Call to Order and Roll Call
The first meeting of the Task Force on Kentucky Public Pensions was held on Monday, July 2, 2012, at 1:00 PM, in Room 171 of the Capitol Annex. Representative Mike Cherry, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator Damon Thayer, Co-Chair; Representative Mike Cherry, Co-Chair; Senators Jimmy Higdon, Paul Hornback, Joey Pendleton, Dorsey Ridley, and Mike Wilson; Representatives Derrick Graham, Brad Montell, Marie Rader, Rick Rand, and Brent Yonts.
Guests: William Thielen and T. J. Carlson, Kentucky Retirement Systems; David Draine and Alexis Schuler, Pew Center on the States; Josh McGee, The Laura and John Arnold Foundation.
LRC Staff: Brad Gross, Judy Fritz, Karen Powell, Frank Willey, and Peggy Sciantarelli.
Background and Opening Remarks
The Task Force on Kentucky Public Pensions was created as a result of HCR 162, enacted in the 2012 regular session of the General Assembly. The Task Force co-chairs, Representative Cherry and Senator Thayer, expressed appreciation to the Pew Center on the States and The Laura and John Arnold Foundation for offering their assistance and expertise at no cost to the Commonwealth. They also acknowledged in the audience two members of the Kentucky Retirement Systems (KRS) Board, Kentucky Secretary of Personnel Tim Longmeyer and Vince Lang. Representative Cherry discussed factors that have further worsened the funding gap in Kentucky’s public pension funds since the passage of House Bill 1 in 2008. Both co-chairs commented on the seriousness of the problem and expressed willingness to consider everything related to the issue as the Task Force and its participants seek to improve the long-term financial health of Kentucky’s public pension funds.
Kentucky Retirement Systems Overview
Guest speakers from Kentucky Retirement Systems were William Thielen, Interim Executive Director, and T. J. Carlson, Chief Investment Officer. They presented an overview of the Systems and provided the Task Force with copies of their slide presentation. Copies of the presentation may be obtained by contacting Task Force staff.
Mr. Thielen gave an overview of the three plans administered by KRS: Kentucky Employees Retirement System (KERS), County Employees Retirement System (CERS), and State Police Retirement System (SPRS), which are qualified public defined benefit plans established under Section 401a of the Internal Revenue Code. He provided information regarding plan administration; the composition of the nine-member Board of Trustees that administers the Systems; the KRS organizational chart; annual totals of retired, inactive, and active members from 2006 to 2011; and membership by system and status (hazardous/nonhazardous) as of June 30, 2011. KRS administers retirement benefits for more than 324,000 state and local government employees and retirees. As of June 30, 2011, KRS assets were $14.77 billion. Each year KRS pays $2 billion in pension and insurance benefits, with 95 percent of benefit payments delivered to Kentucky residents. Other topics discussed included the statutory benefit formula; retirement eligibility criteria for hazardous and nonhazardous members, with participation dates prior to, on, or after September 1, 2008; health insurance benefits for members participating prior to July 1, 2003, between July 1, 2003 and August 31, 2008, and on or after September 1, 2008; FY 2011 analysis of initial retirees, by system; KRS funding sources; United States public pension fund revenue sources from 1982 to 2009; actuarially recommended and actual employer contributions for the FY 2012-2013 budget biennium; and the recommended and budgeted employer contribution rates since 1990 for KERS-Hazardous, KERS-Nonhazardous; and SPRS.
Responding to questions from Representative Cherry, Mr. Thielen confirmed that the health insurance fund, although it has an unfunded liability, is in a better position than the pension fund. He explained that GASB refers to the Governmental Accounting Standards Board, a nonprofit organization of professionals that establish accounting standards for public pension plans and other public entities. GASB standards do not have to be complied with, by law, but are considered by bond rating agencies.
Mr. Carlson gave an overview of the KRS investment program. He spoke about availability of monthly performance reports and other investment information on the KRS web site; educational qualifications and certifications of the KRS investment staff; Pension Fund asset allocation targets, effective July 1, 2011; asset allocation statistics; KRS Pension Fund asset allocation versus averages for similar size funds across the country; fiscal and calendar year investment return for the KRS Pension Fund since 1990; short-term and long-term performance of Pension Fund investments as of April 30, 2012; and risk/return analysis of the KRS investment program.
