State governments around the country are scaling back pension benefits for public employees as a way to balance their budgets. Unfortunately, the issue in Pennsylvania is not as simple to solve as taxpayers may assume.
Under Pennsylvania law, most state employees are covered by the State Employees Retirement System. Most public school employees are covered by the Public School Employees Retirement System. Both systems guarantee a fixed or defined retirement benefit, with the size of each retiree’s benefit depending on factors such as years of service and salary.
Significantly, public employee pensions in Pennsylvania are not financed entirely by the taxpayers. Instead, both the employee and the employer contribute amounts equal to specified percentages of the employee’s salary. The retirement systems invest these contributions and rely on the investment income to help pay for pension benefits. Under a long line of court cases, pension benefits for service already performed are considered deferred compensation. As such, these benefits are constitutionally-protected, contractual obligations. Therefore, if investment income is insufficient to pay all of the benefits, taxpayers are required to make up the difference.
In 2000, both retirement systems were running surpluses. Actuaries projected that the combination of these surpluses and expected investment income would be more than adequate to meet future obligations. However, both systems now face major deficits. Although taxpayers may blame so-called greedy public employees, the real causes were a series of bipartisan policy decisions in Harrisburg and a weak economy.
First, legislators of both parties and successive Republican governors liberalized benefits. Specifically, in 2001, they approved an increase in future pensions for then current employees. In 2002, they provided a cost-of-living increase for those already retired. The assumption was that these initiatives would be affordable, especially since current and future employees were required to pay a larger percentage of their salaries into the retirement systems in order to qualify for the higher benefits. Unfortunately, those assumptions proved too optimistic.
Second, both retirement systems lost money in 2001 and 2002 because of a stock market decline. Normally, the amounts paid into the retirement systems by the state and the school districts would have been increased to offset these investment losses. However, legislators of both parties and two governors (one Republican and one Democratic) decided to reduce the employers’ contributions. As a result, employees continued to pay their share toward the cost of future pensions, but their employers did not. For example, from 2001 through 2010, state government paid less than 4 percent per year while state employees paid more than 6 percent of their salaries. During the same time period, school districts paid only about 4 percent per year while their employees paid about 7 percent.
Third, policymakers assumed that the stock market would come roaring back, thereby erasing the investment losses from 2001 and 2002 and offsetting the reduced employer contributions to the retirement systems. However, instead of the hoped for strong recovery, the stock market collapsed in 2008, thereby making Pennsylvania’s pension deficits even worse.
In 2010, the legislature approved a plan to eliminate the deficits over several decades. Nevertheless, because rising pension costs could jeopardize spending on key programs, Gov. Tom Corbett favors going beyond the 2010 reform. Among other things, he has proposed a transition to a 401(k)-type system for future government service. Under the governor’s plan, state government, school districts and their employees would make specific, defined contributions to the retirement systems, but any future decline in investment income would translate into smaller pensions rather than into an obligation for taxpayers to make up the shortfall.
Although the governor’s proposal may appear reasonable, there is at least one red flag. Specifically, the retirement systems’ actuaries are warning that the cost of meeting the pension obligations for work already performed could increase by as much as $40 billion. Their reasoning is that the retirement systems would have to invest more conservatively because new workers would no longer be a source of money to cover potential investment losses. More conservative investments would result in lower investment income, thereby leaving the retirement systems with less money than needed. If the actuaries are correct, making up for the lower investment income would cost more than the rest of the governor’s plan would save.
The Corbett Administration has disputed the conclusion of these actuaries, but their warning should at least prompt the legislature to take a second look. The last thing the state needs is to “reform” its pension systems only to find that the cost to taxpayers has actually gone up instead of down.
William Lloyd of Somerset represented Somerset County in the state House of Representatives (1981-1998) and served as the state’s Small Business Advocate (November 2003-October 2011). He writes a monthly column for The