No Need to Overinflate Pension Liabilities
February 10, 2017
Lately the governor is saying Kentucky’s unfunded pension liabilities are not the $33 billion reported by the systems’ actuaries, but a much larger $82 billion. That estimate is based on unrealistically low assumptions about the future rate of return on investments.
The size of pension liabilities and amount employers should contribute each year depend on assumptions about future employee growth, retirement, mortality and more. One key assumption is what the average annual rate of return on investments will be. Most pension plans use an assumption of between 7 and 8 percent with a national average of 7.62 percent. Kentucky’s plan assumptions range from 6.75 percent for the underfunded Kentucky Employees Retirement System (KERS) non-hazardous plan to 7.5 percent for some plans.
The $82 billion number is an estimate of the liability assuming a rate of return of only 2.7 percent, the average yield in 2016 for low risk 30-year U.S. Treasuries. If you assume the plans will earn only 2.7 percent per year, the total amount owed becomes much higher.
Some argue plans should calculate defined benefit pension liabilities using low return rates in recognition that the benefits under such plans are guaranteed by law. However, if such low rates were actually used to make funding and investment decisions, it would lead to a poor allocation of resources by governments and/or unwise investment strategies by pension plans.
Public pension funds are well-equipped to maintain diverse portfolios with a long-term investment horizon, including stocks. Normally, only a small portion of resources goes to pay benefits in any one year, allowing plans to withstand fluctuations in financial markets. That’s why pension systems have been able to achieve high rates of return over time. The annual rate of return over the last 30 years is about 9 percent for Kentucky Retirement Systems and 8 percent for the Kentucky Teachers’ Retirement System.
If a plan were to assume average returns of only 2.7 percent a year while maintaining current investment strategies, governments would have to make dramatically higher annual contributions in the short term, leading to big increases in taxes and/or cuts in services. Before long, pension funds would have large surpluses and governments would then contribute little or nothing to the plans. There is no good reason for that kind of heavily front-loaded funding pattern.
Even worse, using such an assumption could lead a plan to adopt a very conservative, low return investment strategy — including not investing in stocks. The result would be much greater reliance on tax dollars rather than investment returns to fund employees’ pensions. Currently, for the country as a whole about 64 percent of what ends up in an employee’s benefit check comes from systems’ investment returns.
All of this is not to say that the current assumptions used by the plans in Kentucky are exactly correct. Special care must be given to investment return and other assumptions in the poorly funded KERS non-hazardous plan, which in its depleted state must maintain greater liquidity to pay benefits. It is critical to regularly evaluate and adjust all assumptions in light of experience, market conditions, a realistic assessment of the future and a commitment to shared responsibility in paying down the liability over time. That very well may mean somewhat of a reduction in investment return assumptions for the KERS non-hazardous plan.
But the motivation of some who tout the size of liabilities using dramatically lower investment return assumptions is to argue defined benefit plans are “unsustainable” and should be closed in favor of defined contribution plans (such as 401ks) that shift risk to employees (Kentucky is already part of the way there with a hybrid plan created in 2013 for some employees). Especially since governments are large and permanent employers, defined benefit plans are an efficient way to attract qualified employees who appreciate the security and predictability of such plans. They work well across the country historically as long as they are funded properly, which is where Kentucky ran into trouble.
We need a clear-headed view of our pension liabilities and, most importantly, a plan to generate the revenue that allows Kentucky to pay down the debt over time while also making the investments in our schools, health and more needed to strengthen the commonwealth.