Call to Order and Roll Call
The 7th meeting of the Public Pension Oversight Board was held on Monday, August 28, 2017, at 1:00 PM, in Room 149 of the Capitol Annex. Senator Joe Bowen, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator Joe Bowen, Co-Chair; Representative Brian Linder, Co-Chair; Senators Jimmy Higdon, Christian McDaniel, Gerald A. Neal, Dennis Parrett, and Wil Schroder; Representatives Ken Fleming, James Kay, Jerry T. Miller, Arnold Simpson, and Russell Webber; J. Michael Brown, John Chilton, Timothy Fyffe, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: John Chilton, State Budget Director; Mike Nadol, PFM Group Consulting LLC; and Adam Reese, PRM Consulting Group.
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.
Approval of Minutes
Senator Parrett moved that the minutes of the June 26, 2017, meeting be approved. Representative Kay seconded the motion, and the minutes were approved without objection.
Senator Bowen stated HB 238 was passed in the 2016 Regular Session and requires the Public Pension Oversight Board (PPOB) to employ the services of an actuary. LRC has issued a Request for Proposals (RFP), and three members from the PPOB will serve as an evaluation committee. The members nominated were Senator Bowen, Senator Schroder, and Representative Linder. Representative Miller moved for the approval of the evaluation committee members. Representative Fleming seconded the motion, and the committee members were approved without objection.
Senator Bowen said that Kentucky is faced with arguably the greatest challenge in its history - its pension liabilities. The pension systems must be saved and obligations met. As with any great challenge, all options to rectify the matter must be explored, and the PPOB must pursue the matter to get to the root cause of the problem and identify a pathway to solvency. PFM is providing an unbiased third party view, and the Kentucky legislature will be making decisions to craft a responsible and reasonable plan and will give those that might be affected ample time to make important decisions.
Introduction and Overview by Office of State Budget
John Chilton discussed the $138.5 million revenue shortfall. In June of FY 2017, in order to resolve the shortfall, money was transferred from various funds throughout state government. The Consensus Forecasting Group’s most recent meeting stated they expect another revenue shortfall of $200 million for FY 2018 and expressed uncertainty regarding subsequent fiscal years. Mr. Chilton stated that, in PFM’s second report, the actuarial assumptions were optimistic and in response, the Kentucky Retirement Systems’ (KRS) Board lowered the expectations for the investment return and payroll growth and computed a new ARC for FY 2019. Using the more realistic assumptions, PFM computed that the general fund will be adversely affected by $700 million in FY 2019 alone. In context, the total state budget is roughly $10.5 billion. The Budget Reserve Trust Fund (Rainy Day Fund) is expected to be fully depleted by the end of FY 2018 due to necessary government expenses. The common target for the Budget Reserve Trust Fund is 5 percent of annual revenues, which would be $550 million in reserve excess monies as of the end of the year.
Mr. Chilton discussed options on how to raise $1 billion, such as, cut spending, increase taxes, adjust benefits, and not pay the ARC. In the last budget cycle (2016), the expenditures in state government were reduced by 9 percent. Some important government services were not subjected to that 9 percent decrease, for example, K-12 education (SEEK), Medicaid, public protection, debt service, etc. To protect these same programs from cuts in FY 2019 would require that all other programs be cut by 34.4 percent. Protecting those same programs, but additionally subjecting education (SEEK) to cuts, requires cuts of 16.86 percent. SEEK would be reduced by $510 million. All of this data presumes the ARC is fully funded in FY 2019.
Pensions and Medicaid have been a growing percentage of the general fund budget. In 2008, Medicaid and pensions made up just less than 20 percent of the total budget, the projection for 2018 is that Medicaid and pensions will make up just over 30 percent of the total budget.
