Call to Order and Roll Call
Thefourth meeting of the Task Force on Kentucky Public Pensions was held on Tuesday, September 18, 2012, at 1:00 PM, in Room 154 of the Capitol Annex. Senator Damon Thayer, Chair, called the meeting to order, and the secretary called the roll.
Members:Senator Damon Thayer, Co-Chair; Representative Mike Cherry, Co-Chair; Senators Jimmy Higdon, Joey Pendleton, Dorsey Ridley, and Mike Wilson; Representatives Derrick Graham, Keith Hall, Brad Montell, Marie Rader, Rick Rand, and Brent Yonts.
Guests: Representatives Linda Belcher, Mary Lou Marzian, and Arnold Simpson; David Draine, Pew Center on the States; Josh McGee, Laura and John Arnold Foundation; Greg Fischer, Louisville Metro Government; Steve Arlinghaus, Kenton County government; Steve Pendery, Campbell County government; and Mike Buchanon, Warren County government.
Approval of Minutes and Announcements
The minutes of the August 21 meeting were approved without objection, upon motion by Representative Yonts. Senator Thayer announced that the date of the Task Force’s next meeting has been changed to October 29 at 1:00 p.m. The final meeting is scheduled for November 20 at 1:00 p.m.
Overview and Preliminary Report by the Pew Center on the States and the Laura and John Arnold Foundation
The guest speakers were David Draine, Senior Researcher, Pew Center on the States (Pew), and Dr. Josh McGee, Vice President for Public Accountability Initiatives, Laura and John Arnold Foundation (LJAF). Copies of their slide presentation and Mr. Draine’s prepared statement were provided.
As emphasized at previous Task Force meetings, Mr. Draine said Kentucky policy makers will need to achieve three things as part of comprehensive pension reform: develop a plan to responsibly pay down the unfunded liability over a reasonable time frame that, ideally, should not impinge on funding for key services or impair the Commonwealth’s economic viability; adopt a reformed retirement system that is affordable, sustainable, and secure; and ensure that under whatever plan is adopted, the state can effectively recruit and retain a talented public-sector workforce. Today’s presentation should not be viewed as an endorsement by Pew or LJAF for any particular policy or approach.
Mr. Draine said there is no quick fix to Kentucky’s pension problems. Under all plausible scenarios, there will be substantial cost to state and local governments to pay for pension promises over the next 30 years. Refinancing the state’s pension debt through bond issuance has the potential to improve the funding situation and reduce long-term costs. Bonding, however, would force the state to take on additional risk and should only be used as part of a comprehensive reform effort. Changing the tax rules for retirement benefits could potentially produce enough revenue to close a substantial portion of the funding gap and lessen the need for other significant tax increases or service cuts. Changing benefits for new employees will not reduce current pension debt or have large cost implications in the near term. The plan offered to new employees is relatively inexpensive, and employees pay much of the cost. While the plan for new employees is not projected to be expensive under Kentucky Retirement System (KRS) assumptions, it exposes Kentucky to a substantial level of risk. Alternative plan designs could better manage the risk and ensure full funding to deliver benefits that are affordable, sustainable, and secure. The model used to analyze Kentucky’s pension plans is based on aggregate plan data and projections provided by KRS. The figures presented should not be viewed as exact savings or cost estimates but instead as offering a means to assess scale and scope. Plan design is about more than only cost. Policy makers need to consider other relevant factors, such as how different plan designs share risk and distribute retirement wealth across employees’ careers.
Over the next 25 years, KRS contributions are expected to rise to almost $5 billion, assuming all assumptions are met. If investment returns are lower than expected, contributions could increase considerably. If contributions grow faster than the economy, which seems likely, this cost would crowd out key public services, stunt public sector hiring, and make it harder to offer raises.
The problem is of such scale that unfunded liabilities will continue to grow over the next decade and only start to dip after 2027. Assuming the state meets its payment schedule and there is no significant economic downturn, the unfunded liability should be largely paid off by 2037. Even so, the Kentucky Employees Retirement System (KERS)-nonhazardous plan will have less than two years of benefit payments on hand in 2022 and will be vulnerable to any deviation from plan assumptions. Solvency concerns impact the plan’s security and investment ability. Paying the full ARC in a shorter time frame or finding other ways to bolster this dangerously depleted plan could be helpful in remedying solvency concerns. While the KERS-nonhazardous plan is in the worst shape, the other KRS plans also have funding shortfalls that need to be paid.
