A Citizen's Guide to Kentucky's Pension Crisis 2019 Update

a citizen’s guide to

KENTUCKY’S

PENSION

CRISIS 2019 Update

A Citizen’s Guide to Kentucky’s Public Pension Crisis 2019 Update With unfunded liabilities exceeding $42 billion in 2018 (up from $36 billion in 2015), Kentucky’s public pension systems are among the worst funded in the United States.

This financial crisis threatens the retirement security of state and local government employees and teachers. But it also has a critical – and negative – effect on all Kentucky taxpayers. The underfunding has prompted national agencies to downgrade Kentucky’s credit rating, meaning it costs taxpayers more to build roads, schools and other important projects that serve the public. More important, the additional funding provided to the pension systems, beginning in FY 2016 to help decrease liabilities, takes money away from other important priorities, such as education.

In February 2016, the Kentucky Chamber released A Citizen’s Guide to Kentucky’s Public Pension Crisis to provide information about Kentucky’s public pension systems and highlight the need for significant changes. Since that time, a number of important steps have been taken by policymakers and system administrators to address the challenges. This update contains the basic facts about Kentucky’s retirement systems included in our original report, provides the most recent information about the financial status of the systems, and highlights developments since 2016.

The public pension situation is complex and confusing. But having a clear understanding of the challenge it represents is vital if Kentucky is to find a way out of this crisis that threatens its financial future. Providing information that enables such an understanding is the purpose of this issue brief, which: • provides background data on Kentucky’s major pension systems • reviews how Kentucky’s pension systems got into such poor shape • compares Kentucky’s performance with national averages • summarizes recent reforms in the system • outlines recommendations for moving forward and putting our pension systems on a sound financial track

An Overview of the Kentucky’s Public Pension Systems KEY ACRONYMS ARC: The amount of money an employer needs to contribute to a retirement plan during the current year for benefits to be fully funded by the end of the amortization period (usually 30 years) KRS: Kentucky Retirement Systems—the state agency that administers: • KERS: Kentucky Employees Retirement System—the retirement plan that covers state government employees • CERS: County Employees Retirement System—the retirement plan that covers city and county government employees (including non-teaching school staff) • SPRS: the retirement plan that covers the state police KTRS: Kentucky Teachers’ Retirement System—the retirement plan that covers teachers in local school districts, employees of community colleges and some state universities

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The Commonwealth of Kentucky operates two main defined benefit pension systems that provide benefits to public employees.

•

1. Kentucky Retirement Systems (KRS) includes five different funds: • Two funds within the Kentucky Employees Retirement System (KERS), covering state government employees who work in hazardous and nonhazardous occupations and non-teaching employees at regional universities.

• Two funds within the County Employees Retirement System (CERS), covering city and county government employees who work in hazardous and nonhazardous occupations. CERS also covers non-teaching employees of school districts, such as bus drivers, cafeteria workers and school custodial staff.

The State Police Retirement System, covering state troopers 2. The Kentucky Teachers’ Retirement System (KTRS) covers teachers and some university and community college employees.

The Commonwealth also operates separate retirement plans for the legislature and judiciary. This report does not focus on those plans, as they are relatively small and better funded than plans covering teachers and state/local employees; however, their unfunded liabilities are included in Kentucky’s total.

Pension benefits paid to public employees are based on a calculation involving three factors set by state law: an employee’s final salary, which is generally based on the average of the highest five years of salary; the benefit factor, a percentage based on the amount of service and dates of employment; and length of service, which includes time actually worked, prior service, purchased service and sick leave. The average yearly pension benefit for state government employees in a nonhazardous position is $21,587; for teachers, it is $37,581 per year. State and local government employees receive Social Security benefits while teachers do not. It should be noted that state and local employees hired after January 1, 2014, are in a 401(k)-type hybrid plan.

Kentucky’s retirement systems are funded by employers and employees, both of whom contribute a percentage of employees’ wages to the retirement system for each pay period. The retirement systems invest these contributions (in the stock market and elsewhere) and use the investment income to fund retirement benefits. The amount paid by employees is set by state law. Experts for the pension plan annually determine the ARC, or Actuarially Required Contribution, that should be paid by state and local governments – the employers – to ensure contributions are adequate to fund the system. The ARC is expressed as a percentage of the employee’s salary that public employers pay. It is important to note that when the balance of a pension fund is low, like KERS, the investment income drops and the ARC rises. The actual amount that is paid to KERS and KTRS is determined by the General Assembly as part of the state’s biennial budget. Local governments are required to pay the full required contribution to the County Employee Retirement System; under law, they may not pay a lower amount than the ARC. A pension fund is considered to have unfunded liabilities or pension debt if the fund does not have sufficient assets to pay the present and future liabilities of promised benefits over time. The funded ratio of a pension plan represents the value of assets in the plan divided by the pension obligation. For example, a funded ratio of 50% means a plan has half the money needed to pay its outstanding liabilities over time.

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*** The next section of the report looks at the financial condition of Kentucky Retirement Systems and Kentucky Teachers’ Retirement System. As the condition of each system is significantly different, each system is examined separately, with recent data provided on: • The number of employees (active, inactive and retired) covered by the system • Total contributions received, benefits paid, total actuarial unfunded liability and funded ratio for FY 2018; (The data include annual health insurance payments under the retirement funds, which are part of the unfunded liabilities calculations.)

