Background Information Regarding
Funding of the Pennsylvania State Employees' Retirement System
And
Comparative Information Regarding
Defined Benefit and Defined Contribution Retirement Plans

While some pension systems may face a crisis due to severe underfunding, that is not the case with SERS.  SERS is 96.1% funded, making it among the best-funded pension plans in the country. By way of comparison, a study last year of 64 state-level retirement plans showed the average funding level was 83%. Even that level of funding isn't considered a problem, given that pension funds have decades to meet their obligations.
Also, SERS’ investment program has been posting outstanding returns - 14.5% last year, which was double the national median for public pension plans, and a three-year net compounded annual return of 18%.  SERS earned $3.8 billion on investments last year.

The "employer normal cost" for the agencies that participate in SERS is 8.25%. That is the percentage of payroll employers would have to contribute each year if SERS’ investments earned exactly 8.5% every year (the actuarially assumed rate of return) and all the other actuarial assumptions were precisely accurate. SERS employers have been paying less than the normal rate every year for the last 10 years. In fact, for two years the rate dropped to zero.
By paying less than normal cost for a decade, the employers, the Commonwealth and taxpayers have saved more than $2 billion.

“Balloon payments” beginning in 2012 are an intentional result of Act 40

SERS employers almost certainly will face an employer rate increase in the future, particularly after 2011, as a result of Act 2003-40.  That statute changed the SERS amortization schedule in a way designed to hold down rates now at the expense of higher rates later, beginning with what amounts to a series of  “balloon payments” beginning in 2012.  Because of Act 40, SERS projects that actual employer rates will remain well below the employer normal rate until 2012.  The Commonwealth could reduce the 2012 rate spike by maintaining a floor rate or moving the rate closer to normal in the intervening years.

Some have suggested that the increased payments required by Act 40 could be avoided if SERS, a Defined Benefit (DB) plan, were replaced with a Defined Contribution (DC) plan.  That could not be done.  Pension commitments are contractual obligations as a matter of both federal and state law - and as courts across the country have repeatedly held.  Employees currently in a defined benefit plan are legally entitled to the benefits they've been promised. The actuarial liability for the promised benefits still exists and will have to be paid.
If SERS were to be closed to new members tomorrow, it might be another 100 years before the last surviving retiree or beneficiary passes away and the plan could be shut down entirely. Meanwhile, and for all that time, the state would have to run both the SERS DB plan and a DC plan.

Both in DB plans such as SERS and in employer-supported DC plans such as private-sector 401(k) plans, there is a provision for an employer contribution.  The difference is that in a 401(k) plan, the employer pays a fixed percentage each year. The employee bears all the investment risk - and pockets all the gains.

In the defined benefit plans, the opposite is true: The employee gets a certain benefit based on years worked and final average salary. What the employee gets is not tied to what the investments earn. Instead, the employer bears the risk and gets the benefit when returns are good.

That is why SERS’ employers have been paying less than the normal rate.

SERS’ current employer rate is less than DC contributions might be

The Commonwealth has, for the last 10 years, been paying less into SERS than it might have been paying into a defined contribution plan.  In fact, certain SERS employers currently offer both DB and DC plans, and the DC plans cost them more. Employees of the State System of Higher Education and Penn State can choose their retirement plan.  The two most popular choices are SERS and TIAA-CREF, which is a defined contribution plan.  For the TIAA-CREF members, SSHE and Penn State must contribute 9.29% of salary per year. They currently contribute only 3 percent for their employees in SERS.  The SERS rate was 2% in 2004-05, 1% in 2003-04 and 0% the two years before that.  SSHE and Penn State thus are examples of employers spending much more on retirement benefits for its DC plan employees than for its DB plan employees.

Example: Assume SSHE has two employees, each making $50,000.  One belongs to SERS, the other to TIAA-CREF.  The current annual employer contribution is $1,500 for the SERS employee and $4,645 for the TIAA-CREF member, a difference of more than $3,000.

It is well documented that DB plans are much more efficient than DC plans in converting present contributions into future benefits. That is, DB plans ultimately provide greater earnings for every dollar put in.  There are several reasons for that, including:

DB plans cost less to administer per person than DC plans because, among other things, DC plans must maintain thousands of relatively small individual investment accounts, keeping track of each individual's gains and losses, changes in investment options, etc.

All the money in a DB plan is managed as a lump sum by investment professionals who have more expertise than the average individual, can negotiate better fees, can invest in areas (private equity, for instance) that just aren't open to individuals, and who (unlike individuals who have to think about investing more conservatively as they near retirement) can always invest with long time horizons.