Analysis under the baseline assumptions suggests the present value of KRS contributions by state and local governments to be $20.8 billion. Under a pessimistic scenario, if investments do not perform as hoped, the value of future contributions will jump to $23 billion. If investments outperform, under an optimistic scenario, taxpayers will only need to set aside about $18 billion. If Kentucky simply closed the existing plan and did not replace it, this drastic change would simply eliminate benefits for new employees and reduce the value of future contributions by just $1.3 billion. Pew and LJAF think it would be a terrible idea to eliminate retirement benefits for new employees. Changing benefits for new employees would not eliminate the funding gap and, even under the most extreme scenarios, would reduce total costs by less than 10 percent.
Increasing the employee contribution rate by one percent would have a $1.26 billion impact on the value of employer contributions over the next 30 years; decreasing the multiplier by one percent, including for current employees, would reduce the value of contributions by $600 million. Changing the benefit calculation by averaging salary over six rather than five years would create savings of $255 million. These approaches may or may not be viable based on the inviolable contract. While use of such traditional levers may offer reasonable savings, they will not be enough to close the funding gap on their own.
Raising the retirement age in Kentucky will not necessarily result in savings because benefits are heavily back-loaded, based on the benefit formula and projected salary increases for late-career workers. If plan assumptions do not match what actually occurs, this result may not hold.
There are many ways in which refinancing pension debt through bonding could be beneficial, but there are substantial risks. Analysis estimates that issuing $1.37 billion in bonds would reduce the value of future contribution costs by about $1.38 billion. Bond service payments are included as part of the employer contribution estimate. The combined cost of paying for both the bond and pensions under this scenario is less than the projected pension contributions. Savings would result from borrowing at a rate less than the investment return delivered by the pension plan and frontloading contributions into the retirement system. Under pessimistic scenarios, the estimated value of savings would be $1.19 billion. Kentucky’s borrowing costs are conservatively estimated at six percent, based on assumptions provided by LRC, but previous pension bond issuances have resulted in borrowing costs below five percent. Beyond the potential savings, bonding would also help alleviate the KERS-nonhazardous plan’s solvency problems.
Increasing salaries by three percent and, in exchange, increasing employee contributions by two percent would save almost $2 billion from the present value of future contributions. Raises can help defray the immediate cost to employees, who have had their salaries frozen for the last three years, and bolster pension funding over time.
Changing the tax exclusion for retirement income has the potential to inject much needed revenue into the pension system. Preliminary estimates from the office of the State Budget Director suggest that counting nonretirement income against the inclusion would initially increase annual revenue about $150 million. If the legislature eliminated the exclusion, revenue would increase by $500-$600 million. Putting that new money into the pension system would reduce the need for contributions from other sources by $2.3 billion under the more modest change, and by $7.5 billion with removal of the exclusion.
Measured use of the options that have been presented would not come close to eliminating the funding gap but would have some impact on future contributions. The analysis did not model elimination of reciprocity for legislative pensions or methods for reducing administrative costs, since they would not offer meaningful reductions in the contributions that state and local governments need to put into the pension system. Mr. Draine concluded the first half of his presentation, and the floor was opened for questions.
When Senator Pendleton questioned whether blame for the pension dilemma is primarily due to the economy or failure to pay the full ARC, Dr. McGee said the two factors are linked and that blame cannot be assigned to one or the other. Poor performance in the economy led to increased costs. Mr. Draine noted that even though full contributions were made by the County Employees Retirement System (CERS), that system faces a substantial shortfall.
Representative Montell asked about the potential insolvency of the KERS-nonhazardous plan and its failure to meet projected investment return. Mr. Draine confirmed that their analysis presumes an assumed investment return of 7.75 percent and compliance with the contribution schedule adopted in House Bill 1 (2008 Special Session). He said that one consequence of the KERS-nonhazardous plan’s low funding level is that there are few assets available to invest. Later in the meeting, Representative Cherry advised that the 10-year investment return as of June 30, 2012, was 5.99 percent and has shown improvement during the past six months.
Representative Yonts suggested the need for bonding as a means to protect potential revenue accruing from the reduction or elimination of tax exclusions. Mr. Draine said that issuing a bond would “lock in” ARC payments. While reducing flexibility in state policy, it would also prevent the state from avoiding necessary payments. Connecticut, when bonding for its teacher retirement system, included a provision that failure to make ARC payments would result in technical default on the bond. Dr. McGee said that explicitly stating legislative intent is another possible way to ensure dedication of resources. Representative Yonts spoke about a recent Courier-Journal article relating to Kentucky’s multiple tax code exemptions. He advised the Task Force to begin working in coordination with the Governor’s Blue Ribbon Commission on Tax Reform.
Senator Higdon said he hopes the Task Force will address the issue of COLAs. Dr. McGee explained that their analysis is based on KRS’ calculation of the current liability and does not include costs that would be incurred by future COLA increases. He said they would be able to quantify the size of the increased liability in the event of future COLA increases but that paying for future COLAs would necessitate additional revenue. Discussion followed regarding Rhode Island’s method of awarding COLAs. The discussion also included a review by Representative Cherry of 2005-2011 KRS cost figures associated with investment return, COLAs, and reduced ARC payments.
