Public Pension Information

Consultant Proposes Significant Changes to Save Kentucky’s Public Pensions

August 28, 2017

The Kentucky Public Pension Oversight Board on Monday was presented with the third and final report from the PFM Consulting Group, which sets the wheels in motion for a probable special legislative session to tackle the $40-64 billion unfunded liability.

The consultant’s report specified recommended changes to both the funding and benefit structure of the state’s three public pension systems – Kentucky Retirement System, Kentucky Teacher’s Retirement System, and Judicial Form Retirement System. Senate Chairman Joe Bowen began and closed the meeting reminding everyone that these are simply recommendations from an independent, third-party consultant, and that there is no legislative proposal currently on the table. PFM itself acknowledged that political headwinds may impact the ability of the legislature to implement each of the recommendations, but the problem with Kentucky’s public pensions are so dire, that they felt obligated to present a variety of options.

There are three supporting documents in this email, and the 40-page presentation from PFM provides the best summation of the recommended changes to each of the plans. The other two documents are the presentation from State Budget Director John Chilton and the full report from PFM.

In general, the consultant’s report recommends trimming many current state and local government retiree benefits and significantly altering future employee benefits. The major proposed changes are:

  • Teachers are the state’s largest group of employees, and it is recommended increasing their retirement age to 65 (currently, teachers can retire with 27 years of service or age 60). Incumbent teachers would maintain a defined benefit plan, but lose many of the enhanced benefit features they current enjoy, such as applying sick time toward retirement. In addition, it is suggested that new teachers that are hired should be moved into the federal Social Security system (which they currently do not pay into), with the state supplementing the retirement by contributing to a 401-k style defined contribution plan. Also, COLAs would only be granted once the plan reaches a 90% funded level.
  • Non-hazardous future employees in the state, county and judicial systems would be moved to a 401-k style defined contribution (DC) plan.
  • Current plan participants (those employees considered “Tiers 1 & 2”) would experience a “soft freeze” in accrued benefits, a tactic often seen in struggling private pension systems. Essentially, employees would have two different pensions upon retirement – they would maintain their accrued benefit until a date certain, at which point future service accrues into a 401-k style defined benefit. However, the defined benefit portion of the plan could still grow as the employees pay increases.
  • It is recommended that an employee’s COLA benefits accrued from 1996 and 2012 (when state employees where automatically given annual COLA increases) be removed from their benefit calculations. This is being recommended because COLA benefits are not considered subject to the “inviolable contract” between the state and an employee.
  • The consultant also recommends a voluntary buyout option for active employees. However, there were few details on how the buyout would be structured.
  • Benefits for retirees currently in the pensions systems were largely left unchanged, although the consultants did identify the retiree medical benefit as a program in which tremendous savings may be realized. Slides 24-27 provide greater detail to the recommendations, but generally, they seek to “harmonize” the benefits received by retirees with those received by active members. Retirees are now receiving a richer benefit than current employees are receiving. 
  • For hazardous employee plans, the consultants recommended modest changes to both current and future hires, such as increasing the retirement ages and eliminating “years of service” as a calculation.
  • Both the consultants and Chairman Bowen recommended against pension obligation bonds. The consultants also recommended consolidation of investment boards across all plans.

The PFM Consulting Group’s  presentation was preceded by a brief presentation by State Budget Director John Chilton. He spent time outlining the impact on the state’s General Fund if it pursues many of the structural recommendations to the pension systems without new revenue. Between fiscal years 2017 and 2018, actual General Fund revenues will fall $325 million short of expectations, draining the state’s Rainy Day fund. In order to even modestly backfill the Rainy Day fund ($250 million), and provide the additional $700 million in the actuarially required contribution, massive cuts across state government would need to happen. If the upcoming state budget holds harmless the same areas of the budget that it did in 2016 (education and public safety), it would necessitate cuts of 34.4% to every other area of government.

The Governor’s Message

Gov. Matt Bevin, who initiated the PFM Consulting Group’s study, has been adamant that Legislature make significant, long-lasting changes to the public pension system in order to clean up the state’s horrible fiscal crisis. He said he will call a special legislative session this fall.

Following today’s report, the Governor issued the following statement:

“This latest report from PFM further confirms the need for urgency as we resolve Kentucky’s pension crisis. Change is necessary. Time is not our ally—we must act now to get our financial house in order. There is no other viable option.

“I am convinced we can get this done and am committed to doing so. For those now retired, for those still working, and for those yet to come: we will save the public retirement systems.

