Call to Order and Roll Call
The second meeting of the Task Force on Kentucky Public Pensions was held on Tuesday, July 24, 2012, at<MeetTime> 10:00 AM, in Room 171 of the Capitol Annex. Senator Damon Thayer, 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, and Dorsey Ridley; Representatives Derrick Graham, Keith Hall, Brad Montell, Marie Rader, Rick Rand, and Brent Yonts.
Guests: David Draine, Pew Center on the States; William Thielen, Kentucky Retirement Systems; Senator David Williams; Representatives Jim Gooch, Dennis Horlander, Adam Koenig, and Tom Riner.
LRC Staff: Brad Gross, Judy Fritz, Jennifer Hays, Karen Powell, Frank Willey, Greg Woosley, and Peggy Sciantarelli.
Approval of Minutes
The minutes of the July 2 meeting were approved without objection, upon motion by Representative Yonts. (This occurred later in the meeting.)
Perspective on National Public Pension Issues (Including Kentucky) and Individual State Reactions to Address These Issues
Returning guest speaker was David Draine, Senior Researcher, Pew Center on the States. Copies of his slide presentation are available from Task Force staff.
Mr. Draine explained that the nonprofit Pew Center is a division of the Pew Charitable Trust. The Center, based in Philadelphia, has been looking at public sector retirement for about five years and is sharing data analysis on a nonpartisan basis with policy makers in all states.
Mr. Draine said that Kentucky Retirement Systems (KRS) faces a funding gap of $12.5 billion for its pension promises. Like pension plans in other states, KRS suffered losses from the 2001 recession; when actuarially recommended contributions increased following the recession, the state was not able to keep up and fell short in making its employer contribution each year since 2003. Kentucky should have set aside an additional $166 million in FY 2011 to pay for KRS pension promises. Given both the unfunded liabilities facing the state, as well as the ongoing inability to make the payments necessary to sustainably fund Kentucky’s pensions, the Kentucky Public Pensions Task Force will need to confront three challenges. The state must find ways to sustainably and affordably close the existing funding gap, ensure that the promises being made are sustainable and do not put the state at risk, and ensure that the retirement benefits being offered are effective at recruiting and retaining a talented public sector workforce.
One issue that Kentucky’s leaders need to address is whether to adopt a pension model other than the traditional defined benefit plan. Options used by other states include 401(k) style defined contribution plans, hybrid plans that include both a traditional pension and an individual retirement account, and cash balance plans that offer an individual retirement account but also include many of the protections commonly associated with traditional pension plans. One pressing question is the cost impact of putting new employees into a new plan, given that their employee contributions will no longer go into the existing plan. Before answering that it is important to note that most states, including Kentucky, work to prefund their pension plans. Prefunding pension obligations is important for intergenerational fairness, to help smooth costs over time, and to enable states to invest the money to help pay for benefits. If new workers go into a new plan, their contributions would no longer go into the existing plan, but their benefits would no longer be an obligation of the current plan.
Concern has been raised that switching to a new plan would force the state to spend more in the short term to pay off its existing funding gap. Transition costs have been cited as a reason not to close existing pension plans. States need to balance numerous factors and consider all the options available but should not worry that some approaches will force them to pay massive transition costs.
For most state plans, payments to close the funding gap are set as a certain percentage of salary. For example, in 2013 the contribution rate to pay for the unfunded liabilities of the Kentucky Employees Retirement System (KERS) nonhazardous plan was 24 percent of pay. Some have argued that, based on pension accounting rules, states should no longer set contributions as a percentage of salary; instead, the annual contribution should be a level dollar figure and more “front loaded” than Kentucky’s current rate. This means that contributions in 2013 would have to be higher than the plan is currently estimating, but contributions in the future—in 2033—would be substantially lower.
It is crucial for state policy makers to realize that developing a credible plan—rather than how payments are scheduled—is paramount to closing the funding gap. This is what Alaska realized when switching to a defined contribution plan in 2006. The first year it tried to make more payments up front, but policy makers quickly realized that because new workers were still entering the retirement system as a whole, even though in a different plan, it made sense to use the old approach. It is critical for a state to develop a plan to close the funding gap and meet the necessary payments. The practical experience of states like Alaska shows that the old accounting rules were not so rigid as to prevent states from coming up with their own approaches to fix their pension systems.