Representative Montell inquired whether the proposals forthcoming from Pew and LJAF will address Kentucky-specific issues such as double-dipping, overtime pay, and spiking. Dr. McGee said that those issues, while related to good governance, are generally not huge cost drivers. Mr. Draine said their proposals will be well designed and also look at protections that would be considered good policy but not necessarily major cost drivers. Senator Thayer advised members that they will have the opportunity to offer and vote on suggested “good government” type reforms. He reminded them, too, that proposed reforms will also apply to the legislative and judicial retirement plans.
Mr. Draine began the second part of his presentation by describing four alternative models illustrated for the KERS-hazardous and nonhazardous plans: the traditional defined benefit (DB) plan currently offered to new employees, a simple defined contribution (DC) individual retirement account, a cash-balance plan, and a stacked hybrid pension plan in which workers have both a traditional pension and an individual retirement account. He explained that each alternative model was designed to cost the same as the current plan under the plan’s assumptions, keeping employee contributions the same. He also reviewed charts comparing projected wealth accumulation for the plan design alternatives for a hypothetical employee hired at age 25, under both optimistic and pessimistic scenarios; and illustrating pay replacement ratio for the hypothetical employee, both with and without social security benefits.
Mr. Draine said the cash-balance option requires the plan to manage investment account moneys, with the employer guaranteeing a minimum return. Workers in a cash balance plan can use the money in their account to purchase an annuity. Cash balance plans offer two key protections commonly associated with DB plans: a guarantee against investment risk and protection against outliving one’s retirement assets. Stacked hybrid plans include a small traditional pension and an individual retirement account for participating employees. Kentucky’s current DB plan offers a 1.1 percent multiplier for employees who work nine years or fewer in state or local government—more or less the same level of generosity as the DB component of the sample hybrid plan, but without the advantage of an individual retirement account to which the employer contributes. It is clear that workers earn a lot less pension wealth early in their careers than late in their careers. This creates an incentive to work longer and can help the state retain talent, but it also places workers on a retirement savings path that is less than secure for much of their working life. Research indicates that workers respond more strongly to wage increases than retirement benefit increases; thus, wage may be a more effective retention tool. Back-loaded benefits are a key characteristic of a traditional pension plan. Whether back-loading benefits is the right way to structure retirement savings is a question that policy makers will need to answer.
Mr. Draine posed questions for the Task Force to consider. How should workers earn benefits over time—a limited benefit early in the career with a spike in late career, or smoother? Should the taxpayer bear all the risk, should it all go to the worker, or is there an effective way to share it? What will be the best way to recruit the workforce needed to deliver public services, considering that retirement savings is only one element of compensation?
Representative Montell asked whether the retirement system would assume the risk for purchase of annuities under a cash balance plan, or would the annuities be purchased through the private sector. Dr. McGee explained that the private sector has more constraints than government with respect to annuitization rates. Because insurance companies are constrained in how they are allowed to invest money set aside for annuities, the annuitization rate would go down substantially under a third-party purchase. If the state chooses to subsidize annuitization, it would be best to do it through the retirement plan. Mr. Draine said that as long as the annuities are purchased in a fair and responsible manner, the risk should be manageable. Nebraska’s model provided for annuitization through the state.
There were no further questions. Senator Thayer thanked the speakers and said the Task Force looks forward to continuing the dialogue at the next meeting.
Testimony From Interested Groups
The guest speakers were Greg Fischer, Mayor of Louisville Metro Government; Steve Arlinghaus, Kenton County Judge/Executive; Steve Pendery, Campbell County Judge/Executive; and Mike Buchanon, Warren County Judge/Executive. They provided copies of their PowerPoint presentations.
Mayor Fischer said their group has been working together on issues affecting Kentucky’s metropolitan areas, along with Boone County Judge/Executive Gary Moore and Lexington Mayor Jim Gray, who were unable to attend today. He said that the rising pension costs are alarming and unsustainable, as demonstrated by pension reform initiatives passed this summer by the cities of San Diego and San Jose, and the declared bankruptcy of the city of Stockton, California. On behalf of the group, he urged that Kentucky act to reverse the trend of escalating annual contribution rates; fundamentally redirect the system to provide long-term relief and predictability for local governments; and provide for shared responsibility from all stakeholders, including current and future employees, employers, and retirees.
