Kentucky currently has one of the largest pension funding gaps of any U.S. state. According to credit rating agency Standard & Poor’s, Kentucky’s pension program is the most underfunded in the nation, with only 37.4 percent of the system’s current total obligations funded – far below the national median of 74.6 percent. According to a new government pension website created by Kentucky Gov. Matt Bevin’s (R) administration, Kentucky’s pension spending has generated a negative cash flow of $7 billion over the past decade, with spending growing five times as fast as revenue.
Kentucky has made some efforts to reform its pension system in the past. In 2013, the state created a hybrid cash balance plan for new employees, eliminated retiree cost-of-living increases, and required the state to make full pension payments. These were all positive steps, albeit small ones, toward creating a fiscally sustainable system, but they failed to address the primary problems with the state’s investments.
Kentucky currently sponsors eight pension plans in its three major retirement systems, providing pension and retiree health care benefits to more than 166,000 retired public sector and nonprofit employees. While the full details of the plan have not been released, Bevin has long called for substantive structural changes. Chief among these changes would be to replace the current state pension plan with a 401(k) retirement plan for new employees, which would also be made available to current employees who would like to transfer their traditional pension account.
Moving state workers to a defined-contribution model would put the state on a path toward lowering costs and improving flexibility. Under a defined-contribution plan, employers pay a fixed amount during the course of a worker’s career, which is then deposited into a personal account the worker controls and manages. This gives workers greater control over their retirement and the ability to customize a pension to fit every worker’s unique needs. Additionally, changing to a defined-benefit model provides more budget certainty to taxpayers.
Kentucky’s serious pension problems have been compounded by its unrealistic expectations for the funds’ investments. While Kentucky’s pension system recently decreased its expected rate of return to 6.75 percent, down from a high of 7.75, this is nowhere near the rate that should be imposed to meet realistic market expectations. Taxpayers cannot afford for states to continue overpromising and underfunding their pension plans. If the rate of return consistently falls short of expectations in the near future, the state’s pension system may be in even more trouble than is currently thought.
Bevin proposes lowering the assumed investment return rate to a more realistic level. Pension experts recommend states use an expected rate of return between 2.3 percent and 3.1 percent, figures based on Treasury bond yields.
Decreasing the expected rate of return does come with consequences. Because the rate is used to determine the present value of benefits that will be paid to retired workers in the future, reducing the rate of return will increase the apparent level of obligations.
Overpromising benefits and underfunding have created several problems the state will soon have to face. According to Governing Magazine, Kentucky’s largest pension plan “lost nearly a third of its assets, dropping to $2.3 billion in 2015 from $3.1 billion in 2014.” If the largest fund’s assets continue to fall, the state will be forced to convert all investments to cash. The state has already moved several of its investments to low-risk, low-return bonds to pay for retiree payments.
The growing pension debt in Kentucky has had a negative effect on the state’s credit rating. Bond-rating agencies have lowered Kentucky’s rating to the third-lowest rating of all U.S. states. It now only sits behind Illinois and New Jersey. Maintaining a higher credit rating is important because lower ratings increase the cost of borrowing money, which could make it difficult to pay all the state’s bills without imposing tax increases.
Bevin’s proposed reforms would move the state in the right direction. Lawmakers shouldn’t wait a single day more to protect taxpayers and improve the health of public workers’ pensions.
Jesse Hathaway is a policy advisor for budget and tax issues at The Heartland Institute.