Pension accounting rules have substantively changed. The Government Accounting Standards Board (GASB) that sets these rules agreed to changes that let states set their own policies in determining recommended contribution rates. Kentucky should still identify a reasonable, affordable payment schedule to close its funding gap but is no longer required to estimate a given recommended contribution. Instead, GASB has shifted the rules from a funding-based approach—where GASB made states report whether they are making adequate annual contributions—to an accounting-based approach in which states focus on reporting their liabilities. This is not to say that closing existing pension plans is the best move for Kentucky—just that the different options should be considered on their own merit and not based on hypothetical costs caused by accounting rules that are no longer in effect.
Investment risk is particularly relevant to how pensions impact state budgets and is inherent in how states run their pension systems. About 60 cents of every dollar used to pay benefits comes from investments. Pension plans could avoid much of the risk by putting money in low-risk investments—e.g., Social Security’s placement of assets in Treasury bonds—but this would make retirement benefits much more expensive. While investment risk is not something to be avoided at all costs, it is important for policy makers to understand the risk.
It is also important that policy makers take a long-term view rather than focus only on individual years of data. When investment return was strong at the end of 2010, the median state pension plan had a 13 percent return, but in December 2011 the return was only one percent. While returns were very strong in the 1990s, from 2001 to 2011 states failed to meet their investment assumptions. When investments fell short, many states demonstrated that they had taken on more risk than they could handle, and recommended contributions increased in the midst of severe budget pressures that made it hard to meet increased payments. Most of the time when states do not meet their investment assumptions it is due to recession—a time when states are also facing tight budgets and decreased revenue.
While states like New York and North Carolina made the recommended contributions to shore up their pension plans, other states like Kentucky and New Jersey failed to do so. To avoid taking on more risk than they can afford, states may share some of the risk with workers and retirees. Wisconsin offers a dividend to boost retiree pension benefits when times are good but can take the dividend back if investments fall short. Alternatively, states can have employee contributions or cost-of-living adjustments (COLAs) reflect the health of the pension fund. A number of states, including Rhode Island, now set rules for giving cost-of-living adjustments when the plan is fully funded. In Arizona, contributions to the pension system are shared equally between workers and taxpayers; following the system’s investment losses in 2008, the contributions of both increased to help restore firmer footing to the pension system.
In a traditional defined benefit pension plan, all or most of the investment risk stays with the taxpayer. Some states have switched to different models to share some or all of the risk. In a 401(k) style defined contribution plan, workers bear the investment risk, receiving the gains when markets do well but having retirement assets suffer during recessions. Hybrid plans, which combine a traditional pension plan with a defined contribution plan, and cash balance plans, which give workers an individual retirement account with a guaranteed minimum return by the state, are models in which taxpayers and workers share investment risk.
The Task Force must face the challenge of developing a feasible plan to deal with KRS’s $12.5 billion unfunded liability. The cost of making recommended contributions competes with other important public priorities. Ultimately, states that face substantial funding gaps and have been unable to make full contributions will need to raise taxes, cut services, ask employees to contribute more, or reduce benefits, or some combination of these. Policy makers will need to consider ways to fairly share the burden. Concern has been raised that in states like Kentucky contractual protections may hinder reducing existing liabilities. This is not a simple question with a simple answer. Whether something may be legally viable in another state may not mean it would be feasible for Kentucky. However, a number of states have either made or proposed pension changes to reduce existing liabilities that seem to be legally viable. These approaches may be available options for Kentucky if putting more money into the system is not feasible and affordable.
Many states have increased contribution rates for employees. Changing employee contribution rates for new employees only would have minimal impact in the short term, and some states have also asked current employees to pay more. Alabama, Colorado, Kansas, Louisiana, Maryland, and New Jersey are among states that have recently made such a change. Since 2010, Arizona, Colorado, Florida, Maine, Minnesota, New Jersey, Oklahoma, Rhode Island, South Dakota, and Washington have reduced or eliminated cost-of-living adjustments for current workers or retirees. Thus far, judges in Colorado, Minnesota, New Jersey, and South Dakota have upheld the cuts.
Limiting future accrual is another approach states can use to reduce existing liabilities. While benefits that have already been earned are legally protected, states may be eligible to alter a public employee’s future earned benefits. In Rhode Island, current employees keep what they have earned under old pension rules but now earn benefits based on the new hybrid system. San Diego voters recently approved a referendum instructing city officials to freeze pay for the purpose of calculating pension benefits. If the city gives raises, those salary increases would not count toward the pension formula.
In 2011, when Connecticut’s governor offered public unions a choice of finding savings through either pension cuts or layoffs, the unions chose to work with the governor on pension reform. Voters in San Jose, California, passed a referendum allowing workers the option to either pay more into their pension system or receive a reduced benefit. Illinois’s Governor proposed a similar approach whereby workers would either accept reduced cost-of-living adjustments—the preferred approach—or lose retiree health benefits and forego having future raises count for pension calculation.
