The Case for Public Pension Reform: Early Evidence from Kentucky

• Publication year: 2012

47 Creighton L. Rev. 585. THE CASE FOR PUBLIC PENSION REFORM: EARLY EVIDENCE FROM KENTUCKY

THE CASE FOR PUBLIC PENSION REFORM: EARLY EVIDENCE FROM KENTUCKY

MARIA O'BRIEN HYLTON(fn*)

"The great enemy of freedom is the alignment of political power with wealth."

-Wendell Berry(fn1)

I. INTRODUCTION

Over the past few years, public pensions have moved from the extreme and obscure periphery of American politics toward the churning center. It is hard to find even an unsophisticated citizen who is unaware of the ongoing bankruptcy in the City of Detroit,(fn2) the pension crisis in Illinois,(fn3) or the bankruptcies of Stockton and San Bernardino, California.(fn4) Public pensions (and other post-employment obligations, specifically health care), are penetrating the public's consciousness as they begin to threaten the ability of states and municipalities to perform the normal functions of government forcing a painful choice: dramatic tax increases and/or painful cuts in services.

The small city of Central Falls, Rhode Island, recently experienced all of this-cuts to the city budget with resulting job losses and tax increases.(fn5) Nothing about that situation was attractive to any of the key players, save possibly the bondholders who were largely protected. Instead of waiting for a full-on crisis and the shock of bankruptcy, many rational voices have been calling for an entirely different approach: amend public plans now in order to avoid draconian cuts later.

This paper focuses on one state-Kentucky-that has taken this advice to heart and recently enacted substantial pension reforms. Although Kentucky has never been described as the worst state in terms of public pension finances-that honor goes to Illinois(fn6)-this small state of only 4.38 million people sponsored plans that were only 30% funded as of 2012.(fn7) By April 2013, however, Kentucky enacted legislation that creates a cash balance-type plan for all new employees and requires the state to begin fully funding its annual required contribution in 2015.(fn8) How and why did this small state with a long and unattractive history of financial misbehavior(fn9) manage to confront its crisis before it was forced to consider even more painful choices? I argue that increased transparency and a carefully crafted political consensus pushed lawmakers to undo years of short term horizon thinking, political corruption, and the usual moral hazard story in favor of long term planning that should improve the state's finances over the long term. The Kentucky story is both a common cautionary tale of years of over promising by elected officials eager to placate public sector unions and an optimistic narrative about the positive consequences of increased transparency.

In Section II, I briefly review the financial state of Kentucky's plans and the corruption plagued environment in which "funding" and "investment" took place for many years. In Section III, I describe the reform process, the details of the new plan requirements, and evaluate the prospects for replication in other financially stressed states. In particular, I describe the hybrid cash balance vehicle as superior to the traditional defined benefit plan for public employees. Section IV focuses on the role of transparency and argues that the trend toward greater information for citizens and taxpayers, as evidenced by the recent Governmental Accounting Standards Board ("GASB") rule changes for public plans, can only help to create an environment of informed urgency needed for meaningful reform. Section V concludes and offers some suggestions, based on the Kentucky experience, for similarly situated states and municipalities.

II. CORRUPTION, SCANDAL, AND SHORT TERM THINKING

The motto of the Commonwealth of Kentucky is "United We Stand, Divided We Fall."(fn10) Until the Kentucky Legislature intervened in the spring of 2013, the state came perilously close to the utter collapse of its pension plans-what would have been a major fall indeed. What exactly it would have meant to "fall" under these circumstances is not entirely clear, however, once the financial predictions went from bad to dire, the political class finally mustered the support necessary for meaningful reform.

