State pensions: After reform, officials sort out details

//June 23, 2017

State pensions: After reform, officials sort out details

//June 23, 2017

The changes outlined in Senate Bill 1, which Gov. Tom Wolf signed June 12, won’t start to impact new state hires until Jan. 1, 2019, and new public school teachers hires until July 1, 2019.

That gives Pennsylvania officials a little under two years to figure out key details about what happens next. Who gets the business of managing the 401(k)-style elements of the new plans, and how Pennsylvania makes sure its current employees have enough money to retire, are among the biggest questions facing state officials as they inch closer to those deadlines.

The answers have the potential to affect not just people who work for the state, but anyone who does business or pays taxes in Pennsylvania.

Public, private impact

The pension reforms Wolf signed this month are designed to make sure Pennsylvania can afford the retirement benefits for teachers and most other state employees.

The new plans achieve these savings by essentially cutting the amount of money, or defined benefits, the state will guarantee workers hired after the 2019 deadlines. These new employees will pay into plans with defined-contribution elements, which look more like the 401(k)s that are common for employees in the private sector.

Specifically, teachers and other state employees — with the exception of hazardous-duty workers like state police — will choose from three plans: a defined-contribution plan, and two hybrid plans, which combine a guaranteed benefit with defined-contribution elements.

The reforms mean state workers will have more control over how they invest their money, but will be less protected during economic downturns.

The potential impact on the private sector is a little more subtle.

For one, third-party administrators will take over the business of handling the defined-contribution plans, according to the legislation. That work could theoretically go to anyone with the expertise and capacity to handle it, said Jay Pagni, a spokesman for the State Employees’ Retirement System.

Big names like Vanguard, Fidelity and TIAA have dominated contracts in other states with similar pension structures. Those same types of large providers also oversee defined-contribution plans for Pennsylvania’s state-affiliated universities.

As with many of the details of the fledgling reform, how exactly the state plans to go about procuring a vendor remains to be determined.

“This is very embryonic right now,” Pagni said.

Businesses can also add the reforms’ tax implications to the long list of wait-and-sees that come along with the legislation. While some professionals may have watched hybrid plans bring about relatively quick costs-savings in their own companies, they will have to wait much longer to see those returns materialize for state government.

When private companies switch from traditional pensions to hybrid plans, they often freeze the defined benefit so that no new money is going into it, and future benefits for both new and current employees migrate to a 401(k) plan, said John Jeffrey, a partner at Susquehanna Township-based Conrad Siegel Investment Advisors Inc.

Things play out differently in the public sector, where unions often demand a starker line between new hires and existing employees. Although Republicans say the reform plan should save taxpayers more than $5 billion in the long run, plus up to $3 billion more in reduced costs and fees for investment management, the state is still on the hook for its current employees’ pension plans.

“It’s a win for the taxpayer long term,” Jeffrey said. “But it will take quite a while before it truly impacts the bottom line. For many years to come, the majority of the employee base is still going to be people getting the same benefits they always got.”

‘First step’

Like many elected officials and pro-reform groups who supported the bill’s passage, Jeffrey called it a “good first step.”

The State Employees’ Retirement System and Public School Employees’ Retirement System have combined unfunded liabilities of more than $70 billion, according to estimates. While the recent reforms help stop the bleeding, they do little to close the gap between the benefits the state has already promised employees and the money it has on hand to pay them.

“It does a good job of making sure promises we make in the future are ones we can certainly keep,” said state treasurer Joe Torsella, who sits on the boards for PSERS and SERS. “What it doesn’t do is make sure we can keep promises we already made.”

One of the most immediate steps the state can take to live up to those earlier promises is to cut fees and reduce redundancies between the two funds, Torsella said. He and Wolf have pushed for such moves over the past several months.

The pension reform bill has a mechanism to further prod the state in the direction of lower costs. The language, a few paragraphs deep in the bill, requires the boards to “strive towards” saving about $1.5 billion over the next 30 years.

Torsella hopes SERS and PSERS will keep in mind the idea of saving money through collaboration as they figure out how best to administer the new plans.

Here is a quick breakdown of the options Pennsylvania’s state employees will have under the new pension system:

1. The first hybrid option, which would become the default plan for those who don’t make a choice, would require the employee to contribute 8.25 percent of their pay for retirement.

