Candidates have three different takes on the next governor's biggest problem, underfunded state pensions

By Matthew Young

University of Kentucky School of Journalism and Telecommunications

Kentucky’s financially struggling pension system is one of the most serious issues facing the next governor, and one of the few issues all three candidates consistently discuss and have clear differences about. The system’s unfunded liabilities have already lowered the credit rating of the state, making it more expensive to borrow money and discouraging investment by employers.

But just how do pensions play such a large role? For anyone who does not study finances, understanding a pension system is complicated, and the Kentucky General Assembly has made it even more confusing over the last decade or two.

Not too long ago, at the turn of the century, the Kentucky pension funds were in great shape. The system was fully funded, and it looked like smooth sailing. But an economic downturn put a hole in the ship, the downturn of the stock market shrank the returns on investments for the pensions, which had typically accounted for about two-thirds of pension fund revenue. At the same time the economic recession left the state with less revenue to plug the holes, and the pensions have been taking on water ever since.

The legislature and governors have not fully funded  state employees’ pensions since 2000, and not for teachers since 2008. To compound the problem, lawmakers have spent money from both funds on other projects. The IOUs left in place of the cash have not been satisfied yet, leaving the unfunded liabilities in the tens of billions of dollars, depending on how far you look into the future. The estimate is based on projected payments to current employees until the end of their lives.

Another big problem is that there are more retirees in the system as the baby-boomer generation leaves the workforce. Payments from the Kentucky Retirement Systems are double what they were 10 years ago, and the worker-to-retiree ratio has fallen to nearly one worker per retiree. The problem is made worse by cost-of-living adjustments that have been approved by the legislature without being funded, making benefits even greater.

The actuarially required contribution (ARC) for the next fiscal year is anticipated to be nearly $800 million, which would be more than $100 million greater than last year. The Kentucky Teachers Retirement System is expected to ask the legislature for $520 million next year. The state already borrowed $900 million to shore up KTRS in 2010.

In 2013 the legislature undertook major overhauls of the pension fund to stop some of the bleeding. New hires were place in a hybrid style plan that required them to contribute a dedicated percentage of their income (5 percent for Kentucky Employees Retirement System non-hazardous employees) to the pension fund. Cost of living adjustments were eliminated for all retirees unless the KRS board determined liabilities were funded at 100 percent or greater, and the cost of living adjustment is fully paid for. Double dipping has been eliminated, and transparency and oversight were increased within the pension system.

Most importantly, making the ARC was changed to be the expectation by 2015, and would require a waiver by the legislature in a budget bill in order not to do so.

To avoid further downgrades in the state’s credit rating, analysts say, the changes Kentucky made in 2013 were not enough. The state must dedicate a specific stream of revenue to the pension fund, rather than continue the current plan.

The legislature has a separate pension fund for its own retirees and judges, which has been much better funded than KERS and KTRS. The return on investment for the legislature’s pension fund was also five times greater than that of the KERS, which posted a meager 2 percent return for the fiscal year that ended June 30.

The candidates have substantially different ideas on how to tackle to the pension crisis.

Democrat Jack Conway does not have a concrete plan, choosing to take more of a wait-and-see approach: For KERS, he said, “I think we can get to the ARC for the next budget cycle.”

Conway said he won’t be more specific on solving the rest of the problem until after he sees the recommendations of a task force on pensions created by Gov. Steve Beshear.

“What the ratings agencies are saying to us is that, ‘This nonsense where you had last year, the legislature telling the governor to find $80 million in savings and taking $30 million out of the road plan, that’s not going to cut it. Find a dedicated source of revenue,” Conway said.

While Conway said he believes a dedicated revenue source can be found for the state employees pension, “finding one for the teachers is going to be tougher.”

Conway said he is open to a variety of options, including taxing casino gambling if voters legalize it.

Moving teachers to a defined contribution plan – like a 401(k) plan where employees and employers make contributions -- is “absolutely off the table” for Conway because they do not participate in Social Security.

