Pennsylvania’s public employee pension plans are on a path to long-term fiscal sustainability thanks to a multiyear effort by policymakers to address the state’s sizable unfunded pension liability. Although the plans’ funded level remained relatively low in 2020 at 58%—below the national average of 70%—the state made three consecutive years of payments to the plans that were sufficient to cover benefits and reduce debt, which is real progress. In addition, a new benefit plan put in place to better manage financial risk, along with efforts to reduce investment fees by billions, limits the threat of developing new unfunded liabilities.

It will take decades for Pennsylvania’s pension plans to achieve full funding, but an understanding of how policymaker decisions created a more positive trajectory can inform efforts elsewhere to improve the fiscal sustainability of public employee pensions.

Pennsylvania serves as both a cautionary tale and a turnaround story. The Pennsylvania State Employees’ Retirement System (SERS) and the Pennsylvania School Employees' Retirement System (PSERS) were fully funded in 2000, thanks largely to strong investment gains in the 1990s stock market. But unfunded benefit increases and a longtime pattern of not fully funding annual required contributions meant that the state went from a $20 billion surplus in 2000 to a $60 billion deficit in 2015—one of the largest dips recorded nationwide.

By 2010, Pennsylvania faced a substantial pension challenge. Contributions toward SERS and PSERS in the preceding decade turned out to be less than half of the actuarially recommended amounts, placing Pennsylvania 49th among states in fiscal discipline for meeting pension funding requirements. From 2003, the last year in which Pennsylvania reported its pensions as fully funded, to 2010, the gap between funding and promised benefits rose to $27 billion. At that point, the outlook was bleak. Without changes, the cash flow pressure to pay for rapidly increasing benefit payments would have left the state retirement system headed towards insolvency.

Increased contributions

Knowing that funding levels were insufficient to pay for promised benefits and that previous benefit enhancements were unsustainable, Pennsylvania lawmakers enacted Act 120 in 2010. This legislation set a slow but steady ramp-up toward making full employer pension payments to both PSERS and SERS, as recommended by the plans’ actuaries. Importantly, it also created a benefit tier for new hires that reversed the enhancements made in the early 2000s.

The contribution ramp-up increased annual payments from less than $1 billion in 2010 to more than $6 billion in 2017. However, unfunded liabilities continued to rise to $65 billion during this time. Then, starting in 2018, when the payment reached what is known as the annual required contribution—the amount recommended by the plans’ actuaries to fully fund the pension system over time—the state began to see progress in paying down its pension debt, achieving positive amortization.

Benefits of creating a risk-managed hybrid plan

The changes made by Act 120 were important steppingstones to Pennsylvania's pension turnaround. Still, they did not fully address the risk of future unfunded liabilities that could strain the state’s ability to fund pension benefits. As a result, lawmakers overwhelmingly—and on a bipartisan basis—approved Act 5 in 2017. That law made additional improvements to funding policy and put in place a new benefit plan design, called a risk-managed hybrid plan, that allowed the state to mitigate a significant amount of its risk exposure as well as share some losses and gains with employees. The goal was to make costs more predictable. State analysts estimated at the time that the reform package could save Pennsylvania taxpayers $8 billion to $20 billion over the next three decades, depending in part on the performance of plan investments.

Under Act 5, the default plan for state employees and teachers hired on or after Jan. 1, 2019 is a hybrid design that combines a reduced defined benefit program—a traditional pension—with a separate defined contribution savings account, like a 401(k). The new design further shares risk and gains by adjusting employee contributions based on investment performance—a provision that will help make employer costs more predictable.

Even with these new risk-management features, the plan provides retirement security to career workers and improves the savings rate for those who change jobs midcareer. In fact, an analysis by Pew demonstrated that on average, career workers covered by the new hybrid plan can expect their retirement income to replace over 90% of their final salary when including Social Security. Those who leave before retirement can expect to achieve a savings rate of at least 10% of their annual salary—a benchmark that only 13 states have achieved.

Investment fees and risk reporting

The creation of the Public Pension Management and Asset Investment Review Commission (PPMAIRC), as required by Act 5, laid the foundation for limiting investment fees, boosting transparency, and introducing stress testing to the pension program.

Research demonstrating that Pennsylvania’s investment fees were among the highest in the nation helped inform the savings targets that the commission was tasked with meeting to recommend measures to reduce investment expenses. In the last financial report published by PSERS before the commission met, for example, the plan reported a total of $455 million in external investment fees—an amount that exceeds 0.8% of assets, which is more than twice the national average for these fees.

The bipartisan PPMAIRC met throughout 2018 and released a final report that December identifying nearly $10 billion in potential long-term fee savings—far exceeding the $3 billion legislative mandate. The panel also made recommendations to strengthen investment transparency practices and conduct annual stress tests to assess plan performance under various economic conditions.

Many of those recommendations have been adopted. For example, the PSERS board decided in late 2021 to eliminate $6 billion in hedge fund holdings and reallocate the proceeds to lower-cost investments over time. That should result in an estimated $3 billion in savings over 30 years.

In addition, the state legislature in 2020 approved a measure requiring SERS and PSERS to publish annual stress tests. Both plans have complied; the reports prepared by SERS have been leading examples of forward-looking risk reporting designed to inform long-term decision-making. This includes projections assessing the impact of low or volatile investment returns on plan funded levels and costs to help state officials understand the potential impact of investment and other risks. Earlier use might have helped avoid some of the costly decisions that Pennsylvania lawmakers made that have led to today’s funding challenges.

Overall, the changes made in Pennsylvania have put in place many prerequisites for long-term success, including a funding plan designed to pay down pension debt and the fiscal discipline to stick with it. The state also introduced a benefit plan design that will help ensure that employer costs stay predictable for new workers while maintaining a path to retirement security for the entire workforce. In addition, the changes incorporate efforts to manage the pension funds in a more cost-effective, responsible, and transparent fashion, with a needed emphasis on reducing fees and measuring risk through regular stress testing.

David Draine is a senior officer, Greg Mennis is the director, and Keith Sliwa is a principal associate with Pew’s public sector retirement systems project.