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Pension Challenge:
Commonwealth of Pennsylvania
Governor’s Budget Office
June 5, 2008
This Page Intentionally Left Blank
Executive Summary 5
• In 2001 and 2002, in response to strong earnings performances and favorable funded
ratios, the General Assembly passed Act 9 in 2001 and Act 38 in 2002 that enhanced
retiree benefits, including an increase in the benefits multiplier from 2.0 percent to 2.5
percent for most employees.
• Coupled with stock market losses between 2001 and 2003, these benefit enhancements
threatened to dramatically increase employer rates in the short term. As a result, the
General Assembly passed Act 40 of 2003 to change the projected payment schedule and
delay the onset of higher contributions. Pre-Act 9 gains and losses (in reality only gains)
were amortized over 10 years, and post-Act 9 gains and losses (including all of the bear
market losses) were amortized over 30 years.
$1,250
FY2012-13 (114 percent). School
$1,000
Districts’ cost for retirement will spike
$750
at the same rate, with the total
contribution growing from $261 million $500
• Although investment returns have been remarkably strong over the long term for both
SERS and PSERS, there have been several periods of below-average returns lasting more
than one year. For SERS this occurred most recently in 1980-81 and 2001-02. Were a
similar dip to occur between now and 2013, the effect on commonwealth contribution
rates would be disproportionately large due to the particularities of state law.
• If we do not take action soon, we may run out of time to fix the problem with an
affordable funding alternative that will moderate the rate spike.
• Despite investment losses earlier this decade, the earnings performance or funded ratios
of SERS and PSERS are not Pennsylvania’s major pension challenges. Both systems have
recently announced strong investment returns: 22.9 percent for PSERS in FY2006-07
and 17.2 percent for SERS in Calendar Year (CY) 2007. At the date of their last
actuarial valuation, SERS and PSERS were 97.1 percent and 85.8 percent funded,
respectively.
• After more than four years of top-decile investment returns, it is possible that FY2012-
13 contribution rates could be significantly lower than previously forecast.
• For SERS, the permanent 4.0 percent minimum contribution floor provided by Act 8 of
2007 has assisted in reducing the forecast FY2012-13 rate.
1
Footnote 5 on page 22 includes an explanation for the apparent discrepancy between the commonwealth and
school contribution rate increases.
• Recent updated projections that the spike will be lower in FY2012-13 than was
previously expected could be quickly reversed if market conditions change and
investment performance over the next few years ceases to be strong. The FY2012-13
rate spike forecast is highly volatile and is subject to significant change based on the
systems’ investment returns each year.
PSERS
• For PSERS, setting a minimum contribution rate floor equal to the current FY2007-08
contribution level would prevent pension contributions from falling over the next five
years, but this action alone would have very little impact on the rate spike, because
these extra contributions would be relatively small compared to the deferred losses that
become due in FY2012-13.
• Conservatively assuming a single year of 0 percent returns in FY2007-08 and then 8.5
percent returns thereafter, a rate floor equal to the current pension rate would reduce
the forecast FY2012-13 rate only marginally – from 15.2 percent under current law to
14.6 percent – if applied without more comprehensive reform. This 0.6 percent of
payroll reduction ($95 million) would be in return for combined (state + schools)
contribution increases costing $1.13 billion vs. current law through FY2011-12.
SERS
• Because SERS is closer to being fully funded than PSERS, rate floors alone do assist in
reducing the projected rate spike, but only if investment performance continues to be
strong for the entire period through FY2012-13, an assumption that is too risky to be
the basis for state policy.
• Proposals that seek to increase minimum contributions move pension funding policy in
the right direction, but they are not comprehensive enough on their own.
• The commonwealth should adopt a new policy to determine the annual pension
contribution rate. The purpose of this change would be to:
• To insulate the commonwealth and school districts from a rate spike that will occur if
investment performance lags between now and FY2012-13, the proposal would add to
current law:
1) A temporary, higher contribution rate floor for PSERS through FY2011-12 which
would be set at the FY2007-08 rate, to prevent contributions from falling over the
next five years only to have to increase dramatically in FY2012-13. This floor will
lessen the relative rate increase that will be faced by the commonwealth and school
districts in FY2012-13, and will produce additional revenues that will help to reduce
the size of the rate spike.
2) A permanent, higher rate floor for both systems equal to the “normal cost” rate minus
2 percent of payroll. The normal cost rate represents the full cost of pension benefits
accruing to current employees. SERS contributions will be phased in up to this new
floor through graduated rate increases, which are anticipated to be 0.5 percent of
payroll per year for five years.
3) A method of maximum contribution rate increases based on the funded status of each
system, which will allow state and school district budgets to absorb the impact of
higher contribution rates after FY2012-13 over several years (see table below)
• To ensure that the commonwealth is protected from severe gains or losses, the policy
adopts a permanent system of floors and collars that limits annual changes in the
contribution rate (either up or down).
• The systems will still calculate an actuarial rate each year, but changes in the actual
contribution rate (both up and down) would be limited to the increments shown in the
table below.
• This asymmetry will supplement each system’s assets during strong market periods,
allowing the collar system to mitigate against a need for dramatic contribution increases
during and after bear market periods.
• After significant market losses, the underlying assets and liabilities (and thus the
contribution rate needs) of SERS and PSERS may change faster than the collar system
can adjust to. As such, the proposal adds an extra fail-safe increase to the contribution
rate if the rate determined by the collars approach is not adequate to reach the actuarial
rate in 10 years.
• In FY2012-13, the Budget Office projects that implementation of the proposed changes
would virtually eliminate the rate spike. Assuming one year of 0 percent returns for
both systems and then 8.5 percent thereafter, combined employer contributions to
SERS and PSERS – including contributions from Pennsylvania’s 501 school districts –
$1,750
$1,500
Employer Contribution
$1,250
($ millions)
$1,000
$750
$500
$250
$0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Fiscal Year Ending
PA Contribution to SERS ($ millions)
PA Contribution to PSERS ($ millions)
Schools Contrib. to PSERS ($ millions)
• Provides greater security that the commonwealth and school districts will be able to
meet all future pension funding obligations;
• Provides a plan that is actuarially sound;
• Creates a funding schedule that provides for incremental changes in contribution
amounts so that future state and school district budgets can gradually absorb the impact
of higher pension contributions;
• Makes contribution rate increases and decreases more predictable for the
commonwealth and its school districts, allowing them to identify and plan for changes in
retirement costs sooner; and
• Continues to provide benefits that are comparable to or better than those provided to
other public employers and that allow for retirement with dignity.
