Call to Order and Roll Call
The 9th meeting of the Public Pension Oversight Board was held on Thursday, November 2, 2017, at 1:00 PM, in Room 154 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, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: John Chilton, State Budget Director; Mark Bunning, Deputy Secretary, Finance and Administration Cabinet
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes
Approval of Minutes
Representative Simpson moved that the minutes of the September 25, 2017, meeting be approved. Mac Jefferson seconded the motion, and the minutes were approved without objection upon the addition of a conversation between Senator Schroder and Beau Barnes.
A moment of silence was observed for the passing of Senator David Givens wife, Lynne Givens.
In his opening remarks, Senator Bowen stated that Director John Chilton will be presenting a bill draft and questions should be directed to him and his staff. Senator Bowen reminded the members that it was outside the responsibility of LRC staff to participate in a question and answer exercise when talking about a bill draft.
Pension Proposal Overview
John Chilton, State Budget Director and Mark Bunning, Deputy Secretary, Finance and Administration Cabinet presented. Mr. Chilton opened with a general overview of the presentation and bill draft, which Governor Bevin has named “Keeping the Promise.” Mr. Chilton began by defining two key terms, retirement age and solvency, as it relates to the proposed bill. Retirement age is defined as the age at which an employee is eligible for unreduced or full retirement benefits, but not the time at which an employee must retire or is encouraged to do so. Solvency relates to the ability of an organization to pay all outstanding debts and can be viewed from two perspectives. An organization is insolvent: (1) if it does not have enough liquid assets to meet near-term obligations or (2) if the value of its assets is less than its liabilities. Mr. Chilton noted that each of the state-administered pension plans had a value of assets less than their liabilities and that current funding levels for each would require termination of the plans under federal rules that apply to non-government plans.
Mr. Chilton provided an overview of the severe underfunding of the plans and noted that Kentucky’s aggregate funding level of 37.4 percent ranked last, or 50th, out of state retirement plans, and the total unfunded liability ranged from $33 billion to $84 billion depending on the discount rates utilized. In addition to funding levels, Mr. Chilton recognized the cash flow trends for each of the plans, which include almost $7 billion in negative cash flow across all the plans over a period of eleven years. Mr. Chilton stated that the negative cash flows are projected for the next eleven years as well.
Mr. Chilton discussed reasons why the plans are underfunded and highlighted findings from the performance audit conducted by the PFM Group (PFM). The underfunding has been the combined result of investments performance, funding, and structural issues of the plans. Mr. Chilton noted that 62 percent of the increase in underfunding was due to structural issues, such as assumption changes or actuarial back loading, while investment performance and funding accounted for 23 percent and 15 percent, respectively. Mr. Chilton provided a summary for each underlying system, pointing out the KERS nonhazardous and TRS plans, which made up two-thirds of the total underfunding. Lastly, Mr. Chilton highlighted the CERS plans, which made the necessary contributions, but still saw funding levels decline. Mr. Chilton discussed retiree healthcare and stated that it was about $6 billion underfunded.
Mr. Chilton provided an illustration of actuarial back-loading, and pointed out how additional underfunding can occur as a result of plans using a percentage of payroll method. Referencing projections included in the PFM report regarding the KERS nonhazardous plan, Mr. Chilton noted how underfunding actually would increase for several years before actually reducing the unfunded amount.
Mr. Chilton also provided a summary of a solvency analysis for the KERS nonhazardous conducted by PFM, which projected the plan would go insolvent in FY2022 if future funding reverted to the patterns of funding prior to FY2016.
Mr. Chilton discussed the TRS and CERS nonhazardous plans and emphasized the plans are not in as good of shape as many seem to believe. While better funded than KERS, if subject to federal standards, the Internal Revenue Code would require benefits in both plans to be frozen. Using the investment assumption required for corporate plans, which is the Corporate Bond Index, Mr. Chilton noted the unfunded liabilities for both plans would increase significantly. Regardless, under any set of assumptions, neither of the plans are in good shape and a long-term (30 year) commitment will be needed to address the underfunding.