• Factors contributing to the underfunding • Investment performance • Recent developments • Outlook going forward

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Kentucky Retirement Systems Total Number of Employees Covered Kentucky Retirement System, FY 2018 Pension Fund KERS Non-Hazardous KERS Hazardous CERS Nonhazardous CERS Hazardous State Police Pension Fund TOTALS

Active

Retired

34,845

Inactive * 45,768

42,175

3,963

4,716

84,435

Totals 122,788

% of Total 32.4%

Average Benefit $21,587

3,010

11,689

3.1%

$15,467

81,608

56,629

222,672

58.7%

$11,739

9,285

2,581

7,647

19,513

5.1%

$27,771

891

290

1,445

2,626

0.7%

$39,686

133,419

134,963

110,906

379,288

100%

*Persons who have earned time in the system but are no longer employed in a position covered by KRS. Source: FY 2018 Comprehensive Annual Financial Report, Kentucky Retirement Systems

Components of KRS Membership

Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

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Key Financial Facts Kentucky Retirement Systems, FY 2018 (Dollar amounts in millions) Fund

KERS NonHazardous Pension Fund KERS Nonhazardous Insurance Fund KERS Hazardous Pension Fund KERS Hazardous Insurance Fund CERS Nonhazardous Pension Fund CERS Nonhazardous Insurance Fund CERS Hazardous Pension Fund CERS Hazardous Insurance Fund State Police Pension Fund State Police Insurance Fund TOTALS

Total Assets* 6/30/17

Total Deductions (Benefit payment s etc.)

Change In Net Position

$2,092.7

Total Additions (Contribu -tions, interest income, etc.) $947.8

Total Assets* 6/30/18

Total Actuarial Unfunded Liabilities

Funded Ratio

$991.6

($43.8)

$2,048.8

$13,655

12.9%

$781.4

$198.0

$132.6

$65.2

$846.7

$1,548

36.42%

$605.9

$114.3

$69.1

$45.2

$651.1

$512

55.5%

$484.4

$47.8

$18.8

$28.9

$513.3

($117)

129.9%

$6,739.1

$1,107.9

$760.7

$347.1

$7,086.3

$6,241

52.7%

$2,160.5

$322.8

$136.6

$186.2

$2,346.7

$721

76.68%

$2,227.6

$383.2

$249.8

$133.3

$2,361.0

$2,470

48.4%

$1,179.3

$164.7

$75.8

$88.9

$1,268.2

$427

74.6%

$256.3

$71.0

$59.0

$12.0

$268.4

$721

27.1%

$178.1

$25.7

$13.8

$11.8

$189.9

$74

71.55%

$16,705.3

$3,383.2

$2,507.8

$874.8

$17,580.4

$26,252

34.07% (Pension) 66.27% (Ins.)

*Restricted for benefits Source: FY 2018 Comprehensive Annual Financial Report, Kentucky Retirement Systems

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KRS 2018 Funding Status (In billions)

Source: FY 2018 Summary Comprehensive Annual Financial Report, Kentucky Retirement Systems

As the chart above indicates, the largest pension fund in KRS, CERS Non-Hazardous representing 58.7% of the total employees in KRS, is more than 50% funded. This is due primarily to the fact that the full ARC has been paid over time by local governments. The KERS Non-Hazardous plan, which accounts for approximately one-third of all participants in KRS, is funded at only 12.9% (the lowest rate in the country) and reduces the overall average funding level of KRS. Factors Contributing to Underfunding of KRS It has been widely reported that the failure of the Governor and General Assembly to recommend and enact full funding of the employer’s contribution for state employees is the primary reason for Kentucky’s pension underfunding crisis. However, it is important to note that other factors, such as investment losses since the 2008 recession and issues with actuarial assumptions, also played a key roll in Kentucky’s pension shortfall.

(Efforts taken to revise actuarial assumptions used by KRS are highlighted under the Recent Developments section.)

The chart below, developed as part of a 2012 legislative task force on Kentucky Retirement Systems, quantifies the key contributors to pension underfunding in KRS.

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Sources of Underfunding for Kentucky Retirement Systems

Other, 24.7% Benefit Changes, 1.6% Actuarial Assumptions Not Met, 6.8%

Changing Actuarial Assumptions , 12.6%

Investment Returns Falling Short, 18.7% Unfunded COLAs, 18.2% Employer Contribution Shortfall, 17.4%

Source: The Pew Charitable Trusts, 2013

A recent presentation by KRS to the Kentucky Chamber elaborated on these and other factors contributing to the underfunding, including: •

Severe pension contribution underfunding of KERS from 2003 to 2014. As an example, the chart below shows the actuarially recommended employer contribution (as a percent of payroll) compared with the amount actually enacted by the General Assembly for KERS Non-Hazardous from FY 1993 to FY 2019.

KERS Non-Hazardous Employer Rates Amount Required Compared with Amount Enacted FY 02 to FY 19

*Rates for quasi-state agencies (universities, Mental Health Centers, etc.) set at 49.47% for FY 19 only Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

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•

•

• •

The employer contribution rate is based on a percentage of payroll, a model which has been used since the 1950s. However, payroll has been declining over time as state employment has fallen, especially in recent years, meaning fewer employees are making contributions to the retirement system. KRS officials have noted that using this approach creates a downward spiral for the system. As the number of public employees continues to decline, the employer contribution (based on percentage of payroll) becomes inadequate, and the ARC must be increased every year.

There has been a reluctance to change actuarial assumptions (such as workforce growth, assumed investment returns and growth in payroll). The use of outdated assumptions resulted in an ARC calculation that was lower than actually needed to maintain the health of the system. (These assumptions have now been updated.)

COLAs were provided to retirees that were not funded. (All COLAs were eliminated as of January 2014).

