Despite Poor Process, Kentucky Enacts Meaningful Pension Plan Design, Funding Policy Reforms

Kentucky Gov. Matt Bevin recently signed into law a set of changes to how state and local pension benefits are funded, while also creating a new retirement benefit for future teachers and other public education professionals. Senate Bill 151 is a controversial pension reform bill due to the public perception that the legislation cuts benefits for current teachers — a misperception attributable to an unfortunate political process that has already prompted labor backlash and litigation. However, this controversy is rooted in broader state politics, and the controversy is obscuring the solvency benefits of the total package.

The funding policy improvements of SB151 will be important for preventing the state employees pension plan— currently, around 15 percent funded — from sliding into insolvency. And the prospective cash balance plan that will be offered to future teachers represents a step forward in terms of risk reduction (albeit it an insufficient step that leaves open the need to improve teacher pension funding policy).

These pension plan positives for Kentucky may only become clearer to protestors once the perception of benefit cuts fades. In the end, ironically, the policy prompting protest and rancor in Frankfort these days did not cut a single dollar of an active teacher or retiree benefits or cost-of-living-adjustments (COLAs), and it still preserves a guaranteed “no loss” retirement benefit for newly hired teachers.

Legislation Summary

The Pension Integrity Project at Reason Foundation provided technical assistance on policy concepts presented by Gov. Bevin and legislative leaders as they crafted various reform proposals over the past year. Ultimately, Gov. Bevin and legislative leaders explored a wide range of policy designs, and SB151 was the final product of an iterative process that saw several different versions of reform legislation that dialed back the scope of reform along the way.

Nonetheless, Senate Bill 151 constitutes a significant improvement overall, with meaningful risk reduction and better funding policy across Kentucky’s various retirement plans. Major policy elements of the legislation include:

• Teachers’ Retirement System (TRS):
  • New members of TRS will be offered a cash balance plan that guarantees against any principal losses and credits employee accounts with 85 percent of investment returns over 0 percent.
  • The only change to affect existing members is that their accrual of sick leave that can be cashed into spike a pension at the end of a career is being capped — a provision in SB151 applicable to public sector employees across the state.
    • Note: There were no changes to employee contribution rates, COLA reductions, or benefit changes for current members of the TRS defined benefit pension plan.

• Kentucky Retirement System (KRS):
  • Members of most plans will be offered an optional defined contribution plan that would serve as a primary retirement income benefit, including:
    • Kentucky Employees Retirement System (KERS)
    • County Employees Retirement System (CERS)
    • Legislators’ Retirement Plan (LRP)
    • Judicial Retirement Plan (JRP)
  • The bill creates a statutory funding policy that will be one of the most effectively risk-managed in the nation, with amortization payments based on a level-dollar schedule and 5.25 percent discount rate for KERS and the state police plan, and 6.25 percent discount rate for CERS. The years in the amortization schedule were re-set to 30 years in order to make the shift to level-dollar more manageable for state and local budgets.
    • Note: These changes effectively codify the same practices adopted by the KRS board during the summer of 2017, ensuring that future KRS boards won’t be tempted to reverse course on conservative practices to ensure retirement system sustainability.
  • The design of the cash balance plan available to current members will change from offering a 4 percent rate of return guarantee, with 75% of returns above that minimum, to being credited with 85 percent of returns above 0 percent. Over the past 10 years, there has been no 10-year period with a geometric average return less than 0 percent (even accounting for the financial crisis), reflecting the minimal risk associated with this kind of plan design.

• Legislators’ Retirement Plan (LRP):
  • Benefits for current members were adjusted for this plan—with a slightly lower accrual rate adopted for prospectively earned service. No existing accrued benefits were cut.

