has been very proactive.”
Mayor Kenney proposed increasing the pension system’s funding by 4.17%, or $29.8 million, in his 2020 fiscal year budget plan thanks to a higher-than-expected city fund balance. The city also has more flexibility to increase pension funding thanks to forecasts for a 4.58% increase in tax revenues in 2020.
The Pew analysis showed that even under “adverse return scenarios,” required contributions are not expected to rise appreciably over time as a percentage of Philadelphia’s budget resources. Mennis noted that if Philadelphia sticks to its higher contribution level schedule, the pension system’s funded ratio will increase under any economic scenario and will insulate it from even the biggest downturns.
This was not the case in other cities Pew studied for its report including Baltimore, Pittsburgh, Chicago and Houston, who all lagged behind Philadelphia in their retirement system contributions, according to Mennis.
Dubow said that collective bargaining has also played a central role in steering Philadelphia’s pension funding back on track with the city’s police officers and firefighters agreeing to make additional contributions. A stacked hybrid structure was also established in 2016 for new non-uniformed employees where the defined benefit is capped at $65,000 and employees can also participate in a voluntary defined contribution plan. These changes are expected to increase the pension fund’s assets by $333 million and decrease liabilities by $108 million from 2018 to 2029, according to city officials.
Pew projects that the stacked hybrid plan design for new hires will expose to Philadelphia to lower levels of investment risk over time as it becomes a larger portion of the city’s total pension liability. The benefit design does not provide for indexing the $65,000 salary threshold to any measure of inflation, which Pew notes will lead to a declining share of total salaries being subject to the defined benefit plan as wages rise resulting in reduced costs and risks for the city.
Thomas Aaron, a Moody’s senior analyst and public pension specialist, said that while it is important for Philadelphia to combat its liability burden quickly, setting up future savings through a 401(k)-style plan for new employees will go a long way toward establishing enhanced fiscal health.
He stressed though that it would take “significant” time for the city to see any material impact because of obligations still tied to current workers.
“The advantage is about managing future risk,” said Aaron of the hybrid model. “It will lower the size of the defined benefit guarantee.”
Dubow said the city’s pension ramp up received a major boost from a recent move by the Pennsylvania legislature enabling Philadelphia to dedicate a portion of its sales tax revenue to the pension fund with larger contributions than required by law. The city is also planning to utilize more than $770 million of sales tax revenue through 2029 for the pension fund.
The Kenney administration has also sought to improve the pension fund’s investment returns while also lowering manager fee costs. Dubow said the city’s pension costs have been reduced by nearly $15 million annually thus far by dropping “expensive” managers and utilizing more index funds. The Pension Board has also reduced the fund’s assumed rate of return to 7.6% from a previous 9% level and will lower it again to 7.55% for the 2020 fiscal year starting July 1.
“The [Pew] report shows we are in better position to withstand stresses than other cities,” Dubow said. “It also emphasizes that we need to keep doing what we’re doing to get to 80 percent and ultimately 100 percent.”
“Everyone in the city understands how big an issue this is and wanted to be part of finding a solution,” Dubow said. “A lot of people have worked hard together to get to the point we are at.”