Policy Brief: An analysis of Senate Bill 1
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The Bluegrass Institute for Public Policy Solutions, Kentucky’s free-market think tank, has warned for years that failing to adequately address what has become a $65 billion public pension crisis due to the awarding of arbitrary, unaffordable, overly generous, retroactive, and, in some cases, utterly corrupt, benefits not only threatens our commonwealth’s current economic security but also saddles future generations with a liability that’s immoral, unconscionable and unnecessary.
However, the Bluegrass Institute has not settled for simply helping Kentuckians understand the reality and scope of this crisis. We’ve been offering serious solutions that, if followed, will provide:
Adequate and secure retirement incomes for public employees.
An affordable, accountable and transparent public employee benefit structure that awards only earned benefits. Such a structure eliminates unfunded enhancements as well as guarantees of future unsustainable benefits.
Improved governance of the public pension systems that ensures taxpayers are protected from further malfeasance.
Senate Bill 1 (SB 1) creates a cash balance retirement system for newly hired state employees and teachers, which, if correctly implemented, can begin to satisfy the need for adequate and secure retirement incomes for public workers while protecting taxpayers with an actuarially sound structure of benefits that avoids future, arbitrary and unfunded benefit enhancements – the primary contributor to Kentucky’s current deep pension hole.
Philosophically, we have been and remain unopposed to placing employees in a 401k defined-contribution plan. However, SB 1’s proposal to place all new workers in a cash-balance plan while addressing some of the more egregious and costly abuses of the system appears to offer an acceptable compromise between ideological proponents of 401k-style plans and others who advocate for the status quo, which would result in continuing the current – and unsustainable – defined-benefit plan and is unacceptable.SB 1 also ensures that teachers, who are among Kentucky’s most important and valuable employees but do not receive Social Security benefits, will be properly recognized for their contribution to the future of our commonwealth by receiving a secure, consistent pension benefit. Finally, it recognizes what the Bluegrass Institute Pension Reform Team correctly predicted all along, and which was confirmed by credible analysis: diverting payroll contributions for new employees into traditional defined contribution accounts would significantly – and unnecessarily – increase costs.
The cash-balance approach provides a portable, defined benefit for new state workers and teachers while providing some protection for taxpayers by limiting the amount employers (taxpayers) would be required to contribute to fund new employees’ future retirements.
The legislation’s proposal requiring new teachers to contribute 9.1 percent while the employer (taxpayers) kicks in 8 percent of their salaries creates a strong new pension tier which, when combined with the current economic recovery and its expected and sustained positive investment results, will provide a solid, secure and generous retirement for our valued teachers.
Legislators, however, should refrain from portraying the cash-balance plan as representing significant savings for taxpayers since SB 1 shifts part of the plan’s funding responsibility onto local school districts. While moving new hires and some current state employees into 401k-style defined-contribution pension plans – as Gov. Matt Bevin’s “Keeping the Promise” plan released in the fall proposed – would be costly, claiming or offering the perception that the cash-balance substitute will save the commonwealth great sums of money when, in reality, 2 percent of the 8 percent employer payroll contribution would be borne by local school districts, is misleading since taxpayers fund school districts as well as state retirement systems.
At the same time, we applaud the decision to attempt to address some of the more costly and egregious abuses of the system covering current employees by:
Capping the use of additional unused sick days to retire early and/or increase the amount of lifetime pension benefits.
State workers under SB 1 would no longer be allowed to apply future unused sick days after July 31, 2018, toward service credits in a manner that allows them to retire early.
Teachers, who currently receive 10 unused sick days per year – for which they are compensated at 30 percent of their value upon retirement – would only be allowed to include the amount of compensation awarded for sick days prior to July 31, 2018, into the formula used to determine the size of their pension payments.
While we don’t oppose offering teachers some reasonable reward for unused sick days, such an incentive should not be used to increase retirement benefits for a lifetime.
Also, offering an affordable, reasonable sick-day incentive for teachers while capping the irresponsible use of applying the amount of that unused sick-day compensation to a lifetime of pension benefits is a way to guard against a harmful exodus of teachers from our schools while not violating the terms of the commonwealth’s inviolable contract with its employees.
Requiring new teachers to work longer before retiring with full benefits.
While SB 1 allows beneficiaries with fewer than 20 years in the Teachers’ Retirement System (TRS) as of July 31, 2018, to retire after 27 years of employment, it incentivizes those members to continue working and contributing to the system for least eight more years by offering a higher benefit factor of 3 percent for members who are at least 60 years old and have served more than 35 years.
This fairer approach is in keeping with legislators’ intent when they created the TRS in 1938, when Americans’ life expectancy was much shorter – 64 years of age – than it is today. Americans’ life expectancy has risen to nearly 79 years of age, a number which likely will continue to increase.