Current Law 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20
PA Contribution to PSERS ($ millions) $353 $318 $329 $340 $944 $1,178 $1,135 $1,136 $1,162 $1,189 $1,218 $1,248
Annual Change -10.0% 3.5% 3.5% 177.2% 24.8% -3.7% 0.1% 2.3% 2.4% 2.4% 2.5%
Sch Districts Contrib. to PSERS ($ millions) $245 $250 $256 $261 $888 $872 $820 $828 $840 $853 $867 $881
Annual Change 2.2% 2.3% 2.2% 239.9% -1.8% -6.0% 1.0% 1.4% 1.6% 1.6% 1.7%
PA Contribution to SERS ($ millions) $221 $228 $236 $244 $621 $657 $618 $639 $660 $682 $704 $727
Annual Change 3.2% 3.5% 3.4% 154.5% 5.8% -5.9% 3.4% 3.3% 3.3% 3.2% 3.3%
Combined PA Contribution ($ millions) $574 $546 $565 $584 $1,565 $1,835 $1,753 $1,775 $1,822 $1,871 $1,922 $1,975
Annual Change -5.0% 3.5% 3.4% 167.7% 17.3% -4.5% 1.3% 2.6% 2.7% 2.7% 2.8%
Reform Plan 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20
PA Contribution to PSERS ($ millions) $466 $479 $496 $513 $573 $645 $715 $788 $865 $949 $1,039 $1,135
Annual Change 2.8% 3.5% 3.6% 11.6% 12.6% 10.8% 10.2% 9.8% 9.6% 9.5% 9.3%
Sch Districts Contrib. to PSERS ($ millions) $369 $377 $385 $394 $447 $494 $538 $586 $637 $693 $752 $815
Annual Change 2.2% 2.3% 2.3% 13.3% 10.5% 9.1% 8.8% 8.8% 8.7% 8.5% 8.4%
PA Contribution to SERS ($ millions) $249 $286 $325 $366 $404 $418 $444 $476 $508 $541 $576 $613
Annual Change 14.9% 13.6% 12.6% 10.4% 3.5% 6.2% 7.2% 6.7% 6.5% 6.5% 6.4%
Combined PA Contribution ($ millions) $715 $765 $821 $879 $977 $1,063 $1,159 $1,264 $1,373 $1,490 $1,615 $1,748
Annual Change 7.0% 7.3% 7.2% 11.1% 8.8% 9.0% 9.1% 8.7% 8.5% 8.4% 8.3%
Note: PSERS rates include health care premium and commonwealth contributions are adjusted for quarterly cash-flow timing.
Includes 22.93% PSERS return as of 6/30/07 and 17.2% SERS return as of 12/31/2007. Assumes zero percent investment return
for PSERS in FY2007-08 and for SERS in CY2008. Assumes 8.5% returns for both systems in all future years.
About PSERS
1.1 The Public School Employees’ Retirement System of Pennsylvania (PSERS) provides
monthly retirement, disability retirement, death benefits and a health insurance
premium assistance program to its members.
1.2 The System currently has 264,000 active members and 168,000 beneficiaries.
Members are employees of the commonwealth’s 501 school districts as well as 233
other school employers, which include charter schools, state colleges, community
colleges and approved private schools.
1.3 PSERS’ defined benefit (DB) pension fund has three funding sources:
• Employer contributions
• Employee contributions
• Investment earnings
1.4 Employer contributions are shared by the commonwealth and school employers.
The commonwealth reimburses school employers slightly more than half the cost of
providing retirement benefits for school employees, a ratio which will gradually
increase over the next 20 years.
1.5 Each December, the PSERS Board determines the employer contribution rate based
on system experience, the current actuarial valuation and the advice of PSERS’
actuaries. The certified rate is the percentage of payroll that school employers are
required to pay into the pension fund to accumulate assets to pay pension benefits
for members when they retire.
1.6 Employees contribute between 5.25 percent and 7.50 percent of their salary to help
fund their retirement benefits, depending on the benefit level selected in 2001 and
the date hired. Absent legislation to the contrary, the employee rate does not
change from year to year, and employee rates for current employees cannot be
changed, even by statute, without employee consent.
1.7 Investment returns are the greatest contributor to the pension fund. Over the last
decade, nearly 81 percent of the pension fund was funded by investment returns, 12
percent by member contributions and 7 percent from school employers. As of
December 31, 2007, PSERS had an investment portfolio of approximately $67.4
billion.
1.8 The Commonwealth of Pennsylvania State Employees’ Retirement System (SERS) has
110,000 active members and 108,000 annuitants in 2007. Members are current and
former employees of the Commonwealth of Pennsylvania or one of its related
organizations.
1.9 SERS is also a defined benefit fund and also has three funding sources:
• Employer contributions
• Employee contributions
• Investment earnings
1.10 Each spring, the SERS Board determines the employer contribution rate based on
system experience, the current actuarial valuation, and the advice of the system’s
actuaries.
1.11 As with PSERS, investment returns are the greatest contributor to the SERS pension
fund. Over the last 10 years, nearly 85 percent of SERS’ pension fund was funded by
investment returns, 9 percent by member contributions and 6 percent from
employer contributions. At the date of the last valuation in December 2007, SERS’
assets were valued at $35.5 billion on a market value basis.
1.12 PSERS and SERS’ defined benefit plans guarantee eligible annuitants a monthly lifetime
benefit based on age, final average salary and years of credited service.
1.13 Commonwealth and school employees become vested in SERS and PSERS once they
have attained five years of service. Accrued pension deductions and statutory
interest are returned to employees who leave state or school service before reaching
the vesting requirement.