Mr. Chilton stated that subject to discussion is the actual size of the pension liability. In 2016, actuaries computed an aggregate unfunded liability of $33 billion. That figure was computed using an assumed investment return averaging 6.75 to 7.5 percent. Using rates that are recommended by PFM, rates of either 5.1 or 6 percent, the unfunded liability is $42 billion. Using a corporate bond index rate, which non-governmental plans are required to use, the indication is that the funding is actually $64 billion. Finally, if the U.S. Treasury rate at 2.72 percent is used, the unfunded liability is $84 billion. Mr. Chilton said that the $64 billion sum is the calculation that is closest to what non-governmental plans are required to use. Therefore, $64 million is the amount his office has used.
Mr. Chilton discussed how the underfunding occurred for Kentucky Employees Retirement System (KERS) non-hazardous and Kentucky Teachers’ Retirement System (TRS). The most often cited reason is inadequate investment returns and lack of adequate funding. The funding method, the percentage of payroll, has been used and embedded in statute, and involves an actuarial back loading of payments that would reduce the unfunded liability. An employer rate is established each year as a percentage of payroll and is paid to the pension fund. The percentage growth in aggregate payroll has not been increasing at the target estimate of 4 percent and actuarial back loading combined with the faulty assumption has resulted in 25 percent of the underfunded amount. Mr. Chilton also discussed other areas of underfunding, including actuarial assumption changes of 22 percent, a market performance assumption of 15 percent, cost of living adjustments (COLA) of 9 percent, a plan performance market of 8 percent, and plan experience of 6 percent.
Mr. Chilton said that while TRS and CERS non-hazardous plans are in better shape than other Kentucky plans, the funding levels for both plans are below 60 percent – specifically, 59 percent for CERS non-hazardous and 54.6 percent for TRS. Using the Corporate Bond Index rate, TRS’ unfunded liability goes from $15 billion to $34 billion, and the unfunded liability for the CERS non-hazardous plan goes from $5 billion to $9 billion. Using the same Corporate Bond Index rate, the aggregate underfunding for all eight plans goes from $33 billion to $64 billion.
Representative Kay said that a pension bond could be another option to raise the $1 billion. A pension bond was done in 2011, and the PFM Group, in its second report, indicated that it was a successful way to raise money and fund the debt. Representative Kay said that his biggest concern was with revenues not matching up with what is being budgeted. He asked Mr. Chilton how the state could assure there is not a $200 million revenue shortfall. Mr. Chilton stated that the $200 million shortfall in revenues goes to the general fund and is not from the money that goes into the pension plans. In the budget for the Commonwealth, there is going to be $200 million less then what was planned during the budget process. A separate component that relates to funding for the pension plans is how much money comes out of the budget and is available to put into the pension plans. Representative Kay said he was aware that the shortfall was with the general fund and wants to avoid, during the 2018 Regular Session in January, writing the budget in such a way that results in a big shortfall. Mr. Chilton stated the Governor addressed that in 2016 in the budget he presented to the legislature by not budgeting to 100 percent of what the Consensus Forecasting Group adopted. The budgeting practice in the past had been to budget every dollar that was adopted by the Consensus Forecasting Group.
Senator Bowen stated that pension obligation bonds are a solution if the market performs, but there is no guarantee.
Public Pension Performance Audit (Final Report & Recommendations)
Mike Nadol, PFM Group Consulting LLC (PFM), discussed that through past legislative reforms, recent board actions, and significant additional funding in FY 2017-2018, Kentucky has already taken many positive steps to address its retiree benefits. Without these prior actions, the current situation would be far worse. Even with a stronger foundation placed quickly and decisively into place, a long-term commitment to reform will also be needed to rebuild on this foundation toward regaining fully sustainable fiscal health. The actuarial, funding, benefit, and investment approaches across the Commonwealth’s different plans are complex, interconnected, and impact many, diverse stakeholders in varying ways. In their recommendations, PFM sought to balance these concerns through a consistent approach that also resolves the current crisis on a sustainable basis. In so doing, PFM has also sought to reflect the policy principles and direction set forth by Governor Bevin and the Commonwealth’s leadership.
