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Pensions: Pennsylvania's Pounding Headache

If Pennsylvania does nothing about its $47 billion-and-rising unfunded pension liability, an Illinois-sized shadow could loom over the Keystone State.

Gov. Tom Corbett’s proposal to revamp Pennsylvania’s two public pension systems is before the legislature. Unfortunately for supporters of the bill, many other thorny issues are up for debate over the last three weeks of the session, including the sale of state liquor and lottery systems, and transportation funding.

The question remains: Will the Keystone State dither like Illinois or take action to deal with its pension funding shortfalls as Rhode Island did?

If nothing happens this session, though, Pennsylvania’s looming fiscal headache could drive budget wonks to drink, privatized liquor stores or not.

Fitch Ratings and Moody’s Investors Service downgraded Illinois this week after its lawmakers failed to act on pension change. That prompted Illinois Gov. Pat Quinn Thursday to convene a special session.

Corbett’s budget secretary, Charles Zogby, projects the combined unfunded liability for the State Employee Retirement System and the Public School Employees’ Retirement System will spike to more than $65 billion by 2018.

“Pension costs alone will consume 60 to 66 cents of every new dollar in general-fund revenues into the state over next several years,” he recently told the Senate Finance Committee, where the bill sits.

“It’s a budget buster. It eats up a lot,” said Natalie Cohen, a managing director with Wells Fargo Securities LLC.

The deficits could well be higher, given that many consider the pension systems’ existing 7.5% expectation of annual investment return overly optimistic.

But Corbett isn’t trying to overhaul the state’s defined benefit pension systems. He wants to throw it out completely, at least for new hires.

The governor’s plan would create a 401(k)-style defined contribution retirement benefit for future employees, with no guaranteed benefit, and adjust calculations for future benefits for current employees. The plan would not cut benefits to existing retirees.

It would follow the pension bill of 2010, known commonly as Act 120. That package reduced pension benefits for new state and school employees hired after Jan. 1, 2011, and artificially capped increases in taxpayer contributions, effectively delaying required payments, according to an analysis by the Commonwealth Foundation.

Pennsylvania, like Illinois, is no stranger to downgrades. Three weeks after last year’s session ended, Moody’s lowered Pennsylvania’s general obligation bond rating to Aa2 from Aa1. Moody’s said escalating pension liabilities will challenge the return to fiscal balance for a state already shaky.

Fitch and Standard & Poor’s assign AA-plus and AA ratings, respectively. The three continued to warn about pension costs in April, when Pennsylvania held a $950 million GO sale.

“The major credit rating agencies point to increased pension contributions and the growing unfunded liability in these systems as major threats to Pennsylvania’s economic recovery and future, and indeed, have signaled that the failure to address pension reform will result in a downgrade of the commonwealth’s credit rating, costing taxpayers even more,” said Zogby.

“It would be more expensive for us to go to the capital markets for debt raising if we were downgraded,” he said. “We’ve already, as you know, seen one downgrade so certainly another would begin to impact on our costs.”

Zogby, while not dismissing pension obligation bonds as an option, said that move could raise other problems, such as turning a soft liability into a hard one.

“The track record of pension obligation bonds is not a particularly good one and it’s a fairly risky endeavor,” he said.

Another downgrade wouldn’t surprise business consultant and actuary Richard Dreyfuss.

“There is the potential for one. This is not going unnoticed by the bond rating agencies, who want to know, ‘What is your plan, Pennsylvania?,’ ” said Dreyfuss, a senior fellow at the free-market think tanks Commonwealth Foundation and Manhattan Institute.

Dreyfuss, who worked for Hershey Co. for 21 years, said two types of reforms, both interrelated, are necessary: plan design and funding levels.

“There’s been some good, healthy debate on plan design, such as what do you do with new hires, do you switch people to 401(k), and can you legally alter future benefit accruals,” he said.

But Corbett’s plan falls short in the more important funding component, he added. Ideally, he said amortization periods should be 15 years, not 30 years for state workers and 24 years for school employees. “They are way too long to begin with, but even beyond that, Pennsylvania has a poor track record of even contributing that amount.


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