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The Funding and Benefit Structure of the Statewide Retirement Systems: A Report with Recommendations
Authorization: 2001 Senate Resolution 286


The study pursuant to 2002 Senate Resolution No. 286 has reached the following conclusions regarding the funding and benefit structure of the statewide retirement systems:

Financial Soundness
• At present the systems are financially sound, with a funding ratio higher than all but a few systems in sister states. However, actuarial projections forecast sharply increasing employer contribution levels. Within the next ten years employer contributions are projected to reach a higher percentage of payroll than ever before.

Comparisons with Other States
• Largely because of a high benefit multiplier and the option to withdraw employee contributions at retirement, the Public School Employees’ Retirement System (PSERS) and the State Employees’ Retirement System (SERS) would appear to be among the more favorable statewide defined benefit retirement plans. The higher employee contribution makes PSERS less generous than SERS. The least favorable feature of the plans is most likely the lack of guaranteed inflation protection.

• The wide variety of terms of the statewide public retirement systems makes it very difficult to rate them comparatively. A valid comparison of retirement benefits should examine them in the context of total compensation and, indeed, all terms and conditions of employment, a task that is beyond the scope of this study.

Benefit Adequacy
• The conventional analysis of the adequacy of retirement benefits measures preretirement income against equivalent postretirement income. Largely because retirees do not incur work-related expenses and have a lower tax burden, the postretirement income may be about 25% lower than the preretirement income and still support the preretirement standard of living. The ratio of the retirement benefit to the income amount considered equivalent to the preretirement income is the replacement ratio. If that ratio is 100% or greater, the replacement ratio target is met.

• PSERS T-D and SERS AA general employees working for at least 30 years and retiring at age 65 will have sufficient pension benefits, in combination with Social Security, to meet or exceed applicable replacement ratio targets.

• SERS uniformed and safety employees receive a sufficient pension to meet the replacement ratio targets once Social Security commences, but require bridge income until eligible.

• The programs do not provide benefits that equal or exceed the replacement ratio targets on a stand alone basis. Social Security benefits, and in some cases, bridge employment, must be included to meet the targets.

Employer Contribution Rates
• Actuaries for the systems currently project employer contribution rates to rise sharply in the near future, to a peak of 27.73% of payroll for PSERS (in FY 2012-13) and 24.21% for SERS (FY 2011-12). These rates, easily higher than any in the history of the systems, are especially disconcerting because they follow a period when the rates fell to 0%.

• The primary cause for the escalation of employer contribution rates is the poor performance of the equity markets from 2000 to 2002. However, the benefit enhancements enacted by Act 9 of 2001 and Act 38 of 2002 contributed toward making the systems more vulnerable to weak investment returns.

• The adoption under 2003 Act No. 40 of a 30-year amortization period for recent investment losses and future gains and losses not caused by benefit enhancements may help alleviate the pressure on employer rates caused by the ten-year amortization under Act 9.

• Consistent funding at normal cost would reduce the probability of wide fluctuations in employer contribution rates. The employer contribution rate floors instituted by Act 40 represent a step toward a more consistent funding strategy.

Cost-of-Living Adjustments
• Like some other states, Pennsylvania has responded to the erosion of the purchasing power of pension benefits by the enactment of ad hoc cost-of-living adjustments (COLAs). These have generally come at intervals of four or five years. Recent COLAs have attempted to make up for at least one-half of the lost purchasing power since the last COLA or retirement, whichever was later.

• Most states use some variant of an automatic COLA based on the Consumer Price Index, modified in a variety of ways to reduce the cost. While expensive, automatic COLAs can be funded on a normal cost basis.

• Despite the desirability of inflation protection in our inflationary economy, COLA protection of retirees is rare in the private sector.

• COLAs and benefit enhancements must be considered in the context of the other benefits provided by the plan. Given the relatively high benefit multiplier provided by the systems since Act 9, future retirees may be able to maintain adequate benefit levels without COLA legislation.

• The benefit adequacy analysis suggests that long-term retirees may be able to largely protect themselves against inflation by saving an appropriate portion of their benefits.

• Techniques exist for tying the grant of COLAs to investment performance or to an employee option to assist the funding by an increased contribution or a reduced benefit multiplier. These may be considered preferable to funding the COLA entirely by amortization.

Early Retirement Incentives
• Early Retirement Incentive Programs (ERIPs) liberalize retirement benefits to induce employees to elect early retirement, usually by removing actuarial benefit reductions that would otherwise apply. For the Pennsylvania statewide retirement systems, the predominant inducement has been “30 and out”: reduction of the service requirement for full retirement benefits from 35 to 30 years.

• ERIPs are often used to reduce payroll expenditures. Payroll savings are usually limited to the first three to five years after an ERIP is offered.

• The keys to a successful ERIP include strict controls over the filling of vacated positions and the salaries of replacements. Public agencies have a difficult time maintaining adequate controls on rehiring.

• ERIPs can be very expensive in the long run because pension benefit costs, combined with the payroll costs of replacement employees, are likely to outstrip initial payroll savings.

Defined Contribution Plans
• Under a defined contribution (DC) plan, the amount of the benefit depends on the amount contributed to the plan by employers and employees and investment returns on those contributions. This arrangement is attractive to some public employers because such a plan is fully funded by definition. However, defined benefit (DB) plans continue to predominate among public employees throughout the nation.

• DC plans shift investment risk to employees. Because employees rarely match the professionally invested returns under a DB plan, the effective benefit under DC is generally lower per amount contributed than under DB.

• DC plans offer superior portability and afford larger benefits to employees with shorter service. DB plans favor workers with longer service.

• Transition from a DB to a DC or DB-DC hybrid is a difficult undertaking that requires careful consideration of a host of issues. Because of this, and because the respective advantages and disadvantages of the DB and DC structures seem to nearly balance out, no recommendation is given on this issue.

Stabilization of Employer Costs
The General Assembly and the retirement systems may wish to consider the following strategies to control increases in employer contributions to the retirement systems:
• Presumptively set an employer contribution floor at normal cost, with measured reductions if warranted by high investment returns, pursuant to a predetermined formula or mechanism

• Investigate alternative methods of adjusting contribution rates for investment returns

• Include recurring plan changes in plan design by including them in the normal cost

• Lay off return risk by purchasing annuities to cover retirement benefits, using vehicles that permit the system to participate in positive returns

• Educate public employers on the unfavorable consequences to the systems of granting preretirement salary increases primarily to boost individual pension benefits

• Closely monitor the effect on the plans of such factors as public and private initiatives, the retirement of the baby boomer generation, and regional variations in economic and demographic conditions

Providing Future Benefit Increases
The General Assembly may wish to consider adopting one of the following approaches toward structuring the systems to permit future COLAs and other benefit increases at a reasonable cost to public employers and taxpayers:

• Adopt a more conservative rate of return assumption and fund COLAs from resulting actuarial gains

• Set aside a portion of actuarial gains as a reserve fund, which can be drawn upon to defray COLAs

• Create an optional benefit tier that includes a guaranteed COLA formula in return for increased employee contributions

• Provide an automatic benefit increase when investment returns exceed a certain predetermined level on a year-by-year or cumulative basis

• Include firm controls on replacement rates and salaries in any ERIPs, and institute them only when necessary to reduce immediate payroll cost or improve the age mix of the workforce.