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Taming Pac-Man

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You've heard of the carrot and the stick?  It appears Gov. Corbett will be trying a variation on that tactic when it comes to taming the cost of public pensions.  Call it the stick and the stick.

Corbett made clear last week that when he presents his new budget proposal next month he will not be taking any more whacks at state funding for public school and state-owned and related universities if...

Maybe that should be IF...

The legislature approves changes he plans to propose on state funding for pensions for state employees and school teachers in districts across Pennsylvania.

The two pension funds currently have a long-term deficit of $41 billion, an unfunded liability amounting to 32 percent.  The unfunded liability is actuarial speak for the difference between the funds obligations to current and future retirees and its assets.

In order to fill the hole, the state and local school districts must increase their contributions to their respective funds.  The state is solely responsible for the state employees retirement fund.  It splits the difference with local school districts in feeding the school employees pension fund.

Under formulas currently in the law, payments to both will escalate dramatically over the next eight or nine years until the $41 billion hole is filled.

According to a report by the governor's Budget Office, the additional payments are so substantial they will eat up available new funding.

For instance, the projection is that while tax revenue will rise by $818 million in the next fiscal year, state payments to the pension funds will rise by $511 million. That leaves $307 million to fund any and all increases in spending in the rest of government.


As the budget report puts it: "Gov.Corbett has vividly described this dynamic as a 'tapeworm' or 'Pac-Man' eating away at the state's budget, an acknowledgment that growing pension costs are severely undercutting the commonwealth's ability to fund essential programs and services."

What to do about it?  There's the rub. By law, the state cannot cut the pensions of retirees.  It is obligated to pay.  Currently, the state pays out about $8 million a year to the 300,000 retirees covered by the two funds.

It may sound sensible to end the current defined benefit plans, whereby your pension is guaranteed based on formula that takes into account years of service.

Private industry long ago abandoned defined benefit plans in favor of defined contribution plans: you set up a 401k, they often match whatever you contribute.

But an abrupt shift from the current method to a 401k-like plan would deprive the two funds of the employee contributions that currently go into it, further depleting its assets.

(Pension funds are like Ponzi schemes.  They take the money contributed by the newest participants to pay the pensions of retired ones.)

Corbett, who plays his hand close to his vest, hasn't said what he will propose, but if I had to guess I would say he will tinker with the formula used to determine the size of the pensions.

It's been done before.

In 2010, confronted with a rising deficit in the pension fund, the legislature passed a law that applied only to new employees.  Among other things it: reduced the pension multiplier from 2.5 to 2.0 percent, raised the retirement age from 62 to 65, and included a provision that required employees to contribute more if the pension fund did not reach its investment goals.

A word about the multiplier.  It is a crucial part of the formula in determining a pension.  The formula goes something like:  years of service x final average salary x the multiplier.

So, if you are a 30-year-employee, with a final average salary of $50,000, you would multiple your years of service by 2.5 percent.  30 x 2.5 = 75.  You would retire at 75 percent of your final salary.  Your pension would be $37,500 a year.

For the post-2010 employee, though, the formula will 30 x 2 percent for a pension equal to 60 percent of their salary -- or $30,000 a year. It amounts to a 20 percent reduction.

Can Corbett change the formula in mid-stream for current employees? In other words, can he tell an employee who has been with the state for 10 years that their multiplier will be 2.5 percent for that period, but drop to 2 percent in future years?  He probably can.

The legislature giveth and the legislature taketh away.  The multiplier was 2 percent for many years under 2001 when the legislature increased it to 2.5 percent.  At the time, the state employee pension fund was flush with cash and the legislature figured the state could pay for the increase through investment earnings thanks to booming stock market  (Remember the tech boom?).  Well, the market promptly crashed. And it crashed again during the Great Recession sending the value of pension funds all over the country tumbling.

Pennsylvania is not the only government with a pension problem.  Nearly every state and local government has one.  Philadelphia's is in even worse shape than Pennsylvania.  The city's pension's accrued liability stands at 53 percent.

How did we get into this mess?

In theory pension funds are supposed to work this way: the employee contributes money, the employer contributes money.  The fund manager invests the money in stocks and bonds and earn money on those investments.  Combine them together and they should cover the cost of providing pensions. That's the way it worked for years.

Three things happened to make the situation different in Pennsylvania.

One was the downturn in the stock market throughout the first decade of the new century. Funds that were earning double digits suddenly were losing money.

Second, the state failed to keep up with its contributions at an appropriate level.  It used temporal upswings in the market (and the value of the fund) to give itself sort of a contribution holiday, making smaller payments and diverting that money to other programs (including, during the Rendell years to basic education.)

Third, they jacked up benefits beyond what actuarial prudence dictated.  For instance, when the legislature hiked pensions by 20 percent during the Ridge administration in 2001, it assumed the stock and bond markets would chug along, yielding double-digit gains on investment.  So much for that idea.

If Corbett can devise a plan that would lower the cost of pensions, it will enable the state to lower its emergency contributions to the funds, freeing up money for other state programs.  But, it will also mean lower pensions for state workers and school teachers -- sometimes significantly lower than what they were planning for retirement.

This has the makings of a donnybrook.

-- Tom Ferrick

 

 

 

 

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