Unfunded Pensions Could Spell Disaster for Kentucky

Unfunded Pensions Could Spell Disaster for Kentucky
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On March 9, ebullient cheers erupted from a crowd of hundreds of teachers on the steps of Kentucky’s capital when state lawmakers announced they would cancel a vote on Senate Bill 1. The bill would have instituted cost-saving reforms for the state’s struggling public pension system.

Teachers throughout Kentucky have hailed its delay as a victory. Its unpopularity largely stemmed from the fact that it included cuts to pension benefits for teachers who have already retired. Yet given that Kentucky has an estimated $43.4 billion in unfunded pension liabilities — and just 31 percent of its pension funded — it’s becoming apparent to many state legislators that something must be done to reform the pension system.

A pension is a type of retirement fund designed to provide workers with a consistent source of income after they retire. The way it works is that an employee or employer agrees to contribute a certain amount of money into a fund, which is then invested in the stock and bond market. This fund steadily grows over time, and when the employee retires, he receives the money that has accumulated to fund his retirement.

Pensions have long been a part of public service. Virtually all federal, state, and local governments offer pension plans to employees. In addition, all federal and 87 percent of state and local government pensions are run as “defined-benefit” plans, as opposed to “defined-contribution.” With a defined-contribution pension, the amount an employee receives after retirement depends on the performance of the pension plan’s investments. A defined-benefit pension, on the other hand, is paid out at a predetermined yearly amount to the employee once they reach retirement age, no matter how the investments perform.

When governments offer an employee a defined-benefit pension plan, they use a number of actuarial calculations to determine how much money the employer and employee need to contribute in order to fully fund the pension. Therein lies the problem. The actuarial calculations are often inaccurate, and many state governments have failed to institute reforms to resolve these inaccuracies. Any shortfalls between the assets in a pension fund and the amount that the fund is obligated to pay out in benefits are called “unfunded pension liabilities.” Over time, the size of the obligations many pension plans owe to their employees have expanded much faster than their assets, resulting in huge unfunded pension liabilities.

This was exactly what happened in Kentucky. A state commission report by the consulting firm PFM Group found that 70 percent of the growth in Kentucky’s unfunded pension liabilities was the result of overly optimistic assumptions that proved to be inaccurate. The remaining 30 percent was the result of government failures to provide adequate contributions to the pension fund.

The growth of Kentucky’s unfunded pension liabilities threatens to put the state in dire fiscal straits. According to a 2017 report issued by the nonpartisan watchdog Truth in Accounting, the state has a shortfall of $48.9 billion between its assets and the bills it’s obligated to pay. That amounts to a burden of $39,000 for every taxpayer in Kentucky. In a state whose annual revenue was $11.7 billion in 2016, a shortfall of close to $50 billion is concerning to say the least.

In light of the states worsening pension crisis, the credit rating agency Moody’s downgraded Kentucky’s debt rating last year –– a move that exacerbated the state’s fiscal problems by increasing its borrowing costs. The growth of unfunded pension liabilities has also put pressure on Kentucky’s budget. Over a nine year period, pension funding in the state’s budget increased from $624 million in 2008 to $1.5 billion in 2017. Such increases divert funds from other government priorities such as public education, or force the government to take on more debt through increased deficit spending, thereby worsening the state’s financial position even further.

Absent major reforms to its pension system or decades of accelerated economic growth, Kentucky faces a number of unattractive future scenarios: It will have to either levy dramatic tax increases, impose dramatic spending cuts across the board, or face spiraling deficit spending. A day of reckoning is coming. If the pattern that led Kentucky’s pension programs into crisis is allowed to continue, two of Kentucky's largest pension programs, the Kentucky Retirement Systems Nonhazardous Pension Plan and the Teachers Retirement System, will be insolvent by 2022 and 2044, respectively.

Although Senate Bill 1 roused strong opposition from teachers’ unions throughout Kentucky, the fact of the matter is that the state is going to have to make some tough decisions. Reforming the pension system is actually in the teachers’ best interests. Kentucky can either get its house in order now or face economic chaos down the line. By agreeing to some reduction in benefits in order to fix the pension system, teachers can avoid more dramatic cuts later. The cost of delay is too great to ignore.

Jack Hipkins is an Advocate for Young Voices based in San Diego, California. He writes about U.S. foreign policy, taxes, and economic theory. He can be found on Twitter @J_Hipkins.

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