The state teachers’ pension fund, PSERS, just reported a 6.7% return over the past twelve months. That is a very good investment return. Sadly, when starting from a deep hole, “good” isn’t enough to get out.
Pennsylvania’s two largest public pension funds have both been doing well in the markets recently, but it hardly matters because they are committed to making completely unrealistic payments. The Harrisburg-based pension funds, Public School Employee Retirement System (PSERS) and State Employee Retirement System (SERS), pay benefits to retired public workers using the compounded returns on money those workers contributed to the funds during their careers. The two funds together have about 850,000 members and $79 billion in assets ( source: public fact sheets from PSERS and SERS).
The rule for running a pension system is this: member contributions, plus expected investment returns, must be greater than or equal to promised benefit payments. Somewhere along the line, however, the state administration and its employee unions lost the script. Over numerous rounds of union contract negotiations through the decades, successive administrations promised benefits that weren’t realistic given what workers were willing to pay in. Today PSERS and SERS together are underfunded by a reported $70 billion, which is $5,400 for every man, woman and child in the state. To become fully funded, the pension funds would have to increase their assets by nearly 3/4ths, which is effectively impossible.
For example, the state collected and spent about $86 billion last year in its operating budget. If it wanted to close the pension funding gap immediately the state would need to redirect all spending on road maintenance, police services, court proceedings, welfare payments, wildlife supervision and prison programs for nearly a year. Obviously no such thing will happen.
Moreover, the true finding gap is even bigger than $70 billion. The pension funds’ numbers rely on an unrealistically high projection of future returns. SERS and PSERS calculations assume future annual rates of return of 7.25% and 7.5% respectively, compared with actual 10-year average returns of 7.2% and 6.3%. Both funds have missed their own self-imposed standard in the past, and with the 10-year US government bond (the guaranteed return available on the lowest-risk investment) currently yielding only 1.6% the next ten years look even more difficult. Absent a heroic performance and a run of good luck for the state’s investment managers, the pension funding gap will keep growing.
As a first step to getting out of the hole, the funds should level with the public by restating their liabilities based on a more realistic return assumption.
Next, with accurate numbers in hand, the legislature should move quickly to bring the state’s pension promises in line with reality. Public employees have to bear some burden: while the pension funding situation is not their fault, neither is it taxpayers' fault. Employee union leadership extracted unrealistic promises from pliant politicians flush with union campaign money, who either didn’t understand the math or didn’t care. Practically, bringing pension promises in line will require increased contributions for working pension members and/or reducing pension benefits promised but not yet earned.
For its part, the government can undertake asset sales, particularly the breakup and sale of its liquor monopoly, and contribute the proceeds to the pension funds.
For fairness' sake perhaps some of Pennsylvania’s past governors and union bosses should make a symbolic contribution by reducing their own rich pensions. After all, they created this situation.
To ensure this situation never repeats, defined-benefit pension plans, whereby the state promises a set of future payments regardless of market returns, must be phased out. Instead, the state should offer employees defined-contribution plans wherein employees earn the market rate of return on a mix of low-fee investments they choose from a menu according to their risk tolerance. Defined benefits would still be available: should an employee desire fixed, guaranteed payments, he could elect to have his pension money invested in commercially available low-risk annuities.
Public employees were promised something that was never realistic. Correcting years of bad policy won't be easy, but it is the only way forward.