1.14 For vested members, PSERS permits normal retirement with an unreduced benefit at
age 62 with one year of service, or at age 60 with at least 30 years of service, or at
any age with 35 years of service. SERS members are grouped into multiple different
classes according to their employment, but Class AA employees (the largest group of
members) can retire with an unreduced benefit at age 60 with 3 years of service, or
at any age once 35 years of service are reached.
1.15 For the majority of PSERS and SERS members (class T-D and class AA respectively),
annual retirement benefits are payable monthly and the maximum single life annuity is
1.16 Early retirement is available to members under age 62 (PSERS) who have at least five
years of credited service. The monthly benefit is reduced based on the retiree’s age,
gender and years of service. For retirees who are at least 55 with 25 years of
service, a lower benefit reduction factor is used to calculate the monthly benefit.
1.17 Members who are unable to perform their work due to illness or disability may be
eligible for a disability benefit. Eligible members must have at least five years of
credited service and must provide documentation to a medical examiner that proves
incapacity to perform their job duties.
1.18 In addition to providing a monthly benefit, PSERS and SERS also allow retirees to
withdraw all or part of their contributions and statutory interest at the time of
retirement, and to take a corresponding reduction in the monthly payment so that
the entire benefit is actuarially equivalent to the maximum single life annuity. The
monthly benefit is reduced according to how much the retiree elects to withdraw.
1.19 PSERS retirees, spouses and eligible dependents may also opt into coverage by the
PSERS group health insurance plan. The Health Options Program (HOP) is a
voluntary health benefits program funded by participant contributions. Enrollees
choose from indemnity, fee-for-service and managed care plans, and in most cases
premiums are deducted from the retiree’s monthly benefit.
1.20 The Premium Assistance program provides eligible Pennsylvania school retirees with
up to $100 per month in non-taxable reimbursement to help pay for basic health
insurance purchased from an approved plan, which can be either HOP or a
Pennsylvania school employer's plan. Retirees are eligible for premium assistance if
they have at least 24.5 years of credited service regardless of age, or have at least 15
years of credited service and terminated service on or after age 62, or are receiving a
disability retirement benefit from PSERS.
1.21 After several years of above-average investment returns in the late 1990s, by 2001
the systems had built up strong funded ratios. In 2000, the PSERS plan was super-
funded with a ratio of assets to liabilities of 123.8 percent; in 2001, the funded ratio
was 114.4 percent. Likewise, SERS’ funded ratio was 132.4 percent in 2000 and
116.3 percent in 2001.
2
For PSERS, a 2.0 percent benefits multiplier is applied to all purchased non-school service (such as out-of-state,
maternity, non-intervening military and government). Similarly, SERS uses a 2.0 percent multiplier for purchase of
non-state service.
1.23 Based on these improved circumstances, Act 9 of 2001 was enacted by the General
Assembly and significantly increased future liabilities by enhancing retirement benefits.
1.24 New classes of service were created (Class T-D for PSERS and Classes AA and D-4
for SERS), and employees opting into the new classes became eligible for an increased
annuity of 2.5 percent of final average salary for all credited years of service (3
percent of final average salary for members of class D-4).
1.25 To reflect the increased level of benefits, employee contributions were increased
starting in January 2002 for all members opting into the new classes. For PSERS,
member contribution rates were increased from 5.25 percent and 6.25 percent to
6.5 percent and 7.5 percent, respectively. For SERS class AA members, contribution
rates were increased from 5.0 percent to 6.25 percent, and the class D-4 employee
contribution rate was set at 7.5 percent. No retroactive increases in employee
contributions were required for participation at the higher multiplier level. The
increased multiplier and employee contribution rates were made mandatory for all
employees hired after June 30, 2001.
1.26 The monthly health benefit premium assistance contribution for PSERS increased
from $55 to $100 per month, and Act 9 also reduced the vesting period from 10 to 5
years.
1.27 Act 9 also reduced the amortization period for the systems’ unfunded actuarial
accrued liabilities from 20 years to 10 years on a level dollar basis.
1.29 The Joint State Government Commission, a research arm of the General Assembly,
issued a report in February 2004 called “The Funding and Benefit Structure of the
Pennsylvania Statewide Retirement Systems: A Report with Recommendations.”
1.30 The report compared qualifications, funding, and benefits of SERS and PSERS to those
of 79 statewide state employee and public school employee defined benefit
retirements systems in all 50 states.
1.31 According to the report, “Largely because of a high benefit multiplier and the option to
withdraw employee contributions at retirement, PSERS and SERS would appear to be among
the more favorable statewide plans.” Among the more generous features of PSERS and
SERS retirement benefits were:
• Benefits Multiplier: Of the 79 statewide systems that were compared to SERS
and PSERS, only four retirement systems used a benefit multiplier higher than the
2.5 percent used by the Pennsylvania systems, and only four other systems used
the same multiplier.
• Early Retirement Provisions: Both SERS and PSERS allow early retirement
with only five years of service. PSERS permits early retirement with a more
generous reduction factor at age 55 with 25 years of service. According to the
report, “The only system with as liberal an early retirement rule as the Pennsylvania
systems use is Nevada’s. Ten systems make no provision for early retirement.”
• Withdrawal Provisions: SERS and PSERS allow retirees to withdraw an
amount equal to all employee contributions with accumulated interest at 4.0%
guaranteed and take a reduction in the monthly benefit so that the entire benefit
is actuarially equivalent to the maximum single life annuity. Only two of the 79
systems reviewed in the commission report allow such a withdrawal, while one
plan allows any actuarially equivalent option approved by the board and another
allows withdrawal of half the benefit. Fourteen plans allow withdrawal of a
limited term of the benefit, of which 12 establish a maximum period of three
years.
Further, the current methodology used to calculate the early withdrawal amount
results in subsidized retirement benefits at the expense of the pension systems’
funds. Although both systems assume an 8.5 percent annual investment return
in their actuarial valuations, the present value of the withdrawal is calculated
using a 4 percent interest rate. This increases the value of the withdrawal
amount relative to the long-term earnings assumption of the systems.