Most of SERS’ funding comes from investments, not taxpayers

Through SERS, the Commonwealth is able to offer employees an attractive retirement benefit while paying only a small fraction of the cost of the benefit.  Over the last 20 years, only 13% of SERS’ funding has come from employers.  Another 10% has come from members.  All the rest – 77% – has come from investment earnings.  During the last decade of below-normal employer rates, only 7% of SERS funding has come from employers and investments have provided 83%.

Of particular importance for public sector employers, DB plans are better suited to protecting workers in higher risk public safety positions, such as firefighters, police officers and corrections officers. In a DC plan, made up of individually owned accounts, it's considerably more difficult to provide ancillary benefits such as disability benefits and death benefits.

Creating a new DC plan can be an expensive proposition.  In California, the estimated transition cost was $7.6 billion.  It cost Florida $86 million to set up an optional private account plan.  Fewer than 5% of the eligible employees chose to make the switch.

It cannot be assumed that a DC plan will save money.  West Virginia switched to a DC plan for its teachers but recently switched back to a DB plan after its actuaries determined the DC plan cost more.  West Virginia’s actuaries predict the switch back to DB will save taxpayers millions of dollars annually in pension contributions.  As noted above, the DC plans for SSHE and Penn State employees currently cost employers more than SERS does.
Even assuming a DC plan for new employees ultimately would result in savings, those savings would not be immediate.  It could take a decade or more before there would be enough employees in the new plan to make a meaningful difference in state agencies’ budgets. 

Private sector employers that switch to DC plans may do so not to save money but to avoid what are perceived to be excessively restrictive accounting rules for private sector DB plans and to reduce fluctuations in costs (fluctuations which in turn affect earnings projections and stock price).
Some private sector employers have been able to escape or greatly reduce their DB plan obligations by declaring bankruptcy and dumping pension liabilities onto the federal government, an option the Commonwealth certainly could not and would not want to contemplate.

In addition to the difference in employer cost structure – fixed for DC, variable for DB – the two types of plans differ in their appeal to, and influence on, employees.  For instance, DC plans do not require vesting and are highly portable.  Those can be attractive features if employers are recruiting employees who do not plan to work for any one company for more than a few years.  Government sponsored DB plans, on the other hand, encourage employees to devote careers to public service even if a private sector opportunity may offer somewhat higher pay.  Any consideration of changing from DB to DC, or vice-versa, must take into account not only costs, but also how the change may affect, for better or worse, employee recruitment and retention.

An often-cited theoretical advantage of DC plans is that they allow employees to control their own investments, thereby maximizing their savings so as to provide a financially secure retirement.  In reality, “401(k) plans are still coming up short,” according to a new report with that title, issued by The Center for Retirement Research at Boston College.

It states: “These plans have shifted all the risk and responsibilities for retirement saving from the employer to the employee and many employees make mistakes at every step along the way.  A significant percent of eligible employees fail to join the plan, few contribute the maximum, most do not diversify their investments or re-balance their accounts over time, many over-invest in company stock, and roughly half of participants cash out when they change jobs” .The report concludes that “if they are to serve as an effective vehicle for retirement saving” DC plans must be made “easier and more automatic”. The full Center for Retirement Research report is available online at http://www.bc.edu/centers/crr/ib_43.shtml

A PERC study found DC plans are no panacea

In 2002, the Public Employee Retirement Commission (PERC) did a detailed study of the issues involved in the possible implementation of a DC plan.  The resulting PERC report, titled, “Selected Issues Related to Governmental Defined Benefit & Defined Contribution Pension Plans,” identifies numerous  complex issues that would have to be considered before attempting to implement any conversion to a DC plan. 
Among other things, the study found conversion to a DC plan would “increase the potential (legal) liability” of SERS and the Commonwealth and would present “contract impairment and due process issues.”

The full PERC report is available online at http://www.perc.state.pa.us/perc/lib/perc/dbdc_report.pdf

In 2004, the Joint State Government Commission, acting at the direction of the House of Representatives, conducted a study and issued a detailed report entitled, “The Funding and Benefit Structure of the Pennsylvania Statewide Retirement Systems: A Report with Recommendations.”
The JSGC study devoted a chapter to studying the possibility of creating an optional or, for future employees only, mandatory defined contribution plan (having first noted that “existing employees may not be required to switch to a DC plan, as this would violate the Contracts Clause of the United States and Pennsylvania Constitutions”).
The JSGC conclusion:  “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.” (Emphasis added)

The study noted the employer-rate increases projected under Act 40 and identified steps that could be taken to control fluctuations in employer costs.  Recommendations included, “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.”

The full JSGC study is available online at http://jsg.legis.state.pa.us/PENSIONS.HTM.