States like Illinois and New Jersey and cities like Chicago and Detroit have attracted national headlines for their pension problems, but for absolute distress, no place has greater trouble with its retirement system than oft-ignored Kentucky. The Bluegrass State’s pension plan has lower funding levels than any other state plan, and one of its major pension funds is just four years from insolvency. The state already devotes about 13 percent of its revenues to pensions—about double what other states spend—and it’s not nearly enough to fix the problem. What should be most troubling to people outside of Kentucky, however, is that what got it into this mess is only a more severe version of the problems afflicting many local-government pensions, whose funding levels have failed to recover even after a nine-year bull market. Where Kentucky stands right now, in other words, is where many other pension systems are heading.
According to Kentucky pension-system reports, the state owes at least $43 billion that it hasn’t funded in its pension system, though a state study, using more conservative estimates, suggests that the system could be as much as $64 billion in the hole—not counting $6 billion in unfunded retiree health-care costs. Since 2008, state contributions to the pension system have more than doubled, to $1.5 billion annually from $624 million, but it hasn’t been enough. Local governments face a 50 percent jump in pension costs next year. To fund the system adequately, the state would have to cut other spending by more than 15 percent, or raise taxes sharply. But Governor Matt Bevin rules that out: “I do not intend to raise taxes to pay for the sins of the past.”
Those sins are many. The conventional narrative is that government pension systems have gotten into trouble because politicians didn’t fund them sufficiently, but that’s only a small part of the story. According to PFM Consulting Group, about 15 percent of Kentucky’s debt can be traced to under-financing its annual required pension contributions. The far bigger problem is that Kentucky’s pension system, like those in other states, has employed dubious accounting standards that underestimated problems in the system. “Sadly, it seems past assumptions were often manipulated by the prior pension boards in order to minimize the ‘cost’ of pensions to the state budget,” Bevin and two legislative leaders wrote in a recent op-ed. “The result was to provide a false sense of security.”
Kentucky’s retirement system, for instance, used a technique known as “backloading,” which pushes off into the future payments that would reduce a system’s debt. That method sustained for years the illusion that the system was still affordable, even as its costs were mounting. Kentucky also used assumptions—such as how long its retirees would live—that proved wrong, with costs winding up higher than projected. Like many government systems, the state has also failed to meet its investment projections because they turned out to be too optimistic, and it enacted cost-of-living adjustments without properly accounting for them. Finally, the state designed costly benefits out of line even with other those offered to government workers in neighboring states—including allowing workers to retire early with full benefits. The average age at which Kentucky teachers retire, for instance, is 55, or about five years below the national average.
Still, Kentucky workers argue that their pensions are small and that they couldn’t possibly bear reductions to them. The state’s retired teachers receive on average a pension of just $36,244, according to press reports. But that number is misleading, because it includes everyone garnering payments, including those who worked only a few years and now receive partial pensions. By contrast, Kentucky teachers who retire with full benefits—and who generate the most costs in any system—do quite well. According to the pension plan’s most recent annual report, teachers retiring during fiscal 2016 with 30 years of service earned an average pension of $64,668, or 80 percent of their final average salary, while those who left with 25 years of service received $47,220, or 65 percent of final salary. By contrast, median annual household income in Kentucky is $43,470.
Facing this crisis, the state is considering recommendations made by its consultant, PFM Group, to end cost-of-living adjustments, raise the retirement age to 65, and enroll new hires in a 401(k) style plan instead of a defined-benefit pension. Employees object to any changes for current workers, arguing that their pension plans cannot be altered because of legislation that declares that retirement benefits for government workers “constitute an inviolable contract” in Kentucky. To them, this means that workers have the right to keep earning benefits for an entire career at the rate in effect when the state first hired them. By contrast, in federal court cases, judges with jurisdiction over private-sector pensions have consistently ruled that while a pension contract protects benefits that a worker has already earned, it doesn’t prohibit an employer from changing the terms of a pension plan for work that an employee hasn’t performed yet. How Kentucky courts resolve this issue may very well determine whether the state has a chance to fix its pension problems without steep tax increases or devastating cuts in government services. Though the state can’t make its current pension debt go away, it could save substantially by reforming benefits and then applying the savings to paying off its pension debt. One Kentucky labor leader has promised that if the state attempts such reform, workers “will storm the Capitol with torches and pitchforks.”
Whether taxpayers promise to do the same, if they get stuck with the state’s huge retirement bill, will probably determine Kentucky’s fiscal future.
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