Kentucky's pension crisis: The wrong question

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Editor’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.