The intent of legislators was to create a fully funded system that allowed teachers to retire with dignity in their later years, not one whereby workers could step away while relatively young and collect generous taxpayer-funded benefits during a retirement period of life that outlasts the number of years they worked and contributed into their public pension plan. Allowing this practice to continue is simply unsustainable and unfair to the taxpayers who fund these additional – and often substantial – number of retirement years.
Incentivizing teachers to remain in the system longer should also help address valid concerns about “mass retirements” and unmanageable turnover in Kentucky’s public-school classrooms.
Reducing automatic cost-of-living increases (COLAs) for TRS retirees from 1.5 percent to 1 percent at least for the next 12 fiscal years.
While employees in the Kentucky Retirement Systems (KRS), the commonwealth’s other large pension plan in addition to the TRS, have not received a COLA for several years, SB 1 ensures that teachers, who don’t participate in Social Security, receive a modest inflation-covering increase in their benefit checks.
Reducing the COLA percentage seems fair, as well, to future legislators, who, like the current General Assembly, will frequently be forced to deal with a changing economic landscape and unforeseen fiscal challenges.
This is an actuarially sound move, which may somewhat reduce future stress on the systems. However, considering Kentuckians’ rapidly increasing longevity, the commonwealth’s pension plans still will remain stretched to near-breaking point for decades just to provide already-promised benefits.
Defenders of the status quo already have made their opposition to these common-sense steps known with claims of great loss by beneficiaries and threats of lawsuits. The Kentucky Center for Economic Policy, for example, claims this modest reduction in the annual automatic cost-of-living increase will cost a 59-year-old teacher getting the average pension about $73,000 during the remainder of her lifetime. However, noticeably missing from this sky-is-falling narrative is any context involving a recognition that lifespans now stretch 15 years further, on average, than when legislators originally created the TRS in 1938. To offer an analysis of long-tern pension policy without intentional and careful consideration of growing life expectancy is irresponsible and lacks credibility.
Ending the inviolable contract for new teachers hired after July 1.
Allowing future adjustments to benefits will help prevent adding to the current mountain of unfunded liabilities in the TRS, which currently has a problematic funding level of only 56 percent.
It will reduce taxpayers’ risk and increase the financial involvement of beneficiaries in their own systems. This is needed to prevent burdening future generations of Kentuckians with even more backbreaking debt.
Reforming practices related to legislators’ pensions.
Both the Bevin administration’s proposal and SB 1 propose stripping benefits from retired politicians who padded their legislative pensions by taking high-paying jobs in other government positions.
Passage of Senate Bill 3 during the historic first week of the 2017 legislative session made legislators’ pensions subject to the Open Records Act, and confirmed what the Bluegrass Institute revealed in a landmark series of reports on Kentucky’s retirement systems in 2012: House Bill 299, otherwise known as the Greed Bill, passed in 2005, allowed legislators, whose seats represent part-time positions, to multiply their length of service in the legislature against the salary of any job in state government and swell the size of their retirement checks at great cost to taxpayers.
Passage of SB 3 in 2017 revealed that some General Assembly retirees have received spiked benefits for years by applying six-figure salaries earned in non-legislative positions to the new final average-salary formula of their part-time legislative pensions. As a result, some retired legislators now collect annual pensions much larger than the incomes they earned as part-time lawmakers.
For example, former Richmond Democratic Rep. Harry Moberly, a 31-year fixture in the state legislature before retiring in 2010, collects an annual legislative pension benefit of $154,912 even though he only earned $41,000 during his final years in the General Assembly.
Former Democratic Rep. J.R. Gray of Benton, who earned part-time pay during his 26-year tenure in the House, now gets $117,000 in annual retirement benefits because he spent three years as Gov. Steve Beshear’s labor secretary.
Former Senate Republican Leader Dan Kelly, a Springfield Republican appointed by Beshear to a circuit court judgeship in 2009, gets to base his legislative pension not on the $40,000 or so he earned as a legislator but on the $104,239 he receives as a judge. Kelly now collects $8,686.63 a month in public-retirement benefits.SB 1 would strip these former politicians of the extra benefits earned due to the Greed Bill and would base legislative retirees’ pensions only on their actual service in the legislature instead of allowing them to spike their retirement checks by including their highest three years of salary received in another government position.
Both the Bevin administration and legislative leaders rightly included these legislative-pension reforms despite the likelihood they will face a legal challenge.SB 1 also proposes other changes to legislative pensions, including:
Decreasing lifetime benefits for longtime lawmakers currently in office by reducing their benefit factor. Legislators currently multiply 2.75 percent of their final salary by the number of years they serve to determine their retirement allowance; SB 1 lowers that factor to 1.97 percent.
Allows some lawmakers to move into a 401k-style account.