Benefit Adequacy
1.32 The commission also analyzed the adequacy of benefits provided for Class T-D
members of PSERS (96 percent of active PSERS members as of June 30, 2002) and
Class AA members of SERS (94 percent of active SERS members as of December 31,
2002). The report analyzed “replacement ratios,” which are defined as the
percentage of pre-retirement income needed to produce an equivalent standard of
living post-retirement.
1.33 The report concludes that PSERS T-D and SERS AA general employees working for
at least 30 years and retiring at age 65 will have sufficient pension benefits, in
3
Joint State Government Commission, The Funding and Benefit Structure of the Pennsylvania Statewide Retirement
Systems: a Report with Recommendations. Harrisburg, PA, February 2004
1.34 For the average employee, no additional retirement savings are needed to meet the
targets, although careful management of income is needed to offset the effects of
inflation.
1.35 Further, under the economic assumptions used, because of the relatively high
benefits multiplier provided since Act 9 of 2001, the report notes that full-career
employees may be able to maintain their pre-retirement standard of living after
retiring without post-retirement cost of living (COLA) increases.
1.36 Pennsylvania has historically provided some degree of inflation protection for retirees
by enacting periodic “ad hoc” cost-of-living-adjustments (COLAs) to supplement
their existing pension benefits. The provision of ad-hoc COLAs is consistent with
the practice in several other states. Since the first COLA in 1967, COLAs have
generally been enacted in Pennsylvania in intervals of four or five years.
1.37 The last COLA for PSERS and SERS retirees was enacted in 2002. Consistent with
prior practice, the Act 38-2002 COLA aimed to restore at least 50 percent of the
lost purchasing power since the previous COLA in 1998.
1.38 Given the interval since the 2002 COLA, there are a number of bills proposing
COLAs for retired SERS and PSERS members pending in the General Assembly. At
this time, however, there are extenuating and compelling circumstances which must
be taken into consideration.
1.39 House Bills 2084 and 2379 are the principal COLA bills pending in the General
Assembly. These bills would provide a supplemental post-retirement adjustment
effective in 2008 for all members who retired before July 2, 2007, and therefore
includes SERS classes AA and D-4 and PSERS class TD members who retired with
the enhanced benefit plan provided by Act 9 of 2001.
4
A national study on replacement ratios, which was developed by Aon Consulting in cooperation with Georgia
State University, concludes that a person can maintain the same standard of living after retirement as before
retirement with a lower gross income. This is primarily because post-retirement reductions in tax liabilities,
savings levels and work-related expenses effectively extend the buying power of the post-retirement dollar. The
study develops the replacement ratio targets against which SERS and PSERS post-retirement income is measured;
these are the post-retirement income amounts that are estimated to be equal in value to as net pre-retirement
income amounts, and are expressed as the percentage of pre-retirement income that is required post-retirement
to maintain the same standard of living.
Aon Consulting. Replacement Ratio Study™: A Measurement Tool for Retirement Planning. Chicago, IL, 2001 sourced
from Joint State Government Commission, The Funding and Benefit Structure of the Pennsylvania Statewide Retirement
Systems: a Report with Recommendations. Harrisburg, PA, February 2004
1.41 The actuarial analysis as reported by the Public Employee Retirement Commission
(PERC) calculated the increase in employer contributions for PSERS from the COLA
proposed in House Bill 2084 Printer’s Number 3689 to be 2.71 percent of payroll in
FY2009-10, or $348 million per year for the next 20 years. The increased cost for
SERS would be 2.90 of payroll, or $166 million per year. As a result, the combined
annual increase in employer contributions for both systems would be $514 million
per year for 20 years. This represents a total amortization of more than $10.3
billion for this COLA alone.
1.42 This increase would be in addition to the sudden and substantial increase in the
employer contribution rate that will be paid by state and school employers to PSERS
and SERS beginning in 2012-13, the reasons for which are outlined in detail in the
following section.
1.43 Although protection of purchasing power for retirees is common and desirable
practice for public-sector retirement plans, the Joint State Government Commission
report notes that “COLA protection of retirees is rare in the private sector.”
1.44 In addition, COLAs must be considered in terms of the adequacy of existing benefits
as provided by the plan. The benefit multiplier provided by SERS and PSERS for class
AA and TD retirees is higher than the accrual rate for almost every other statewide
pension system in the United States.
1.45 Pennsylvania’s first priority with respect to current retirees and active workers who
participate in our state retirement systems must be to find a way to avoid the
FY2012-13 pension funding crisis, which threatens PSERS most acutely.
Supplemental annuity increases should take into consideration the above-average
level of retirement benefits already being received by SERS and PSERS beneficiaries
and should not be considered at all until the General Assembly has passed pension
funding reform legislation that solves the FY2012-13 rate spike problem and
guarantees the solvency of both state pension systems.
2.1 As noted in the prior section, in 2001 and 2002 the Pennsylvania General Assembly
passed two bills that significantly increased the future liabilities of each pension
system by enhancing retiree benefits.
• As noted in the previous chapter, Act 9 of 2001 increased the monthly health
benefit premium assistance rate, reduced the vesting period from 10 to five years
and increased the benefits accrual rate (benefits multiplier) from 2.0 percent to
2.5 percent for most retirees.
• Act 38 of 2002 increased costs by granting a Cost-of-Living-Adjustment (COLA)
and changed PSERS’ actuarial methods to accelerate the recognition of gains.
2.2 After stock market losses and benefit enhancements threatened to dramatically
increase employer rates in the short term, Act 40 of 2003 changed the projected
payment schedule by amortizing pre-Act 9 gains and losses (in reality only gains) over
10 years, and post-Act-9 gains and losses (including all of the bear market losses)
over 30 years.
2.3 This mismatch provided much-needed ‘breathing room’ by postponing the previously
forecasted large increases in the employer contribution rates until FY2012-13.
2.4 As a result, however, for the last six years the commonwealth has paid neither the
full cost of pension benefits accruing to current employees (the normal cost rate) nor
paid down the systems’ unfunded liabilities.
2.5 After many years of “super-funded” status, SERS is now 97.1 percent funded and has
a $914 million unfunded actuarial liability. As of its last valuation in June 2007, PSERS
is 85.8 percent funded and has an unfunded actuarial liability of $9.4 billion.