Mr. Carlson stated that KRS is responsible for managing assets on behalf of 10 different plans; seven of those plans have the same asset allocations, and three have different asset allocations, based on the specific cash flow needs and liquidity requirements of the plans. The allowable ranges for asset allocation are more constrained than they have been historically, in order to help ensure a more consistent meeting of targets and improve long-term investment performance.
He said that KRS invests 20 percent in U. S. stocks. Many other public pension plans have 30-35 percent invested in U. S. stocks. On a one-year basis, the U. S. Equity portfolio is performing slightly below the benchmark. KRS and many other public pension plans have struggled in the Non-US Equity market, where the benchmarks have been more difficult to meet since 2003 when benchmarks were re-made by index providers. Over the coming months KRS will look at ways to improve performance of the Non-US Equity program. The Emerging Market Equity program is working well and is expected to be a good source of future growth for the pension and insurance funds. Total equity in the KRS Pension Fund portfolio, which is about 44 percent, is underperforming the benchmark on a one-year basis by .75 percent. Total Fixed Income—20 percent of the portfolio—is outperforming the benchmark by approximately one percent. Total Real Return has only been in place since the beginning of the current fiscal year but is about seven percent above the benchmark. The total Absolute Return program is just over one year old is working very well, at six percent above the benchmark. The total Real Estate program was restarted about three years ago and is lagging on a one-year basis but has earned almost eight percent versus the two percent benchmark on a three-year basis. With respect to risk/return, KRS has substantially reduced volatility and risk in its portfolio, although slightly underperforming (by .09 percent) from the median return of 77 public pension plans across the country on a five-year annualized basis.
Due to shortness of time, Representative Cherry asked Mr. Thielen to return to a future meeting to give the remainder of his presentation, since it deals with actuarial basics and funding levels—areas of prime interest to the Task Force. Representative Cherry thanked the speakers and assured the members that they would have an opportunity to ask questions of Mr. Thielen and Mr. Carlson when they return.
National Public Pensions Issues (Including Kentucky) and Individual State Reactions to Address These Issues
The guest speakers were David Draine, Senior Researcher, and Alexis Schuler, Senior Officer/Campaigns, Pew Center on the States; and Dr. Josh McGee, Vice President for Public Accountability Initiatives, Laura and John Arnold Foundation. Copies of their slide presentations and Mr. Draine’s prepared remarks that accompanied the presentation are available from Task Force staff.
Mr. Draine explained that he is the lead researcher on public sector retirement systems at the Pew Center and that his research had centered on six Kentucky pension plans: KERS Hazardous, KERS Non-Hazardous, State Police Retirement System, Judicial Retirement Fund, Legislator’s Retirement Fund, and Kentucky Teachers’ Retirement System. Representative Cherry interjected that the Task Force will not be examining the Teachers’ Retirement System, but that any recommendations developed by the Task Force might also be applied to the judicial and legislative plans.
Mr. Draine’s slide presentation included charts illustrating 2011 funding levels and recommended and actual contributions in Kentucky’s pension plans; growth of liabilities and decline in assets from 2000 to 2011; contribution rates for the KERS Non-Hazardous plan; the widening gap faced by state pension systems nationally; the impact of reforms on a hypothetical Rhode Island state worker in 2012; and a U. S. map showing states that have reduced the cost-of-living adjustment (COLA) or switched to a new plan type, or both.
In summary, Mr. Draine said that since 2003, public employers have not been able to make the full contributions recommended by actuaries. Kentucky’s pension plans were fully funded in 2001, with a substantial surplus. A combination of benefit increases—including COLA’s—and investment losses from the 2001 recession created a funding gap. From 2004 onward the plans did not get enough contributions from the state to keep them on a sustainable path. The pension reforms enacted in 2008 will provide long-term savings but will have a limited impact in the short-term. Initial estimates suggested that the reforms will have saved the state a little over $30 million in 2011; meanwhile the state fell short by about $300 million in making contributions that same year. In the KERS Non-Hazardous plan, for example, the total annual cost for pension and retiree health care benefits was a little under six percent of payroll in 2003, compared to a little over 44 percent in 2013. Even if benefits are cut for new workers, closing the funding gap would still require a substantial infusion of money.