"We will not kick the can down the road any longer. We were elected to fix this problem and we will. The fiscal abuse of Kentucky’s retirement systems is over."

Detailed Committee Notes and Committee Q&A – For those interested in the nitty gritty of today’s report, the following are extensive notes from the committee testimony today and the questions/answers from committee members:

State Budget Director John Chilton:

For FY2017, there was a revenue shortfall of $138.5 million. The Consensus Forecasting Group has met twice to come up with planning estimates for FY18. Preliminarily, the expect another revenue shortfall of $200 million, with much uncertainty in future out years.

PFM report #2 said expectations were too optimistic, so the retirement systems board created a new ARC. Note that term “ARC” will be changed to “ADC” (Actuarily Determined Contribution), but they are largely used interchangeably. This new ADC/ARC will require an additional $700 million. 

Rainy Day Fund is expected to be depleted by the end of this year due to necessary government expenses. Common targets for a Rainy Day fund is 5% of revenues (should be $500 million in KY). Need to replace that trust fund to the level of at least $200 million, plus the $700 million for ARC.

How can the state raise $1 billion in revenue needed for the pension systems? Cut spending, increase revenue, adjust benefits, or don’t pay the ARC. The Governor and legislature will fully fund the ARC.

In the last budget proposal, state government expenditures were cut 9%, with some services not subject to that decrease (Medicaid, SEEK, corrections, etc.). Protecting the same programs that were cut in 2016, will require a 34.4% cut in other areas. With a cut in SEEK, that’s a 16.6% reduction everywhere else ($500 million for cuts in education). Would go down to 14.5% if they were allowed to cut everything (even what they’re not allowed to do).

Medicaid and Pensions have gone from just shy of 20% of the budget in 2008, but that will make up over 30% of the budget in 2018. That puts the big squeeze on all of the other budget items.

Pension funds and Medicaid expenditures are outgrowing receipts dramatically.

Some discussion about how big the pension liability actually is. In 2016, we computed $33 billion. An assumed rate of investment return of 5.5% to 6% kept the liability at $40 billion. Using the US Treasury rate as the investment rate sets the liability at $85 billion. The non-government blended rate = $64 billion, which is what they consultants are using in their report.

Kentucky ranks 50 out of 50 on aggregate unfunded liabilities (KTRS and KRS Non-Hazardous are the drivers).

How did the under funding occur? It’s not investment returns and underfunding. The statutorily required funding method creates an actuarial backloading (percentage of payroll). Percentage growth in aggregate payroll, combined with actuarial backloading contributes to 25%. In the absence of pension changes, more money must be contributed to compensate for returns that aren’t occurring. PFM suggested that payroll increases for employers ranges from 50-88%, creating $689 million. It’s a hidden payroll tax of sorts.

KTRS and CERS-Non hazardous are in better shape, but not in good shape. If they were in the private sector, federal code would have frozen the benefits. Chilton pointed out that these are long-term issues requiring a 30-year outlook.

Pensions are still severely underfunded; the outlook is bad; and there is no budget reserve trust fund.

Q&A with the Budget Director:

Rep. Jerry Miller – on p.6, you said that it was a $1 billion problem, but in a later slide (18) you said it was $1.5 billion. Is that attributable to CERS? Yes.

Rep. James Kay – one option to address pensions not listed here is a pension bond (not recommending it, but it is there). Chilton said they would address it later in the presentation.

Kay – when it comes to returns and benchmarks, we are actually exceeding our expectations. Big concern is that our revenues aren’t matching what we’re forecasting. How do we prevent another $200 revenue shortfall?

             That is a shortfall in revenues that go into our General Fund, not the pension plans. The revenue shortfall is not directly a shortfall for the plans, but it impacts the GF, which is where much pension funding comes from.

Kay – just want to ensure that when we draft the next budget, it is written correctly and not subject to similar shortfalls.

             Gov addressed that in 2016 by not budgeting to the full amount that CFG had indicated. The Governor put in a $125 million buffer, which would have addressed the 2017 shortfall.

Sen. Joe Bowen suggested that pension bonds are an option only IF the market performs.

Sen. McDaniel noted that the Governor did send a budget over with that buffer and encouraged he do it again.

PFM Consulting Group Presentation Notes/Q&A

This will take incremental actions and approaches over years, but also some strong actions now. Wanted to reiterate that the options given here are a framework. Admitted those options are hard to swallow.

We did not come into the process with any bias or predetermined processes or structure in mind. Informed by level of distress they found in the plan. Recommendations are all targeted at the complex, interconnected elements of the systems that are contributors to the challenges that they face.