Retirements are increasing as Baby Boomers leave the workforce. The graphs below show the change in active vs. retired employees in KERS Non-Hazardous and CERS Non-Hazardous employees (the two largest plans in KRS).

KERS Non-Hazardous

CERS Non-Hazardous

Source: FY 2018 Summary Comprehensive Annual Financial Report, Kentucky Retirement Systems

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• •

Special retirement incentives were provided to employees retiring from 19992010.

Service purchases were allowed below actuarial costs. (Employees were previously allowed to purchase service credit by paying only the employer and employee contribution for each year of service. This did not account for the full cost, and KRS now requires payment of full actuarial costs to buy service time).

Investment performance The chart below, prepared by Legislative Research Commission staff, shows the investment returns of all five pension funds in KRS for one-year, three-year, five-year, ten-year and 20-year periods and compares those returns to benchmarks and peer group returns. In the past year, all funds equaled or exceeded benchmarks and earned more than the assumed rate of return on a one- and three-year basis. The KRS investment performance was not as good as the returns of peer groups.

Kentucky Retirement System Investment Returns

MV stands for market value of assets, AROR is the assumed rate of return used by the system, and N indicates returns are net of fees.

Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

In 2017, the KRS board lowered the assumed rate of return for all of the plans in the system to more accurately reflect actual results: • KERS-Non-Hazardous was lowered from 6.75% to 5.25%.

• KERS-Hazardous was lowered from 7.5% to 6.5%.

• SPRS was lowered from 6.75% to 5.25%.

• CERS-Hazardous and Non-Hazardous were lowered from 7.5% to 6.5%.

Recent Developments Relating to Kentucky Retirement Systems Kentucky has made significant changes to the Kentucky Retirement System in recent years. The following summarizes these changes by year of enactment by the Kentucky General Assembly or date of the administrative changes: •

2008 Special Session (HB 1): Increase in employee contribution of 1% for health insurance; impose Rule of 87 (age at retirement plus years of service); impose minimum retirement age of 57; use high five- instead of high three-year salary to calculate benefits; accrued overtime cannot count toward years of service; 15 years of service required to be eligible for health insurance.

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•

2013 General Assembly (SB 2): A legislative task force, working with experts from the Pew Charitable Trusts, undertook a review of Kentucky Retirement Systems, resulting in a major reform of benefits for new state and local public employees.

Included in the 2013 reforms: payment of full ARC by legislature for the plan affecting state employees (KERS); suspension of cost of living adjustments for current retirees unless prefunded; limits placed on the “spiking” of pensions (where raises are given to employees immediately before retiring to boost retirement benefits); a new hybrid defined contribution plan for new employees hired after January 1, 2014, with a 401(k)-style account with a guaranteed return of 4% per year; new employees are not covered by inviolable contract provisions.

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2016--New System Management: Governor Matt Bevin issued an Executive Order in 2016 that reorganized the board of KRS and included additional board members with investment expertise. The new board subsequently hired a new Executive Director, who is an investment professional, and took action to revised outdated assumptions used to determine the ARC (explained below).

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2018—Updated Actuarial Assumptions: Reviews of Kentucky Retirement Systems by outside experts have found that assumptions used in determining the Actuarially Required Contribution (the percentage of salary that employers contribute to the pension system) were inaccurate and resulted in an ARC that was too low and contributed to underfunding of the system. In particular, assumptions made about state payroll growth, growth in the number of employees and interest earned on investments were higher than actual rates. The new KRS board has taken action to revise these assumptions—lowering the assumed rate of return on investments, growth in employees and payroll growth—resulting in a higher ARC that will infuse more funds into the system. The chart below shows the change in employer contribution for the ARC for KERS in recent years: Employer Contribution Rates for KERS

Source: FY 2018 Summary Comprehensive Annual Financial Report, Kentucky Retirement Systems

•

2016 to Present—Full Funding of ARC: After more than a decade of underfunding, the FY 2016-2018 state budget provided more than $1.1 billion in

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additional pension funding over the biennium. The full ARC plus an additional $150 million was provided to the Kentucky Employee Retirement System (KERS) over the biennium. This trend continued last year with the enactment of the FY 2018-20 budget, which fully funded KERS and KTRS. •

2018 General Assembly—SB 151: Legislation enacted in 2018 retained the hybrid plan for new employees in KRS and removed the guaranteed rate of return of employees in the current hybrid plan. This legislation, which also made changes for teacher retirement discussed in the next section, was found unconstitutional on procedural grounds in December 2018.

Outlook for KRS KRS officials report the recent changes in funding and actuarial assumptions have made a positive difference, noting: •

Higher employer contribution rates and direct appropriations have helped. KERS and SPRS plans are more stable, and for FY 2019, KERS Non-Hazardous incoming contributions exceed retiree benefit payments for the first time in recent years. (See below.)

Cash Flow: KERS Non-Hazardous Pension Fund (FY 17 to Q1FY19)

Source: Cash Flow Review, Kentucky Retirement System, November 26, 2018

• • •

The insurance plans showed an improvement in funded ratio, with unfunded liabilities declining by $910 million.

FY 2018 investment returns were $410 million more than expected.

The system has more investment expertise on the board, a more conservative asset allocation and lower investment fees.

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If these trends continue, KRS projections indicate the funded ratio for the two largest plans will increase significantly over the next 20 years. KERS is projected to reach a funded ratio of 69% by 2038 and CERS will attain 82%. (See graphs below.)