Mr. Chilton reviewed details of the proposed pension plan introduced by the Governor, Senate President, and Speaker of the House, clarifying proposed changes for each system. With regards to the nonhazardous plans of KERS and CERS, retirees would see no changes or reductions to their monthly pension checks. For existing Tier 1 or Tier 2 members, there would be no change to the full retirement age and employees would continue to accrue their defined benefit until reaching a full, unreduced, retirement benefit (reaching 27 years of service, Rule of 87, or age 65). Once reaching the threshold for an unreduced benefit, Tier 1 and Tier 2 employees would move into a new defined contribution plan. Any existing Tier 3 member (those hired on or after January 1, 2014) and all new hires would immediately roll over or be enrolled in the new defined contribution plan.
In response to questions from Representative Simpson and Senator Bowen, Mr. Chilton stated that any current service, benefit, or accrual that a member has as of the effective date of the proposed legislative changes would be secure. Any additional service for the member after that date would go into the defined contribution plan. Also, any years of service that a member has purchased or is purchasing on an installment basis would be secure.
In response to a questions from Senator Higdon, Mr. Chilton stated that the retiree healthcare is funded separately from the pension plans, in a separate trust, with a separate employer contribution rate. This plan covers retiree healthcare costs from the date of retirement until the retiree qualifies for Medicare, after which there are some subsidies provided for items not covered by Medicare. Current Tier 2 and Tier 3 employees also contribute one percent of payroll, while the proposed bill would require all active employees (Tiers 1, 2, and 3) to contribute 3 additional percent towards retiree health benefits. Mr. Chilton noted there had been much discussion regarding the proposed increased contribution, and the topic was something likely requiring more consideration.
In response to a question from Mr. Brown, Mr. Chilton clarified that the benefits promised under current law for Tier 1 and Tier 2 employees, either as of June 30, 2018 or up to 27 years of service, would be secure. Mr. Chilton said on a go-forward basis, there might be changes, but that would not impact existing accruals or those accrued up to 27 years.
In response to a question from Auditor Harmon, Senator Bowen clarified that any service credit purchased is effectively the same as accrued service time, so both would be considered in the purpose of calculating the member’s retirement benefit.
Representative Kay commented regarding the plans underfunding and the reasons outlined by the final PFM report. He noted that investment performance, which accounted for roughly 25 percent of the increase, included underperformance relative to the market and expensive investments with a lot of fees. Outside of investments, whether funding below the ARC, providing unfunded COLA increases, or mandating a level percent of payroll funding method by statute, Mr. Kay pointed out that at least 50 percent, if not more, of the problem could be directly attributed to what the legislature has or has not done.
In response to Representative Kay’s comment, Mr. Chilton mentioned that investment performance and the underfunding have historically been more discussed because they are the most visible. Mr. Chilton agreed that the other structural issues had been in the statute for a long period of time and largely not been the focus. Mr. Bunning also referenced the CERS plans, which have made their required contributions, but still are underfunded by 40 percent, to highlight the impact other structural issues have had on funding.
Senator Bowen made a statement to remind the members of the Public Pension Oversight Board (PPOB) that most of the funding provisions and policies for TRS are not in statute. It is a decision by TRS Board.
Mr. Chilton continued with a review of a few additional proposed changes for nonhazardous employees. First, all active employees would be required to contribute 3 percent more of their salary to help prefund the retiree healthcare program. Secondly, any future retiree, that accepts a full-time position in the public, would be required to suspend their current pension for the duration of their reemployment. Third, compensatory time payments only would be included in the benefit calculation for any member retiring on or before July 1, 2023. Fourth, a full 60 months of service would be required in calculating a members “high 5” average salary. Fifth, eligible compensation for the purpose of calculating benefits would be limited to match that of Social Security. Lastly, any uniform or equipment allowances would no longer be included as creditable compensation, and any unused sick leave would be frozen as July 1, 2018 for the purpose of determining retirement eligibility.
Mr. Chilton reviewed the new Defined Contribution Plan being proposed and outlined mandatory and optional contributions. All employees participating would contribute a mandatory contribution of 3 percent of their salary, while employers were required to make a 2 percent contribution. In addition, employees could choose to contribute an optional amount up to 6 percent more of their salary, which would be matched 50 percent by their employer. A total of 14 percent could be saved if the employee maximized their contributions (9 percent employee and 5 percent employer).
