The state of Pennsylvania, as well as many other states, faces a pension crisis. The state has not set aside enough money each year to pay the pensions it is legally obligated to pay state workers and public school employees. Because of its failure to fully fund its pension system, credit rating agencies have downgraded the state’s debt. This means the state has to pay higher interest rates whenever it borrows. Although legislation has been proposed to fix the problem, legislators have failed to act and the problem is becoming increasingly urgent. Now is the time for the PA General Assembly to take action both to substantially increase funding each year, but also to reform the pension system so that newly hired workers are not promised retirement benefits that are not fully funded during their working years.
Pennsylvania, like every other state government, has a defined benefit (DB) pension plan. Each state worker and public school employee is to receive a pension that is determined by a formula that accounts for how much the employee earned and how long the employee worked for the state or public schools. The amount of money in the pension fund depends on how much employees and the employer contribute and on how much the assets appreciate in value over time. Ideally, the amount added to the fund each year plus investment returns should be enough to account for the increase in the amount owed to state employees as a result of their working one more year. But the actual amount contributed in recent years has usually been much less than that.
It might appear that the way to resolve the pension crisis would be to move state workers from defined benefit plans to defined contribution (DC) plans, where the employer and employee contribute a specified amount that is invested on each employee’s behalf. It is not likely, however, that courts would permit the commonwealth to move existing workers from DB to DC plans. Thus the most that could be done is to offer a DC plan to newly hired workers. Such a change could gradually reduce the seriousness of the problem over time, but it would not fix the most pressing problem. That problem is not setting aside enough money in the pension fund to pay current workers and retirees what they will be owed in the future.
In almost every year since 2001, Pennsylvania has added too little to the pension funds to fund the growth in what the state owes current workers (accrued liabilities). As unfunded liabilities grow, the expected cost to future taxpayers increases by the amount of the shortfall plus the reduction in investment earnings resulting from the smaller amount invested.
It is urgent that the state contribute more each year to the pension fund to reduce unfunded accrued liabilities (UALs). Given the substantial amount of liabilities that are not funded, fixing the problem will take a long time. At the very least, the state should increase contributions so that UALs are no longer growing as they have been.
If the state does not take steps to reduce unfunded accrued liabilities, taxpayers will have a very large debt to pay in the future. The most fiscally responsible approach would be for the state to contribute enough each year so that those liabilities eventually decline to zero and the pensions are fully funded. Whether or not it contributes more every year until the pensions are fully funded, the state will need to contribute extra in the future to offset what it did not contribute in the past.
Contributing enough each year to move state pensions toward full funding will be difficult. It would require that the commonwealth transfer approximately $2.5 billion from the general fund to the pension funds each year in addition to what the state is already planning to contribute. This would require a cut in spending for other programs or an increase in taxes of about 8 percent.
If contributions to the pension fund from the general fund do not increase, then the state employee retirement system and public school employee retirement system funds will gradually become depleted. If that happens, then all pension payments to retirees will need to be paid out of the general fund. Funding all current pension payments out of the general fund would either require a huge reduction in spending on state services or a big tax increase. If all current pension payments had to come out of the general fund budget it would consume about 35 percent of that budget.
If we continue to ignore the pension funding crisis in Pennsylvania, we are imposing a substantial burden on future generations. The problem is already large enough that it will be painful to fix, but each year of inaction only adds to the size of the future cost to taxpayers, which will likely be felt through higher taxes or reduced state spending.
Dr. Tracy C. Miller is a fellow for economic theory and policy with The Center for Vision & Values. He holds a Ph.D. from University of Chicago.