My Reaction to the Kentucky Pension Crisis

On Monday night, my wife and I watched Kentucky governor Matt Bevin conduct a Q&A on the state's pension crisis. I know what you're thinking, "what a perfect date night!" Before you judge, my wife is a Kentucky public school teacher and I'm a financial planner, so our interests were both piqued. 

Before I get into my thoughts, a quick background on the pension crisis:

Pension Crisis Background

Who does this impact?

There are eight different pension plans in question, covering about 500,000 people in total (Courier Journal):

  • Kentucky Employees Retirement Systems (KERS)- This consists of two plans:
    • Hazardous
    • Non Hazardous
  • County Employees Retirement Systems (CERS)- This also consists of:
    • Hazardous
    • Non-Hazardous
  • State Police Retirement System (SPRS)- This system and the two above are administered under Kentucky Retirement Systems (KRS).
  • Teachers Retirement System (TRS)
  • Kentucky Judicial Form Retirement System (KJFRS)- This system covers:
    • Judges
    • Legislators

How bad is it?

Standard & Poor's, the world's leading credit rating agency, ranked KY as the worst funded pension system in the United States.  The current pension debt is at $33 billion, but could be as high as $64 billion according to the Bevin administration. Kentucky's pension plans will run out of money if nothing is done to help fix the ailing system. Some are even projected to fail by 2022 (via PFM Consulting Group).

How did it get this bad?

There are three primary reasons for the current state of KY's pensions:

  1. The plans have not been adequately funded. This didn't happen overnight. Over the course of the past two decades, state legislators have failed to sufficiently fund the pension systems.
  2. Poor investment decisions and assumptions. The government actuaries overestimated the future return on their investments. As I look over the list of investments in the plan (you can see a list of them here), I see that many of them are very expensive. Some of the managers on the investments are charging 2 to 2.5% with added "performance" fees on top! With the emergence of low-cost mutual funds and ETFs, there is no reason to be in such expensive funds.
  3. An aging population base. KY retirees are living longer and there are less new hires to replace them than expected. This is leading to fewer people paying into the system to support older retirees. We're seeing a similar problem with Social Security.

Where Do We Go From Here?

The government has three main courses of action: (1) Cut spending, (2) Increase taxes, or (3) Adjust benefits. Most of the backlash has come from the last one.

The government contracted Public Financial Management (PFM) Consulting Group to recommend potential solutions for adjusting benefits. They came up with the following suggestions(see the full report here). I'll give the recommendation from PFM, followed by my thoughts on each- for what they're worth:

  1. Changes to Actuarial Assumptions
    • First, they recommend a more aggressive payment structure. Up till now, we have made payments that allow the debt balance to continue to grow. Think of it like paying only the minimum due on your credit card- you're good for this month, but your debt balance grows.
    • Second, they recommend adopting more realistic investment return assumptions going forward.
    • Both of these are no-brainers and should have been implemented a long time ago. PFM projected the 2019 impact of these two changes alone at over $1.8 billion.
  2. Benefit Changes
    • PFM recommends that all non-hazardous service (including teachers, judges, and legislators) pension systems use a 401(k) plan instead of a pension. Hazardous service plans (including State Police) would keep their pensions.
    • New non-hazardous service hires would go straight into a new 401(k) plan. This would also make teachers in the 401(k) plan eligible for Social Security benefits.
    • Current plan participants would have their current pension frozen and offered a buyout option. Teachers, however, would continue their pension plan if they are already enrolled.
    • They recommend increasing the retirement age for all pension participants not yet retired. This would be 60 for hazardous members and 65 for non-hazardous. They also recommend suspending Cost of Living Adjustments (COLAs) for retirees until the plan is 90% funded.
    • These benefit changes are the most controversial of their recommendations. The addition of the 401(k) is "on par" with the current times as pension plans have been on a steady decline over the past 25 years. The increase of the normal retirement age will be quite unpopular. No one likes to be told that they have to work longer, but the current ages are unsustainable. With people living longer and longer, some current early-retirees spend more time in retirement than they did working! No system would be able to sustain that indefinitely. These major overhauls should be a last resort, but some may be inevitable.
  3. Funding Changes
    • They recommend that the required plan contributions be based on a given formula. This amount should also be reflected in the state budget. This is to ensure that future contributions are not up to subjective changes.
    • They also mention shifting some costs to local school boards, such as Social Security.
    • I agree with the top two, but it's hard to know where I stand on the third one without knowing the true impact on local school boards.
  4. Investment Practices and Approach
    • PFM recommends consolidation of the KRS and the TRS plan assets (everyone except the legislators and judges). They used the Indiana Public Retirement System as an example. With this consolidation, PFM claims they could save up to $5 million per year. They could save on investment costs, staffing overhead, and have greater coordination among plans.
    • On paper, this makes sense. Not sure why they excluded the legislators and judges here though. This is a very general recommendation and would be a giant change with many minute details to account for. But, if they could make it happen without undue burden, it could be a good thing.

Conclusion

In summary, we have a big problem in Kentucky. The current path we are on is not sustainable and changes have to be made. Participants, legislators, and employers must communicate to come to a satisfactory resolution.

To participants- Educate yourselves! Pour over the reports (linked below). Come up with your own informed opinions and let your legislators know how you feel!

 

Resources

PFM Pension Crisis Recommendations

ALL PFM Consulting Reports

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