Mr. Chilton moved on to review the proposal regarding TRS and stated that there was no recommendation to change the full retirement age, and both current and future teachers would not be covered by Social Security. The current defined benefit plan would remain open for all current members of TRS, who would continue to accrue benefits until they qualified for a full, unreduced, benefit (27 years of service or age 60). A current member, that qualified for a full benefit on July 1, 2018, would have the option to accrue up to 3 additional years of service or move into an enhanced Social Security replacement defined contribution plan that would save 18 percent of their salary. New teachers, or those active that meet the unreduced retirement threshold after July 1, 2018, would be enrolled in a new defined contribution plan. All current members, with less than five years of service, would have the option to transfer to the newly created defined contribution plan. In addition, future retirees would be required to suspend their pension to accept full-time positions covered by a state-administered retirement system for duration of their reemployment.
Mr. Chilton provided a review of the new Defined Contribution Plan being proposed and outlined mandatory and optional contributions for TRS members. First, all new teachers and active teachers, that reach the 27 year threshold after July 2018, will make a mandatory contribution of 9 percent of their salary, while the state would be required to contribute 4 percent and school districts would be required to contribute 2 percent. In addition, employees could choose to contribute an optional amount up to 3 percent more of their salary. A total of 18 percent could be saved if the employee maximized their contributions (12 percent employee and 6 percent employer/school district). For teachers with 27 plus years on or before July 1, 2018, the employee would have a mandatory 10 percent contribution and the state would be required to contribute 8 percent.
Mr. Chilton continued with a review of a few additional proposed changes for TRS members. First, sick leave balances would be frozen as of July 1, 2018, for those university members that receive service credit for accumulated unused sick leave. Secondly, school districts could continue to provide payment for up to 30 percent of a retiring member’s accumulated unused sick leave, and lump-sum payments for accumulated sick leave will be utilized in retirement benefit calculations only for those retiring on or before July 1, 2023. After that date, all payments for sick leave would be excluded from benefit calculations. Sick leave policies and cash payments for sick time will continue to be made according to local school board policy. Third, the use of a “high 3” average salary would be permitted for members retiring before 2023, while after that date a “high 5” would be utilized and must include 60 full months. Lastly, much like the KERS and CERS plans, all active employees would contribute an additional 3 percent of their salary to fund the retiree post-retirement healthcare program.
Regarding retired teachers, Mr. Chilton stated that current retirees would not see their existing benefit reduced; however, future COLA adjustments would be temporarily suspended for five years. All future retirees would not receive any COLA increases until their sixth year of retirement.
In response to a question from Representative Miller, Mr. Chilton stated that teachers have not paid for their COLAs.
In response to a question from Representative Kay, regarding an exemption to the proposed suspension of retirement benefits for elected officials and the Governor’s appointees, Mr. Chilton reiterated that he could neither speak to the motivation for the exemption nor was he involved in the decision-making process. Representative Kay suggested that this portion of the bill should be considered as changes are made.
Auditor Harmon suggested a few additional items for consideration. First, regarding the suspension of pensions for those returning to work, given a retiree would suspend existing benefits and not double dip, it seems that suspending the required break in service should be considered. Secondly, he asked for consideration regarding the “block 50” payments for compensatory time. Mr. Harmon mentioned the use of “sick 50” payments in his office, but given sick time will not be utilized in the same way, this might not be an option and could have impact. Senator McDaniel commented that there are several agencies that practice the “sick 50” payments, but one of the unfortunate consequences is it actually allows an agency to defer the fiscal burden of payment to the retirement system instead of the agency.
In response to a question from Mr. Brown regarding the topic of the retired re-employed, Senator Bowen reminded the committee that questions and comments should be limited to points of clarification, but not the rational or motivation behind the proposed legislation. The Director was on hand to help clarify and answer technical questions.
Mr. Chilton continued the overview, addressing proposed changes for the hazardous plan members. For active members, the current defined benefit and 4 percent cash balance plans would remain open, and there would be no change to the full retirement age. New hires would have an option to participate in the current cash balance plan or the defined contribution plan. Other proposed changes included: capping sick leaves at the balances accrued on June 30, 2018, and eliminating sick leave from being used to determine retirement eligibility for retirements after July 1, 2018; requiring a full 36 months in the “high 3” calculation; removing uniform and equipment allowance from creditable compensation; and requiring both the employee and employer to contribute to the retirement system in the case of reemployment after retirement with no second retirement account for any retiree re-employed. Lastly, all active hazardous employees would be required to contribute an additional 3 percent of their salary to fund the retiree post-retirement healthcare program.
