The governor’s budget proposes the deepest cuts to K-12 education Kentucky has seen, delivers another hit to services that have been cut repeatedly since 2008 and completely eliminates funding for 70 programs. Defenders of the cuts call them inevitable using unexamined arguments that we must put much more money into pensions.
Kentucky made a huge $700 million increase in contributions to pensions in the last budget, and there’s strong evidence these increased payments are paying off. So why do proponents say an additional $500 million is needed next year?
These claims are the result of assumption changes made in 2017 by the Kentucky Retirement Systems (KRS) board. Recall that the governor unilaterally abolished the prior KRS board in 2016 and expanded it by four additional members, a change codified into law by the 2017 General Assembly. The new board proceeded to make big, immediate changes to the investment return and payroll growth assumptions in all KRS plans, the key factors used to calculate how much employers must contribute.
The new assumptions are the most conservative in the country, and require huge increases in contributions next year. The employers in the Kentucky Employees Retirement System (KERS) non-hazardous plan — which, besides the state, also includes community mental health centers, domestic violence shelters, universities and other entities — must increase their pension payments next year from 49 percent of employees’ pay to 83 percent. Big increases are also required for local employers in the County Employees Retirement System (CERS), deeply straining counties, cities and school districts.
These drastic assumption changes have triggered a crisis the implications of which are now becoming clear. As state and local officials face the fallout, it’s appropriate to scrutinize the underlying decisions that have led us to where we are.
KRS board members claimed past assumptions were too rosy because they didn’t pan out over the last 10 years — the period containing the Great Recession and its aftermath. No one can predict with certainty how the economy and financial markets will perform over the next few decades (consider the variation in the economy and markets over the last 30 years). But if experience and analysis lead us to be more conservative, corresponding assumption changes can be made in very small increments over long periods of time — there is no need to act hastily, as the KRS board did.
The truth is fully paying down liabilities is neither as urgent, nor ultimately even as necessary, as those calling for radical action claim.
While the accounting rules have pension plans pay off existing liabilities over a 30 year period, in fact they are owed over a longer time frame than that. Think of a current 24 year-old state employee who will live into her 90s — her final check will come around 70 years from now.
Over the many years current liabilities are owed, employers and a constant influx of new employees will make additional contributions each year, and the plans will earn investment returns. These investment returns will grow plans’ fund balances, creating a cushion to ensure the ongoing payment of benefits in perpetuity. Already, Kentucky’s plans as a whole have $31 billion in assets built up, compared to less than $4 billion in benefits paid out each year.
If the plans improve from their current funded status but fall short of full 100 percent funding in 30 years for one reason or another, what happens? Absolutely nothing happens. That’s because plans can be healthy at levels below 100 percent funded. Most plans across the country are not now — and many have never been — fully funded, but have no trouble paying benefits year after year. Some experts rightly argue that when it comes to public plans, full 100 percent funding is a waste of tax dollars that could be utilized elsewhere. States, unlike private businesses, aren’t going anywhere and must pay only a small percentage of benefits owed at any one time.
Because existing liabilities are obligated far into the future and full 100 percent funding is never actually necessary, there is plenty of time to make gradual assumption changes as needed and provide the dollars to steer the plans toward steadily improving health over time.
The majority of the KRS board apparently didn’t recognize these dynamics.
Their sudden changes to assumptions include a number of other head scratchers. The board made big changes to assumptions for the retiree health plans that will require, for example, a 50 percent, or $63 million increase in the contribution to the KERS non-hazardous health plan next year. But Kentucky’s retiree health plans are far better funded than others around the country, most of which choose to still operate on a pay-as-you-go-basis, and Kentucky’s plans are already on a strong growth trajectory. Given the uncertainty around what kind of health care system the United States will have in future decades, there is no need to overdo the pre-funding of these plans.
The pension plans are also in a variety of conditions — there’s a huge difference between the CERS non-hazardous plan and the KERS non-hazardous plan, for example. KERS non-hazardous has short-term cash flow challenges requiring special attention that the county plan, whose assets are on a strong growth path relative to benefits paid, simply does not face. But though the board made even bigger adjustments to the KERS non-hazardous plan, all plans had the assumptions that determine contribution rates immediately and deeply reduced.
There are big concerns these assumption changes may not be over — the Teachers’ Retirement System (TRS) isn’t affected by the KRS board decisions because TRS is governed separately. But the General Assembly could force TRS to make similar changes in a pension bill (as the draft pension bill released in the fall did). Since TRS is the largest of all plans, if it were forced to change assumptions the largest hit to the state budget would still be coming.
We should not consider these decisions to be infallible and ordained from on high. Because we now know the consequences they have on state and local services, we should view them critically before making harmful budget cuts that set Kentucky back.