Places legislators elected after 2014 into a hybrid cash-balance plan that’s less generous than the cash-balance plan offered to state and local government workers hired after 2014. For example, rather than receiving a guaranteed 4 percent return on investments each year, lawmakers would simply be shielded from losing money on their accounts. Also, they would have to give up 3 percent of their salary to help fund retiree health care.
While the overall cost of the Judicial Retirement Plan (JRP), the pension umbrella for both legislators and judges, is relatively minor compared to that of Kentucky’s two major plans – KRS and TRS – it’s vital that policymakers, who will be making tough decisions affecting hundreds of thousands of state employees, begin by reforming their own system. Incidentally, the JRP is far and away the healthiest of the commonwealth’s retirement systems with 79 percent of the funds it needs to pay future benefits, compared to the 14-percent level of funding in the rapidly declining Kentucky Employee Retirement Systems (KERS).A lack of funding is not the ‘root cause’ of pension woes While we applaud legislative leaders for advancing the reform ideas found in SB 1, we remain concerned that few policymakers publicly acknowledge that the root cause of Kentucky’s public pension crisis is not – and never was – a funding issue. As a result, we summarily reject the idea that increasing tax burdens on already-overburdened Kentucky taxpayers and businesses will solve this problem.
Gov. Bevin’s two-year budget proposal released in January includes $3.3 billion for the retirement systems, or nearly 15 percent of the entire General Fund.
Despite massive increases in pension spending in recent years, including an additional $1.2 billion contribution to TRS and a total of more than $2 billion in public-retirement spending in the current General Fund budget passed in 2016 – funding levels have continued declining.
This is due in large part to the numerous retroactive benefit enhancements granted for decades without statutorily required independent actuarial cost analyses as well as the unaffordable, actuarially unsound and irrational prospective benefit guarantees resulting in many state employees collecting more annual income in retirement than they received while employed.
Despite incessant claims that Kentucky’s pension problems have been caused primarily by inadequate funding by the legislature or poor investment returns, the Government Finance Officers Association (GFOA) agrees with the Bluegrass Institute’s analysis that benefit increases funded retroactively disrupt plans and represent “a critical error that can result in significant underfunding.” In fact, it’s worth including GFOA’s entire statement on the matter:
When pension plan sponsors provide retroactive benefits to active employees, the result is an immediate increase in the existing liabilities of the plan. These benefits, related to past service, have not been funded by prior employer or employee contributions. The presumption that a short-term, market driven asset surplus makes such benefit enhancements affordable is almost always a critical error that can result in significant underfunding.
The concept of pre-funding is a central tenet of stable and sustainable defined-benefit pension systems. It is a built-in safeguard intended to prevent the systems from being used by self-serving politicians to award arbitrary benefits or enhancements when funding was not available.
Solid fully-funded defined-benefit pension systems operate on the principle of: no funding, no benefit. However, Frankfort’s culture of political patronage throughout the decades has encouraged the practice of some lawmakers in the past to awarded benefits outside the proper funding process in exchange for political support from beneficiaries, who, along with retirees, represent the commonwealth’s largest single voting bloc.
Often overlooked, however, is the role played by the retirement systems’ administrators and actuaries in misleading legislators into approving such increases in benefits. Our analyses and conversations with lawmakers lead us to believe that even when awarding benefit increases, legislators often were unaware that they were retroactively enhancing pre-funded benefits.
Actuaries and administrators of Kentucky’s retirement systems have, through the years, acted as fiduciaries for beneficiaries without much concern for taxpayers. They used their knowledge of the systems to mislead legislators and have held the biggest shovel when it comes to digging Kentucky’s pension hole. As a result, we must have a new approach toward governing these systems.
New governance approach, more oversight needed
Awarding arbitrary, overly generous and unaffordable benefits is also the result of a lack of proper oversight of Kentucky’s pension system. Conspicuous by its absence from SB 1 is any change in the governance of the systems, which we urge lawmakers to address during the debate and amendment process that will occur in the second half of the 2018 General Assembly session.
While we applaud the addition of numerous well-qualified members to the TRS and KRS boards during the Bevin administration, there remains an urgent need for an objective third-party fiduciary who serves to advance and protect the best interests of taxpayers.
Board members and actuaries hired by these boards are fiduciaries for beneficiaries and retirees while the concerns and interests of taxpayers rank low in priority and often are marginalized or even ignored. This even though taxpayers assume, by far, the greatest risk and bear the heaviest burden of funding the commonwealth’s public retirement system.
For many previous decades, state workers, board members and legislators have conspired to use Kentucky’s retirement systems and the benefits they award for their own financial, political and even personal gain. The results, which include the decline of a state public pension disaster now considered one of the nation’s worst, make it abundantly clear: business as usual is no longer acceptable.
