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February 6, 2013
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Kentucky pension shortfall a potential bankruptcy bomb

State pension participants, politicians, taxpayers have compound interest in fixing system

By Frank Goad

Kentucky Retirement Systems (KRS) is underfunded by more than $30 billion and falling further behind. Investment yields that are supposed to produce two-thirds of system funds were stunted by the 2008 economic crisis. That serious situation is worsened significantly, though, because successive administrations and legislatures have been shorting appropriations to the pension systems for more than a decade, cutting the financial feedstock that was to compound for investment.

Kentucky Retirement Systems is unfunded by nearly $30 billion.For many state employees who put their money into pension programs, those golden years appear less secure than they once did.

To be fair, KRS is in bad shape for a wide variety of reasons beyond underfunding. The reasons include: diversion of funds due KRS by elected officials; questionable investments; investment underperformance and losses from a stuttering economy; reduced tax revenues; and unfunded mandates (e.g., cost of living raises). It all adds up to chaos in the KRS.

According to the Institute for Truth in Accounting, the funding gap for the retirement systems has grown by roughly $3 billion in the past year alone, and the shortfall for the Kentucky Retirement Systems’ six groups is over $30 billion; KRS proper reported its unfunded liability at more than $19 billion for FY 2011-2012. A recent Pew Center on the States study describes the commonwealth’s pension situation as “unsustainable” due to this liability and because KRS is paying out more than it is taking in.

Compare KRS’ status in 2000 to that reported in 2010 in the chart at left.

Within these overall numbers for six public pension plans, the Kentucky Employees Retirement System (KERS) is at only 27 percent funding of the pensions and healthcare payments for which it is responsible. KERS went from being considered one of the best-managed funds in the country in 2000 to its current status as one of the poster children for poor management.

Pension shortfall chartOn Feb. 1, members of the Kentucky Chamber, National Federation for Independent Businesses, Associated General Contractors of Kentucky and more than 40 business associations held a news conference in the Kentucky Capitol to urge pension reform action.

Many say there essentially are two choices: the state declares the pension system bankrupt to shed some of it obligations (unlikely to ever happen), or it doubles the sales or income tax (e.g., 12 percent sales tax vs. the current 6 percent) and commits all the added revenue to KRS. Raising taxes that drastically could be a poison pill, though.

Illinois, the state in the worst shape with a $96 billion pension system deficit, in January 2010 raised its personal income tax from 3 percent to 5 percent and corporate taxes from 4.8 percent to 7 percent. A year later, the Illinois Policy Institute declared the tax hikes a failure, saying it caused business to leave the state and raised unemployment from 8.7 percent to 10 percent.

Illinois fell from 16th on the 2011 State Business Tax Climate Index to 29th in 2013, the Tax Foundation reported. It was the largest drop by any state. (Kentucky is 24th, unchanged.) Still wrangling with pension reform, Fitch Ratings dropped Illinois’ financial outlook from “stable” to “negative” – something no legislature or governor wants to see.

An unavoidable bill – for taxpayers

The balance between cash and annuitized payments is known as the assets-to-liabilities ratio, and is a key measure of a retirement system’s stability and security over the lives of those entitled to receive payments. In the Pew Center’s study, Kentucky is one of only four states with less than 55 percent of the funds needed for a proper ratio.

It is important to remember that a state employee’s pension is a legal contract with the state: They pay into the system to get specific benefits when they retire – a defined-benefits model. The state – and its taxpayers – is obligated to pay at the rate the contract promised.

Benefits may legally be reduced or the plan changed – a popular suggestion is shifting to a hybrid 401(k)-style pension – only going forward from the day legislation to do so is enacted. There is no effect on current obligations.

In the end, this is a taxpayer issue – the commitments made by governors and legislators are legal obligations to state residents collectively, including the liabilities. Taxpayers owe the money needed to shore up the system. For over a decade, the legislature has not put the money into KERS that it was supposed to, spending tax revenue on other projects and obligations. The debt owed by law to KERS grew.

About the only way for Kentucky to pay reduced benefits to current retirement system members is to declare bankruptcy for the state’s pension systems. Even if a state wanted to file bankruptcy, a judge might not allow it. In 2012, a U.S. bankruptcy judge in Hawaii dismissed the Northern Marianas Islands Retirement Fund bankruptcy filing. (The Marianas Islands are a U.S. territory.) The judge wrote that the fund is a “governmental unit … not eligible for relief under Chapter 11 of the Bankruptcy Code.” This set legal precedent and serves as a guide for other troubled pension systems across the country.