20-Year Projections KERS Non-Hazardous 90%

Unfunded Liability and Funded Ratio

80%

$12,000

70%

$10,000

60%

$8,000

50%

$6,000

40% 30%

$4,000

Funded Ratio

Unfunded Liability ($ in Millions)

$14,000

20%

$2,000

10% 0%

$2018

2020

2022

2024

2026

Unfunded Liability

2028 Year

2030

2032

2034

2036

Funded Ratio

Unfunded Liability: $13.7 B to $4.0 B, Funded Ration: 13% to 69% CERS Non-Hazardous

Unfunded Liability and Funded Ratio

100%

$6,000 $5,000

80%

$4,000

60%

$3,000

40%

$2,000

Funded Ratio

Unfunded Liability ($ in Millions)

$7,000

20%

$1,000 $-

0% 2018

2020

2022

2024

Unfunded Liability

2026

2028 Year

2030

2032

2034

2036

Funded Ratio

Unfunded Liability: $6.2B to $2.7 B, Funded Ratio: 53% to 82% Source: Presentation to Kentucky Chamber, Kentucky Retirement Systems, January 11, 2019

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KRS has offered several recommendations to ensure the financial condition of the system continues to improve: KRS Recommendations 1. Adopt level dollar funding to pay for unfunded liability over 25-30 years. (This approach will address the problem of inadequate employer contributions due to declining payroll.)

2. Guard against contribution decreases and benefit increases.

3. Keep agency cessation provisions and do not allow quasi-governmental agencies (mental health centers, universities) to leave system without paying unfunded liability.

4. Consider revenue options to meet retiree obligation.

5. Keep actives and future hires in the hybrid plan until funding levels improve (401K type plans don’t offer short-term relief to the system).

Source: Presentation to Kentucky Chamber, Kentucky Retirement Systems, January 11, 2019

Kentucky Teachers’ Retirement System Total Number of Employees Covered Kentucky Teachers’ Retirement System, FY 2018 Membership Status Active Inactive Retired Total Average Benefit

72,205 52,845 54,377 179,427 $37,581/year

Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

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Key Financial Facts, FY 2018 Kentucky Teachers’ Retirement System (In millions of $) Fund

Total Assets* 6/30/17

Total Deductions (Benefit payments, etc.) $2,047.1

Change In Net Position

Total Assets* 6/30/18

Total Actuarial Unfunded Liabilities

Funded Ratio

$18,707.7

Total Additions (Contributions, Interest income, etc.) $3,321.0

KTRS Pension KTRS Health Insurance KTRS Life Insurance

$1,273.9

$19,981.6

$14,299.6

57.7%

$958.4

$394.7

$162.8

$231.9

$1,190.2

$2.13

36.3%

$87.8

$2.16

$5.5

($3.3)

$84.5

$18.7

83.4%

Total

$19,754.8

$3,718.2

$2,215.6

$1,502.6

$21,257.1

$14,320.43

*Restricted for benefits Source: Comprehensive Annual Financial Report, Kentucky Teachers’ Retirement System, FY 2018

Factors Contributing to Underfunding in KTRS The factors contributing to underfunding for KTRS are similar to those highlighted in the previous section relating to KRS. A 2017 report by the consulting firm PFM reviewed Kentucky’s pension systems and allocated the reasons for the unfunded liability at KTRS as follows: • Actual funding less than requested: 16% • Actuarial backloading: 33% (This means the actuary’s recommended contribution was not large enough to offset interest due on the unfunded liability in that year.)

• Investment performance less than market performance: 10% • Market performance less than assumed investment earnings: 19.5% • Actuarial assumptions: 19.8% • Plan experience different from assumptions: 2.4% Factors Contributing to KTRS Underfunding Plan Experience 2.4% Actuarial Assumptions 19.8%

Market Performance 19.5%

Funding Less Than Requeste d 16.0%

Actuarial Backloading 33.0%

Investment Performance 10.0%

Source: Commonwealth of Kentucky, Pension Performance and Best Practices Analysis, Interim Report #2: Historical and Current Assessment, PFM, May 22, 2017

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The employer contribution for KTRS is primarily General Fund. KERS receives 50% of its funding from the General Fund, with the rest coming from Federal and Agency Funds.

KTRS does not have a true ARC in the same manner as KERS; it has a statutory employer contribution rate of 6%, and actuaries calculate the additional contribution required for full funding. At the time of the PFM report, KTRS had not received the full funding recommended by actuaries, except for a bond issue in FY 2011 (see Recent Developments for explanation of bond). It should be noted that more than $970 million in additional funding was provided to KTRS in the FY 2016-18 biennium, and the enacted 2018-20 biennial budget essentially provides full funding for KTRS, appropriating $1.236 billion in FY 19 and $1.137 billion in FY 20.

Source: Commonwealth of Kentucky, Pension Performance and Best Practices Analysis, Interim Report #2: Historical and Current Assessment, PFM, May 22, 2017

The current contributions rates for KTRS as determined by the system actuary are as follows.

KTRS Contribution Rates (Percentage of Salary)

Member* Employer** Total Contribution

University Employees Members Hired before 7/1/2008 7.625% 27.975% 35.6%

Members Hired on or after 7/1/2008 7.625% 28.975% 36.6%

Member* Employer** Total Contribution

Non-University Employees 9.105% 29.455% 38.560%

9.105% 30.455% 39.560%

*Includes statutory contribution for pension and health insurance ** Includes statutory contribution for pension and health insurance, supplemental funding, life insurance and additional to comply with board funding policy Source: Comprehensive Annual Financial Report, Kentucky Teachers’ Retirement System, FY 2018

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Investment Performance The chart below, prepared by Legislative Research Commission staff, shows the investment returns of KTRS for one-year, three-year, five-year, ten-year and 20-year periods and compares those returns to benchmarks and peer group returns. KTRS investment returns exceeded benchmarks in the one-year, five-year and ten-year categories and earned more than the rate of return of all peer groups.