2.6 Despite investment losses earlier this decade, the funded ratio of SERS and PSERS is
not Pennsylvania’s major pension challenge. Although the systems’ ratio of assets to
liabilities should continue to be monitored closely, strong investment returns since
2003 have returned both SERS and PSERS to a comparable or better ratio of assets
to liabilities than many peer systems and regional neighbors (Fig. 2.1).
2.7 The major challenge facing Pennsylvania’s pension systems is the requirement to fund
the projected dramatic single-year increase in employer contributions that is
anticipated in FY2012-13.
2.8 Under current law, and assuming one year of 0 percent offsetting returns for both
systems and then 8.5 percent returns thereafter (the systems’ current assumption),
current projections forecast that commonwealth contributions to PSERS and SERS
will increase by at least $900 Million between FY2011-12 and FY2012-13. School
employer contributions will also increase by more than $600 million.5
5
Pursuant to Act 29 of 1994, the commonwealth share of each year’s employer contribution to PSERS is paid to
the system on a one-quarter lag basis. Consequently only three-quarters of the sharply-increased FY2012-13
contribution would be appropriated in budget year 2012-13. The final quarterly payment of the 2012-13
commonwealth contribution will be made to PSERS in the first quarter of the 2013-14 budget year. School
employer contributions to PSERS are not subject to this one-quarter lag provision.
$2,250
$2,000
Employer Contribution
$1,750
$1,500
($ millions)
$1,250
$1,000
$750
$500
$250
$0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Fiscal Year Ending
2.11 The current funding rules are not the only pension funding policy the commonwealth
could adopt that is consistent with generally accepted actuarial policies and practices.
Other approaches can reduce the spike in funding requirements in FY2012-13.
2.12 However, funding rules for SERS and PSERS are set by state statute, and legislative
action is required to change them.
3.1 Investment earnings are the greatest contributor to improving the funded status of
the pension systems.
3.3 Since the bear market of 2001-2002, both systems have generated five years of top-
decile returns, mirroring the double-digit returns experienced in the late 1990s.
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-10.0%
-15.0%
PSERS Investment Returns (Actuarial Valuation for Period Ending Jun 30)
SERS Investment Returns (Actuarial Valuation for Period Ending Dec 31)
3.4 These investment returns reflect the remarkably strong long-term average annual
earnings performance for both systems. For example, SERS’ 20-year average return
through December 31, 2007 was 11.5 percent per year when calculated as a
geometric mean and 12.0 percent per year as an arithmetic mean.
3.5 Strong investment returns have reduced the forecast FY2012-13 contribution rate
for both systems. As shown in Figure 3.2., assuming 8.5 percent investment returns
in all years, the projected contribution for PSERS has been reduced from 27.7
percent of payroll in the 2003 valuation, to 22.5 percent at the 2004 valuation, to
18.74 percent in the 2006 valuation, to 11.23 percent in the 2007 valuation.
PSERS 2003
25%
Valuation
Percent of Payroll
PSERS 2004
20%
Valuation
5% PSERS 2007
Valuation
0%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
3.6 For SERS, and assuming future supplemental annuities and 8.5 percent investment
returns in all years, the projected rate spike has also been reduced significantly, from
24.9 percent in the 2003 valuation to 8.5 in the 2007 valuation.
SERS 2003
25%
Valuation
Percent of Payroll
5% SERS 2007
Valuation
0%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Calendar Year
3.7 Since the problem of the rate spike became apparent, the General Assembly and the
Governor have enacted several pieces of legislation that have assisted in reducing the
forecast FY2012-13 contribution rate.
3.8 For SERS, Act 8 of 2007 began to address the looming pension crisis by preventing
contributions from falling below a minimum rate of 4 percent. In the absence of this
reform, commonwealth contributions to SERS would have been halved in FY2007-08
and gone to zero for four years thereafter, a step that would have exacerbated the
large contribution rate increase due in FY2012-13.
3.10 However, despite the improved outlook due to strong recent investment returns and
legislative changes, the systems’ robust investment performance of recent years is
now being followed by a period of market weakness and uncertainty. As a result,
projection models forecast at least a 177 percent increase in the commonwealth
employer contribution for PSERS between FY2011-12 and FY2012-13, and a 155
percent increase for SERS in FY2012-13.
3.11 Maintaining the pension contribution schedule required under current law would
provide the lowest impact on the state budget until FY2012-13.
3.12 Under current law, employer contributions for SERS could be held virtually static at
4.0 percent between FY08-09 and FY11-12, and contribution rates to PSERS could
actually decrease from 7.13 percent currently to approximately 4.75 percent
between FY2008-09 and FY2011-12.
• Taxpayer resources could be invested in other state priorities over these years,
such as economic development, roads and bridges, and public schools.
3.13 However, although long-term investment performance for both SERS and PSERS has
been remarkably strong (see §3.2-3.4), there have been occasional periods of below-
average returns that coincide with weaker domestic and global investment markets.
For SERS this occurred most recently in 1980-81 and 2001-02. Were a similar dip to
occur between now and 2012-13, the effect on contribution rates for the
commonwealth and its 501 school districts would be disproportionately large due to
the particularities of state law. As a result of current statutory methods for funding
our pension systems, just one or two years of lower-than-expected investment
performance could return the spike to previously projected levels.
3.16 Each year, members of the Pennsylvania General Assembly have proposed numerous
pension funding bills, reflecting the interest in returning the pension systems to a
sustainable footing.
3.17 In February 2004, the Joint State Government Commission released an analysis of the
challenges facing PSERS and SERS in a study, The Funding and Benefit Structure of the
Pennsylvania Statewide Retirement Systems: a Report with Recommendations. This report
noted that “actuarial projections forecast sharply increasing employer contribution levels.”