Kentucky isn’t alone. In January, the federal agency insuring private pensions for more than 40 million Americans, the Pension Benefit Guaranty Corp. (PBGC), announced its largest deficit in nearly 40 years of operations. The agency backs defined-benefit plans for corporations and protects pensioners if theirs goes belly-up, like American Airlines pension system did in 2005. PBGC said its deficit grew to $34 billion in 2012 while assets went up only $4 billion to $85 billion; its pension obligations grew to $119 billion in 2012. The federal agency, like Kentucky’s funds, has run deficits for 10 straight years.

How we got there

While there is plenty of blame to go around, most critics agree about the KRS decline’s main causes. Jim Waters, president of Bluegrass Institute for Public Policy Solutions, told Kentucky Educational Television that chronic underfunding combined with “a perfect storm of recessionary times that caused a drop in investment returns and tax receipts, and the growth in medical costs. What made it worse is that new benefits were added along with the acceptance of non-profit, government-affiliated organizations into the system.”

Organizations such as Bluegrass Mental Health and Commonwealth Credit Union are part of KERS. Many more like them have been added over the years by legislators and governors, often as political favors.

When it comes to underfunded pensions, Kentucky is considered second only to Illinois, which is known as the worst-managed pension system in the nation. The Securities and Exchange Commission is investigating payments of millions of dollars by KRS to “investment agents” its board of directors hired. Investment losses, however, are small compared to the system underfunding in the state budget by the legislature and governors.

Lawmakers need to find $23 billion for Kentucky’s retirement systems to put them in good health – in addition to the current streams of revenue. That would provide enough capital to let KRS’ investments generate returns and move it further toward stability. With a $9 billion annual budget of revenues under legislative control, $23 billion is going to be tough to find, but it’s owed legally.

Some blame the media, too, for not sounding the alarm sooner. Until mid-2012, despite being heralded for years by a variety of voices – including an April 2007 Lane Report cover story – the issue received little attention. And KRS critics note the state auditor’s office has passed over retirement system activities to investigate much smaller but politically juicier targets.

The multiheaded hydra

It’s important to understand that KRS is not one system but six:

• Kentucky Employees Retirement System (KERS), which functions as the umbrella organization.

• Kentucky Teachers’ Retirement System (KTRS).

• County Employee Retirement System (CERS).

• State Police Retirement System (SPRS).

• Kentucky Judicial Retirement System for judges (KJRS).

• Kentucky Legislators Retirement System (KLRS).

KERS and CERS have different pension rates for employees with hazardous and non-hazardous jobs. To add yet another layer, KRS administers both a pension fund and a health insurance fund for all six systems.

For each, the funding formula is as follows: employee contributions are 12 percent of total receipts, the state contributes 20 percent, and investment gains are to generate the other 68 percent. This is a reasonable model when all the entities fulfill expectations, but almost every pension in America has had a rough go since the financial markets fell in 2008.

KRS states that it paid out more than $1.6 billion in benefits in FY 2011-12, and more than 95 percent of recipients live in Kentucky. So, most of the money paid out does support the state.

The county in FY12 with the lowest amount of KRS money coming in was Robertson, with 64 payees getting $852,000. Franklin County had 6,025 employees who got $182 million. The highest was Jefferson’s 13,806 payees receiving $277 million. Averaging those figures, the typical Louisville KRS pensioner got $20,056 while one in Frankfort received $30,221.

Failing to pay the piper

Arguably the biggest problem KRS has faced, and the main reason it has fallen from its position in 2000, is that in biennial Kentucky budgets the legislature did not fund approximately $800 million of the $1.8 billion the state was obligated to have paid into the system.

In its annual report, the Kentucky Retirement System said: “KRS has continued its effort to raise awareness of the impact of reductions to the actuarially recommended employer contribution rates for the KERS and SPRS plans. For 13 of the last 18 years and for 10 years in a row, the state has appropriated less money than recommended by the KRS actuary and established by the Board of Trustees to adequately fund the annual required contribution (ARC). This underfunding, coupled with past increased benefits, unfunded annual cost-of-living allowances and two major economic recessions in the last decade, has resulted in funding ratios (the ratio of assets to accrued liabilities) for the KERS nonhazardous and SPRS pension trusts that have dropped to alarmingly low levels.

“The [2008] Kentucky General Assembly passed a pension reform bill (House Bill 1) that included a schedule to increase employer contributions over the next several years until reaching the full ARC in 2025 for KERS non-hazardous, 2019 for KERS hazardous and 2020 for the SPRS system. For the past two fiscal years, the governor and the Kentucky General Assembly have met the increased funding schedule set for them in House Bill 1. It is vitally important that they continue, at a minimum, to increase funding according to the House Bill 1 schedule during the next biennium. This will have a favorable effect by slowing the growth rate of the unfunded liability and the expected growth rate of employer contributions in future years. KRS will continue to monitor and ask for increased funding support from the governor and the General Assembly in the years ahead.”