The Kentucky Retirement Systems ("KRS") consists of plans for three broad groups of employees: the state police, employees of the counties ("CERS"), and the general Kentucky Employees Retirement System.(fn11) KRS is basically an umbrella organization that provides management services to employees of more than 1,600 state agencies. KRS has approximately 334,000 members(fn12) that include employees of state supported universities (non-teaching staff), employees of local health departments and mental health agencies, and various employees of state government.(fn13) The County plan includes employees of city and county government agencies, police and firefighters, librarians, and various other employees who work for the local boards of education in non-teaching positions. The State Police plan includes, as expected, state police officers. The KRS and the CERS both categorize plan participants on the basis of hazardous or non-hazardous status.(fn14)

A. THE PRE-2014 DEFINED BENEFIT PLAN

Like many states, Kentucky offered its employees a traditional defined benefit plan managed by the KRS. The defined benefit was determined by length of service, an employee's final average salary, and a retirement multiplier. This meant that the state took full responsibility for managing the plan's assets in order to ensure that all obligations under the plan could be met. The retirement benefit was paid out for the remainder of the participant's lifetime, and the final average salary was typically determined by the average of the highest three or five years of salary. A 1.5% cost of living ("COLA") increase was guaranteed by statute, although this was rescinded in 2012 and 2013 and ultimately eliminated as part of the 2014 reforms.(fn15) Like most of these public defined benefit plans, funding came from employee contributions, state contributions, and investment gains from performance of the plan's assets.(fn16)

For a variety of reasons, which are discussed in further detail below, Kentucky repeatedly failed to make the state's contributions over a substantial period of time. This resulted in a total unfunded liability for the plan of $18 billion-one of the worst funded plans in the entire country.(fn17) By the time the legislature made fundamental changes to the KRS plan in the spring of 2013, the staggering scope of the problem in Kentucky had begun to attract national attention. The Pew Charitable Trust,(fn18) The Mellman Group,(fn19) and Morningstar(fn20)had all noted the seriousness of the Kentucky funding predicament and concern about a "cultural" inability of the legislature to implement needed reforms surfaced.(fn21) Morningstar, for example, reported that Kentucky's pension solvency issues were significant as "[o]verall, the state's plans are at a very low 46.8% funded level with an unfunded liability of roughly $5,000 per capita."(fn22)

The Pew Center on the States notes that "devastating market losses," "repeated failures" by the state to make its contributions, unfunded COLAs, and faulty actuarial assumptions explain most of the shortfall.(fn23) And, of course, the longer these problems remain unad-dressed, the more intractable they become: "as the unfunded liability grows, so, too, does the following year's recommended contribution. Currently sixty-three cents of every taxpayer dollar that goes in to the Kentucky Retirement System pays for past promises rather than for new benefits."(fn24)

B. 2014 PLAN AMENDMENTS

In early 2014, after considerable wrangling, but also surprising unity, the Kentucky Legislature passed House Bill 404 and Senate Bill 2 which fundamentally reformed the KRS system for future hires. Most important, all employees hired on or after January 1, 2014 will be enrolled in a hybrid cash balance plan. The defined benefit plan is now closed to new participants.(fn25) New judicial employees and legislators will no longer have access to the old plan, nor will employees classified as non-hazardous. Like other cash balance plans,(fn26) each employee will have a hypothetical account to which 4% interest will be paid plus a share of investment returns. Basically, each employee is guaranteed a 4% return on her contributions; additionally, the employee splits with the fund any investments returns-75% to the participant and 25% to the fund. The cost of living increase which was guaranteed under the defined benefit plan is no longer payable unless the legislature authorizes pre-payment.(fn27) And, the state has committed itself to fully funding its Actuarially Required Contribution ("ARC") every year going forward.

Full funding, which was consistently ignored by the legislature(fn28)for many years is apparently addressed by the new law. Senate Bill 2 mandates full funding by 2015 and requires the state to make 100% of its contribution each year. Basically, funding is expected to come from the following sources:

* A reduction in the $20 tax credit for each taxpayer, spouse, and dependent. This is expected to raise an additional $32.5 million in revenue;

* Changes to the American Taxpayer Relief Act of 2012 are expected to raise $30 million;(fn29)

* Various changes to the Kentucky code, including changes in fees

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