  1. Severity of the problem requires strong action;
  2. Protect existing employees and retirees to the best extent possible. Acknowledged risk of litigation, which tends to happens when attempts at changes have been made. We believe multiple of our options would pass judicial scrutiny;
  3. Want to craft a path that reduces risk and increases likelihood of success. I.e., don’t want them to have to keep coming back every years. Part of that requires changes to the benefits structure.

They did test some of the recommendations to ensure that for state & local officials, they would have adequate income replacement,

Major Areas of Concern:

Actuarial Assumptions (Slide 8) – KRS requires “level percentage of pay,” which contributed heavily to the short fall. Recommend using the “level dollar” approach, akin to most home mortgages. 

  • Investment return assumptions – recommend 5.0-5.25% for KERS-NH and 6.0-6.25% for all other plans. Much of that was adopted by the retirement board. They are using a 5.1% for KERS non-haz, then 6.0% for all others.
  • Recommend an ARC/ADEC payment of $1.8 billion in FY19.
  • Recommend a closed amortization period of 30 years. If all necessities are met, the plan will be fully-funded in 26 or 27 years depending.

Benefit Levels & Risk Exposure (Slide 13) For “civilian” new hires (Judicial and non-hazardous employees), recommended a 401(k) system. Nadol noted that there is still a risk involved with even the hybrid cash balance.

(Slide 14) Recommended structure for hazardous employees is different, reflecting the unique nature of their work. Recommended a retirement eligibility at age 60 and maintenance of the hybrid-cash balance structure. Additionally suggested that if they prefer to retire earlier, they could do so at a reduced benefit level. 

(Slide 15) Move prospective Kentucky teachers into the Social Security system, with the balance of their expected benefit coming from a defined contribution plan. Recommended 65 year retirement age.

(Slide 18) Goal is to allow for retirement plans that allow maintenance of lifestyle from final years of employment. Although benefits may not match salary, the total income target of 77%-85% adequately maintains lifestyle because there are fewer employee contributions match once retired, taxed at a lower rate, etc. Every recommendation except CERS-H experiences greater replacement income than their target of 77-85%.

(Slide 20) Prefaced comments by noting that they recognize the seriousness of addressing current employees. At the same time, the circumstances are so dire, that we have to go beyond “stop digging.”

Modifying benefits for future hires only stops digging; it does not get you out of the hole. Only way to begin chipping away at the system.

(Slide 20) Applies to “civilian,” current retirees. Freezes accrued benefits. Allow for a buyout and DC “rollover.” Understand that the elimination of accrued benefits from 1996-2012 COLA benefits. Noted that in the private sector, benefits would be frozen, but the recommendation only freezes the service component, and can still grow as they receive higher salaries.

(Slide 21) Current hazardous employees would maintain benefit structures but increase retirement age to 60 (from 55). Director Chilton noted that this doesn’t require people to retire at 60.

(Slide 24) Retiree medical benefit is relatively rich compared to pre-Medicare retiree counterparts, and provides a significant opportunities for saving. Career retirees pay no premiums v. employees, and their benefit is richer.

Relative to other states, they can buy a Medicare Advantage, zero-premium drug plan in every county. If you created harmony across coverage in all systems to make it consistent with employee rates reduces the liability by over $1 billion and reduces the employer contribution by $115 million.

(Slide 27) Savings in employer contributions on the retiree health benefit would offset the costs of moving teachers to Social Security.

(Slide 28) Voluntary buyout. Identified the CCU and KEMI voluntary cessation statutes as an optional buyout mechanism. Unfunded liability would be reduced by those employees making one-time contributions into the system. A 30% buyout percentage saves the GF 14.5%. Director Chilton noted the uncertainty of calculating the cost of the buyout without knowing with any certainty of how many people will retire.

Question & Answer with PFM Consultants

J. Michael Brown asked about provision in introduction to their report that recommended maintaining the inviolable contract. Was Stites & Harbison law firm a consultant in your report?


Brown asked if the inviolable contract was defined in here?


Brown then asked if any of the analysis would be made available?

             Nadol did not commit to sharing that information

Sen. Joe Bowen – do these recommended changes mirror anything that you’ve seen in other states?

             In some ways they do, but one major difference is that Kentucky’s problems are more severe than other states & systems that we’ve seen. Illinois has similar retirement ages. Notion of adjusting COLA benefits based on plan status is something that Wisconsin has done for many years. The “soft freeze” with a layer built on top has been done elsewhere with greater constitutional flexibility.

Sen. Joe Bowen said he would need to be convinced that borrowing money to pay a debt is a good idea.

