By Erick M. Elder
and Gary A. Wagner
The Pennsylvania legislature is again debating reforms to avert a potential pension funding crisis. Every taxpayer should be concerned, but the people who bear the most risk are current and future retirees.
More than 325,000 retired Pennsylvanians and 370,000 active workers rely on the commonwealth's two largest pension plans, the Public Schools Employee Retirement System (PSERS) and State Employee Retirement System (SERS). According to our new research, it's statistically unlikely those plans will be able to keep their promises to these workers over the long term if changes aren't made.
The good news is that, based on the assets the two plans have on hand, they can guarantee benefits for the next five years. The bad news is that, in the pension world, five years is not a long time. After those five years, the payment probability plummets.
Within 15 years, the chances the state will have enough on hand to pay retirees falls to only 31 percent for PSERS and 16 percent for SERS.
A common way to measure a pension's financial health is its funding ratio. Here's an easy way to understand it: 100 percent means that, if a plan's actuaries are correct about several assumptions (which we'll discuss), it could pay all workers what they were promised and end up with an account balance of zero after all promised benefits have been paid. PSERS and SERS have funding ratios of 63.8 percent and 59.2 percent, respectively.
Now, back to those assumptions. Each of them — such as the number of working years, rates of salary increases, and annual investment returns — is made by a qualified expert, but ultimately, it's an educated guess. Special attention must be paid to the uncertainty surrounding future investment returns, which account for 70 percent of the plans' funding, and thus are critical.
As anyone with a 401(k) over the last decade can tell you, investment returns are volatile. SERS had returns of 24.3 percent in 2003, and negative 28.7 percent in 2008. We invest because we expect to come out ahead over the long run, but this type of risk makes it nearly impossible to guarantee how much will be on hand for retirees decades from now.
To be fully funded, PSERS and SERS would need an additional $50 billion on hand today. Even then, there would still be less than a 50/50 chance that their investments would perform well enough to make every payment. This is because standard pension accounting assumes investment returns will perform exactly as predicted. When you account for the volatility from the start, the numbers change dramatically.
Of course, PSERS and SERS might earn more than expected, but that's highly unlikely. Should they fall short, some sort of pension reform would be necessary to keep retirees afloat. There are four unappealing options:
First, increase pension contributions by the state. This would likely affect all Pennsylvanians through higher taxes or cuts to public services.
Second, increase contributions by workers to their own plans.
Third, reduce worker benefits.
Finally, use contributions intended to fund future benefits to pay current retirees, a "pay as you go" approach that compounds the underfunding problem and shifts the burden to future generations.
Investing in safer, less volatile assets is often cited as a solution to reduce investment risk. However, this isn't a magic bullet because the lower average returns generated by safer investments would require significantly higher contributions in order to fulfill benefit promises. Shifting a plan's investment strategy without a permanent increase in contributions will only compound the long-term funding challenges.
Time is running out. Unless reforms are undertaken relatively soon, Pennsylvania's shortfall is likely to take it down the same path as New Jersey and Illinois, leaving only the most painful options on the table. Proactive states like Rhode Island, Utah, and Michigan have marginally increased contributions, changed benefit formulas, or adopted elements of 401(k)-style plans in a manageable way now, in order to avoid drastic changes later. These were tough choices, but doing nothing was a far worse option.