Doylestown Wealth Management - LPL

165 West Ashland Street Doylestown, PA 18901
P: (267) 864 - 2000 | F: (267) 864 - 2010

Pay As You Go

There are two extremes on the pension funding spectrum.  At one pole, there is a single-payment, fully-funded plan, where the sponsor makes a one-time payment which is sufficient (subject to realistic assumptions on investment return, retirement timing, salary increases, and pensioner longevity) to meet all future cash flow obligations.  Purchasers of fixed annuities are familiar with this type:  in exchange for an upfront payment, the insurance company will provide a stream of future cash payments for the life of the annuitant (and perhaps their spouse).  At the other extreme there is the Pay-as-you-go (PAYG) plan, in which no money is reserved and beneficiaries are paid by the entity sponsoring the pension out of its operating funds.

From a mathematical point of view, the payment of pensions can be done by either method; as a practical matter, a funded plan is preferred to a PAYG.  Having a pool of money separate from the regular accounts of the entity reduce the risk that pension will not be paid in full because of an unwillingness or inability to meet those obligations.  Being required to account in the present for expenses of the future can avoid nasty surprises when the bill finally comes due.

Pennsylvania’s School Employees Retirement System (PSERS) pension fund, like most employer-sponsored plans, has always fallen somewhere between a fully-funded and PAYG system.  In recent years, however, the plan has shifted dramatically in the PAYG direction, with most of the system’s contributions being used to pay current benefits.  And while contributions by the state and school systems are at historically-high percentages of payroll, the PSERS’s plan shows little chance of moving away from the PAYG pole.  This is problematic because of the steady scheduled increases in beneficiary payouts which will be required going forward.  These increases will require a ramp up in taxes, a reduction in benefits, or both.

A rough rule of thumb for determining the degree of PAYG qualities of a pension system is the ratio of assets in the fund to the projected benefit obligation (PBO).  The PBO must be determined actuarially and necessarily involves assumptions about the rate of future investment returns, the demographics of the workforce, and the longevity of retirees and their beneficiaries.  Currently, the PSERS’ pension fund has a net asset value (NAV) amounting to roughly 50% of its PBO, which might lead to the conclusion that the fund lies in the middle of our fully-funded/PAYG spectrum.

However, another way of looking at where the PSERS plan falls on the fully-funded/PAYG continuum is to consider where the cash used to pay beneficiaries comes from.  In theory, this cash can come from four places: borrowing, current cash flow (dividends, interest, rents, etc.), sales of fund assets, and contributions.  (We will ignore borrowing here since PSERS’s has not taken this risky step.)  Obviously, a fully-funded plan would be able to rely on income from its assets and investment sales to meet its obligations—although investment sales could occur after the fund’s PBO began to shrink.  Conversely, a pure PAYG system would require all beneficiary payments to be provided by the state and school districts’ operating budgets.

Since money is fungible defining a source of funding for beneficiary payments is a matter of accounting priorities.  PSERS’s receives inflows from four sources: employee contributions deducted from paychecks, employer contributions from both the state and the school districts, income from assets in the fund (dividends, interest, rents, etc.), and sales of fund assets.  For this analysis, we have assumed that PSERS came up with the funds for benefit payments first from asset income, then from employer contributions, and then from asset sales.  One might argue that PSERS sold assets from retiree accounts to current employee accounts to make the required payments (thereby investing the employer contributions), but since all of the fund’s assets are held in one big pool and not segregated by beneficiary, this amounts to a sematic and not a practical difference.

If we review PSERS’s situation, we can see that the large majority of payments to its beneficiaries in recent years have come from state and school district contributions.   This is a dramatic reversal from the early part of this century, when the pension fund was able to meet roughly half of its cash flow needs from its net current income—dividends, interest, rents, etc., minus the investment fees paid to outside managers.  However, the interest rate reductions, increased investment fees, and steadily-rising beneficiary payments have forced the fund to rely largely on state and school district contributions and asset sales to meet its payment obligations in recent years. In other words, PSERS has kept up with its increasing payments to beneficiaries by diverting ever-larger employer contributions each year–the very definition of a PAYG approach.

The situation seems unlikely to change anytime soon.  Required payments to beneficiaries have risen at a consistent 6% rate since 2000, which means they are on pace to reach $13.5 billion by 2030.   To put this number in context, that’s about what the payroll for active PSERS’s teachers and staff is right now.  Obviously we would require either a vicious bout of inflation or a substantial tax increase to meet that level of payment—and even then we would still be paying-as-we-go and every year would require increases.  Without major changes in benefit formulas, we will continue on the path of recent experience, in which employer contributions have gone from $750 million in 2008 to $ 3.8 billion in 2017 without any meaningful rise in the PSERS’ pension fund net asset value, while at the same time its PBO has jumped from $ 70 to $102 billion.

A recent PSERS publication suggested that the fund is “turning the corner.”  In their increasingly pay-as-you-go pension plan, however, the only thing around that corner is another hallway in the maze of increased financial support from the state and school districts, ultimately provided by the taxpayers of Pennsylvania.

Source: PSERS, Comprehensive Annual Financial Reports

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  

Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Doylestown Wealth Management, Inc. are separate entities from LPL Financial.