Rep. Jerry Miller – inactives are a big part of each tier. Did you consider forcing inactives to take a buyout?

             Short answer is No, but one of the real difficulties is with people who are inactive. Realistically, that has to be a voluntary effort.

Auditor Mike Harmon – for the movement of teachers into Social Security, does that require federal changes in addition to state changes?

             We can do that now with new teachers without federal permission.

Harmon – as you contemplate into 401(k), are there a choice of 4 of 5 recommended plans?             

             We are looking at different funds, such as identifying a funds targeting a preferred retirement date.

Harmon – will there be a legacy fee to continue to fund Tier 1 and Tier 2s if they choose to stay and not to take the buyout?

             The recommendations does not contemplate an increase in employee contributions.

Sen. Jimmy Higdon – is a fan of voluntary buyouts (which he called “one positive recommendation).

Rep. James Kay – do these recommendations have a financial impact on them?

             Yes, but… The report does include estimated costs based on a certain set of assumptions and scenarios. We worked with the plan actuaries to get a sense of impact. Those estimates are detailed plan-by-plan in the report. The “but” part….all of the impacts exist in a dynamic approach with the actuarial assumptions that are used. For instance, when changing a scenario from 6 to 7%, it makes a big impact. Also, there is an impact on real-world experience. Recent returns make this a little bit easier, but an economic downturn would make this much much worse.

Kay – the one thing I hear the most is, What’s going to happen to me? People close to retirement are retiring in droves. Does this report anticipate mass exodus and the cash crisis that comes with that?

             Valuation assumptions already include a presumption that people retiree when they’re first eligible.

             It could be possible to consider the concept of “grandfathering” to give close-to-retirees some better options.

             Chilton – one of the aspects informing retirement are fear of losing options that they have now. The Governor has made it clear that there is time for people to make well-informed decisions under multiple options.

Sharon Mattingly – when you looked at the idea of having a 401(k), did you look at what impact that would have on the Deferred Compensation Authority?

             Chilton – the state has a 401(k), and whether that or another program is established, we’ll consider that.

Sen. Chris McDaniel – moving to level dollar from percentage payroll is probably the biggest recommendation. What kind of a savings are we looking at long-term?

             Will get back to McDaniel, but there is some data in subsequent slides.

Sen. Joe Bowen – level dollar gets you to solvency quicker than percent of payroll funding. It’s a conservative approach and emphasis needs to be placed on that.

PRM Funding (Slide 31) Moved quickly through the recommendations due to time constraints.

Investment Practices & Approaches (Slide 34) – consider consolidating all of the differing systems. In Indiana, they consolidated their systems and achieved savings over time. Suggested that it would be cheaper and easier to attract one chief investment manager to oversee all three systems rather than have three distinct officers over three plans. Regarding CERS separation, if that were something that would happen, we’re seeing that could add some new costs.

Chilton – we are not talking about pooling the investments of the plans, but consolidating the investment board for administrative efficiency, volume pricing, transparency, etc. Other states have had good success with this. Would focus solely on investments, not benefit structures.

Sen. Jimmy Higdon – regarding the comment about the level-dollar, Chilton made note earlier that 25% of the liability is attributed to the funding method. Going to level-dollar will get that paid down more quickly. Not sure why percentage-of-payroll was written into law, so glad to see that you recommended that.

Auditor Mike Harmon – with regards to the optional buyout that was recommended, we have employees who choose to retire, because when they look at the benefit, they are essentially “working for free.” If they move to a 401(k), could they remain employed to watch those benefits grow?

             Situations vary, but there may be scenarios in which the individual has a better benefit under 401(k).

Sen. Wil Schroder – re: Slide 35, can you break down why larger plans get larger returns?

             There is a table in the full report that cites research to that effect. A much larger fund can take a stake in a venture that is simply too risky for a smaller one.

Rep. James Kay asked where we get revenue, and to clarify that they are against separating CERS from KRS.

             Re: separation, that is correct . We think we understand the concerns of advocates, but a consolidated approach decreases complexity, adds to transparency and saves on administrative costs. There are pros and cons to any plans, but we are generally against it.

             Re; dedicated revenues and state funding, there are various control measures, such as a mandated increase in funding (state approprs or employer contributions).

             Chilton said that revenue is the $64 billion question. 

Rep. Brian Linder wanted to remind viewers that he stood with the Governor and members of legislative leadership to announce that there would be no emergency clause. 

Public Pension Performance and Best Practices Analysis Report #3

PFM Briefing

Presentation: State Budget Director John Chilton