The analysis made multiple recommendations to members of the General Assembly,
including the investigation of “alternative methods of adjusting contribution rates for
investment returns”.6
3.18 In September 2006, the Pennsylvania Auditor General released performance audits
for each of the two pension systems. The audits found no fault with the systems’
investment management but highlighted a future underfunding of the pension systems
due to the causes noted earlier in this white paper. The Auditor General’s
Department urged “the Boards, the Governor, and the General Assembly to work together
to address this critical issue that will soon impact the SERS and PSERS retirement plans.” 7
In the release accompanying the audits, the Auditor General observed that “Now is
the time to act, to make sure that the state’s pension obligations do not escalate into a
financial crisis that threatens the economic competitiveness of Pennsylvania or the long-term
prosperity of its residents.” 8
3.19 The time to confront Pennsylvania’s looming pension funding challenges is now. If
the administration and General Assembly do not take action soon, we will run out of
time to fix the problem and find a funding alternative that will moderate the rate
spike.
6
The Funding and Benefit Structure of the Pennsylvania Statewide Retirement Systems: a Report with Recommendations,
Joint State Government Commission, February 2004
7
A Special Performance Audit by the Pennsylvania Department of Auditor General, September 2006
http://www.auditorgen.state.pa.us/Reports/Performance/Special/SERSFinal.pdf
8
Auditor General Jack Wagner Urges General Assembly, Governor to Shore up Two Largest Public Pension Plans,
Releases performance audit reports on SERS, PSERS. Harrisburg, PA. September 26, 2006
http://www.auditorgen.state.pa.us/department/press/wagnerurgesgenassemblygovtoshoreuppublicpen.html
4.1 Some legislators and interested parties have suggested that the commonwealth’s
pension funding problems could be solved by switching from the current “defined
benefit” pension plans to a “defined contribution” plan. The Rendell administration
analyzed future funding requirements if new entrants to PSERS and SERS hired after
June 30, 2008 were to receive benefits through a defined contribution (DC) plan as
opposed to the current defined benefit (DB) plans.
4.2 As a result of this analysis, the Rendell administration is not proposing the transition
from defined benefit to defined contribution retirement provision for either
commonwealth or school employees, for the reasons presented below.
Under state laws prohibiting the impairment of contracts, plan conversion could not
be unilaterally imposed on the state’s current employees – it could only be
introduced for new employees hired after the effective date of the change. As a
result, it would be many years before any significant number of employees would be
enrolled in a defined contribution plan.
4.4 Introducing a DC Plan will not reduce the systems’ current unfunded
liabilities
SERS and PSERS face significant unfunded liabilities as the result of benefit
improvements approved prior to Governor Rendell’s taking office and lower-than-
forecast stock market returns earlier this decade. A DC Plan will not reduce these
liabilities nor the 2012-13 rate spike in any meaningful way because the future
benefits of existing DB members cannot be unilaterally rescinded.
To achieve long-term savings from a DC plan, the employer contribution rate must
be set at a lower rate than the current DB plan normal cost rate. But this same
result could be achieved simply by reducing the benefit level in the DB plan. For new
hires, either a DB plan or a DC plan could set contribution levels at whatever benefit
level is identified as affordable by the administration and the General Assembly. The
commonwealth can reduce future pension costs in either a DB or DC scenario:
There is no intrinsic plan design cost benefit from a DC plan.
$2,000
$1,500
$1,500
Area shown to Right
$1,000 $1,000
$500
$500
$0
2007
2009
2011
2013
2015
2017
2019
2021
2023
2025
2027
2029
2031
2033
2035
Fiscal Year Beginning July 1 $0
PSERS DB Plan, Current Law 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
PSERS DB for Existing Members; DC Plan for New Members Fiscal Year Beginning July 1
Employer contribution rate for the DC Plan is set to the employer normal cost rate for the current DB plan. Assumes 0%
return in 2007-08 and 8.5% returns thereafter.
Certain SERS employers currently offer both DB and DC plans, and the DC plans
cost them more. Employees of the State System of Higher Education (SSHE) and
Penn State can choose their retirement plan. The two most popular choices are
SERS and TIAA-CREF, which is a defined contribution plan. For the TIAA-CREF
members, SSHE and Penn State must contribute 9.29 percent of salary per year [as of
January 2006]. This compares with the contribution rate for SERS of 4.0 percent in
2006-07 and 2007-08. The SERS normal cost rate of 8.42 percent is also lower than
the employer contributions for the comparable DC plans.
DC administrative costs may also be much higher over the long term – and
administrative charges are typically paid out of the participants' accounts, which
reduces investment returns.
Proposal 2: Make a “Fresh Start” on the Pension Systems’ Asset and Liability
Bases
4.10 SERS’ and PSERS’ strong recent investment performance have led some legislators
and other interested parties to advocate for various “Fresh Start” proposals.
4.11 Fresh Start proposals would reduce the systems’ official unfunded liabilities by
statutorily resetting the credit base of each system’s assets to recognize all of the
systems’ strong recent investment gains in a single year. Because SERS and PSERS
have recorded consistent, above-average returns since 2003, a Fresh Start would
improve the systems’ funded position on paper, because their actuaries normally
recognize each year’s investment gains and losses incrementally over five years. This
“five-year smoothing” method is commonly used in the public sector because it
reduces the impact of investment volatility by recognizing on the books, in each year,
only 20 percent of the investment gains and losses recorded in each of the prior five
years.
4.12 After “Fresh-Starting” the asset base at market value, the systems would slowly
phase back into the smoothing method over five years.
4.13 Assuming constant 8.5 percent annual investment returns (the systems’ current
assumption), a market value Fresh Start would maintain the commonwealth’s
contribution rates at similar levels to today’s. Further, using an 8.5 percent returns
4.14 However, in the absence of any additional contribution rate protection (see section 5
below), the systems’ five-year smoothing methodology is a critical means of insulating
PSERS’ and SERS’ $100 billion asset base from market volatility. As previously noted,
average annualized long-term investment performance for both systems over the past
10 years has been strong. However, there have also been occasional periods in
which investment returns have been considerably below long-term averages. If
investment performance suddenly deteriorates for whatever reason during the first
five years after a Fresh Start, and if the systems are unable to achieve their 8.5
percent annual earnings assumption for one or two years, SERS’ and PSERS’ asset
bases will have no unrecognized gains on hand to help offset these losses.