Mr. Nadol discussed key policy principles and goals. He stated that the severely distressed condition of the KERS non-hazardous plan, and the systemically high level of unfunded liabilities across all of Kentucky’s plans in the aggregate, require strong action to reduce the risks of: continued increases in funding that crowd out other vital public spending and/or reach levels that cannot be sustained in the budget while keeping the state’s taxes at a competitive level to support the Commonwealth’s growth; resorting to the payment of benefits on a pay-as-you-go cash basis, which would be fiscally unsustainable; and plan insolvency, jeopardizing the retirement security of tens of thousands of former state and local government workers. To the extent possible, accrued benefits for service earned by employees and retirees should be protected within a framework consistent with the state’s inviolable contract provisions and federal Employee Retirement Income Security Act (ERISA) standards for private plans. While legal challenges to any changes the General Assembly may make are almost inevitable, based upon advice of counsel who have studied KRS 61.692 and similar statutes nationwide, it appears that the legislature has many options that would pass judicial scrutiny in light of the extremely serious pension situation facing all Kentuckians. Long‐term solvency of the retirement system as a whole must be ensured so that current retirees and future retirees can rely on secure retirement benefits. Risk levels systemically and for each individual plan should be reduced as much as possible to avoid recurrence of the severe deterioration in the retirement systems’ health. Future liabilities should be valued conservatively, and the future risk to the Commonwealth associated with changes in economic conditions, investment returns, demographics, and actuarial methods and assumptions should be minimized. The Commonwealth’s benefit structures should reduce future exposure to risk and the potential for unfunded liabilities to reemerge, in order to safeguard plan sustainability for KRS, TRS, and Judicial Form Retirement System (JFRS) participants, employers and the taxpayers. The Commonwealth’s overall approach as an employer should provide career state and local employees and teachers a sufficient and sustainable benefit for a dignified retirement through a combination of benefits from KRS, TRS, and JFRS, social security, and personal savings, while also accommodating and providing flexible and competitive options for workers who may spend only a portion of their career in public service.
Adam Reese of PRM Consulting Group (PRM) discussed the actuarial assumption recommendations. First, the study recommends modifying statutory provision KRS 61.565 to convert the level percent of payroll amortization method for KRS to a level dollar method. This consistent approach to reducing the Commonwealth’s long-term pension debt will substantially increase the likelihood of steady and meaningful progress toward regaining a healthy funded status. The second recommendation was to modify KRS 161.550 and KRS 21.525 to apply a level dollar amortization method to TRS and JFRS. Third, the Kentucky state-administered retirement systems should adopt and maintain prudent and realistic investment return assumptions, such as, KERS non-hazardous and SPRS at 5.0 to 5.25 percent, KERS hazardous and CERS at 6.0 to 6.25 percent, TRS at 6.0 to 6.25 percent, and JFRS at 6.0 to 6.25 percent. The magnitude of the impact of the recommended actuarial assumptions on the estimated FY 2019 aggregate actuarially determined employer contribution for all systems, employers and funds total $1.836 billion.
Mr. Reese discussed altering the funding policies’ of the systems relating to the method of discharging any legacy unfunded liability for each system. In this set of recommendations, Mr. Reese said that KRS and TRS, respectively, should maintain the current 30-year amortization periods beginning June 30, 2013 and 2014. Also, it was recommended that JFRS apply a 30-year amortization period for its existing unfunded liability, with 20-year closed periods for future unfunded amounts. A reset period of 30 years under a new level dollar amortization might be considered to modestly smooth the fiscal impact of the significant shift in assumptions approved in May and July. As to the other retirement plans, PFM recommended in this Report similar amortization schedules, as well as the resulting escalation in required contributions in the near term.
