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Research & Commentary: Kentucky Should Embrace Pension Reform

August 25, 2017

In this Research & Commentary, Matthew Glans examines pension reform in Kentucky and how the state can build on previous reforms.

In fall 2017, Kentucky Gov. Matt Bevin (R) will call for a special session of the General Assembly to discuss the state’s $64 billion unfunded pension liability and how the state can reform the troubled system. Since his inauguration, Bevin has made pension reform one of his primary policy goals. Bevin has called for independent audits of every state pension system and substantial structural reforms to the pension system as well. Bevin also wants pension beneficiaries to make extra contributions to help reduce the system’s deficit.

Kentucky currently has one of the largest pension-funding gaps of any U.S. state. According to credit rating agency Standard & Poor’s, Kentucky’s pensions are the most underfunded in the nation, with only 37.4 percent of the system’s current total obligations funded – far below the national median of 74.6 percent. According to a new government pension website created by Bevin’s administration, Kentucky’s pension spending has generated a negative cash flow of $7 billion over the past decade, with spending growing five times as fast as revenue.

Kentucky has made some efforts to reform its pension system in the past, but these reforms have not gone far enough. In 2013, the state passed new laws that created a hybrid cash balance plan for new employees, eliminated retiree cost-of-living increases, and required the state to make full pension payments. These were all positive steps, albeit small ones, toward creating a fiscally sustainable system, but they failed to address the primary problems with the state’s investments. More reform is still needed.

Kentucky currently sponsors eight pension plans within three major retirement systems, providing pension and retiree health care benefits to over 166,000 retired public sector and nonprofit employees. While the full details of the plan have not been released, Bevin has long called for substantive structural change. Chief among these changes would be to replace the current state pension plan with a 401(k) retirement plan for new employees, which would also be made available to current employees who would like to transfer their traditional pensions.

Moving state workers to a defined-contribution model puts the state on a path towards lowering costs and improving flexibility. Under a defined-contribution plan, employers pay a fixed amount during the course of a worker’s career, this amount is then deposited into a personal account which the workers controls and manages, This allows the worker greater control over their retirement and the ability to customize it to their own needs. These plans not only give worker’s more control over their own money but give more budget certainty to taxpayers.

Kentucky’s serious pension fund investment problems have been compounded by its unrealistic expectations for those investments. While the fund recently decreased its expected rate of return to 6.75 percent, down from a high of 7.75, this is nowhere near the rate that should be imposed to meet realistic market expectations. Taxpayers cannot afford for states to continue overpromising and underfunding their pension plans. If the rate of return consistently falls short of expectations in the near future, the state’s pension system may be in even more trouble than is currently thought.

Bevin also proposes lowering the assumed investment return rate to a more realistic level. Pension experts recommend states use an expected rate of return between 2.3 percent and 3.1 percent, figures based on Treasury bond yields. According to the R Street Institute, “Depending on whether one uses the current rate-of-return assumption or this risk-free rate of return, Kentucky’s pension systems are between $35 billion and $95 billion short of what would be required to pay off the promises made to state workers over the years.” 

Decreasing the expected rate of return does have consequences. Because the rate is used to determine the present value of benefits that will be paid to retired workers in the future, reducing the rate of return will increase the apparent level of obligations. Opponents of the decrease argue it is unnecessary because actual public pension investment returns have exceeded assumptions. Proponents of a decrease argue that even if state and local pension funds continue the current high return rate assumptions, it will take large-scale increases to bring their funds into actuarial balance, which will prove difficult in the current economy.

Overpromising benefits and underfunding have created several problems the state will soon have to face. According to Governing Magazine, Kentucky’s largest pension plan “lost nearly a third of its assets, dropping to $2.3 billion in 2015 from $3.1 billion in 2014. It now has just 19 percent of the assets it needs to meet its total pension liabilities over the next three decades.” If the largest fund’s assets continue to fall, the state will be forced to convert all investments to cash. The state has already moved several of its investments to low-risk, low-return bonds to pay for retiree payments.

The growing pension debt in Kentucky has had a negative effect on the state’s credit rating. Bond-rating agencies have all lowered Kentucky’s rating to the third-lowest rating of all U.S. states. It now only sits behind Illinois and New Jersey. Maintaining a higher credit rating is important because lower ratings increase the cost of borrowing money, which could make it difficult to pay all of the state’s bills without imposing tax increases. Kentucky’s failing pension system is a testament to years of overspending and providing benefits it couldn’t afford.

