The conversation in the Public Pension Working Group has returned to debates about what caused Kentucky’s plans to be poorly funded. Some are relying on analyses from groups like PFM to say the legislature’s underfunding is only a small part of the problem. PFM put “funding less than ARCs” (actuarially required contributions) at only 15 percent of the cause.
But lack of funding plays an underlying role in many of the other causes, and ignoring that paints an inaccurate picture of the problem — and distorts understanding of what needs to happen next.
Saying “ARCs should’ve been higher” implies they would’ve been paid
One way PFM and others quantify the relative causes of the problem is by separating the assumptions that go into the funding request from the funding itself. This includes aspects like the payroll growth assumption, investment return assumption and amortization period (and how those assumptions and others created “actuarial backloading,” which just means ARCs in the early years of a payment schedule were too low to offset interest due on the unfunded liability).
A problem with such a separation is if the assumptions had been more conservative, the ARC would’ve been bigger. But the legislature was not coming close to making the full payment on state plans when the ARC was smaller. Why take for granted they would have funded a larger request?
The gap between assumptions and actual experience emerged slowly over a period of less than a decade, and was fully public in comprehensive annual financial reports for the legislature and others to see. Over the years the retirement systems themselves also raised issues through committee presentations, and the legislature chose to contribute only what they thought they could afford when making the budget.
Underfunding harms investment returns
Investment returns are a big part of the problem, with PFM putting them at 29 percent of the cause of the Teachers’ Retirement System (TRS) funded status, for example. While the Great Recession is the biggest contributor of lower returns, underfunding employer contributions can also reduce a plan’s investment returns.
That happens because the plan has to sell assets when the market is depressed in order to pay benefits. Underfunding helped force assets in the Kentucky Employees Retirement System (KERS) non-hazardous plan to fall from $6 billion in 2008 to $2 billion today. By selling assets when markets are unfavorable, the system books capital losses. An adequately funded pension plan, in contrast, can ride out the ups and downs of the markets without being required to make unwise investment choices like selling assets when times are bad.
In addition, a plan receiving inadequate contributions has to maintain a more liquid portfolio, including holding more cash and other low-performing assets, in order to pay benefits each month. That reduces overall investment returns from what they would otherwise be.
Not pre-funding benefits is also a funding problem
Another issue presented as a separate cause of the problem involves benefits that were not pre-funded. Not pre-funding cost of living adjustments (COLAs) is specifically identified by PFM as a cause of between 16 percent and 22 percent of the problem in the Kentucky Retirement System (KRS) plans. Yet this, too, needs to be understood as an underfunding issue.
COLAs were reasonable given KRS pension benefits are modest ($11,730 a year on average for County Employees Retirement System (CERS) non-hazardous employees and $21,587 for KERS non-hazardous). However, it was the decision of the legislature to award ad hoc COLAs through the budget process even though they were not authorized by statute or built into the actuarial calculations that went into the retirement systems’ budget request. In fact, by statute KRS wasn’t allowed to include the cost of such COLAs, even though the General Assembly regularly awarded them. In contrast, the TRS 1.5 percent COLA is in statute and included in the actuarial calculation, and as PFM shows those COLAs have had no impact on the TRS funded status.
Awarding benefits that were not part of the contribution calculation, yet providing no extra money to pay for them, is also a form of underfunding.
Failing to raise revenue for the budget reduces payroll growth and therefore pension contributions
A cause typically categorized as a “wrong assumption” by the retirement systems is the fact that payroll growth hasn’t kept up with the systems’ assumption since the Great Recession. While the KRS plans assumed payroll (how much in total is paid to employees in salaries and wages) would grow 4 percent a year — which is a standard assumption and on par with previous growth — actual growth in recent years has been much lower or even negative when it comes to state government employment.
But unlike investment returns, state payroll growth is within the control of the legislature. The General Assembly passes a budget every two years that largely determines how many employees there are and how much they are paid, including whether those employees receive raises. The legislature can also create policy to limit the outsourcing of employment, another factor that has reduced government payroll. Instead, the General Assembly has chosen not to raise revenue and enacted budgets that cut services, reduced the workforce through attrition and even layoffs, and provided no raises to state employees in 8 of the last 10 years. The result is smaller employee and employer pension contributions, since those payments are based on the size of the payroll.
In a state with a growing population, an expanding economy and at least some inflation, payroll growth is needed each year just to maintain existing levels of public services. The payroll growth problem was created not just by the systems themselves through their assumptions, but by the General Assembly’s budget and tax choices.
Pension systems work if funded and well-managed
It is certainly true that inadequate contributions are not the only reason our plans fall short of 100 percent funded. But we shouldn’t expect them to be fully funded because of the impacts of the Great Recession alone (plans across the country are 72 percent funded in the aggregate). And public plans, where the government is at no risk of going away, do not have to be 100 percent funded to be healthy and sustainable.
Pension plans remain the standard across the country in state and local government, with only 2 percent of employees covered under 401k-style defined contribution plans. That’s because they are an efficient and effective way to attract and retain qualified employees for valuable public services. With adequate funding and sound management, they work well.
Kentucky has made big strides over the last few years in putting the systems on the right path through extra dollars and additional oversight. Providing the proper funding is the key to solving the remaining problem over time.