In closing, Mr. Draine said that many states simply cannot afford to close the funding gap by putting money into the system without devastating tax increases or draconian budget cuts. It is also not feasible to make new employees bear the entire burden. Policy makers need to be able to ask public employees to share in the cost, while also providing assurance that pension reform will avoid similar challenges in the future. If sustainable reform is passed, the benefits promised will be secure for future generations. Kentucky faces a real challenge but has the opportunity to improve the fiscal health of the state and to ensure that pension benefits are funded responsibly in the future. Mr. Draine thanked the Task Force for the opportunity to share the Pew Center’s knowledge and research on these complex issues.
Representative Yonts asked whether there has been resolution in any states where pension reform has been challenged in court on the basis of contractual promises. Mr. Draine said that the courts ruled in favor of cost-of-living adjustment reforms passed by the legislatures in Colorado, New Jersey, Minnesota, and South Dakota. States were able to prevail by demonstrating that the expectation of a given cost-of-living adjustment was not built into the contract, while existing benefits were built into the contract and untouchable. In some cases, even with an existing contract, the need of the state to function and provide public services resulted in court decisions favorable to state changes. In many other states there are continuing legal challenges, although some have prevailed in lower court. Except for Wisconsin, where the contract explicitly has a dividend system in which benefits go up or down, no state has retirees who have faced a situation where the benefit check for next year is lower than the benefit check in the current year.
Senator Hornback asked how federal health care reform might impact retiree health insurance benefits. Mr. Draine said that Pew has not seen states completely withdraw from offering health benefits for retirees, but some states have increased contributions to help pay for health benefits or asked for more cost-sharing from workers by charging increased premiums.
Representative Cherry said that pre-2003 health insurance benefits are part of the KRS inviolable contract but that cost-of-living adjustments are not an inviolable contract issue. Senator Thayer and Representative Cherry also noted that the Task Force is not including the Kentucky Teachers’ Retirement System in its deliberations but is including the judicial and legislative retirement plans.
When Representative Hall asked whether any state might be viewed as a role model in pension reform, Mr. Draine said he thinks reforms enacted in Georgia could serve as possible lessons for other states. Georgia requires an actuarial evaluation on any proposed pension legislation and a one-year waiting period to allow for deliberation before the bill can be passed. In 2008, Georgia switched to a hybrid plan that offers to new workers only a smaller traditional benefit and an individual retirement account. The purpose was not to save money but to help recruit a talented workforce. Mr. Draine said he believes other states should consider the analysis Georgia used in offering the hybrid plan.
Representative Graham asked whether any state with an inviolable contract similar to Kentucky’s has made the type of pension changes that have been proposed for the Task Force to consider. Mr. Draine said that all of the states mentioned share some level of constitutional protections for pension benefits. The contracts vary by state and are affected not only by case law but also by the way plan benefits are written. Arizona lost a recent court case when the judge ruled that pension changes violated that state’s contract provision. There is variation in what states include in the contracts; but in every state, if not specific state protections, federal constitutional protections may limit the ability to change contractual benefits.
Responding to further comments from Representative Graham, Mr. Draine said that even without a plan change it is important that Kentucky be able to make its contributions in a sustainable way. He further explained cash-balance type plans like Nebraska’s and said he would provide information regarding the average salary of employees in the Nebraska pension system. Representative Graham said he is concerned how the Nebraska reforms impacted employees with annual salaries of $75,000 or less.
Responding to questions from Representative Montell regarding the cost of switching to a new plan, Mr. Draine said it is the Pew Center’s position that the transition cost argument is not correct under the old rules and is moot under the new GASB rules. He said the main debate relates to how quickly a state would be able to pay off its unfunded liability after moving to a new plan. Regardless, the debt needs to be paid, either by raising taxes, cutting services, or asking employees to share more of the cost. When Michigan switched to a defined contribution plan, unfunded liability was not an issue.
Representative Montell asked whether transitional costs of switching to a defined contribution plan would be greater if current employees, as well as new hires, would be earning future benefits under the new plan. Mr. Draine said that transition cost arguments have generally been made with respect to closing a defined benefit plan entirely and switching to a defined contribution plan. In Rhode Island, which closed its existing defined benefit plan and switched to a hybrid plan with a defined benefit component, the case was not made that this would create transition costs. States have two options for scheduling payments to close a funding gap—either as a level dollar amount paid every year over time, or as a percentage of pay. If payments are based on percentage of pay and all existing employees are removed from the system, there is no pay left. If the state follows a transition cost payment schedule in an attempt to speed up payment of the unfunded liability, setting aside all existing employees would result in a greater cost impact.
