"Significant room for improvement" exists in the management of Pennsylvania's $27.5 billion state employees pension fund, said state Auditor General Eugene DePasquale.

The State Employees' Retirement System needs to continue lowering fees to Wall Street money managers and implement a formal education program to gauge investment knowledge of its board members, he told reporters Thursday at the State Capitol in Harrisburg while releasing his latest audit of the system.

"SERS is moving in the right direction but they still have a long way to go," said DePasquale. The study targeted activity from January 2013 to this past March.

Pennsylvania Auditor General Eugene DePasquale
"My recommendations should improve the operations of both systems and reduce their reliance on the taxpayers," said Pennsylvania Auditor General Eugene DePasquale.

The fund is one of the nation's oldest and largest retirement plans for state employees. The commonwealth's other large pension fund is the Pennsylvania School Employees' Retirement System. The unfunded liabilities of the two total $62.5 billion, according to DePasquale.

DePasquale in May released an audit of PSERS, saying it spent $416 million in investment management fees to Wall Street firms.In announcing bith the PSERS and SERS audits, he called for legislative overhaul and operational improvements that include drastically reducing the payment of fees.

"My recommendations should improve the operations of both systems and reduce their reliance on the taxpayers," he said.

SERS' unfunded liability stands at $19.5 billion. The funding ratio of SERS plummeted from 132% in 2001 to 58.7% as of Dec. 31, according to DePasquale, The downward spiral, he said, started with a 2001 state law that sweetened the pension package -- the first of five "pension reform" measures over the past 15 years.

The latest bill, which Gov. Tom Wolf signed two months ago, establishes a hybrid setup for new state employees, combining traditional defined-benefit and 401(k)-style defined contribution plans. DePasquale said that bill answers some concerns about educating board members.

The portfolio of SERS returned 6.5% net of all fees and expenses in 2016, providing nearly $1.6 billion to the fund, according to a comprehensive annual financial report SERS issued Monday.

"SERS continues major initiatives to improve services to our stakeholders, as well as improving efficiencies in the delivery of benefits and reducing cost in the administration to our employers," executive director David Durbin said in the CAFR.

In April it lowered its assumed investment rate of return to 7.25% from 7.5%.

"I hear the people at SERS bragging, but even with their 'good year,' they didn't meet their goal. "Kinda close' doesn't cut it," said DePasquale.

He said a 5% expected rate of return would be more reasonable, "but you can't do that overnight or it would blow up the budget, though not literally the way Trump is threatening with North Korea."

Pension funding shortfalls -- estimates range from $1.6 trillion to $4 trillion nationally -- have raised more red flags in the capital markets the past few years.

According to the Center for Retirement Research at Boston College, the funded ratio of state and local pensions declined under both old and new accounting rules In 2016.

"This decline reflected steady growth in liabilities and slow growth in assets due to poor stock performance," said the center's report.

The recent stock market revival is helping plan assets recover with funded ratios expected to improve in 2017, said the BC study, though it projects funding ratios to stay essentially flat due largely to the current approach of calculating required contributions.

"Thus, to achieve more meaningful progress, plans need to establish contribution levels that will actually reduce unfunded liabilities," said the report, authored by Jean-Pierre Aubry, Caroline Crawford and Alicia Munnell.

Unfunded pension liability at both the state and local levels has been at the forefront in Pennsylvania, recipient of several bond-rating downgrades the past three years. Moody’s Investors Service, Fitch Ratings and S&P Global Ratings have all cited pension underfunding and budget imbalance.

S&P on July 6 placed its AA-minus GO rating on the commonwealth on credit watch with negative implications. Moody’s Investors Service rates the commonwealth's GOs Aa3. Fitch Ratings on July 26 maintained its AA-minus rating.

Gov. Tom Wolf signed a $32 billion budget, but Democrat Wolf and the Republican-controlled legislature have yet to agree on a tax package to fund it. State Treasurer Joe Torsella last week authorized a two-week $750 million line of credit to the commonwealth.

To minimize investment management fees, said DePasquale, SERS must emphasize selecting quality investment managers and consistently monitor their performance. "Also, using internal staff to manage funds instead of paying external investment managers can potentially save millions of dollars in fees."

DePasquale credited SERS for reducing management fees from $345 million in 2007 to $167 million in 2016 and for increasing its passive management ratio from 32% to 46% over the past year. "That trend must continue," he said.

He also said the governor has unusually string control over selection of board members, including the chairman, and that despite fulfilling its statutory duties, SERS' board composition, vague ethics policy and nonexistent attendance policy jeopardize its level of independence and reliability.

DePasquale said SERS properly procured and monitored investment consultants and managers, but inadequately pursued competitive offers, failed to document fee negotiations and lacked written procedures for monitoring private investments.

He also recommended state lawmakers to pass a series of measures, including broader criteria for denying pensions to people convicted of sex crimes.

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Paul Burton

Paul Burton

Paul Burton is the Northeast Regional Editor for The Bond Buyer and the author of the book "Tales from the Newsrooms." He is a sought-after public speaker and has appeared on radio and TV shows, including former CBS News White House correspondent Sharyl Attkisson’s public-affairs program, “Full Measure.”