AROR is Assumed Rate of Return, (G) Gross of Fee Return, (N) Net of Fee Return Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

As it has for several years, KTRS uses an assumed rate of return on investments of 7.5%. As noted earlier, KRS has revised its assumed rate of return to 5.25% for the KERS Non-Hazardous and State Police plans and to 6.25% for the KERS Hazardous plan and CERS Hazardous and Non-Hazardous plans.

Recent Developments 2002 General Assembly—HB 637: Affected new hires, retired/re-employed and members retiring after July 1, 2004.

• New Hires: For new non-university members on or after July 1, 2002, 2.0% benefit factor if retired with less than 10 years of service, 2.5% if retired with 10+ years of service (previously 2.5% regardless of level of service).

• Active Members: Board given authority to provide members that retire on or after July 1, 2004, a 3.0% benefit factor for service in excess of 30 years.

• Retirees: Minimum annual benefit for each year of service increased to $400/year effective July 1, 2002, and $440/year effective July 1, 2003.

• Set ad hoc COLA (above 1.5% statutory COLA) at 1.4% for 2002 and 1.5% for 2003.

• Limitations for teachers who retired and were re-employed.

2008 Special Session—HB 1: For new teachers: increase employee contribution by 1% for retiree health; early retirement changed from age 55 with five years of service to age 55 with 10 years of service; 15 years of service required to be eligible for health insurance.

2010: “Shared Responsibility” plan implemented for providing funding for health insurance for retired teachers: • Employees: Phased-in increase to active teacher contributions by 2-3% of pay • Employers: Phased-in 3% of pay contribution • Retirees: KTRS board required under 65-year-old retirees to contribute the equivalent of the Medicare Part B premium toward retiree health (with full phase-in

by July 1, 2012). Required additional funding from the state in the form of additional contributions and authorized a bond for KTRS to repay past monies borrowed from the pension fund to fund retiree health benefits and to provide funding bridge as

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employee/employer contributions were phased-in over time. 
The total amount bonded was approximately $890 million.

Full Funding: After a decade of receiving less than requested funding, the FY 20162018 state budget provided $973 million in addition pension funding to KTRS over the biennium. This trend continued last year with the enactment of the FY 2018-20 budget, which fully funded KTRS. (See chart below.)

KTRS Employer Contributions FY 2007 to FY 2018

Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

•

2018 General Assembly-SB 151: Legislation enacted in 2018 placed new teachers in a hybrid plan similar to KRS and removed the guaranteed rate of return. The legislation also required use of level dollar funding, which calculates the ARC by amortizing the unfunded liability like a home mortgage to be paid off over time, rather than basing the ARC on payroll. The legislation also imposed the rule of 87 for teacher retirement (age and years of service must equal 87) and imposed a minimum retirement age of 57. As noted earlier, this legislation was found unconstitutional on procedural grounds in December 2018.

Outlook for KTRS KTRS officials note that increased funding provided by the General Assembly in recent years has significantly improved the funding level of the system, increasing from 51.9% in June 2013 to 57.7% in June 2018. (See chart below.)

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KTRS Funding Ratio: FY 13 to FY 18 60.0% 58.0%

55.3%

56.0% 54.0% 52.0%

53.6%

56.4%

57.7%

54.6%

51.9%

50.0% 48.0%

FY 2013

FY 2014

FY 2015

FY 2016

FY 2017

FY 2018

Source: Comprehensive Annual Financial Report, Kentucky Teachers’ Retirement System, FY 2018

The long-term outlook for KTRS is expressed by the actuary for the system in the FY 2018 annual report: “In our opinion, the System has not been funded on an actuarially sound basis since, historically, the full actuarially determined contributions were not made by the employer. However, an additional appropriation of $474.7 million was made during fiscal year 2018 and it is our understanding that the state budget includes additional appropriations to the pension plan for fiscal years 2019 and 2020. If contributions by the employer to the System in subsequent fiscal years are less than those required, the assets are expected to become insufficient to pay promised benefits. However, assuming that contributions to the System are made by the employer and state from year to year in the future at rates recommended on the basis of the successive actuarial valuations, the continued sufficiency of the assets to provide the benefits called for under the System may be safely anticipated.”

Source: Comprehensive Annual Financial Report, Kentucky Teachers’ Retirement System, FY 2018

In terms of changes in retirement benefits for future teachers, the Executive Secretary of KTRS recently cited the teacher retirement system in Tennessee as a potential model.

Tennessee offers a hybrid plan for newly hired teachers that provides a reduced defined benefit plan (5% employee contribution/4% employer contribution/1% service multiplier) combined with a defined contribution plan (2% employee contribution/5% employer contribution). ***

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How Kentucky Compares to Other States on Pension Liabilities An April 2018 report by the Pew Charitable Trusts compared state pension funding levels for all 50 states in FY 2016. (The Public Sector Retirement Systems Project at Pew annually tracks state pension funding and has advised the Kentucky General Assembly on pension reform.) Kentucky ranked 49 out of 50 states—only New Jersey ranked lower. The report found the national average state pension funding level to be 65.9%. Kentucky’s funding level was 31.4% in FY 2016, the year examined by the report.

Funded Ratio of Public Pension Plans, FY 2016

For fiscal year 2018, the Legislative Research Commission reports that Kentucky’s total pension liability for all plans is $42.696 billion dollars.

