Kentucky’s pension crisis: The wrong question

20111129beacon2Editor’s note: The Bluegrass Beacon column is a weekly syndicated statewide newspaper column posted on the Bluegrass Institute website after being released to and published by newspapers statewide.

It’s apparent from KET’s Kentucky Tonight forum on the public-pension crisis last night and legislators’ comments about the issue in Sunday’s Madisonville Messenger that substantially addressing the systems’ combined $40 billion shortfall will require overcoming hurdles related a general lack of knowledge about how defined benefit pension systems work and the lack of resolve to address future benefit accrual rates for current beneficiaries.

Unfortunately, Kentucky’s pension beneficiaries have been misled to believe that the highest benefit they receive for any year of service applies to any and every year they work. However, the level of benefits in a defined benefit system like Kentucky’s are established annually based on assumptions made by the actuaries for each year.

These actuarial assumptions – including investment returns, payroll growth, inflation, longevity, retirement age and attrition rates – are considered annually to both determine the level of benefits for that year and to create the reserve needed to ensure the funds are available to award that year’s benefit to beneficiaries when they retire. (The actual amount of beneficiaries’ pension checks are determined by adding the benefit factor – the percentage of final average salary each year – usually between 1.5 percent and 3 percent – for all years of service.)

Benefits in such a system are synchronized and therefore must, in a properly run defined benefit system, fluctuate according to what the system can properly pre-fund – a determination made by the actuarial assumptions.

The problem here is that the benefits in Kentucky’s retirement plans have always increased but never decreased, which is not the way a defined benefit pension system works but it is the way you can create huge shortfalls.

So, the wrong question here is: Are you going to cut future pension benefits for current employees?

It’s the wrong question because no future benefits have yet been established since, in a defined-benefit system like Kentucky’s, the level of benefits are determined annually based on each year’s assumptions.

The right question is: If a defined benefit system like Kentucky’s is designed to avoid unfunded liabilities, why do we have a $40 billion unfunded liability and what must we do about it?

Glad you asked!

We must first stop the digging, which involves understanding how this liability was created and avoiding such practices in the future.

Quite simply, the liability in each of Kentucky’s major retirement plans exists because after the actuaries determined what the annual benefit levels should be – and after an actuarial reserve was created to ensure benefits would be funded at those levels – some politician in some future year decided to increase the benefit and apply those increases to previous years.

This disrupted the actuarial reserve already created for those previous years to ensure funding for benefits at the proper, actuarially determined level would be adequate and available. Such retroactive benefit enhancements are why the County Employees Retirement System (CERS), which has always paid 100 percent of their actuarially required contribution (ARC) is only 60 percent funded.

Putting the system back on track by ending the practice of both retroactive (past) and prospective (future) benefit enhancements and ensuring that benefits are properly awarded and not spiked in future years is not “cutting” benefits, even if the actuarially determined benefit winds up being lower because of actuarial assumptions.

Rather, it’s the responsible thing to do – if we want to have sustainable retirement systems, something I’m sure the beneficiaries might be interested in, as well. Once these benefit structures are addressed, then we can begin to find additional dollars and begin filling in Kentucky’s pension hole.

Legislative action related to the benefit structures of the systems in recent years has amounted primarily to some adjustments for new hires even though nervous policymakers desperate to be seen as doing something about the problem but not wanting to upset the apple cart have spun these meek moves as major reforms.

They certainly have done little to address Kentucky’s second-worst-in-the-nation unfunded pension liability. Meanwhile, the funding levels of the systems continue to drop toward insolvency.

If Frankfort takes the meek approach again and fails to address the benefit accrual rates of the state’s pension system, it will have failed to learn from history and will put the commonwealth’s entire pension system in peril.

Jim Waters is president and CEO of the Bluegrass Institute for Public Policy Solutions, Kentucky’s free-market think tank. Read previous columns at www.bipps.org. He can be reached at jwaters@freedomkentucky.com and @bipps on Twitter.

Bluegrass Beacon: Will there be a great pension freeze?

BluegrassBeaconLogoEditor’s note: The Bluegrass Beacon column is a weekly syndicated statewide newspaper column posted on the Bluegrass Institute website after being released to and published by newspapers statewide.

The famous Great Freeze occurred when some of the worst cold winter weather in America’s history befell the South at the end of the 19th century, destroying much of Florida’s citrus crop and the economic survival of entire communities along with it.

An interesting phenomenon occurred, however, during that winter, which stretched from late 1894 and into 1895 that may offer a hidden warning about the need to impose a freeze on benefit-accrual rates in Kentucky’s pension systems.

Florida’s Great Freeze actually was two freezes.

The first freeze in December 1894 failed to kill many mature trees and deceptively created conditions for new growth of produce during the warm months that followed, resulting in greater devastation when a harder freeze attacked months later in February 1895.