Judge Buchanon said Warren County’s general fund contributed $325,910—3.5 percent of total spending—toward pension costs in 2003, and $398,000 in 2004. Workforce cuts began in 2008, mostly through attrition and utilization of part-time employees. In 2011, pension costs rose to $1.194 million—7.88 percent of total spending. The Warren County sheriff’s hazardous duty contributions are even higher. If this trend continues, within 10 years Warren County will have a considerably smaller workforce and will be providing fewer services to constituents, and most Kentucky counties will probably become insolvent.
Judge Pendery spoke for both Campbell and Boone Counties. He said pension costs for Campbell County were more than double in 2011 than in 2004. The employer contribution rate increased by 193 percent—from $630,000 in 2004 to over $2.1 million in 2011. The workforce has been reduced by five percent. Boone County contributed 10.45 percent of total spending toward pension costs in 2004; pension costs rose to 14.70 percent of total county spending in 2011. Boone County has reduced the number of full-time employees by 12 percent over the last four years, to partially offset increases in retirement expenditures. In FY 2013, Boone County is projected to spend $5.5 million on pension contributions for the workforce. Judge Pendery stated, too, that a state’s unfunded pension liability can affect its choice as a suitable location for business and industry.
Judge Arlinghaus noted that the figures on the Kenton County slide are incorrect. He said that in 2004 Kenton County contributed 2.7 percent of total spending to pension costs; in 2011, this increased to six percent. Revenue has declined by more than $2 million since 2004. Full-time employees have decreased from 277 to 248. Part-time employees have increased from 99 to 115 and now comprise nearly one-third of the workforce—a trend due in part to burgeoning pension costs. The true cost for pensions is significantly higher than six percent, when considering the number of part-time employees. Kenton County now requires a full year of employment for CERS pension eligibility. Judge Arlinghaus said the counties need the legislature’s help, and he expressed support for the work of the Task Force.
Mayor Fischer said that Louisville Metro contributed 5.3 percent of total spending to pensions in 2004; pension costs rose to nine percent in 2011, or $67 million. If pension costs increase five percent annually over the next 10 years, this could result in a 12 percent reduction of the Metro workforce. The counties represented today have taken action to become more efficient. Louisville Metro has launched major efficiency improvement and cost saving initiatives, including a reduction in overtime, introduction of modern quality principles, and containment of health care costs.
The speakers offered the following recommendations: continue suspension of the COLA until it can be funded; explore options such as cash balance and stacked hybrid plans; offer separate solutions and board governance for CERS and KERS; strongly consider requiring employees to pay more toward their retirement; and reduce state tax code exemptions on pension earnings.
Judge Buchanon said they have concerns about bonding as a solution for the unfunded liability. This option should be further evaluated, coupled with possible adoption of a statutory definition of full funding as 80-85 percent of true actuarial cost.
Representative Graham expressed reservation about creating a separate board for CERS with respect to potential risk and future accountability. Mayor Fischer pointed out the lower level of risk for CERS, which has been paying the full ARC each year. He said the main point of the recommendation is to look at different governance options and models, while keeping in mind the big picture of the state as a whole. Representative Cherry said that the issue of separate boards was discussed in 2008 when House Bill 1 was passed. The biggest concern, as he recalls, was how to divide existing assets. Increased administrative costs and investment management were also viewed as concerns.
Answering questions from Representative Simpson, Judge Pendery agreed that health insurance is a cost driver in pension funding and needs to be addressed. He noted that local governments review health care arrangements for their employees annually. In regard to the suggested review of tax code exemptions, he said the economic development aspect is important and that if there is not a solution to the pension problem, it will be harder to draw businesses into the state. Mayor Fischer said the main driver for their proposals is to reverse the trend of escalating, uncontrollable cost. They defer to the experts on how this may be accomplished and hope that the system will ultimately provide long-term relief and some predictability for local governments. Representative Simpson said he recognizes possible solutions for the retirement system proper but doubts that the recommendations offered today would provide relief at the local level. He added that his heart will always be with local governments, and he hopes that there is a mechanism that will be able to grant the relief being sought for their pension challenges.
Senator Pendleton emphasized that local governments, as well as the legislature, must have the political will to solve the pension problem. He said there are things that can be done at the local level, and it will be necessary for everyone to work together to find a solution.
Closing Comments and Adjournment
Senator Thayer thanked the speakers for their attendance and participation in the effort to address the pension problem. He stressed the importance of remaining focused on solutions—not blame—as the Task Force completes its work in preparation for the final report that is due by December 7. Representative Cherry said he looks forward to proposals that will be offered at the October meeting.
In response to a request from Senator Ridley, Representative Cherry said, if possible, he would have staff provide members with draft proposals in advance of the October meeting, which he will chair. He pointed out, however, that the Task Force will not be voting on proposals at that time.
With business concluded, the meeting adjourned at 2:55 p.m.