4.15 Fresh Start advocates have proposed that some of the potential contribution rate
volatility in the first few years following the Fresh Start could be partially offset
through the use of a temporary collar on rate increases or decreases. However, the
primary objection to the Fresh Start is not that contributions could increase or
decrease too rapidly in the first few years depending on market performance
(although that is a key concern). The key weakness in this approach is that if the
systems are unable to match their 8.5 percent annual return assumption for just one
or two of the first five years of the Fresh Start, they will have no unrealized gains to
offset these losses, and as a result, their funded status will deteriorate significantly.
4.16 Under the Fresh Start approach, a temporary downturn in the markets could
dramatically worsen the pension crisis in Pennsylvania: Not only would the
commonwealth have to prepare for and deal with much higher required contribution
rates, but added to the mix would be a much-deteriorated funded ratio of assets to
liabilities.
4.17 Pennsylvania is facing the looming FY2012-13 rate spike in part because of an
actuarial mismatch that promised short-term relief from a long-term funding crisis.
Enacting a new actuarial technique for the sole purpose of enhancing the funding
position of PSERS and SERS on paper would bring with it the possibility of even
tougher challenges in the future should the markets fail to match the systems’
expectations.
4.18 Increasing statutory contribution floors up to the normal cost rate has been
proposed by some legislators and other interested parties as the way to reduce the
FY2012-13 rate spike.
4.20 With the new floor, the commonwealth would still be required to fund a single-year
increase in employer contributions of $441 million, or 86 percent, between FY2011-
12 and FY2012-13, and even this depends on investment performance returning to
the long-term earnings assumption of 8.5 percent for the entire period between
FY2008-09 and FY2012-13.
4.21 Even with the new contributions floor, school employers would face a single-year
increase of 115 percent between FY2011-12 and FY2012-13.
4.22 As a result, a new PSERS floor would not eliminate the threat of tax increases or
severe cuts in critical state and school district services in FY2012-13.
4.23 For SERS, an increase in the minimum employer contribution floor from 4 percent to
5 percent (as proposed by Senate Bill 826) would require the commonwealth to
increase its contributions to the system by approximately $60 million per year for
the next four years.
• The effectiveness of a new 5 percent floor in mitigating the rate spike depends
on investment performance remaining strong for the entire period between
FY2007-08 and FY2012-13.
4.24 Moreover, a permanent 5 percent floor for SERS would not provide an answer to
the other major challenge facing SERS funding, which is that current employer
contributions are significantly below the normal cost rate. The normal cost rate is
the cost of the benefits accruing to active employees in the current year, and is
currently 8.42 percent of payroll. This discrepancy between the cost of current
employee retirement benefits and the actual contributions that are being made on
their behalf means that each year SERS adds new unfunded liabilities that may need to
be paid by future Pennsylvania taxpayers and system annuitants.
4.25 Because PSERS contribution obligations affect the financial stability of all of
Pennsylvania's 501 school districts as well as the commonwealth itself, Pennsylvania
needs a pension funding proposal that resolves the rate spike challenge for both the
commonwealth and our school districts.
5.2 The proposal calls for the commonwealth to adopt a new policy to determine the
annual pension contribution rate for SERS and PSERS.
5.4 The first component of the administration’s plan will eliminate the forecast FY2012-
13 contribution rate spike by making three reforms to the current approach to
funding the pension systems.
• Prohibit contributions from falling any further before FY2012-13:
In the absence of corrective short-term action, commonwealth and school
employer contribution rates for PSERS are actually now scheduled to decline for
the next several years before increasing severely in FY2012-13. To correct this,
a higher contribution rate floor for PSERS should be set at the FY2007-08
pension rate (6.44 percent) for the next four years through FY2011-12.
This increased rate will prevent contributions from falling over the next five
years only to have to increase dramatically in 2012-13. Although this action is
insufficient to prevent the spike on its own (see Chapter 4), the higher floor
lessens the relative rate increase that will be faced by the commonwealth and
school districts in FY2012-13, and will produce additional revenues that will help
to reduce the size of the rate spike.
5.5 To ensure that the commonwealth is protected from severe peaks and valleys in the
contribution schedule on an ongoing basis, a permanent system of floors and
collars on contribution rates should be implemented to limit annual changes in the
contribution rate (either up or down).
5.6 The systems would still calculate an actuarial rate each year, but changes in the rate
(both up and down) would be limited to the increments shown in the table below.
5.7 The collar is “looser” the further each system’s funded percentage is from 100
percent (fully funded), and the schedule is prudently asymmetrical in that decreases in
the contribution rate occur more slowly when the funded percentage exceeds 100
percent than increases occur when the funded percentage is below 100 percent.
5.9 If a plan is below 100 percent funded, the systems would certify their annual
contribution rate at the lesser of (1) the calculated actuarial rate or (2) the prior
year’s rate plus an increment that changes according to the degree to which the
pension system is under-funded (per the table above)
5.10 If the system is greater than 100 percent funded, the rate would be the greater of (1)
the actuarial rate or (2) the prior year’s rate minus an increment.
Assumptions
Suppose the employer contribution rate for a system in FY2014-15 is 7.8 percent. Prior to the
FY2015-16 valuation, the pension system experiences a loss, decreasing the funded percentage
from 100 percent in FY2014-15 to 89 percent in FY2015-16.
Suppose also that the normal cost rate is 8.0 percent, and an initial actuarial rate of 9.0 percent
has been calculated by the system’s actuaries for FY2015-16.
In this case, the final rate is the lesser of the 9.0 percent initial actuarial rate and the 8.55
percent rate calculated using the collars approach.
Contribution rates cannot fall below the normal cost rate (8.0 percent) minus 2.0 percent = 6.0
percent, but the final employer rate in this case is sufficient because it is higher than this floor.
Assumptions
Suppose that the employer contribution rate for a system in FY2017-18 is 8.9 percent. Prior to
the FY2018-19 valuation, the pension system experiences an actuarial gain, increasing the
funding percentage from 100 percent in FY2017-18 to 111 percent in FY2018-19.