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*LRP is the Legislative Retirement Plan, JRP is the Judicial Retirement Plan Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

To put this in a different perspective: Kentucky’s total unfunded pension liability of $42.696 billion in FY 2018 was almost four times the total General Fund tax revenue the state collected in that entire year.

Kentucky Tax Revenue Compared to Total Unfunded Pension Liability, FY 2018 (In billions) $42,696

$45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000

$10,838

$5,000 $0

General Fund Revenue

Unfunded Pension Liability

Data Source: Financial Outlook Report, Office of State Budget Director, July 26, 2018 and LRC Staff Presentation to Pension Working Group, January 15, 2019

Considered another way, the $42.696 billion in 2018 pension debt amounted to $9,555 for every man, woman and child in the Commonwealth. And it was equal to almost one quarter (23.1%) of Kentucky’s entire gross domestic product (all state economic activity) in 2017.

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Driving Up Costs for Public Projects A state’s credit rating reflects a state’s ability to pay debts and the general health of the state’s economy. The “Big Three” rating agencies (Fitch Ratings, Moody’s Investor Services and Standard and Poor’s Financial Services) assign credit ratings to states that are used for issuing bonds to finance state projects. A higher credit rating generally results in lower interest costs (and lower costs to taxpayers) on bonds issued by states to finance public projects.

A report by Aon Hewitt Investment Consulting examined the factors the rating agencies take into account when assigning credit ratings, which include a state’s: debt and liability; economy; financial management; and government. The Aon report noted that “while each rating agency has a unique rating methodology, we find constancy across the firms with regard to the inclusion of both the current and future of state pension liabilities and plan management.” Rating agencies also look at “the expected future trajectory of the plan based on how it is being managed.”

Credit Rating Factor Summary

Source: How Do Public Pension Plans Impact Credit Ratings?, Aon Hewitt Investment Consulting, December 2017

Rating agencies have lowered Kentucky’s credit rating several times in recent years, citing the state’s huge unfunded pension liabilities as a key factor. Failure to pay down Kentucky’s unfunded pension liabilities will further affect the state’s credit rating, increasing the state’s cost to borrow money and limiting public construction projects that

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create private sector jobs and spur economic growth. The “Big Three” rating firms have issued a number of reports in the past year relating to Kentucky’s pension crisis: •

Standard and Poor’s: Standard & Poor’s reduced Kentucky’s credit rating from “A+” to “A” in a report released on May 2018 due to “increased budgetary strain from rising costs associated with pension obligations within a constrained revenue-raising environment.” The report noted that Kentucky’s “chronic” underfunding of pensions has resulted in large unfunded liabilities, and the high level of fixed costs for pension and Medicaid obligations will likely put pressure on future budgets. S & P reported that it did not expect to raise Kentucky’s rating within the next two years.

•

Moody’s Investor Service: After the 2018 General Assembly adjourned, Moody’s released a report that issued a stable outlook for Kentucky and took a positive view of the pension reforms enacted during that session. The report noted that the reforms were “credit-positive” for Kentucky and would lower Kentucky’s risk over time, but high, unfunded liabilities would still result in higher contribution rates for public employers. The Kentucky Supreme Court invalidated these reforms on procedural grounds on December 13, 2018, and the General Assembly subsequently failed to enact new reforms in a Special Session called by the Governor on December 17, 2018. Moody’s issued a report after the Special Session that did not downgrade Kentucky’s credit rating, but deemed the inaction in enacting new reforms as “credit-negative,” saying it “delayed reforms to the state’s severely underfunded pension plans that were set to provide modest savings over time.”

•

Fitch Ratings: Fitch has raised concerns about Kentucky that similar to those noted

by S & P. Fitch also issued a report similar to Moody’s after the December 2018 Special Session, saying it expects further litigation if there are further pension reforms in 2019 and that, “given the modest savings anticipated, the proposed pension benefit changes, and any related litigation, would not affect the state’s rating.”

Considerations Moving Forward •

Participation in Social Security: An important part of the retirement equation for public employees is whether they are eligible for Social Security benefits. Unlike other government employees in the Commonwealth, Kentucky teachers do not participate in Social Security and are not eligible for benefits. Because of this, teacher retirement benefits are higher than those provided to state and local government employees.

•

Economic Impact: Pension benefits have a significant economic impact on Kentucky as well as a significant number of Kentuckians. In FY 2018, KRS and KTRS paid out a total of more than $4 billion in retirement payments. A total of 558,715 Kentuckians (12.5% of the state population) are affected by the state’s pension systems as active employees, retirees or former public workers with time earned in the systems.

•

Paying the ARC: Paying the full ARC will continue to place strain on the budget as it will require additional funds. It is important to remember that the full ARC was not funded for approximately 12 years, allowing unfunded liabilities to grow at a rapid pace. Proper calculation of the ARC and fully funding it is a necessary step in paying down Kentucky’s unfunded pension liabilities. It is important to note that if another economic downturn occurs, similar to 2007-2008, and stock prices fall, the

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investment income of the retirement systems will decline as well—forcing the ARC to increase.

•

Why not just reduce benefits? State law protects retirement benefits for state and local employees hired before January 1, 2014, under what is known as the inviolable contract, with the law stating that pension benefits “shall not be subject to reduction or impairment by alteration, amendment, or repeal.” Teachers’ retirement benefits are afforded similar protection, although, according to the KTRS legal counsel, certain benefits provided to retired teachers (such as health insurance and use of sick leave in calculating benefits) are not covered. It should be noted that the restrictions imposed by the inviolable contract were raised in the 2018 pension case; however, the courts did not rule on whether the inviolable contract had been violated by the 2018 pension legislation and ruled the law invalid due to the procedural manner in which it was enacted.