Mr. Chilton discussed the proposed retirement changes for legislators. For members that have already reached an unreduced pension benefit, the defined benefit plan will be closed, and those members will begin to participate in the defined contribution plan offered to KERS employees. For members that have not reached the threshold for an unreduced retirement plan, their LRP account will be frozen, and they will participate in KERS until reaching an unreduced retirement benefit and then will be covered by the new defined contribution plan. Any payments from the defined benefit plans would be based solely on their legislative earnings. Current cash balance members and new legislators would immediately roll over into the defined contribution program. All active members would contribute 3 additional percent of their salary to fund retiree healthcare. For existing defined benefit members and current retirees, the benefit calculation would be based solely on legislative salary.
Mr. Chilton discussed the judicial retirement proposal, which would allow current members to accrue a full unreduced benefit, before moving into the new defined contribution plan. Existing cash balance and new members would immediately roll into the defined contribution plan. All active members would contribute 3 additional percent of their salary to fund retiree healthcare.
Mr. Chilton discussed several additional reforms, which include: moving all systems to a level dollar amortization method; creating a two-year window available for KRS and TRS employers to withdraw from the systems by making a full payment of their share of the actuarial liability; and moving the legislative and judicial retirement plans under the jurisdiction of KRS Board. Lastly, Mr. Chilton noted the effective date of the changes would be July 1, 2018 (pension bill will not have an emergency clause), the Kentucky Deferred Compensation Authority (KDC) would administer the new defined contribution plan (called “PERS” under the draft), and there would be a statutory requirement to pay the ADC/ARC.
In response to a question from Senator Parrett, Mr. Chilton stated that all Tier 3 member account values, which include employee contributions, employer contributions, and investment gains, will move over to their new defined contribution account.
In response to a question from Representative Kay in regards to PERS and Deferred Comp transparency and those entities being exempt from procurement procedures, Mr. Chilton stated that PERS would be subject to the PPOB, Executive Branch Ethics Commission, and also statutory conflict of interest language. As it relates to the Model Procurement Code, the plans are not covered because it is not necessary. Mr. Chilton noted that once the Board determines their investment options, there is no procurement process and pricing is set by the market. Representative Kay emphasized that measures should be taken to ensure more robust transparency safeguards are incorporated into any legislation to ensure that procurement and the board’s actions do not benefit those underserving of making money off the government.
In response to a question from Senator Bowen, Mr. Chilton and Mr. Bunning stated any member that had reached the full retirement threshold would continue in the defined benefit plan through the effective date of the bill. At that point, whatever service credit they had would be utilized for calculating their benefit. For a member that reaches 27 years after the effective date, they can continue working, but would begin participating in the defined contribution plan the month after reaching the threshold.
Senator Schroder highlighted the potential that active teachers might reach the full retirement threshold during the middle of a school year and suggested consideration might be made to allow teachers to finish the year instead of participating in the defined contribution plan for such a short period. Mr. Bunning noted that all existing teachers with 27 years of service would have a 3 year window from the effective date.
In response to a question from Representative Fleming, Mr. Chilton stated that while the proposed legislation was just a draft at this point, as part of the legislative process there is a statutory requirement for an actuarial analysis. Mr. Chilton indicated that analysis was in process and expected soon.
Mr. Chilton continued with what happens if pension reform does not occur and the impact it will have on the budget. First, he reviewed investment return assumptions for each system and noted that almost all had reduced their assumption, which was going to increase the unfunded liabilities of the plan. Preliminary projections provided by the plans indicated that almost $1.5 billion in additional money from all employers would be needed. Mr. Chilton discussed the fiscal needs of the general fund, which included replenishing a diminished Budget Reserve Trust fund and meeting expected ARC payments. These needs, when coupled with modest expected revenue growth, results in a need to free up an additional $1 billion dollars each of the next two fiscal years to be fiscally responsible.