J. Michael Brown asked Mr. Nadol about his statement that the frame work of the recommendations should necessarily be consistent with the inviolable contract provisions of Kentucky pension law. Further, he addressed Mr. Nadol’s reference in his comments that there was an analysis provided by government counsel and outside counsel. Mr. Brown asked if the outside counsel referenced was Stites and Harbison. Mr. Nadol said yes. Mr. Brown asked why there was no reference in the report to any definition of the inviolable contract. Mr. Nadol said the written report does not detail any of those issues. Mr. Brown asked if the legal analysis of the recommendations in light of the inviolable contract was or could be made available to the PPOB. Mr. Nadol said he could not speak for the Commonwealth’s counsel, but he would expect that they would be in a position to address questions of a legal nature. Senator Bowen said that the Governor has stated time and time again that this mission is to save the floundering pension systems and at the same time keep the promises made. The mission has not varied from that pledge.
Mr. Nadol discussed the benefit recommendation options for future hires. For KERS non-hazardous, CERS non-hazardous, and JFRS plans, the recommendation is to provide future hires with a 401(k) style defined contribution (DC) retirement benefit with a mix of employer and employee contributions. The components of this DC plan should include the following: (1) mandatory employee contribution of 3 percent of salary; (2) a guaranteed base employer contribution of 2 percent of salary; (3) an employer match to be set at 50 percent of additional employee contributions up to 6 percent of salary (i.e. up to an additional 3 percent from the employer); and (4) a maximum employer contribution of 5 percent and total maximum employee/employer contribution of 14 percent. Employer contributions would vest 100 percent after 5 years and 50 percent after 4 years.
For new hires in the KERS hazardous, CERS hazardous, and SPRS plans, the recommendation is to retain the current cash balance structure for hazardous plan participants, modifying only the requirements for normal retirement eligibility to age 60, and eliminating the option for retirement at any age based on years of service.
For new hires in TRS, the recommendation is a shift to a combination of social security participation and a DC retirement benefit. The components of this DC plan should include the following: (1) mandatory employee contributions of 3 percent; (2) a guaranteed base employer contribution of 2 percent of salary; (3) an additional employer match to be set at 50 percent of additional employee contributions up to 6 percent of salary (i.e. up to an additional 3 percent from the employer); and (4) a maximum employer contribution of 5 percent and total maximum employee/employer contribution of 14 percent. The employer contributions would vest 100 percent after 5 years and 50 percent after 4 years.
Mr. Nadol discussed the benefit recommendation options for current plan participants. For KERS non-hazardous, CERS non-hazardous and JFRS, the recommendations were as follows: (1) freeze accrued benefits under the applicable existing pension tiers; (2) offer an optional buyout for the actuarial value of accrued service with the equivalent cash value to be rolled over to the plan participant’s new DC account; (3) eliminate the application of unused sick and compensatory leave to increase pension benefits; (4) eliminate the portion of any pension benefit payments to retirees resulting from COLAs granted between the years of 1996-2012; and (5) establish a normal retirement age of 65. For KERS hazardous, CERS hazardous, and SPRS, members would retain the primary benefit associated with their current tier, modifying only the requirements for normal retirement age to 55 for Tier 1 and age 60 for Tiers 2 and 3. He also noted that employees can retire earlier with an actuarially reduced benefit. For TRS, the recommendations were as follows: (1) maintain a continued plan design with DB characteristics for incumbent teachers; (2) establish a normal retirement age of 65; (3) eliminate enhanced benefit features provided outside of any inviolable contract requirements; and (4) suspend all future COLAs until the system reaches a minimum 90 percent funded level using realistic actuarial assumptions, then, after reaching the 90 percent funded level, COLA payments could resume but only to the first $1,500 of the monthly benefit.
Mr. Nadol discussed the retiree medical and insurance funds and stated the review of the retiree medical benefit program, led by PRM, found opportunities for reducing the cost of providing coverage by as much as 25 percent. Many Commonwealth retirees were found to receive significantly richer, more costly coverage than their active and pre-Medicare retiree counterparts.