Responding to Representative Yonts, Mr. Draine said that a number of states have raised taxes recently to help pay their unfunded liability. Illinois had a major income tax increase, which did not solve its pension problem. Representative Yonts asked whether there has been any court case that involved a “peeling off” of COLAs that were not part of the base retirement benefit but were treated as such. Mr. Draine said there may possibly be a court case. He said that in Providence, Rhode Island, the retirement board agreed to a six percent annual cost-of-living adjustment, compounded. This quickly became expensive, and the mayor immediately tried to rescind the COLA. Courts upheld it at the time, but unions recently agreed to end it. Mr. Draine said the agreement may have included recoupment of some of the gains. Pew Center has not seen any state make a change that would reduce a retiree’s current benefit payment, with the possible exception of Providence, which he agreed to look into further.
Representative Cherry stated that, in Kentucky, COLAs already earned and added to a retiree’s base benefit cannot be recaptured, although future COLAs might be rescinded since they are not part of the inviolable contract. He also spoke about the magnitude of the unfunded liability and the necessity to either meet the required contributions enacted by the legislature or find ways to reduce costs.
When asked by Senator Higdon, Mr. Draine said that both the “high three” and “high five” years of salary are currently used by states to calculate retirement benefits. States that are changing their pension plans also tend to use “high three” and “high five.”
Senator Thayer remarked that when he had sponsored a bill to create a defined contribution system for new employees, the first argument he always heard was that it would incur a huge transition cost. However, with the change in GASB rules, it appears that the transition cost argument is moot and should not be viewed as an impediment. Mr. Draine affirmed the Pew Center’s analysis that transition cost was not an issue under the old GASB rules. Regardless, the new rules do not demand that states create an explicit payment schedule, let alone one based on moot transition cost rules.
Senator Thayer asked how many states have pension plans that differ from the traditional defined benefit. Mr. Draine said that Alaska and Michigan offer pure defined contribution plans. Nebraska has used the cash balance model for a long time, and Louisiana and Kansas recently passed legislation to shift new employees into that type of plan. Oregon, Rhode Island, Georgia, Ohio, and a number of other states offer hybrid plans. Mr. Draine said he would be happy to provide a complete list later. At Senator Thayer’s request, he also stated the choices that governments face in order to address their unfunded liabilities: free up revenue by increasing assets, raising taxes or cutting services; ask employees to contribute more; or reduce benefits.
Representative Cherry questioned whether the ARC (actuarially required contribution) for the Systems would increase as a result of going to a defined contribution or hybrid plan. Mr. Draine said that the new GASB rules eliminate the ARC as something that states need to calculate or report, but states can—and should—have a payment schedule to close the funding gap in a sustainable way. Representative Cherry asked who would determine a payment schedule for the County Employees Retirement System (CERS), which now pays 100 percent of the ARC. Mr. Draine said plan administrators would be better able to answer this. He commented that he, as a researcher, is curious how the new rules will be implemented. He believes that states and localities that have been paying the ARC will continue to do the same. The ARC is a sensible way to establish a reasonable set of payments. Some places that have fallen short may stop reporting an ARC. In Kentucky, ARC payments still make sense. Straight-line level payments and payments that increase as a share of payroll for all members of the system are both available options. Though no longer required to establish an ARC, if a state chooses to do so, it has the flexibility to decide how it is structured. Representative Yonts said that, without an ARC, Kentucky’s funding gap would quickly escalate.
Representative Cherry said he is encouraged by some of today’s testimony. He hopes that the Task Force can find a solution that will focus on new employees. Senator Thayer concurred. He announced that the Task force will have four more meetings, with recommendations due in December. He thanked Mr. Draine and announced that someone from the Pew Center or the Laura and John Arnold Foundation will participate in all of the meetings. Mr. Draine introduced his colleague from the Pew Center, Brian Keegan, and said they would be available for questions after the meeting.
Kentucky Retirement Systems Overview
William Thielen, Executive Director, Kentucky Retirement Systems, said that KRS wishes to serve as a resource to the Task Force to provide accurate, relevant information. He and the KRS Board do not advocate any particular policy. GASB has never been a funding requirement but rather sets a standard for accounting and for reporting liabilities. GASB 43/45, which KRS implemented in 2006, had a dramatic impact on funding. The new standard, GASB 67/68, changed the way of accounting for and reporting pension liabilities, but it divorces the accounting and reporting from funding. It will be up to the KRS Board to establish a funding policy. Without reasonable funding of the liabilities, the state’s credit rating is likely to suffer. Ultimately, KRS actuaries will have to determine whether there will be transition costs. GASB 67/68 requires that liabilities be determined and reported using the “entry age normal” actuarial method, with a level percent of payroll. This is the current method used by KRS. The KERS-nonhazardous fund has a cash flow problem, which means contributions cannot be “back loaded.” The money must be available up front for investment purposes and to pay for benefits. Actuaries contend that KRS cannot afford an actuarial method that permits “back loading” of benefits in the KERS-nonhazardous plan.
