July 30, 2013
By Rick Dreyfuss
In recent days, Pennsylvania’s debt was downgraded by Fitch Ratings, Chicago’s debt was downgraded three notches by Moody’s Investors Service, and Detroit sought protection through the ultimate downgrade by declaring bankruptcy.
Like most states, Pennsylvania has its share of public pension challenges; a combined unfunded liability of $47 billion equates to more than $3,600 per resident. The recent failure to pass any meaningful pension reform legislation resulted in the state’s downgrade. [EXPAND Read more]
It is likely other rating agencies will follow suit. Inaction on the part of legislators has, in effect, endangered the fiscal health of the Keystone State.
This is a crisis that will only get worse under any scenario. Fitch’s clearly expressed rationale for the downgrade indicates Pennsylvania’s path to solvency is unlikely to improve over the next several years: The commonwealth’s unfunded pension obligations are expected to rise as long as pension funding remains below actuarially required levels, and managing the demands of pension obligations on the operating budget is a key fiscal challenge.
By actuarial standards, this year’s appropriation underfunds the two largest state pension plans by more than $1 billion at the state level alone, giving new insights to the term balanced budget. To date, none of the numerous pension “reform” bills have properly addressed the unfunded-liability concern. In fact, legislative proposals have sought to further defer such liabilities.
In three years, the pension reforms of 2010 have already cost taxpayers more than twice the 30-year projected cumulative savings. Most policymakers appear content to do nothing other than suggesting that, in 30 years or so, all this will resolve itself.
To the current crop of Pennsylvania public officials, compliant pension funding is someone else’s problem. This false hope that the ship will be righted on its own is predicated on three expectations: a rosy annual-return assumption of 7.5 percent, a prediction that unaffordable future contributions will actually be made, and an assumption that no additional benefit improvements, including pension cost-of-living adjustments, will ever be adopted.
It is likely that none of these three assumptions will prove to be valid. Here is where the unspoken political reality hits home: Few have demonstrated the political will to support contributing 100 percent of what the actuaries recommended. Doing so would require redirecting revenue away from existing programs or considering new revenue sources – all in the name of reducing an unfunded liability that seems distant and intangible.
Pension plans have long-term horizons by nature. This makes it politically convenient to defer inconvenient costs. The rationale is, “We will always have forever to pay this off.” Unfortunately, some policy-makers who misunderstand reality are once again turning to pension obligation bonds as a panacea. A debt-leveraging financing scheme, this would effectively be an attempt to borrow our way to prosperity.
That such bonds were made illegal in 2010 seems to be no impediment to those arguing for a pseudo-reform that has already failed in Philadelphia, Pittsburgh, and Allentown, as well as states such as Oregon, California, New Jersey, Illinois, and Connecticut. Pensions are designed to be funded as benefits are earned, not simply assigned to future generations for short-term political expediency. Also on the table is the question of whether newly hired state employees should be enrolled in defined-contribution pension plans rather than defined-benefit plans. This is a basic issue the private-sector conquered long ago.
There is little joy in adopting a defined-contribution plan unless it is accompanied with fully compliant actuarial funding reforms, including no new borrowing. Unfortunately, many of the proposed defined-contribution plans contain a number of design anomalies based upon best-practice standards frequently observed in the private sector, which shows how much politics are involved in developing a simple, standardized plan for all new employees.
Complicating matters, any “transition costs” in converting to a defined-contribution plan are greatly exaggerated given that these figures, to date, have not properly adjusted projected costs to standard actuarial practices. Sustainable pension reform must include funding and plan-design reforms. This means increasing funding levels now to actually decrease the unfunded liability. That’s the simple message Fitch, Moody’s, and S&P are delivering in their recent downgrades. [/EXPAND]