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No Quick Solution: As rating agencies have noted, benefit changes for future teachers and public employees will not have an immediate effect on reducing the unfunded liability, but can lower costs over time. This is because most of the liability in KERS and CERS Non-Hazardous and KTRS relates to current retirees, whose benefits are protected by the inviolable contract.

Actuarial Liability by Membership

Source: LRC Staff Presentation to Pension Working Group, January 15, 2019

•

Ongoing Litigation: A lawsuit filed in December 2017 by public employee members of Kentucky Retirement Systems alleges improper actions by investment managers and KRS board members in making investments in hedge funds and seeks the recovery of losses as a result of those investments. The case is currently being heard in Franklin Circuit Court and a finding for the public employees, if upheld on appeal, could result in additional funds being paid to KRS.

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The Kentucky Chamber’s Perspective This Citizen’s Guide to Kentucky’s Pubic Pension Crisis is intended to provide objective information about the status of Kentucky’s most serious financial challenge. The sources of information are referenced throughout the Guide (and listed at the end) and include the official financial reports of each pension system, reports by legislative staff and national experts. However, in the spirit of full transparency, the following section of the Guide outlines the perspective of the Kentucky Chamber of Commerce—the state’s largest business association, which represents the general interests of approximately 68,000 employers across the Commonwealth.

The general view of the Kentucky Chamber is public retirement benefits should mirror those available in the private sector as much as possible. Private sector employees primarily depend on 401(k) plans and Social Security and must work significantly longer than public employees before retiring. There is little rationale for a retirement system that allows public employees to retire as young as their late 40s after working 27 years, when the youngest most private employees can retire is age 62 (when they are first eligible for Social Security).

When considering changes in benefits for future public employees, there are several elements the business community believes should be considered: • Increase the minimum age for full retirement benefits to at least 62 or impose an age-and-service combination that would achieve equal financial savings.

• Place new teachers in a hybrid style plan with contribution rates that account for the fact that teachers do not participate in Social Security.

• Remove provisions that allow public employees to boost their pensions (such as the use of the highest three salary years to calculate benefits, higher multipliers for higher years of service, and using unused sick leave to count toward years of service).

• Remove inviolable contract applicability for new teachers (like the 2013 legislative provision that removed the inviolable contract for new employees participating in the Kentucky Retirement Systems).

• Adopt the level-dollar method to determine the ARC, which would amortize the total unfunded actuarially accrued liability of pension funds over a set period (like a home mortgage). The current method of calculating the ARC using percentage of payroll is creating underfunding due to shrinking state government payrolls and outsourcing of jobs. Going to the level-dollar method would provide stability for budgeting and planning by state agencies.

The Chamber recognizes that there are legal and ethical guidelines that must be followed regarding public retirement benefits. We wholeheartedly agree with the previous statement by the Governor that Kentucky must honor the promises made to public retirees—it is required as a matter of law and we are also ethically bound to do so.

The Chamber also believes it is important to offer competitive retirement benefits that help Kentucky recruit and retain quality teachers and other government employees.

In our view, the Commonwealth’s interests are best served by a deliberate process that produces thoughtful pension reforms that can win legislative approval and withstand a costly and time-consuming legal challenge that would, at best, delay needed reforms and could ultimately undo needed changes. The best way to develop a clear and certain path forward is through a combination of additional financial investments in the retirement system and benefit changes that are legally sustainable.

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Glossary of Pension Terms Actuary: An actuary is a business professional who analyzes the financial consequences of risk. To ensure the financial viability of insurance and retirement plans, actuaries use mathematics, statistics and financial theory to model demographic trends and economic activity to set adequate insurance premiums and pension contribution rates.

Actuarially Required Contributions (ARC): The amount of money that actuaries calculate an employer needs to contribute to a plan during the current year for benefits to be fully funded by the end of the amortization period. (This calculation assumes the employer will continue contributing the ARC on a consistent basis.) The ARC is made up of “normal cost” (sometimes referred to as “service cost”)—the cost of benefits earned by employees in the current year—and an additional amount that will enable the government to reduce unfunded past service costs to zero by the end of the amortization period.

Assets: The amount of money that a pension fund has on hand to fund benefits. The assets (also known as plan assets) build up over time, generally from three sources: employee contributions, employer contributions and investment returns. Plan assets generally are expended to pay pension benefits when due, refund contributions of members who leave the plan before qualifying for benefits and cover the plan’s administrative expenses.

Assumptions: Estimates made by actuaries about the future behavior of various economic and demographic factors that will impact the amount of pension benefits owed over time. These estimates of factors such as investment returns, inflation rates, state employment levels, and retiree life spans, are used by actuaries to calculate the ARC. Biennial Budget: The biennial budget is Kentucky’s financial plan for spending money for specific or general purposes passed by the Kentucky General Assembly every two years. Biennial budget bills contain annual appropriations that authorize state agencies to spend a maximum sum of public funds during a fiscal year on state programs and operations. Appropriations are made by fund type, including General Fund (most of the state’s tax revenue), Restricted Fund (agency funds such as license fees, tuition, and other charges for services), Federal Fund, and Road Fund (gas tax receipts, sales tax on automobiles).

Cash Balance or Hybrid Plan: A retirement plan that combines the features of a defined benefit plan and a defined contribution plan. Employees receive an individual retirement account to which both the employer and employee contribute. The employer guarantees a minimum return, and when actual returns exceed the guaranteed rate, the additional amount is shared between the employer and employee. Retirement benefits are based on the amount in the individual’s retirement account at the time of retirement.

