After years of grappling with rising pension costs and unfunded liabilities, Pennsylvania lawmakers enacted significant changes in 2017 to reduce the financial burdens on taxpayers while ensuring that workers get promised benefits. Those efforts are bearing fruit in multiple ways.
Most recently, a bipartisan commission that was set up to determine how best to reduce retirement plan fees issued its final report, which included recommendations that could save the state an estimated $10 billion in investment costs over 30 years. That would far exceed the legislative mandate to find $3 billion in savings. In addition, the proposed changes would enhance how the plans for the state’s public workers and teachers assess and report financial risks. Part of that process involves setting a new requirement for annual stress testing of Pennsylvania’s two systems.
According to 2017 data, the Pennsylvania pension systems pay about $580 million annually in investment fees, an amount that exceeds 0.7 percent of assets—among the five highest levels in the country. These relatively high costs are driven by the state’s large allocations to alternative investments, such as private equity, hedge funds, and real estate, which are often accompanied by higher management fees. In fact, alternatives account for about 40 percent of the total assets for the State Employees’ Retirement System (SERS) and the Public School Employees’ Retirement System (PSERS) on a combined basis.
In addition to the focus on reducing fees, lawmakers wanted to make sure that the pension systems were positioned to weather economic cycles. Stress testing involves rigorous analyses that simulate a range of scenarios for economic projections and investment returns to provide policymakers and budget officials with a better sense of potential liabilities and costs. The information can be used to assess the fiscal health of the SERS and PSERS on an ongoing basis and help guide investments and state budget planning.
As one of the more comprehensive reforms efforts in recent years, the original legislation—known as Act 5—established a risk-managed hybrid retirement savings plan for new employees: part pension and part defined contribution plan. It also required the state to uphold its commitments to fully fund the existing pension system.
Officials estimate that these reforms will save taxpayers as much as $20 billion over the next 30 years, depending on investment performance, but lawmakers still had concerns about the hefty fees being paid to investment managers. The law established the commission to examine how the state could enhance investment transparency and reduce expenses. It also tasked the group with studying ways to improve financial risk reporting.
In May 2018, the Public Pension Management and Asset Investment Review Commission began meeting to evaluate ways to reduce fees, enhance the transparency of investment expenses, and improve risk reporting. The bipartisan commission, made up of policymakers and investment professionals, conducted a seven-month independent review of the PSERS and SERS. State Representative Mike Tobash (R) served as the chairman, and State Treasurer Joe Torsella (D) as the vice chair.
The commission took testimony from SERS and PSERS officials, as well as a range of academics and other experts in pension fund management and investments. Researchers from The Pew Charitable Trusts took part as well, following up the technical assistance provided to lawmakers throughout the 2017 reform process.
In December, the panel issued its final report, which was promptly endorsed by Governor Tom Wolf (D). Among the key recommendations, it said the state should:
- Maintain full payment of the annual actuarially determined contribution amounts to the pension plans.
- Establish a central pension investment office to help get better contract terms, eliminate redundancies between the SERS and PSERS, and develop internal investment management capacity.
- Enact legislation that mandates annual stress testing of the systems that is consistent with recommendations made by the Society of Actuaries Blue Ribbon Panel in a 2014 report.
- Increase transparency of investment costs, performance, and benchmarks.
- Enact legislation that mandates increased public reporting of all investment expenses.
- Move to fully index all public stock and fixed income investments rather than using active management to reduce overall investment management fees.
- Adopt measures to reduce risk, such as specific rebalancing policies and limits on the level of illiquid investments.
The Pennsylvania General Assembly may consider steps that require legislative action during the 2019 session.
State and local governments are struggling to meet promises made to public workers and teachers without putting further strain on taxpayers or cutting core services. At the same time, most public sector pension systems remain vulnerable to even a mild economic downturn because of historical underfunding, volatile investment returns, and rising benefit costs. As a result, efforts such as Pennsylvania’s to bring transparency to the real costs of investments and to add tools to measure and manage financial market risks are gaining traction nationwide.
In the last two years alone, six states have adopted formal requirements for routine or annual stress test reporting. And with the recent updates to national actuarial standards on risk reporting that put an emphasis on the value of such examinations, additional states are expected to follow.
Greg Mennis is a director and Chris McIsaac is an associate manager with The Pew Charitable Trusts’ public sector retirement systems project.
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