A Silk Purse from a Sow’s Ear: Making the Best of a Side-by-Side Hybrid Pension
The tentative budget framework negotiated by Gov. Wolf and Republican legislative leaders on Pennsylvanian’s 2015-16 state budget reportedly includes an agreement to establish a “side-by-side” hybrid pension for new employees hired beginning next year. Under this plan, new employees would receive a smaller defined benefit (DB) pension than existing employees along with individual 401(k)-style defined contribution (DC) savings accounts. In addition, several changes would be made to benefits for existing workers for their future years of service.
Based on Keystone Research Center’s understanding of the budget framework pension plan – the details of which may still be shifting – this brief describes and then analyzes this pension plan. We find:
- While a big improvement on the earlier Senate pension proposal, SB 1, the side-by-side hybrid would cut retirement benefits for young, new employees by an estimated 10.5% to 23% compared to the current (Act 120 of 2010) pension benefits for new employees, which are already among the lowest public sector pension benefits in the nation.
- The proposed hybrid would provide a DB pension substantially inferior to the side-by-side DB pension provided to federal employees. Advocates for a side-by-side pension in Pennsylvania have used the federal plan say as their model. The biggest reason for the superiority of the federal employee side-by-side DB pension is that this pension increases every year based on an automatic cost-of-living adjustment (COLA). This inflation protection translates into a lifetime DB retirement benefit 20% higher for a typical retiree than with DB benefit of Pennsylvania’s proposed side-by-side.
- The proposed Pennsylvania side-by-side plan would increase the taxpayer cost of retirement benefits for new employees by 18% to 47%.
- The new pension plan design does nothing to reduce the state’s unfunded pension liability. In fact, Pennsylvania’s unfunded pension liabilities could increase if budget negotiators reduce pension payments in the next few years as is reportedly under consideration. Obtaining temporary budget relief by deferring pension payments requires higher payments down the road, similar to putting pension payments on a credit card.
- Courts are likely to reject as unconstitutional the only savings from the new pension proposal. These savings would result from benefit reductions for existing employees in their future years of service, and thus likely be found to violate a constitutionally protected “contract.” In the unlikely event that courts rule one or more of these benefit changes constitutional, the same savings could be achieved without changing the pension design for new employees.
While the drawbacks of the side-by-side proposal ought to lead to its abandonment, the demands of the leadership of the legislative majority for at least a partial shift away from traditional DB pensions does not appear to be driven by a policy rationale. Therefore, the fact that this shift hurts retirees, taxpayers, and schools and state agencies as employers (by making it harder to recruit and retain great staff) may not matter.
Based on the assumption that the side-by-side pension will become part of the final budget deal, the end of this brief highlights some ways that this proposal could be improved. Specifically:
- The multiplier (amount by which pension benefits increase with each additional year of service) for the DB portion of the pension should be increased substantially above the reported 1% of final salary. If salary above a certain level – e.g., $75,000 – did not qualify for DB benefits (i.e., retirement savings for this portion of salary were 100% part of the DC plan), the DB multiplier up $75,000 could be raised substantially (e.g., from 1% of salary to around 1.5%) without increasing the benefit obligations of schools and the state under the hybrid DB plan.
- Automatic inflation protection similar to that provided for the federal side-by-side DB benefit should be added to the DB portion of the Pennsylvania hybrid once Pennsylvania’s two DB pensions are 80% funded.
- Budget negotiators should commit to exploring the potential for reducing management fees paid to hedge funds and other investment firms that actively manage some of the pooled assets of the Pennsylvania pension funds. This could produce real savings for the state budget rather than savings that will be rejected by the courts, leaving the state in a deeper pension hole when that happens in a few years.
- The pension deal should include a commitment to implement an “ideal” DC savings plan, which would have higher returns and lower costs than typical 401(k)-type plans.
- Since the hybrid pension will require setting up a state-managed pool of DC savings accounts, the state should initiate a process that allows private sector workers the option of saving accounts (technically, individual retirement accounts) that capitalize on the infrastructure set up to manage school and state workers’ DC accounts. To make it easy to do this quickly, Pennsylvania could adapt the Connecticut legislation and implementation process for achieving “retirement security for all.”
These changes to the budget framework’s side-by-side pension deal would mitigate its negative impacts on school and state employees and vastly improve retirement savings options for many private workers, more than half of whom have no savings at all through their job.
 Keystone Research Center, Pennsylvania Has Modest Public Pension Benefits, Pension Primer #13, June 29, 2015; online at http://keystoneresearch.org/sites/default/files/KRC_PensionPrimer13_0.pdf.