Mr. Reese stated that the analysis found that the benefit coverage for retirees, after reaching Medicare age, is materially more generous than the health care coverage provided to current employees. Further, career retirees pay no premium, where current employees pay premiums every month. In addition to the benefit benchmarking to other states: (1) pursue harmonization of the level of retiree healthcare benefits for KRS, TRS, Legislative Retirement Plan (LRP), and Judicial Retirement Plan (JRP) non-Medicare and Medicare retirees so that the basic plan and benefit provided to the retirees is consistent with the LivingWell PPO coverage provided to active Commonwealth employees; (2) pooling JFRS with KRS so that JFRS will be able to leverage the additional scale of the other plans to obtain more competitive premium rates; (3) limit retiree healthcare eligibility to employees retiring directly from Commonwealth service.
Based on these estimated levels of premium reduction, the KRS actuarial liability would decline by about $1.4 billion and the annual employer contribution funding cost would be about $147 million lower. This corresponds to an estimated $37 million in annual savings in the Commonwealth’s General Fund budget for KRS plan OPEB, and an additional $40 million in annual General Fund savings attributable to the TRS recommended changes. Using the current amortization method and schedule, the estimated savings would be roughly $114 million in employer contribution, and $22 million in annual General Fund savings.
Mr. Nadol discussed the impacts to local boards of education, explaining that while local school boards do not currently contribute any of the employer contribution for teacher pensions, there is a local employer share for retiree medical. The recommended changes to TRS may produce an estimated $55 million of retiree medical savings. In addition, non-teaching staff of local school boards comprise 39 percent of the salary base in CERS non-hazardous, and would potentially save an additional estimated $18 million collectively in retiree medical expenditures from recommended changes. These savings would offset the estimated initial costs to school boards of enrolling TRS new hires in social security that would give an estimated initial $11 million statewide in the first full year and would increase roughly $10 million per year in the future.
Mr. Nadol discussed voluntary buyouts and stated that a voluntary buyout of accrued service would allow employees who would prefer to manage their own assets in a DC plan to convert their benefit from the fixed DB plan to a lump sum account balance in the DC plan, on a tax-exempt basis. This opt-out would be voluntary on an employee-by-employee basis, except for Tier 3 of KERS non-hazardous, CERS non-hazardous, and Tier 4 of the Kentucky Judicial Retirement Plan and Kentucky Legislative Retirement Plan (JRP/LRP). This conversion would remove the liability from the retirement system, value the employee’s accrued service as of the date of the conversion without applying future pay increases to the frozen portion of the benefit, improve the funded ratio, and reduce risk to the plan.
In response to a question from Representative Miller, Mr. Nadol stated that PFM had not considered forcing inactives to take a buyout.
In a response to a question from Auditor Harmon, Mr. Chilton stated that their understanding is that new hires would be able to go into the social security system unrestricted.
In a response to questions from Auditor Harmon, Mr. Reese stated that under a 401(k) style plan, employees would be afforded a set of target life cycle funds. Also, PFM’s report does not include any recommendations on employee legacy fee contributions for Tier 1 or Tier 2 employees.
In response to a question from Representative Kay, Mr. Nadol stated that the report does include estimated costs based on a certain set of assumptions and scenarios. PFM worked with the plan actuary’s to develop the majority of the analysis leading into cost estimates. All of the estimated impacts of the different approaches exist in a dynamic relationship with the actuarial assumptions and approach that is used.
In response to a question from Representative Kay, Mr. Reese stated that the current government contributions for FY 2018-19 are set. To the extent that there is employee behavior that is different from the past, that will be reflected in the next valuation. The valuation assumptions already include a very high percentage of employees retiring when first eligible.
In response to a question from Representative Fleming, Mr. Reese stated there is a risk if the 2008 downturn in the market were to happen again. Plans that were funded and had a 38 percent investment loss wiped out 25 years of good funding.