The plan also offers an annuity option, based on the amount in the employee’s retirement account, to employees that select it.

County Employees Retirement System (CERS): The retirement plan that covers a total of 93,720 active and 64,276 retired hazardous and non-hazardous employees of city and county governments, local police and firefighters, nonteaching staff of local boards of education (such as bus drivers and cafeteria workers), circuit clerks, local elected officials and local library employees.

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Defined Benefit Plan: A retirement plan that promises its recipients a set level of benefits, generally for life. In the case of pension benefits, it is based on a “defining” formula that usually includes the number of years served and an employee’s salary multiplied by a preset figure or “retirement factor” (e.g., 30 years x $40,000 x 1.75). In the case of retiree health, the promised benefit is typically the payment of a portion of (or the entire) medical insurance premium. However, it can also be based on a defined formula much like a pension. In this case, a certain monthly income is promised that must be used for health expenses.

Defined Contribution Plan: A retirement plan (often referred to as a 401k-type plan) to which the employer, and often the employee, contributes a defined amount (e.g., 8 percent of salary) to an individual account in the employee’s name while the employee is in active service but which does not guarantee any set benefit. The amount available for retirement is based solely on the amount of money that has been saved, along with investment income credited to the employee’s account. The benefit is exhausted when all funds has been used by the retiree,.

Employer/Employee Contribution: The amount paid by the employer and employee each month into the employee pension plan. The contribution is usually based on a percentage of the employee’s salary/wages.

Hazardous and Non-Hazardous Employees: Hazardous duty employees are classified by state law and primarily cover police, fire, emergency medical services and corrections employees. All other employees are classified as non-hazardous.

Inviolable Contract: State laws that provide Kentucky’s pension benefits are a contractual right and may not be reduced or terminated by the legislature retrospectively.

Kentucky Employee Retirement Systems (KERS): The retirement plan that covers 38,808 active and 45,185 retired hazardous and non-hazardous employees of state government, nonteaching staff at regional state-supported universities, employees of local health departments, regional mental health centers and other quasi-state agencies.

Kentucky Retirement Systems (KRS): The state agency that administers the Kentucky Employee Retirement System, County Employees Retirement System and the State Police Retirement System.

Kentucky Teachers’ Retirement System (KTRS): The retirement plan that covers 75,205 active and 54,377 retired teachers in local school districts and employees of community colleges and some state universities.

Public Pension Oversight Board (PPOB): A state board (created by KRS 7A.200) that assists the General Assembly with its review, analysis and oversight of the administration, benefits, investments, funding, laws and administrative regulations, and legislation pertaining to the public retirement systems in Kentucky. The board consists of 13 members, including six members of the General Assembly, the State Budget Director, the Auditor of Public Accounts, the Attorney General, and four financial experts (two appointed by the Governor and two by the General Assembly).

Rating Agencies: Companies that assess the creditworthiness of bonds and other debt securities and their issuers (such as private companies or governments). The three

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primary rating agencies in the United States are Standard and Poor's, Moody's and Fitch, State Credit Rating: Ratings assigned by rating agencies that reflect a state’s ability to pay debts and the general health of the state’s economy. A higher credit rating generally results in lower interest costs (and lower costs to taxpayers) on bonds issued by states to finance public projects.

State Police Retirement System: The retirement plan that covers 891 active and 1,445 retired Kentucky state troopers.

Unfunded Liability: The difference between the actuarial accrued liability (the total value of pension benefits owed to current and retired employees or dependents based on past years of service) and the actuarial value of plan assets on hand. This is the unfunded obligation for past service.

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Sources • • • • • • • • • • • • • • • • •

FY 2018 Comprehensive Annual Financial Report, Kentucky Retirement Systems, November 29, 2018 FY 2018 Comprehensive Annual Financial Report, Kentucky Teachers’ Retirement System, December 17, 2018 FY 2018 Summary Comprehensive Annual Financial Report, Kentucky Retirement Systems, November 29, 2018 The State Pension Funding Gap 2016, Pew Charitable Trusts, April 12, 2018 Kentucky’s Successful Public Pension Reform, The Pew Charitable Trusts, July 2015 Gross Domestic Product by State, Bureau of Economic Analysis, November 14, 2018 LRC Staff Presentation to Pension Working Group, January 15, 2019 Presentation to Kentucky Chamber, Kentucky Retirement Systems, January 11, 2019 Presentation to Kentucky Chamber, Kentucky Teachers’ Retirement Systems, January 11, 2019 Commonwealth of Kentucky, Pension Performance and Best Practices Analysis, Interim Report #2: Historical and Current Assessment, PFM, May 22, 2017 Pension reforms are positive, but high liabilities still drive increased contributions, Moody’s Investor’ Service, April 9, 2018 Moody’s Takes Dim View of Kentucky Due to Pension Reform Mess, Chief Investment Officer, December 24, 2018 Fitch Rebuts Kentucky’s Governor’s Rating Allegation, Chief Investment Officer, January 14, 2019 Kentucky, Standard & Poor’s Global Ratings, May 18, 2018 Financial Outlook Report, Office of State Budget Director, July 26, 2018 Kentucky pension crisis: What to know about the special session, The CourierJournal, December 18, 2018 How Do Public Pension Plans Impact Credit Ratings?, Aon Hewitt Investment Consulting, December 2017

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If all 4.5 million Kentuckians were asked to pitch in to fix the $42.7 billion pension deficit, it would take $9,555 from every man, woman and child in the Commonwealth.