Nationally, states faced an unfunded liability of $1.38 trillion in 2010 for similar reasons that Kentucky has—insufficient contributions, retroactive benefit increases, and investment losses. Kentucky was one of just four states that had funded less than 55 percent of pension obligations, along with Connecticut, Illinois, and Rhode Island. However, Kentucky was one of just 10 states found to be solid performers in managing retiree health care obligations.
Mr. Draine said that traditional defined benefit pension plans have structural problems that have helped lead to the substantial pension challenges facing the majority of the 50 states. These plans expose states to investment risk and longevity risk and allow state and local policy makers the opportunity to skip payments and push the cost off to future taxpayers. Because traditional pensions concentrate benefits on career employees, they may not reflect the modern workforce that a state needs, and states may miss out on younger workers who might expect to change jobs several times during their careers. These issues can be addressed, and some states that offer traditional defined benefit pensions have plans that are in good shape. North Carolina, for example, has a well-funded, sustainable pension system.
To address the pension challenges, Kentucky will need to have a credible plan to close the funding gap, over time, by making the full recommended contributions. For states with severe unfunded liabilities, making these payments may be unaffordable, and they may need to consider fair ways to share the sacrifice. Secondly, it is important that Kentucky find ways to ensure that the state does not skip on contributions, raise benefits without paying for them, or take on more risk than it can handle. This can include employee contribution rates that adjust based on funding levels, or by switching to hybrid plans or individual retirement accounts that shift risk to workers, or to plans where benefits change based on the health of the pension system. Thirdly, benefits being offered should help the state recruit and retain a talented public sector workforce.
Based on 2010 data, Rhode Island had a poorly funded pension system but passed major reforms in November 2011 that reduced its unfunded liability by an estimated $3 billion. The state drastically reduced the cost-of-living adjustment to retirees—to be returned at a reduced level when pensions are at least 80 percent funded. Those cost-of-living changes are responsible for the bulk of the savings that put the state on a path toward controlling and reducing its funding gap. Rhode Island also put employees, including current workers, in a new plan comprised of a smaller traditional pension plan and an individual retirement account to which both the state and the worker will contribute. Workers will still receive all benefits already earned prior to implementation of the new plan but will earn benefits at a reduced rate under the new plan. Nine other states have also reduced cost-of-living adjustments. In court challenges the changes have been upheld in some cases, and in others the legal battles are continuing. Under the city of San Jose’s recent pension reforms, workers can accept either the new, less generous rules for benefits, or higher contribution rates. A recent proposal by Illinois Governor Quinn gave workers a choice of retaining COLA adjustments or their retiree health benefits.
Some states have been considering new pension plan models that are more affordable, pose less risk to the state, and potentially could offer a benefit better aligned with the states’ workforce needs. Virginia is putting new workers in a hybrid plan with a smaller defined benefit and an individual retirement account.
Louisiana and Kansas created new plans that offer an individual retirement account with many of the protections commonly associated with a traditional pension plan. Workers would have an individual account, and benefits would be based on how much was in the account at retirement. Unlike a 401(k)-style plan, the state would guarantee a minimum return rather than leaving all investment risk with workers, and would allow retiring workers to easily buy annuities that would protect them from outliving their retirement savings. Plans of this type—called a cash-balance plan—are already in use in Nebraska and Texas.
Some cities have made changes as well. When policymakers failed to solve their problems, voters by referendum in San Jose and San Diego closed their existing plans to new employees. San Jose transitioned workers to a hybrid plan, and San Diego created a new 401(k)-style individual retirement account.