While these are significant and prudent policy changes, many other ideas that could have helped improve pension solvency and retirement security were considered, but jettisoned, along the way:

• Cost saving measures for TRS — such as temporary COLA freezes and reductions—were proposed, negotiated down, and then eliminated from the bill. While changes to COLA benefits can be uncomfortable, making permanent or temporary changes can have an outsized effect on the overall affordability of existing pension debt. In the case of Kentucky, for example, several years of unpaid for COLA increases have created their own share of unfunded liabilities that has grown exponentially.
• Freezing defined benefit service accrual at normal retirement age was proposed, but dropped from the bill. This approach would have helped reduce overall contribution rates (while allowing employees in defined benefit plans to continue accruing benefits as they might have expected).
• A defined contribution retirement plan—first mandatory, then optional—was proposed for TRS and then dropped. Allowing teachers access to a DC plan built to provide primary retirement benefits would have given a wider range of future teachers access to a retirement benefit with a path towards retirement income security.

Further, funding policy changes for TRS are still necessary for the legacy defined benefit plan. The teacher plan is currently 56 percent funded, but that is using an unrealistic 7.75 percent assumed rate of return. Assumptions for TRS need to be improved, and the methods of paying off the debt need to be adjusted along similar lines as what has just been adopted for KRS. Thus, there remains a need for additional pension reforms in upcoming legislative sessions to continue chipping away at changes needed to advance the goal of pension solvency.

Process Critique

Politics is often messy, something exemplified in Kentucky on the issue of pensions the last year. The legislative effort that culminated in SB151 was a moving target since the fall of 2017, when Gov. Bevin and legislative leaders jointly announced a plan and related legislation to place all newly hired teachers and public employees in a pure defined contribution plan, among other aggressive policy proposals designed to improve solvency.

That plan was quickly beset by political obstacles. In addition to an abrupt, scandal-driven change in House leadership, TRS’s actuaries and board muddied the waters by releasing misleading actuarial analysis to the press regarding the original Bevin/leadership bill draft. (Specifically, the analysis measured the status quo forecast for TRS and the proposed changes using different underlying assumptions.) That started to pressure legislators to start backing away from the original reform concept.

This was succeeded by a wave of various legislative proposals around different plan design concepts, slowly chipping away at the more aggressive policy proposal in the original bill in an attempt to win over sufficient political and labor support (the latter of which never materialized, as is evident from recent labor protests and school closings).

And just when it seemed as if all chances of movement on pension reform were dead for the legislative session, a negotiated plan by legislative leaders to rush a sequence of pension reform, tax reform, and budget bills hastily through both chambers in a matter of days delivered SB151 to Bevin’s desk in short order at the end of the regular 2018 legislative session.

The language included in SB151 was pieced together from a range of previously introduced or drafted bills that had been considered and analyzed, such that the final text reflected a patchwork of ideas that had been debated in various forums since the Fall of 2017.

The passage triggered several waves of protests by teacher unions—part of a larger narrative emerging in several states around teacher compensation issues—and a lawsuit filed by Kentucky Attorney General Steve Beshear and two labor associations challenging the passage of SB151 on both procedural and constitutional grounds.

It may be fitting that such a convoluted process culminated with the terrible optics of pushing a pension reform bill through the legislature in the dead of night as a “gut and replace” amendment to a piece of unrelated legislation on wastewater issues. But it is not true, as some have asserted, that the bill hadn’t been read by members — every provision was in some version of the reform bills presented over the previous six months. All components had been discussed and debated ad nauseam—it was only the particular combination of ideas that were new. Still, it is always unfortunate when sound policy is tainted by poor politics and poor messaging.

Conclusion

Untangling Kentucky’s 2018 pension reform requires reconciling some tricky contradictions. First, it’s true that SB151 was watered down and did not go far enough to solve all of Kentucky’s pension crisis. But no one reform ever does, and the fact remains that it makes some major policy changes that will de-risk and improve the long-run solvency of the KERS and TRS plans speaks to its merits. Second, the legislation did not cut a single dollar of teacher benefits or COLAs and will create a still-very-attractive retirement plan for new hires. But activists and labor associations are still decrying the reforms as “pension cuts” in the local and national media, distorting the intent and reality of the situation. Third, the bill passed through an unfortunate political process (as did Kentucky’s recent tax reform and budget bills). But Kentucky’s recent experience in pension reform serves as a good reminder that an ugly political process can still occasionally result in good public policy.

Hopefully, the needed follow-on reform work in Kentucky will tread a more conciliatory and collaborative path.