The effects were so devastating that fruit froze on trees, reducing Florida’s entire citrus production from 6 million boxes to 100,000 boxes annually.

It took five years for production to again break even the 1 million box mark.

Could it be that the $1.1 billion in additional pension funding in the current state budget – intended to stabilize Kentucky’s public-retirement plans pending an independent audit – could simply have provided a temporary warming period before the nation’s worst pension crisis deepens?

When independent consultants recently released a second report on the audit of the commonwealth’s pension plans, they claimed an additional $700 million annually – on top of the $2 billion being spent on the retirement systems this year – is needed to keep them from going belly-up.

Will such additional gobs of spending follow the frequent pattern of taxing, spending and pension-benefit increases which never come to pass but always come to stay?

For too long, Kentucky’s public-pension beneficiaries have been led to believe a higher benefit for any year of service must be applied to every year of service.

However, a defined benefit system – as Kentucky has and its government workers and retirees fight to keep – only works when there’s a direct relationship between benefits, funding and investment returns.

The current practice of keeping each of those isolated in silos has created an economic disaster in Kentucky.

Beneficiaries and their political soulmates in Frankfort must understand: healthy defined-benefit systems result in the size of accrued benefits fluctuating each year because benefits are directly connected to a host of other factors, including investment returns and payroll contributions.

It’s not realistic in such a system for benefits to always increase but never decrease, and for those increases to be applied retroactively and prospectively.

Yet this has been the scenario in Frankfort.

Benefits have been handed out arbitrarily by legislators while retirement systems’ boards are relegated to dealing with investments.

In the late 20th and early 21st century, sky-high returns on investments masked the problem. Flush with cash, politicians maintained this scheme with few consequences.

But then the economic weather turned bad, leaving taxpayers out in the cold.

The fact is, if Kentucky had abided by the rules of a defined-benefit system by funding pensions based on normal payroll costs and conservative investment assumptions, the resulting greater-than-assumed rates of return on investment funds during those fat years would have created surpluses for use in leaner times.

The only way Kentucky will survive this fiscal storm is by freezing benefit-accrual rates for all members of every system, and resetting the pension plans so that beginning January 1, benefits are awarded based on their relationship with investment returns and payroll contributions rather than the warm, but deceptive, weather of political palatability.

Jim Waters is president and CEO of the Bluegrass Institute for Public Policy Solutions, Kentucky’s free-market think tank. Read previous columns at www.bipps.org. He can be reached at jwaters@freedomkentucky.com and @bipps on Twitter.

News Release: Bluegrass Institute Pension Reform Team responds to PFM pension report

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For Immediate Release: Tuesday, May 23, 2017                                                                                         

(FRANKFORT, Ky.) – The Bluegrass Institute Pension Reform Team (BIPRT) attended the Public Pension Oversight Board (PPOB) meeting on Monday to hear comments from PFM, the consultant evaluating the state’s retirement systems, regarding its latest report on the audit of Kentucky’s public benefits plans.

It is the belief of the BIPRT that the primary cause of Kentucky’s pension crisis is the benefit structure for employees and retirees. Specifically, retroactive benefit enhancements and unfunded benefits were granted to employees without the use of an actuarial analysis to determine the costs.

For this reason, we were disappointed to learn that PFM was asked to only analyze pension data back to 2005. This limited view of the data precluded PFM from incorporating the impact of large unfunded benefit enhancements granted to employees in the 1980s and 1990s, as we have well documented.

Sen. Jimmy Higdon, R- Lebanon, a member of the PPOB, correctly asked the actuarial representative from PFM about the work of the Bluegrass Institute and the absence of the impact of the benefit enhancements in their report. The response from PFM was that at least 20 years of data would have been needed to fully account for those costs.

If the commonwealth is going to enact real reform, we need to correctly identify the causes of our current dilemma. If we blame lack of portfolio performance, fees paid to external asset managers and lack of funding from Frankfort, we will be missing the true cause of the crisis.

We did find interesting the data presented by PFM comparing the benefits received by Kentucky teachers and public employees to comparable public and private sector employees in surrounding states. As one might expect, Kentucky employees receive, on average, much higher benefits.

The BIPRT is not against defined benefit retirement plans. If a defined benefit plan is to be implemented, however, certain rules must be followed. For decades, Kentucky broke these rules repeatedly leading to our crises today.

Download this detailed list of recommendations offered by the Bluegrass Institute to address this crisis and return our state to economic health and vitality.

For more information, please contact the  Bluegrass Institute Pension Reform Team at BIPRTKentucky@gmail.com or Jim Waters at jwaters@freedomkentucky.com, 859.444.5630 ext. 102 (office) or 270.320.4376 (cell).