For employees covered by SERS, 5 percent would go to the defined-benefit pension, while 3.25 percent would go to the defined-contribution, or 401(k)-style component. For employees covered by PSERS, the split is 5.5 percent pension and 2.75 percent defined contribution.

The guaranteed pension would be based on 1.25 percent of an employee’s final average salary multiplied by years of service. The final average salary is based on the five highest years, up from three now. For state workers, there is an overtime cap of 10 percent of base salary.

Once they retire, employees also can also draw from their defined-contribution account earnings.

2. The second hybrid option calls for a 7.5 percent employee contribution, which is split as 4 percent for the pension and 3.5 percent for the defined-contribution portion for employees in SERS. For employees in PSERS, it would be 4.5 percent pension and 3 percent defined contribution.

The guaranteed pension would be tied to a 1 percent multiplier, supplemented by the defined-contribution savings.

3. The standalone 401(k)-style option requires minimum employee contributions of 7.5 percent with no guaranteed pension. The employer contribution would be 3.5 percent for SERS members and 2 percent for PSERS members.

Still, the two pensions’ large unfunded liabilities need to be paid for over time. Based on some of the early reaction to the bill — that it’s not the comprehensive reform many were seeking — expect additional legislation to follow soon.

Gene Barr, president and CEO of the Pennsylvania Chamber of Business and Industry, compared pension reform to the recent changes in state liquor laws. When Republican lawmakers tried to pass sweeping privatization, nothing happened. When the pieces were broken up, legislation passed, and new bills are now looming.

Not everyone believes the reforms are a step in the right direction.

One reason pensions are so underfunded is that the state hasn’t made consistent contributions over the years, said Stephen Herzenberg, executive director of the liberal-leaning Keystone Research Center.

Herzenberg believes Pennsylvania’s traditional pension could have continued working if the state had consistently funded it and allowed earlier reforms, enacted in 2010, more time to take effect.

“The whole debate has assumed that the big unfunded liability is a consequence of having a defined-benefit plan,” he said. “We didn’t put in enough money.”

What about the people?

Anyone hiring in the private sector could list the bag of tricks companies pull out to attract talent: competitive salaries, flexible work schedules, health care packages.

But in the public sector, where traditional pensions have lasted longer, retirement benefits often trump all else.

“Public employees place an extremely high value on their retirement plans,” said Diane Oakley, executive director of the National Institute on Retirement Security. “What kind of workforce implications (are pension reforms) going to have, especially if that plan isn’t going to produce that same kind of value?”

How employees will react is another unknown as the new plans make their debut.

Herzenberg believes the legislation will help maintain retirement security in the public sector, despite its shortcomings. He cautioned, however, that the key will be finding the right mix of high-return options for the lowest possible rates. That should be achievable given the high volume of public-sector employees in Pennsylvania, which creates stronger buying power.

The need for good returns and adequate investment from both employees and employers is especially important given the fact that most Americans aren’t saving enough for retirement, according to recent studies.

Teachers and other state employees will have three avenues through which to amass savings under the new legislation. Pension experts expect that most state employees hired after the plan’s enactment in 2019 will choose one of the two hybrid plans because most people want as much guaranteed pension benefit as possible.

In other states that have offered employees a choice between defined-benefit and defined-contribution plans, the employees who have gone with the latter have tended to be the ones who aren’t interested in sticking with a job for the long run, Oakley said. Pennsylvania’s shift away from guaranteed pensions, even though the hybrid plans still offer some defined benefit, could mean higher turnover among state employers.

Despite the risks, at least 10 states offer hybrid plans for public-sector employees. Each is unique as states have found that there is no one-size-fits-all solution. The Pew Charitable Trusts said Pennsylvania’s reform should mitigate more risk for the state than reforms passed elsewhere because employees are sharing in much more of the contributions.

As Pennsylvania was making pension changes, Florida opted to make its optional defined-contribution plan the default for new hires. About 18 percent of active members in the Florida Retirement System had chosen the defined contribution option over the pension plan as of June 2016, according to the Reason Foundation.

Pennsylvania will find out in 2019 if its guaranteed benefits, no matter how small, will prove the more popular choice here.

What officials do know is that once employees choose their plan style, they can’t change their mind. There’s no switching allowed.