Mr. Thielen completed the overview that he presented in part at the July 2 meeting of the Task Force. Copies of his slide presentation are available from Task Force staff. He noted that slides 36, 37, and 59 are new.
Mr. Thielen disagrees with allegations in the media that KRS funding problems are caused by mismanagement of the investment program. KRS has managed its investments well but is striving to do better. Since inception in 1984, investment performance in the KRS pension fund is only 0.09 percent below the benchmark, and overall investment return has been 9.72 percent. The fund fell short of the assumed rate of return of 7.75 percent for the 3-year, 5-year, and 10-year period, as did most pension plans in the country, but over the long term the pension fund has significantly exceeded the assumed rate. Investment return for the insurance fund is only 0.06 percent below the benchmark since inception in 1987. Relative to 77 public pension plans across the country of comparable size, KRS is about 0.10 percent below the median in investment return for the past five years, with significantly less risk in the portfolio.
Mr. Thielen’s slide presentation included charts showing the 2006-2011 actuarial funding level for both the pension and insurance funds of KERS and CERS-hazardous and nonhazardous and the State Police Retirement System (SPRS).
The actuarial fund value of the KERS-nonhazardous pension plan has declined from 60 percent in 2006 to 33.3 percent in 2011. The CERS-nonhazardous pension plan had an actuarial fund value of 83.6 percent in 2006; in 2011, the actuarial fund value was 63.1 percent. The SPRS pension plan has gone from 66.6 percent funded to 45.0 percent funded for the same period. The SPRS plan is relatively small, however, with a total asset base of approximately $405 million.
The combined unfunded liability of KERS-nonhazardous was $11.28 billion at the end of FY 2011. Total combined unfunded liability for KERS-nonhazardous, KERS-hazardous, and SPRS was $12.34 billion, a slight increase from FY 2010 due to investment losses in 2008 and 2009, even though investments did well in 2010. Combined unfunded liability of CERS was $6.89 billion, also a slight increase from FY 2010.
A significant cause of the increase in unfunded liabilities is the reduction in employer contribution rates in KERS and SPRS. The shortfall has been $2.86 billion over the last 20 years. Other causes include: cost inflation for retiree insurance; funding to significant new health insurance liabilities that were reported beginning in 2006 as a result of GASB 43/45; benefit enhancements; retiree COLA increases that were not prefunded; and market losses in 2000-2002 and 2008-2009. There have not been any significant benefit increases since 2001. The total increase in the unfunded liability from 2006 to 2011 in the KERS-nonhazardous pension plan is attributed to investment loss (18.7 percent), COLA and benefits (19.8 percent), changes in actuarial assumptions (12.6 percent), employer contribution shortfall (17.4 percent), demographic and salary experience (6.8 percent), and “other” (24.7 percent—due partly to the closed amortization period).
Mr. Thielen gave a brief review of slides relating to historical reductions to the employer contribution rates for KERS-hazardous and SPRS; combined underfunding interest loss for KERS, CERS, and SPRS; cost inflation for retiree insurance; estimated cost of providing a 1.5 percent ad hoc COLA for retirees effective July 1, 2010; savings from the changes enacted into law in 2004 (HB 290); and the benefit changes and phase-in ARC payment schedule enacted in House Bill 1 in the 2008 extraordinary session.
Responding to a question from Representative Graham, Mr. Thielen said that he had offered by phone to meet with and provide information to staff of the Pew Center but had not yet done so.
Responding to questions from Representative Yonts, Mr. Thielen said that the large spike in the adopted employer contribution rate in 2007-2008 was due to implementation of GASB 43/45 and reduction of the assumed rate of return from 8.25 to 7.75 percent. Over the last 10 years, the assumed rate in the pension plan has been 5.52 percent.
Announcements and Adjournment
Earlier in the meeting, Senator Thayer remarked that KET did not televise this meeting or the first meeting of the Task Force. Because of statewide interest in the work of the Task Force, KET will televise future meetings.
Representative Cherry announced that the next meeting will be on Tuesday, August 21, at 1:00 p.m. The agenda may include testimony from interested organizations and employee/retiree groups.
With the business concluded, the meeting adjourned at 12:05 p.m.