Bevin’s proposed reforms are a clear step in the right direction. To protect both taxpayers and public workers long term, Kentucky should follow the private sector’s model and switch workers from defined-benefit pension systems to defined-contribution plans, such as 401ks. Defined-contribution gives retirees direct control over retirement nest eggs and enables them to move in and out of the private sector without losing accrued pension benefits. It also allows governments to budget more accurately because the benefits are paid directly to the employee and are a defined amount of money each year.

The following articles examine state pension reform from multiple perspectives.


A Citizen’s Guide to Kentucky’s Pension Crisis
https://www.heartland.org/publications-resources/publications/a-citizens-guide-to-kentuckys-pension-crisis  
This Issue Brief from the Kentucky Chamber provides background data on Kentucky’s major pension systems, reviews how Kentucky’s pension systems ended up falling into such poor shape, compares Kentucky’s performance with national averages, summarizes recent reforms in the system, and outlines recommendations that would help put the state’s pension systems on a sound and responsible financial track.

Properly Funding a Defined-Benefit Plan Requires Solid Average Returns and Some Luck
http://neighborhoodeffects.mercatus.org/2016/02/02/properly-funding-a-defined-benefit-plan-requires-solid-average-returns-and-some-luck/
Adam Millsap of the Mercatus Center discusses the problems created by overly optimistic investment-return assumptions and how they add risk to defined-benefit pension plans. “The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans,” wrote Millsap.

Public Pension Investments: Risky Chase for High Returns
https://www.heartland.org/news-opinion/news/public-pension-investments-risky-chase-for-high-returns 
Truong Bui writes in Budget & Tax News about a recent Pew report that shows there has been a systematic shift with many public pension plans. Over the past 30 years, an increasing number of public pensions have moved away from fixed-income investments and toward equities and alternative investments.

Keeping the Promise: State Solutions for Government Pension Reform
https://www.heartland.org/publications-resources/publications/keeping-the-promise-state-solutions-for-government-pension-reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.

Kentucky’s Pension Challenges: Opportunities for Real Reform
https://www.heartland.org/publications-resources/publications/kentuckys-pension-challenges-opportunities-for-real-reform
This paper from the Pew Center on the States examines the challenges posed by Kentucky’s failing pension system, how those problems came to happen, and some opportunities for reform.

Research & Commentary: Defined Contribution vs. Defined Benefit Pensions
https://www.heartland.org/publications-resources/publications/defined-contribution-vs-defined-benefit-pensions 
John Nothdurft of The Heartland Institute provides a bullet-point comparison of defined-benefit pensions and defined-contribution retirement plans.

The State Public Pension Crisis: A 50-State Report Card
https://www.heartland.org/publications-resources/publications/no-126-the-state-public-pension-crisis-a-50-state-report-card-1
The Heartland Institute examines problems facing public pension systems, including the enormous burdens they pose in some locations. The report ranks each state on the operation and disposition of its pension plans and suggests ways to solve states’ pension system problems.

Research & Commentary: Public Pensions and the Assumed Rate of Return
https://www.heartland.org/publications-resources/publications/research--commentary-public-pensions-and-the-assumed-rate-of-return
Heartland Institute Senior Policy Analyst Matthew Glans examines the problems facing state and local pension funds, how assumed rates of return affect pension fund debt, and proposals to change the projected rates of return on pension fund investments.

State Pension Funds Fall Off a Cliff
https://www.heartland.org/publications-resources/publications/state-pension-funds-fall-off-a-cliff
Barry W. Poulson and Arthur P. Hall consider different measures of historical and current funding shortfalls in state pension plans. Two case studies—the Public Employee Retirement Association of Colorado (PERA) and the Kansas Public Employee Retirement System (KPERS)—are examined in depth to explore the fatal flaws that have caused funding crises in these plans.

Pension Funds Expected Rates of Return: Biggest Lie in Global Finance
https://www.illinoispolicy.org/pension-funds%C2%92-expected-rates-of-return-%C2%93biggest-lie-in-global-finance%C2%94/
The Illinois Policy Institute examines the high expected rates of return on pension investments used by state and local governments, arguing the high rates are misleading taxpayers into believing pension funds are more stable than they actually are.

 

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.

The Heartland Institute can send an expert to your state to testify or brief your caucus; host an event in your state, or send you further information on a topic. Please don’t hesitate to contact us if we can be of assistance! If you have any questions or comments, contact John Nothdurft, Heartland’s director of government relations, at jnothdurft@heartland.org or 312/377-4000.

Author
Matthew Glans joined the staff of The Heartland Institute in November 2007 as legislative specialist for insurance and finance. In 2012, Glans was named senior policy analyst.
mglans@heartland.org @HeartlandGR