In response to a question from Representative Fleming, Mr. Chilton stated that the Consensus Forecasting Group has done an evaluation of what they expect to happen in the future to the economy and recognizes that there has been a severe downturn, maybe every 7 to 8 years, and the plans are already 10 to 11 years into a cycle looking at the bottom of the last recession.
In response to a question from Sharon Mattingly, Mr. Chilton stated the Commonwealth has a 401(k) in which employees can now participate. Mr. Chilton stated that he is not sure if they will use the same platform or a new one established.
Mr. Nadol discussed the funding recommendations. Funding for all plans should be based on the actuarially determined contribution (ADC). For all the state funded plans, the following rules should apply: (1) budget the total amount based on the ADC; (2) continue to allocate normal cost as percent of payroll; and (3) charge the unfunded liability as a dollar amount based on the unfunded liability amortization associated with that employer’s liability for accrued service. With TRS, the social security costs for new hires could be picked up by local school boards. The funding would be manageable statewide with $11 million in costs in first year, increasing gradually by $10 million each year, with potential retiree healthcare savings to offset. With CERS, the legislature should consider imposing caps/collars on ADEC percent increases.
Mr. Nadol discussed governance and investment practices and stated that aggregating all TRS and KRS assets (investment centralization only) would potentially generate more than $5 million of annual savings in investment management fees based on current KRS rates without factoring in additional negotiating leverage. PFM’s analysis of KRS investment manager fee schedules indicates increased annual fees for both KERS/SPRS and CERS, if split, due to lower asset bases. These additional costs would be $1.1 million for KERS/SPRS and $0.7 million for CERS.
Mr. Nadol summarized that PFM sees that more dollars are required to stabilize these plans. He stated the plans are grossly underfunded and correcting that through improved actuarial assumptions is going to take substantial increased resources. The initial impact on the Commonwealth’s General Fund of applying the more conservative assumptions to all state-funded plans is an estimated increase to the FY 2019 budget of over $1 billion beyond the significant added investments in the FY 2017-18 budget. The combination of implementing all the recommended benefit options is estimated to offset the impact of the assumptions system-wide and reduce the recommended employer contribution by approximately 13 percent below the prior published/current assumptions if all preliminary options are included and fully realized.
Mr. Nadol states that it is the hope of PFM that all future Kentucky state and local government employees would have access to a balanced set of retirement benefits providing positive income replacement levels, including social security participation (not now available to teachers and many local government public safety employees), additional defined contribution (401(k)-style) plans with significant minimum employer contributions and additional employer matches, and quality retiree healthcare coverage consistent with that provided to active employees. All current Kentucky state and local government employees would have the value of their accrued benefits maintained and receive benefits for future service as good as or better than those available for future hires. All retired Kentucky former employees would receive at least the same benefit level guaranteed upon retirement, and would see significant improvements to the funding of their benefits by strengthening the solvency of these vital commitments. In addition, all Kentucky stakeholders would begin to see steady and meaningful restoration of fiscal stability to the Commonwealth’s retirement systems, along with greatly reduced risk of renewed pension crises in the years ahead. In turn, this progress would ultimately lead to more resources available for critical investments and services, fair employee raises going forward, and improved financial health and credit strength.
In response to a question from Auditor Harmon, Mr. Reese stated that under the buyout, some employees could roll their money over to a 401(k) and continue to work.
In response to a question from Representative Kay, Mr. Nadol stated that PFM does not recommend CERS separating from KRS. The analysis and benchmarking indicates a consolidated approach can be more efficient and more cost effective.
Senator Bowen stated that the presentation was a third-party analysis and, while the information is useful, it will be up to the General Assembly to ultimately craft an effective and fair plan going forward.
With no further business, the meeting was adjourned. The next scheduled meeting is Monday, September 25, 2017.