One argument against closing existing plans and replacing them with new ones is that it would impose immediate costs on states due to accounting rules. The Pew Center has looked at this issue. Both academic analyses and the practical experience of states like Alaska that made the switch suggest that accounting rules are not so rigid as to require these extra costs. Furthermore, recent changes in GASB accounting rules make that point moot. This is not to say that states need to close their existing plans but simply that neither the costs nor the benefits of doing so should be exaggerated.
In closing, Mr. Draine said that there is no one-size-fits-all solution, and Kentucky policy makers will need to find an approach that works for the state. It is not just about reducing costs but also about designing a system that meets the state’s needs while being fiscally responsible and sustainable. Kentucky’s problem is solvable and that the Pew Center is ready to offer help in providing the data and analysis needed in order to make an informed decision.
When Representative Montell asked whether it would not be a common sense approach for states to choose pure defined contribution plans as an alternative, Dr. McGee said that both Alaska and Michigan have defined contribution plans, and several states offer defined contribution as an option. In Florida new hires may choose a defined contribution option if it better matches their preferences. Several states have considered the defined contribution approach, but there has not been a lot of movement in that direction recently.
Representative Montell said he is interested in the cash-balance plans of Louisiana and Kansas, where both the employee and employer contribute to the employee’s individual account and the employer guarantees a minimum return. Mr. Draine explained that when actual returns exceed the minimum rate some of the excess money goes to the employee, depending on how the rules are set up, but the employer keeps part to make up for possible low returns in the future. Dr. McGee said the return promise to employees is very flexible in a cash balance plan, which is a defined benefit plan. The minimum return promise is zero, and the minimum floor is often set above that but certainly at less than the current investment return assumptions of the existing plan. That is why it is less risky. Louisiana promises employees the plan’s return minus one percent. If the plan returns 10 percent, the employees’ accounts would get nine percent, which can float between zero and “sky’s the limit.” The Kansas and Nebraska plans promise a floor and have a mechanism for sharing gains above that floor. Nebraska promises a floor of five percent. When investment return exceeds that floor, a dividend goes to employees, but the dividend plus the floor cannot be greater than eight percent.
When Representative Yonts asked about the limiting effect of Kentucky’s inviolable contract with employees, Dr. McGee said that is a difficult question to which he cannot give a direct answer. He said that the inviolable contract is not unique to Kentucky. Illinois and other places have strong constitutional or case law protections for pensions. It is a tricky situation but is navigable, he believes. Everywhere that pension changes are made will involve legal issues that will go “all the way to the top” to be sorted out in order to protect states’ economic viability.
Representative Yonts asked how employees in Rhode Island reacted to the new plan and whether that state has an inviolable contract. Dr. McGee said the employees, as expected, were not supportive, since their prospective benefits were reduced. Although Rhode Island does not have constitutional protections for retirement benefits specifically, a trial court has found that there is a contract with employees for benefits. The plan is being challenged under a contract clause of the state and federal constitutions. He emphasized that in order for a state to have the strongest case possible, it is the responsibility of state leaders who are meeting these challenges to take a thoughtful and reasoned, data-driven approach and to demonstrate that the changes are reasonable and necessary.
Representative Graham questioned a comparison with the plan in Rhode Island, since it has a much smaller population than Kentucky. When he asked how many employees are in Rhode Island’s retirement system, the speakers said they would have to get that information. Mr. Draine said they are not suggesting Rhode Island as an example for Kentucky. The lesson to be drawn from the pension reforms in Rhode Island is the process that was used to find solutions and devise an affordable plan. He said there are many different options and ways to make them work—whether it be a cash balance, hybrid model, defined benefit, or defined contribution plan. What is important is that policy makers ensure that risks will be managed, contributions made sustainably, and implications for the workforce carefully considered. Dr. McGee added that they are not suggesting that Kentucky adopt Rhode Island’s solution but to consider Rhode Island’s approach, where that state’s treasurer emphasized that “this is about math, not ideology.” Representative Graham said he agrees but that Kentucky must also consider other variables, such as the inviolable contract. He added that he is looking forward to the recommendations that will be forthcoming.
Representative Cherry said he is flexible with regard to whatever options may ultimately be recommended; however, he believes the most difficult issue faced by the Task Force is how to address the huge unfunded liability.