This conflicts with Gov. Steve Beshear’s proposal to give relief to cities and counties by extending the amount of time they have to fully fund their healthcare costs from five to 10 years. They are in a tough spot because, as members of CERS, they have a legal mandate to fund their portion 100 percent every year. If they get the proposed extension, it only means they’ll have to find the revenue later.

Sen. Damon Thayer, R-Georgetown, is co-chair of the legislative tax reform task force, and he doubts the governor’s request will be approved. He has publicly stated that the funding gap will only grow if the governor’s reforms are passed.

Wish lists and misdeeds

When asked what he would most like to see the legislators do this year, KRS Executive Director William Thielen said, “There are three things: First, have them do what the recent task force told them they should do – pay KRS all it’s due each year. Second, suspend the cost-of-living adjustments and any other increased benefit payouts. Third, find some extra money and work harder toward making the system whole again.”

Other groups call for additional changes. Tea Party adherents loudly advocate for three in particular, and all wrap around the repeal of HB 299 from 2005, whose “reciprocity” allows legislators to take state jobs after their elective term and, if they stay at least three years, have their pensions calculated on the job’s pay rate but including their legislative time. Legislators are paid a daily rate, presently $188.20 in salary plus $135.30 for expenses. A few years in a state job can multiply a former legislator’s pension several times.

Another HB 299 provision, however, makes individual state pension information secret. State salaries are a matter of public record, but pensions are classified. Making pension compensation public record won’t reduce state liabilities but is considered to be a deterrent to “double-dipping” after retirement.

A third Tea Party-advocated reform is excluding non-government system participants. They name the Kentucky Education Association, non-profits and attorneys in private practice who work under contract with the state.

To ease some of the underfunding, the governor quietly authorized the issue of a series of Pension Obligation Bonds that total over $700 million. This year’s legislature will try to quietly authorize another series of such bonds, many believe. The bonds do lower unfunded pension liability, and might reduce concern about that debt, but do so by borrowing money upon which interest must be paid.

“The governor and our legislature are doing their best to kick this can down the road,” said Chris Tobe, former member of the KRS Board of Directors. “It’s ugly, messy and none of them want their name or party associated with it. You will most likely see a Tea Party candidate in the next election running for governor on an anti-bankruptcy ticket.”

Tobe is a chartered financial analyst (CFA) who served as a pension investment expert for the state auditor from 1997 to 1999 and was on the KRS board in 2008-09. In August 2010, Tobe filed a whistleblower complaint and agreed to provide information to the Securities and Exchange Commission regarding certain KRS board-authorized investments made by outside investment firms.

“The legislature is underfunding the pension by as much as $800 million a year,” according to Tobe, “and has done so for 10 straight years. That is the main reason we are in such a deep hole.”

He agrees with KRS director Thielen that the legislature needs to start funding at 100 percent or Kentucky is “… going down the same road as Illinois and could wind up having to bankrupt the system. We are only about two years behind them.”

It could be difficult to avoid.

“Pension obligations are rock solid,” Tobe said. “They have a higher priority in state budgets than municipal bonds, and that’s by law. That’s what makes talk of pension reform and our current situation so dangerous – it does nothing for our current liabilities.”

Pension reform is just the tip of the iceberg and is about more than just underfunding the KRS. Resolving it means substantial and far-reaching changes requiring political courage by legislators and Gov. Steve Beshear.

Legislative ideas

A Kentucky Public Pensions Task Force appointed by the General Assembly worked last year and made these recommendations:

♦ Fully fund state contribution payments beginning in FY 2014-15.

♦ Place new employees into a hybrid cash-balance plan with a guaranteed return of 4 percent rather than the traditional defined-benefit plan.

♦ Place new legislators and judicial-system employees into the new cash-balance plan.

♦ Repeal annual cost-of-living adjustments in pension benefits.

♦ Extend amortization for unfunded liabilities from 26 years to 30 years.

♦ Require longer employment breaks before retirees can return to government jobs – also known as “double dipping.”

♦ Shift more cost to a government employer when employees boost their final salaries via overtime and other methods to increase their pension.

♦ Increase the KRS board from nine to 11 members with representation for city and county governments and school boards.

♦ Require KRS to establish a website with financial condition information.

Frank Goad is a correspondent for The Lane Report. He can be reached at editorial@lanereport.com.

 

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Lane Report Cover January 2013 In This Issue
Kentucky pension shortfall a potential bankruptcy bomb
State pension participants, politicians, taxpayers have compound interest in fixing system
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