A fiduciary for taxpayers?
Taxpayers will be expected to find a way to come up with the $65 billion needed during the coming decades to fill Kentucky’s unfunded pension-liability hole. Who will be their advocate throughout this reform process?
Kentucky’s pension predicament is now in crisis mode and threatens the commonwealth’s economic security. All stakeholders should support dismantling the current governing system and the construction and implementation of a new approach based on best practices employed by other states and proven to protect taxpayers while ensuring sustainable pension systems.
For example, a primary contributing factor to Tennessee’s success in achieving a fully funded public pension plan is the fact that the Volunteer State’s Treasurer, who’s appointed by a joint vote of the state’s Senate and House of Representatives, oversees the Tennessee Consolidated Retirement System.
Having the state treasurer overseeing all systems is a best practice worth emulating in Kentucky. Based on the results from Tennessee and other states, enlisting the treasurer’s involvement would result in a level of accountability, competence and leadership never previously achieved in the history of the commonwealth’s retirement systems. This is especially true considering Kentucky’s treasurer is elected and therefore would be held consistently accountable for the systems’ performance every four years when voters statewide go to the ballot box, which would certainly provide some additional protection against the irresponsible spiking of benefits and continuing – and costly – unfunded pension liabilities.
Because Kentucky’s treasurers are elected and historically have been fiscally conservative no matter their political party and who must convince voters of their financial capability and competence in order to win office, giving them a leadership role in overseeing the commonwealth’s pension system would contribute greatly toward proper implementation of SB 1 and bring a historical level of accountability, transparency and sustainability to Kentucky’s ailing retirement system.
Conclusion
Accomplishing the reforms offered in SB 1 during the current legislative session is critical to addressing Kentucky’s public pension crisis, which is threatening to crowd out funding for other services considered essential by most citizens, including public safety, education, healthcare and infrastructure.
What has happened with the Kentucky pension system just since the turn of the century has been rapid and tragic. The KERS, once among the nation’s healthiest government-operated pension funds with a funding level of 139.5 percent in 2000, has taken a rapid plunge toward near-insolvency in 2018.A key contributor to this dramatic decline was passage of Senate Bill 142 (SB 142) in 1998, which significantly raised the benefit factor for all KERS Nonhazardous employees from 1.97 percent to 2.0 percent. The legislation also created a 10-year window during which members who retired during that decade received an even-higher benefit factor of 2.2 percent that was calculated using an enhanced final compensation formula which based the size of those retirees’ pension checks on their highest three years of salary instead of the previous highest five years of pay.
This means a KERS member who earned a 1.25 percent benefit factor in 1960, when the compensation formula was based on the highest five years of salary and who later retired between 1998 and 2008 got a 2.2 percent benefit factor based on the enhanced high-three formula for service rendered between 38 and 48 years earlier. These benefit enhancements were not funded with either employee or employer payroll contributions but were enacted with no additional funding for two years.
In fact, Jim Carroll, who’s president of a group called Kentucky Government Retirees – essentially a Facebook site – is a major beneficiary of SB 142. Carroll won the lottery without buying a single ticket. Now, he and other pension-system talking heads in Frankfort are pounding the drum for higher taxes while opposing any reform in the way public-retirement benefits are calculated, awarded or governed.SB 142 and its fattened benefit passed the House by a 93-0 vote despite an independent actuary’s analysis that such an arbitrary increase in benefits is not an effective use of public dollars, would result in spendable income for retirees exceeding pre-retirement spendable income and cost taxpayers nearly $280 million over the next 30 years. In fact, he said the bill represented “danger” and created a “dangerous precedent.”
It didn’t take long for the “danger” to manifest as KERS’s funding level began a dramatic decline soon after the bill’s passage, dropping from 139.5 percent in 2000 to 38.3 percent in 2010 to its present level of barely 14 percent.
Even with the actuarially sound reforms contained in SB 1, common-sense changes in the governance and oversight needed to prevent a repeat of past egregious and arbitrary benefit enhancements and an expected modernization of the commonwealth’s tax structure, it will take a generation and likely more significant reforms to fill Kentucky’s cavernous pension hole.SB 1 reforms offer a starting point on the road back to a fair, healthy and sustainable public pension system and to a commonwealth that provides true and lasting opportunity for all citizens.
The Bluegrass Institute Pension Reform Team includes Director William F. Smith, M.D., Aaron Ammerman, a financial advisor and member of the Bluegrass Institute Board of Directors, and Jim Waters, president and CEO of the Bluegrass Institute for Public Policy Solutions. For more information and comment, please contact Bluegrass Institute president and CEO Jim Waters at 859.444.5630 (office) or 270.320.4376 (cell) or jwaters@freedomkentucky.com.