Responding to comments from Senator Thayer, Dr. McGee said that pension changes almost always will result in litigation, and trial courts are likely to push the issue through the appeals process to the highest state court. Mr. Draine said that the legal issues have not been resolved in many states and that there is no binding precedent. He said there are things which states can do fairly, but there are things that clearly cannot be done—i.e., take away benefits already earned. There will undoubtedly be legal challenges with respect to benefits expected but not yet earned, cost-of-living adjustments not yet granted, and future employee contributions, for example.
Dr. McGee said that the Pew Center and the Foundation will not be able to promise the Task Force complete legal certainty on pension issues. Mr. Draine said that courts have indicated that the degree to which a state has explored and exhausted all options impacts whether a given change might be ruled legal. To build a strong case, states must show, for example, that their approach is the only one available and that additional revenues cannot be found without challenging the viability of the state.
Senator Thayer, noting that pension reform has become a bipartisan issue, inquired about the party affiliations of the Rhode Island legislature and the state treasurer who was the main impetus behind pension reform in that state. Dr. McGee said that Rhode Island is an overwhelmingly Democratic state with a Democrat majority in the General Assembly, and that the Treasurer is a rising star in the Democrat Party.
Senator Thayer, recalling Mr. Draine’s earlier testimony, asked why it may not necessarily be the case that replacing a defined benefit plan with a defined contribution plan would impose an immediate cost to the state. Dr. McGee said that under current GASB rules, closing a plan requires a shift in the way unfunded liability is amortized. That is the basis for much of the transition cost argument. He went on to explain that when on an increasing schedule, some would claim that closing a plan would force a switch to a level schedule much like a mortgage, where payments are the same across time. However, other states that have moved to a defined contribution plan—Alaska being one—did not move to this level schedule. They kept their increasing schedule and spread the cost over total payroll. Also, there is no theoretical reason for accelerating funding payments. If a state, before closing its plan, already had a responsible funding schedule that would pay down the debt over a reasonable time period, then after closing the plan that same funding schedule should be responsible. The only time an infusion of cash into the system would be needed is when there is an actual cash flow problem—i.e., if benefit payments would exceed fund assets. Most states do not have an actual cash flow problem. In addition, the most recent GASB revisions—which hopefully will go into effect within the next two years or so—have done away with the annual required contribution, which is essentially the element of accounting that would recommend a funding schedule altogether. Since GASB is getting out of the funding policy business, it is a moot point going forward.
Senator Thayer asked about the fiscal implications of pension reforms in Alaska and Michigan, which have defined contribution plans. Dr. McGee said that is a great question but that he is not prepared to provide exact details. He said that Alaska made the move in the early 2000s and Michigan in the early 1990s and, therefore, have insulated themselves from some of the recent volatility in the market, although their members have borne that volatility. He said he believes the fiscal implications are positive for those states. They did not aggregate market losses to the state budget nor have the volatility that has been very difficult to deal with at the state level.
Representative Cherry indicated that the transition cost issue has concerned him with respect to the defined contribution approach. Dr. McGee said that the transition cost argument is very specific to closing a plan and moving to a defined contribution plan. The argument does not hold when leaving a plan open and moving to a FAC (final average compensation) hybrid plan like Rhode Island’s or cash balance plans like Louisiana’s and Nebraska’s. Representative Cherry asked whether there would still be costs involved with a hybrid plan because of less going into the system in contributions. Dr. McGee said that is true but that it is important to note that these systems are not “pay as you go” like Social Security. Unless underfunding is so severe that there is a cash flow problem, there is no reason to deviate from a responsible funding plan.
Closing Remarks and Adjournment
Representative Cherry announced that the next meeting is tentatively scheduled for July 24. He thanked the speakers and said he expects other organizations and groups may be making presentations at future meetings. Earlier in the meeting he advised the members that the Pew Center and the John and Laura Arnold Foundation will continue to offer assistance and that he anticipates they will be submitting specific proposals to the Task Force.
With the business concluded, the meeting adjourned at 3:00 p.m.