Reform may be on the way for the second worst funded state public pension system in the nation. Kentucky Governor Matt Bevin has called for a special session later this year to address the problem. Thanks to decades of consistent underfunding, the road to pension solvency will be arduous. But after attaining historic right-to-work legislation in the first months following Republican takeover of the Bluegrass State, prospects are brightening.
Just how dire is the situation? Kentucky’s state pension plans are underfunded by more than $32 billion—and that’s presuming a rate of return (6.75 percent) far in excess of the risk-free rate. The recently released ALEC report Unaccountable and Unaffordable 2016 ranks the state’s pension funding level at 49th nationally. And using a risk-free rate of return of 2.344 percent (the average of the 10 and 20 year U.S. Treasury bond yields from March 2015 to March 2016) rather than the plan’s current 6.75 percent assumed rate of return presents a sobering statistic. For every $1 of assets the pension plans should have accumulated for investment at the risk-free rate in order to meet future obligations, the state has only accumulated 23.4 cents.
Using the risk-free rate of return, Kentucky’s unfunded pension liabilities of $95 billion are in excess of $21,600 per capita. Keep in mind, the entire state government appropriations per capita this year amounts to under $2,600. In other words, assuming a risk-free rate of return, every dollar of state government spending for the next eight years would need to be diverted into the pension fund in order to erase these unfunded liabilities.
Some may argue that the risk free rate is an overly conservative measure. But the fact is, Kentucky Retirement Systems lost 0.52 percent on its investments net of expenses in fiscal year 2016. This follows a negative return of -2.01 percent net of expenses in fiscal year 2015. These negative returns during the most recent full two year fiscal period come at a time when equities markets increased by more than 5 percent.
In short, by assuming pension fund balances and contributions will earn relatively higher rates of investment return, the expected future value of current pension assets and annual contributions increases exponentially. As a result, the annual required contribution (ARC) required to ensure a pension fund can honor obligations at a future date declines. Inflating the assumed rate of return, an often an arbitrary decision, can create an illusion of better financial health.
But what if those assumed rates of return fail to come to fruition? A diminished pension balance can be catastrophic as earnings from accumulated pension assets over decades are responsible for far more of pension revenue available for payouts to beneficiaries than contributions themselves. In fact, investment earnings of $4.3 trillion accounted for 63 percent of pension sources of revenue from 1986-2015, according to NASRA.
Governor Bevin has acknowledged these problems. In addition to the nearly $1 billion in additional pension contributions in fiscal year 2017, the governor is also prepared to adjust the assumed rate of return downwards to reflect reality. He admonished, “We need to use real numbers… We need to use actual data. We need to use true rates of return, and not hypothetical ones.”
Failure to address the crises could result in draconian pension cuts in the future, painful tax increases or a shift in spending from essential government services to pension costs. The municipal bankruptcy of Detroit, the unpaid state obligations in Illinois and Puerto Rico’s debt calamities are stark reminders that not even governments are immune from the laws of mathematics. The retirements of more than 350,000 current or future public sector retirees are at risk. As the governor stated, “We cannot allow these systems to fail…There have been too many people who have worked too hard in expectation of things that have been promised to them. It is our obligation to make sure they get those things.” Kentucky’s special session on pension reform may lead the way for other states to avert financial calamity while protecting public sector employees.
Bob Williams is a senior fellow at State Budget Solutions, a project of the ALEC Center for State Fiscal Reform. Joel Griffth, Director of the ALEC Center for State Fiscal Reform, contributed to this blog.