Mr. Chilton identified the three primary options available: reducing spending, increasing revenues, and reducing the cost of pensions. With regards to reduced spending, Mr. Chilton noted that spending for several programs was reduced by 9 percent during the last budget. During that process, there were important government services that were not subjected to cuts, including K-12 education (SEEK), Medicaid, public protection, debt service, etc. Mr. Chilton discussed the growing share of pension and Medicaid expenditures, which account for over 30% of the general fund, and their rapid growth over the past eleven years. Mr. Chilton provided an alternative look on the budget constraint, considering what level of cuts would be required in FY2018 to raise $1 billion. In this example, if excluding education, Medicaid and pension spending, the remaining portion of the budget would have to be reduced by 34 percent. Subjecting education (SEEK) to cuts would still require cuts of over 16 percent. SEEK alone would be reduced by $510 million (out of existing $3.024 billion appropriation).
Senator McDaniel emphasized another important consideration, which was the level of additional funds pulled from federal draw down dollars. He noted that the majority of federal funds occur with the “all other” category that is being discussed. Reducing these funds by 34 percent would not just mean losing the existing state spending, but also the federal matches that are made available.
Mr. Chilton commented that the budget situation is a real crisis. The financial obligations the Commonwealth is facing are huge and there are some really tough policy decisions that will have to be made in all areas.
Senator Bowen commented about the question of whether the plans were in crisis or not. While people might argue about this question, he asked members to consider a plan with two people, which is only 54 percent funded. Under such a scenario, one of the two would not receive a pension and that would be considered a crisis for the person not receiving a pension. When talking about levels of funding at 54 percent, 59 percent, 33 percent, and 14 percent, these funding levels by any metric are failing numbers.
Mr. Chilton discussed benefits and the value of a defined contribution plan. First, the employee controls his/her investments and can be as conservative or as aggressive as desirable. Secondly, after vesting (5 years), the entire account is nonforfeitable and will continue to grow. Third, money can be withdrawn without IRS penalties as regular monthly amounts or as a lump-sum to satisfy unexpected needs or desires. And last, when the employee dies, the account passes to family members or a charity.
Mr. Bunning provided an example of the value of a defined contribution account. Using a current teacher salary scale, an average retirement age of 60, and career of 37 years, a teacher under the current defined benefit plan would receive a monthly benefit of $5,400. Using the defined contribution model, considering the teacher contributed the maximum 18 percent contribution and earns 7.5 percent while employed, the value of the account after 37 years would be $1.59 million.
In response to a question from Representative Kay regarding the value of the example if the 30 year Treasury yield of just under 3 percent was assumed, Mr. Bunning stated this was an example to compare the two plans together. In this case, the teachers assume 7.5 percent. In addition, Mr. Bunning referenced the investment options currently offered by Deferred Comp and noted most have returns of 7.5 percent or more.
In response to a question from Senator Parrett regarding tax reform, Mr. Chilton stated the Governor and others have decided that tax reform is coming, but not before pension reform.
In response to a question from Senator Neal, Mr. Chilton stated the actuarial analysis is in process and should be available soon. While the proposed bill was not developed with a certain target, it is believed that the $700 million additional amount required will be less. Mr. Bunning also stated that PFM provided an impact for each of their recommendations, but the bill is drafted differently so its impact must be calculated actuarially.
In response to a question from Senator Neal regarding the risk associated with a defined contribution approach versus a defined benefit approach, Mr. Bunning commented that it would depend on the individual participant. Some people like the flexibility and ability to make personal investment choices, instead of relying on a board. Senator Neal emphasized that not all state employees have the background or ability regarding investing, so one of the criticisms of defined contribution plans can be the level of risk placed on the individual.
In response to Senator Neal, Mr. Chilton commented that one of the requirements in the defined contribution plan was that the plan administrator provide underlying members with professional licensed investment advisors to help people make investment decisions.
In his closing remarks Senator Bowen mentioned a few of the highlighted portions of the presentation and suggested the board had learned the consequences of doing nothing. He highlighted there was no emergency clause in the bill, giving people plenty of time to make decisions, and it also allowed current employees to stay in the plan until retirement eligibility. Lastly, there is no claw back of benefits suggested, and the bill draft provides for sharing the risk.
With no further business, the meeting was adjourned.