With disputed elections and a national pandemic occupying most of the political conversation, ordinary budget issues tend to take a back seat. But with Governor Wolf soon to release his proposed budget, some of those issues will cycle back to the top of the news, if only briefly. When they do, we should pay special attention to a long-running problem in the Commonwealth and most other states: the growing cost of state employee pensions.
Private businesses, being accountable to market forces, had to deal with their pensions crisis years ago, and mostly shifted people out of traditional pensions (i.e., defined-benefit plans) and into 401(k)s and IRAs (defined-contribution plans). They were and are limited by having to pay for things they promise. State governments may not be able to run up their deficits the way the Congress can, but they can shift debt obligations so far into the future that voters do not notice them. Shareholders would react badly to this in a private business. In government, it happens all the time.
Pennsylvania has about 140,000 full-time state employees, according to the U.S. Census Department’s 2019 Annual Survey of Public Employment & Payroll, and about 48,000 more part-time workers. A significant portion of the state’s workforce depends on our state’s taxpayers to fulfill their pension obligations when they retire. At the rate pensions are being funded in Pennsylvania, that looks far from certain.
The bill will come due someday, and in some states that day is not far off. Pennsylvania is not the worst state when it comes to pension shortfalls — Illinois is the undisputed titleholder in that field — but the Commonwealth is below the national average by any measure. Just over half (54.8%) of the state’s pension promises were funded as of 2018. The debt service-to-revenue ratio in Pennsylvania is the eighth-worst in the nation, according to a J.P. Morgan analysis. Moody’s Investors Service notes that Pennsylvania’s pension shortfall (the difference between what is promised and what is available) is the nation’s sixth-worst.
Meaning, a pensions crisis is not far off for Pennsylvania — no matter how little you hear about it from our state’s leaders.
The City of Philadelphia is in even worse shape. Pension funding has been on a steady decline in the last decades. A Pew Trusts report from 2019 notes the alarming slide from city pensions being 77.5% funded in 2001 to just 46.8% funded in 2018, even worse than the rest of the state. Taxes keep increasing, but the money never manages to fix the problem.
Part of that is because even as the cost of employee pensions rise, states and cities keep hiring more. The cost of pensions are growing even faster than tax revenues, so that even in places with relatively good business climates, rising costs and debt obligations continue to outpace the ability to pay for them. Businesses have had to make hard choices for this reason. Governments act like nothing has changed.
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States and municipalities exacerbate the looming fiscal problems by writing into official predictions a much higher rate of return for pension investment funds than the market will actually deliver. This is a ruse, and one that makes it easier to kick the can down the road in the short term. If these high rates of return were realistic, the value of the funds would grow and less funding would be needed. But as this report from Equable shows, the average state’s assumption has been far below the actual rate for many years now. The result: funds are not growing fast enough to keep up with the pensions they pay out, and the state is not putting in enough, either. It all adds up to a ticking fiscal time bomb.
Republicans used to be associated with financial prudence, but this problem cannot be attributed to only one party. It is true that Democratic states tend to have much worse fiscal problems, but the GOP is certainly not immune from kicking the can down the road, as seen in the massive explosion of federal debt under President Trump. The economic downturn of the last year will surely push many more states farther into the red.
After recklessly increasing pensions in 2001, Pennsylvania has made some progress. The legislature used to enact ad hoc cost of living increases (COLAs) for retirees that outpaced the rate of inflation, but have not done so since 2002. In 2010, the legislature reduced benefits for new hires and increased the amount employees contribute to their own retirement — though this is still below the rate most private sector employees contribute to theirs. The state also made local governments pay more, but that merely shifted the burden of debt rather than addressing the root cause: unsustainable financial promises made to future retirees.
The big change came in 2017, decades after the private sector had shifted to this model, when the state required new employees to join a defined-contribution plan instead of the defined-benefit plan that had existed before, or to join a hybrid of the two. In 2019, the state cut its assumed rate of return slightly, from 7.25% to 7.125%. That hardly corrects the problem, but it is a small step towards reality.
Still, more needs to be done to bring the state back to fiscal solvency. People speak of an underfunding crisis, but most of the problem is really an overpromising crisis. Plenty of businesses have done the same over the years, promising big retirement benefits in place of current pay increases. A lot of them, like General Motors, ended up bankrupt, but states do not have that option. Instead, they ask the taxpayers to cough up more money so they can double down on their bad decisions.
People speak of an underfunding crisis, but most of the problem is really an overpromising crisis.
Legislators (and many voters) have the habit of believing that if they want something bad enough, they can just vote it into being with no negative consequences. But wishful thinking and good intentions cannot hide that truth that real life involves tradeoffs. Delaying the pain will not mitigate it in the long term — and will likely make it worse. Those who point this out are called heartless, but it is far crueler to make promises that can never be fulfilled.
Waiting for pension funds to fail will mean sudden and drastic cuts for retirees who can ill afford it. It would be better for Harrisburg to be truthful with state employees up front, promising only what the state can actually deliver and letting people plan their retirements based on honest projections.
Pennsylvania needs to get smart and fix the problem instead of kicking the can for tomorrow’s taxpayers. The state should take away the hybrid option for new hires and enroll them in a pure defined-contribution plan. Increasing the employees’ contribution levels is essential. The private sector realized this long ago as people who retired at 65 began to live, on average, for decades after. Now it’s time for Pennsylvania and other states to catch up to reality.