Republican Matt Bevin, who opposes casinos, said he would keep all current retirees on the pension plan, but would give them the option for them to move to a defined contribution plan, like a 401(k). All new hires would be put into a defined contribution plan, which does not typically bring the same level of benefit as a pension.

The state has been too generous with its workers, Bevin argues, and has put itself in a place it can no longer afford. Bevin supports joining 29 other states in applying for a federal waiver to allow Kentucky teachers to participate in Social Security so they can have a guaranteed source of income during retirement if their 401(k) runs dry. This plan would also require the state and school districts make the employer contribution to Social Security unless this requirement were to be waived by the Social Security Administration, a move that is not likely to occur.

But experts said moving new hires to a defined contribution plan could cause the funds to run out of money even sooner because there would be no new workers contributing to the fund to cover benefits paid out to current and future retirees. Conway says it would create an $8 billion problem in the next 15 years.

The idea of bonding billions more to pay down the unfunded liabilities is not agreeable to Bevin, either. The fund would have to garner four times its current return to make bonding a viable alternative. In 2015 the return on investment was only 2 percent for the pension fund. When interest rates for bonds (in a state with a less than stellar credit rating) and fees to the investment managers are factored in, a 2 percent return would only dig the fund deeper into a hole.

Independent Drew Curtis sees the problem differently: “What it all comes down to is the checks must go out. If we don’t send the checks out, that instantly throws the state economy into recession.”

He proposed a $5 billion dollar line of credit to help cover the pension shortfalls. Rather than a bond, which would take out all $5 billion at once, and immediately begin to require interest payments, a line of credit would allow smaller amounts to be taken out when needed, similar to the way a credit card works.

“We don’t need to get to 100 percent funding if we have checks going out,” he said.

When the pension system performs well and can produce enough return on investment to send the checks out, the line of credit would be left alone. In years the fund needs extra cash, the line of credit could be tapped to pick up the shortfall, and paid back when times improve. This system would guarantee retirees still get their benefits, but would leave the legislature free to put funding toward the ARC rather than payments to beneficiaries, Curtis says. He says he would fund “ARC plus,” at 110 percent for the next 20 years.

Curtis admits that funding KTRS is trickier, but he takes a similar approach to Conway, saying there are a few years of wiggle room to assess the situation before the funding shortfall must be addressed.

PENSION TERMS EXPLAINED

ARC: Actuarially Required Contribution. This is the minimum yearly payment that must be made into each pension fund to cover the normal cost of pensions for the state, as well as the amount needed to pay down unfunded liabilities. If this payment is not made, unfunded liabilities increase.

ARC plus: A higher payment made to the pension system to bring down unfunded liabilities more quickly.

Unfunded Liabilities: The amount that is projected to be owed to current retirees in future years that the state will not have under current funding rates. Unfunded liabilities are measured in terms of years (the 10 year unfunded liability measures how much more money the state needs to pay pensions for the next decade) or in terms of how much more is needed to pay current retirees for as long as they are expected to live.

KERS: The Kentucky Employees Retirement System. The pension fund that goes to all non-hazardous state employees. From secretaries to police officers, about 120,000 retirees are currently in KERS.

KTRS: The Kentucky Teachers Retirement System. This covers all public school teachers in Kentucky, and includes about 141,000 retirees. Teachers do not receive Social Security, leaving this pension as their only guaranteed source of income.

Defined Contribution Plan: A system that sets the amount an employee pays in as the standard. The amount the employee gets in payouts depends on the performance of the investment. The 401(k) fits into this category.

Defined Benefit Plan: An employee makes contributions to the system, usually a set percentage of wages, for as long as they work. After retirement they are guaranteed a certain payment each month, often a percentage of their monthly pay when employed.

KRS: The Kentucky Retirement System. This is the system that manages all pension plans for the state, such as KERS and KTRS.