Suppose also that the normal cost rate is 8.0 percent, and an initial actuarial rate of 7.5 percent
has been calculated by the system’s actuaries for FY2018-19.
In this case, the final rate is the greater of the 7.5 percent initial actuarial rate or the 8.4 percent
rate calculated using the collars approach.
Contribution rates cannot fall below the normal cost rate (8.0 percent) minus 2.0 percent = 6.0
percent, but the final employer rate is sufficient in this case because it is higher than the floor.
5.11 Should a period of significant sustained market losses occur, there is a possibility that
the underlying assets and liabilities (and thus the contribution rate needs) of SERS and
PSERS could change faster than the collar system can adjust to. While this is an
unlikely scenario, the consequences would be serious and therefore provisions
should be made to deal with it.
5.12 To insure that system assets are protected if a protracted market downturn occurs,
a fail-safe provision should be implemented that will override the collars system in
certain scenarios. The administration’s proposal requires that annual increases in the
contribution rate must be at least sufficient to reach the actuarially-calculated rate
within a maximum of 10 years.
5.13 Each year, after determining the initial actuarial rate, the systems’ actuaries will also
calculate whether the initial rate should be overridden by a larger increase in the
employer contribution rate.
5.14 If the initial rate increase identified by the collars system is less than one-tenth of the
difference between the prior year’s rate and the current year target rate (the
actuarially-calculated rate), then the systems would increase the final employer rate
above the limits specified in the collars table, such that the annual increase is no less
than one-tenth of the difference between the target rate and the prior year's rate.
Assumptions
Suppose that the final employer contribution rate in FY2019-20 is 7.0 percent. A serious
market downturn leads the system’s actuaries to calculate a FY2020-21 initial actuarial rate of
12.0 percent. Suppose also that the system is 96 percent funded.
Before taking into account the fail-safe provision, this would generate a preliminary employer
contribution rate of 7.25 percent (0.25 percent greater than the rate in FY2019-20).
However, because the initial, calculated actuarial rate for FY2020-21 (12.0 percent) is greater
than this preliminary employer rate (7.25 percent), a fail-safe adjustment may need to be applied
in order to safeguard system assets.
In this case, this initial actuarial rate for FY2020-21 (12.0 percent) minus last year's employer
rate (7.0 percent) is 5.0 percent.
In order to reach the actuarially calculated rate within ten years, the systems would then
calculate one-tenth of this difference. In this case, the difference is 0.5 percent. The final
employer rate must be increased by at least this amount over the prior year’s rate in order to
meet the fail-safe requirement.
In this case, the “collars” approach would only increase the employer rate by 0.25 percent over
the prior year. Therefore, an additional 0.25 percent contribution is also needed as a fail-safe
adjustment, in order to reach the 0.5 percent increase that is required.
Therefore, the final employer contribution for FY2020-21 would be 7.5 percent (not 7.25
percent), a rate of increases that if continued would expect to reach the actuarial rate within 10
years.
5.15 The administration’s pension proposal does not make any changes in determining the
amortization rate. The systems would not undergo another Fresh Start and would
therefore retain current law amortization schedules. The proposal also retains five-
year smoothing of actuarial gains and losses in determining actuarial value.
5.16 Any new benefit enhancements or ad hoc COLAs enacted by the General Assembly
would be funded over a ten-year period with level dollar payments. Amortization
payments for any newly enacted benefits and COLAs would be added to the
contributions calculated through the floors and collars system outlined in this
section.
5.17 Future actuarial gains and losses would continue to be amortized using level dollar
funding.
5.18 The administration’s pension reform plan would address both the FY2012-13 rate
spike and the need to manage future pension system liabilities.
5.19 The changes proposed in this section deliver a funding schedule that provides for
incremental changes in contribution amounts so that future state budgets can
gradually absorb the impact of higher pension contributions. This provides greater
security that the commonwealth and school districts can meet all future pension
funding obligations.
$2,250
Combined state and schools contribution
$2,000
$1,750
$1,500
($ millions)
$1,250
$1,000
$750
$500
$250
$0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
$800
$700
Commonwealth contribution
$600
$500
($ millions)
$400
$300
$200
$100
$0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
$1,750
$1,500
Employer Contribution
$1,250
($ millions)
$1,000
$750
$500
$250
$0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Fiscal Year Ending
Combined PA Contribution ($ millions) $574 $546 $565 $584 $1,565 $1,835 $1,753 $1,775 $1,822 $1,871 $1,922 $1,975
Annual Change -5.0% 3.5% 3.4% 167.7% 17.3% -4.5% 1.3% 2.6% 2.7% 2.7% 2.8%
Reform Plan 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20
PA Contribution to PSERS ($ millions) $466 $479 $496 $513 $573 $645 $715 $788 $865 $949 $1,039 $1,135
Annual Change 2.8% 3.5% 3.6% 11.6% 12.6% 10.8% 10.2% 9.8% 9.6% 9.5% 9.3%
Sch Districts Contrib. to PSERS ($ millions) $369 $377 $385 $394 $447 $494 $538 $586 $637 $693 $752 $815
Annual Change 2.2% 2.3% 2.3% 13.3% 10.5% 9.1% 8.8% 8.8% 8.7% 8.5% 8.4%
PA Contribution to SERS ($ millions) $249 $286 $325 $366 $404 $418 $444 $476 $508 $541 $576 $613
Annual Change 14.9% 13.6% 12.6% 10.4% 3.5% 6.2% 7.2% 6.7% 6.5% 6.5% 6.4%
Combined PA Contribution ($ millions) $715 $765 $821 $879 $977 $1,063 $1,159 $1,264 $1,373 $1,490 $1,615 $1,748
Annual Change 7.0% 7.3% 7.2% 11.1% 8.8% 9.0% 9.1% 8.7% 8.5% 8.4% 8.3%
Note: PSERS rates include health care premium and commonwealth contributions are adjusted for quarterly cash-flow timing.
Includes 22.93% PSERS return as of 6/30/07 and 17.2% SERS return as of 12/31/2007. Assumes zero percent investment return
for PSERS in FY2007-08 and for SERS in CY2008. Assumes 8.5% returns for both systems in all future years.