Philadelphia’s Road to Pension Recovery

Philadelphia has taken steps to put its underfunded public employee pension system on what will be a long road to recovery. Will those efforts work, and can the city stick to the plan?

The Pew Charitable Trusts brought together about 40 city policymakers, municipal union leaders, and public finance experts on May 3 to discuss these questions and others. The conversation followed the release of Pew’s pension “stress test” analysis of the Philadelphia municipal system. This analytical tool looks at a range of scenarios for economic projections and investment returns to provide insight into potential long-term liabilities and costs.

The analysis showed that the city should move toward full funding over the next 15 to 20 years—even under the more pessimistic scenarios—if leaders continue to make large contributions and maintain other reforms.

“The city is taking its medicine,” said Greg Mennis, director of Pew’s public sector retirement system project. “On the other hand, it can be hard to stick to the plan. Stress testing is … really a reminder of what could go wrong.”

Officials from the city’s Board of Pensions and Retirement, AFSCME District Council 47, the administration of Mayor Jim Kenney, and city council staff, along with public finance experts, took part in the discussion in Pew’s Philadelphia office. Attendees welcomed the stress-test research and raised concerns about how to lock in the changes—which include increased contributions by the city and all employees, as well as restructured benefits for some new hires—to ensure retirees’ welfare.

Philadelphia’s pension system has below-average funding compared to major cities. At the start of the current fiscal year, the city had about $5.4 billion on hand to cover an estimated $11.5 billion in liabilities to future retirees. That’s a funding ratio of 46.8 percent, far below that of many other cities. The funding ratio dropped below 50 percent following the 2008 market crash. And that followed a long decline attributable in part to years when the city deposited less than needed, as previous Pew research found. (See Figure 1.) 

Philadelphia’s system provides retirement income for around 37,700 beneficiaries who worked for the city, airport system, or water department. (Employees of Philadelphia Gas Works and the school district have separate funds.) The municipal system is funded by contributions from roughly 28,800 current workers through paycheck withholding; city taxes; and returns on stocks, bonds, and other investments managed by the city pension board.

In recent years, Philadelphia has paid more into the fund than statutorily required, opting to use a special formula to calculate a higher contribution to attain a healthier funding ratio. As mandated by Pennsylvania law, the city also has been directing some sales tax revenue to the fund.

In addition, the city pension board—consisting of the finance director, solicitor, controller, personnel director, managing director, and four labor representatives—has adjusted how it invests the money. And, starting in 2016, administration and union negotiators agreed on higher contributions from current workers and creation of a “stacked hybrid” plan for newly hired, nonuniformed workers. That plan combines elements of a traditional defined benefit and a lower cost 401(k).  

By fiscal 2018, the last full year available, the city’s total contribution reached $782 million--an inflation-adjusted increase of 57 percent from a decade earlier, consuming a rising share of city revenues and crowding out other spending needs. From fiscal 2008 to 2018, the share of local revenues contributed to the fund rose from 11 percent to 15.5 percent. (See Figure 2.) 

As part of the stress test analysis, Pew found that city contributions will remain high for many years under various economic scenarios, but eventually will decline as a share of local revenues. In February, the city controller’s office released a report finding that changes to the system had resulted in positive cash flow and a safer investment strategy, although the report also said additional changes were needed. Both analyses confirmed the pension board’s projections of an 80 percent funding ratio by the early 2030s under various scenarios.

“Philadelphia’s current policies offer a sustainable path to full funding, even if [market] returns don’t meet expectations,” David Draine, a senior researcher at Pew and author of the report, said in presenting the stress test findings.

Attendees discussed steps that the city might take to ensure it sticks to the recovery plan, such as codifying current contribution policies into law, formalizing the annual stress tests, and better integrating them into the annual budgeting process.

Mennis noted that seven states now mandate the use of pension stress tests, which can provide legislators with detailed financial information and economic projections for their pension systems to use in budgeting decisions.

“That’s the big piece that we’re seeing [in other places], which would allow us to view the pension system squarely in the context of the city budget,” Mennis said.

Most Philadelphia employees have shouldered additional pension costs or risks in recent years, either by paying a higher percentage of salary into the fund or by shifting their contributions into the 401(k)-style account. Newly hired, nonuniformed employees in the hybrid plan get a traditional defined benefit pension on earnings up to $65,000, and the defined contribution plan for earnings above that level. Total annual employee contributions between fiscal 2015 and 2018—from the previous contract period to the current one—rose from $58.6 million to $83.3 million. (See Figure 3.)

One attendee noted that shifting some of the investment risk to workers, as the hybrid plan does, exposes them more directly to the ups and downs of the stock market.

The pension board, which uses staff and external financial experts to manage its assets, has made several changes to its investment practices in recent years. These include a small annual reduction in its assumed annual rate of return, a shift of assets into lower-fee “passive” investments, and a transition from hedge funds into real estate funds.

The assumed rate of return affects investment decisions as well as the amount the city needs to contribute. The rate, set by the pension board in consultation with the administration, is now 7.6 percent—still above most other systems’ rates, according to the pension board. The city’s actual returns have swung from a 20 percent loss (down $864 million) after the 2008 market crash to a 19 percent gain (up $699 million) after the 2010 rally. (See Figure 4.)

Of all the steps Philadelphia has taken to shore up the pension fund, the most important, Mennis told the group, is the city’s commitment to make higher contributions, including sales tax revenues. Maintaining the course will be a difficult but essential part of the challenge ahead.

Larry Eichel is the project director and Thomas Ginsberg is a senior officer with The Pew Charitable Trusts’ Philadelphia research initiative.