August 14, 2016
Dan White is a senior economist at Moody's Analytics in West Chester and an adviser on pensions to the National League of Cities
In the back-and-forth drama of Pennsylvania's budget woes, nothing has been more ever-present than pension reform. The compromises involved in true reform have put the concept out of reach for several years, but now the legislature and Gov. Wolf have put an ambitious emphasis on reform for the fall. This is laudable, long overdue, and essential for getting us back on a more sustainable budget track.
However necessary, it won't be painless, and voters should be prepared for the possible economic implications of reform. The bottom line is that the commonwealth has made promises to the tune of roughly $60 billion over the next 30 years that it cannot keep under current law.
The good news is that the solution is undeniably simple from a fiscal standpoint. We need to come up with at least $60 billion, almost double our current annual budget, over the next 30 years. The bad news is the solution is extremely complex from a political standpoint. Where does that money come from?
The only things we know for sure about pension reform are that changes will be unfair and painful to some Pennsylvanians. But the longer we wait to implement a solution, the less fair and more painful eventual reforms will be. At this point, with pension payments making up an increasing share of state spending, even making the wrong fix could be more beneficial than no fix at all.
Economically, this boils down to choosing the least of several evils. Where will the money come from so as to cause the least amount of harm to the Pennsylvania economy? In the end, there are really only four practicable options to choose from, each with its own pros and cons.
The first place to reasonably look is elsewhere in the budget. While one can almost always look at a state budget and identify wasteful spending, the Pennsylvania budget is already pretty lean. The commonwealth pays more in mandatory spending programs like pensions and Medicaid than almost any other state.
This means discretionary programs, things like education and public safety, have already been crowded out to below-average levels. Reducing them even further, which is what will happen automatically if no pension reforms are implemented, could have disastrous economic consequences.
It would put additional pressure on already struggling municipalities and school districts, and, if allowed to go on long enough, would eventually result in severe cutbacks to basic government services. What's more, it's unlikely that such cuts, if not draconian to the point of curtailing services, would even be able to raise enough money to pay all of the accumulated pension tab.
The second place most often looked to is taxes. In theory this isn't always a bad solution because it can spread the pain across a broad number of people. However, especially in this case, it also allows for inefficiencies to remain in the pension system, preventing funds from regaining long-run sustainability, and can impose large burdens on the economy.
The reason a tax increase won't address long-term sustainability is that benefit payments would still rise at a faster rate than tax revenues. Pennsylvania is one of the oldest states in the country, and it won't be long until we have a small pool of government workers supporting a much larger pool of retirees.
This will force annual pension costs up exponentially over the next few decades, while tax revenues will continue to advance at a more pedestrian pace in line with underlying economic growth, even accounting for a one-time tax hike. The size of the tax increase that would be necessary to keep up with that growth, and pay off our past liabilities, would be extremely painful in what is already a relatively high-tax state.
The drawbacks of these first two options lead to the inescapable conclusion that reforms to the pension plans themselves must be made. Changes to the plans, though typically the most important steps in reform, are also often the most challenging politically and legally.
This is especially true when dealing with possible reforms affecting current retirees, or those set to retire in the next several years. Changes to these benefits have been successfully challenged in the courts as unconstitutional in some states. What's more, benefit changes to current retirees also typically come with the most painful economic consequences.
Pension beneficiaries live generally on a fixed income, and would have a tough time quickly adjusting to lower incomes without drastically changing their spending habits. In addition to being unfair, this also has wide-ranging impacts on consumer spending, and can increase demand for other government services, offsetting savings from lower pension payments.
This leads us to reforms aimed at current workers and future retirees. In general, this method is the least painful option open to policymakers from an economic standpoint. Younger workers have more time to adjust their spending and saving habits before they retire. This allows the economic pain of larger contributions, longer work requirements, or less benefits to be lessened and spread out over a lengthier period of time.
However, the most economically efficient means of reducing future liabilities over the long run is to transition current and future workers onto a defined contribution plan. Moving to a plan more in common with a 401(k) than a traditional defined-benefit pension substantially reduces the risk of future cost overruns, and gives workers more eventual control of their retirement while limiting the potential economic pain of reducing long-term liabilities. Care should be taken, however, to keep the public sector competitive vs. the private sector by ensuring relative parity in terms of overall compensation and benefits.
It is unlikely that any of these changes are individually capable of wiping out our $60 billion liability and eliminating future risk. A combination of several measures will need to be taken to ultimately get Pennsylvania back to where it needs to be.
When selecting these measures in the months ahead policymakers would do well to look beyond the near-term political consequences to the long-term economic picture facing the commonwealth. Only by summoning tremendous political courage will such a feat be possible, and in an election year it will be incumbent upon us as voters to be understanding of the tremendous task laid in our legislators' laps by their predecessors. Take note of how seriously your elected officials approach Pennsylvania's long-term fiscal future, and vote accordingly.