(Editor’s note: The Q&A section of this post was edited for length and continuity.)
Kentucky has a $30 billion hole in its budget.
In about five years, Kentucky Employees Retirement Systems will run out of money.
It’s a problem that could trigger major companies exiting Louisville to Southern Indiana because there’s only one way to fill the pension hole – raise taxes, says Chris Tobe, the financial expert who’s been warning about pensions for years.
Tobe is an investment manager with Louisville-based Stable Value Consultants.
In a worse-case scenario, one of two things will happen … either taxes will rise exponentially as they have in Illinois, or thousands of retired public employees will see their pensions and their standards of living drastically reduced.
Tobe has been talking about this issue for years. In fact, Beshear removed him as an investment committee member and trustee at Kentucky Retirement Systems – the only member with actual finance and investment credentials.
Governors and legislators stopped paying the state’s required annual contribution to certain pubic employee retirement funds years ago, diverting the money to other General Fund spending as an alternative to raising taxes.
Last year, the Washington, D.C.-based Pew Center on the States found 34 states aren’t adequately funding employee pension funds at even 80 percent of long-term obligations. Four states, including Kentucky, have less than 55 percent of the money set aside to assure the liquidity of pension funds, according to the Pew research.
Here’s a breakdown of pension plan underfunding:
• Kentucky Employees Retirement System non-hazardous: 24.5 percent (27 percent in 2011)
• KERS hazardous: 74.1 percent (68.4 percent in 2011)
• CERS non-hazardous: 61.3 percent (58.9 percent in 2011)
• CERS hazardous: 58.9 percent (56.6 percent in 2011)
• State Police Reirement System: 39.1 percent (38.1 percent in 2011)
Kentucky is only behind Illinois when it comes to having set aside the lowest assets-to-liabilities ratio.
This problem is only going to get worse due to changes in contribution accounting rules for states and cities, with local governments having to disclose pension obligations that were hidden, according to the New York Times. Those changes recently forced Seven County Services to declare bankruptcy.
The General Assembly and Gov. Steve Beshear came up with a half-measure solution earlier this year after people such as Tobe warned Kentucky is following in the footsteps of Illinois and other insolvent states.
Senate Bill 2 essentially punishes future state employees by limiting them to hybrid 401(k) self-funded retirement plans. But there are still about 300,000 state and public workers in Kentucky owed full pensions, with an ever-increasing percentage reaching retirement age.
Shockingly, this problem became a crisis in 2002 with the Democratic administration of Gov. Paul Patton and an economist named James Ramsey who was Patton’s finance secretary … the same James Ramsey who is president of the University of Louisville. And who is now facing budget cuts as Kentucky founders.
Insider Louisville: If we were in the room with the governor and his finance secretary, would they have a hundred different reasons why you’re wrong?
Chris Tobe: Well, they’re going to say we can only do what we can do. Politically, we can’t raise taxes. We can’t cut education. We’ve been forced into this corner and pensions have been forced out. All we can do is, Let’s just hope for the best and hope the economy bails us out.
But if I’m running a big company and I’m thinking about opening up in Kentucky and I’m doing my due diligence and look at this pension mess, I say, “This isn’t some place I want to go. Because there’s a chance of a huge increase in corporate taxes. It’s almost inevitable.”
That, from the business point of view, is the big kicker. Indiana already taking businesses from Illinois. We’re going to see tons of Louisville businesses moving across the river, and we’ll see the business growth in this region in Southern Indiana. No company in its right mind is going to come here. That’s the Louisville story … the growth in this region is going to be across the river. And don’t think when companies are looking that the Indiana people won’t tell them. “Oh, you don’t want to go to Kentucky!”
Frankfort has screwed up our entire economy here.
Is there anyone who is talking about this beside you?
If you’re a politician, how does this sound for a platform? “I’m going to raise your taxes more than anyone else, and I’m going to cut education more than anyone else in history? I’m going to solve this pension problem you don’t know you had because we’ve been lying and covering it up for the last 20 years.”
You’re serious when you say the courts see the pension contributions workers have already earned as sacred, legally speaking. State officials can’t say, “These people are just out of luck. They’re never going to get their pensions.”
That’s my understanding from a legal conference I attended at Ohio State a couple of months ago. It’s a hierarchy. There are retiree health benefits that are a big part [of the $30 billion deficit] that have lesser legal protections. All retirees from state government will have the same level of health care as a current state employee. You could lower health benefits for everyone. That is one [fix] that could be contested in the courts.
So, when we look at the liability of the state, the total liability for the state for all retirement and retiree health, [state officials are] supposed to be putting in around $2.2 billion per year. That’s the actuarially required contribution, or ARC, you should have. They’ve only been putting in about $1.2 billion. So they’re about a billion dollars short. Now back in ’02, with Ramsey and Patton, it was only a couple hundred million. But then [the funding gap] began to grow with the Patton administration. It continued to grow through the Fletcher Administration. And it is continuing to grow through the Beshear Administration. I measured it during 2012, and the gap was about $866 million … the gap. Okay? A Western Kentucky professor estimates it at $1 billion for the upcoming year.
So Senate Bill 2 tries to put $100 million toward that $1 billion dollar gap.
What do you mean “tries to put”?
The Economic Policy Institute says the tax changes that are going to produce another $100 million could only be $30 million. So we’re not even sure how much of that $100 million is real. It’s a rosy scenario of what these revenue changes will make. So, now instead of borrowing $1 billion dollars per year to fund it, we’re borrowing only $900 million to fund it.
Okay, here’s the real problem. Illinois is roughly three times the size of Kentucky. Take away Chicago and the Chicago suburbs, the rest of Illinois is kind of like Kentucky. They have a [pension funding] gap of about $3 billion per year, and we have a gap of about $1 billion to fill. They’ve had a very difficult time getting to even 10 percent of their numbers. Everything they’ve tried has backfired. They’ve increased their corporate income tax by 40 percent, and that’s still only gotten them about 10 percent of the way there. But it takes those kinds of numbers to get there, the numbers are just so big. The numbers are so big, they’re almost impossible to get a handle on.
If we doubled our sales tax [to 12 percent] maybe we could get there. It takes either the biggest tax increase in history. Or the biggest spending cut in history. Or maybe both. You could do both in the same year and still not there there on closing this gap. Does that give you a feel for the size of this thing? In Kentucky, we also subsidize teacher retirement. So when they started cost shifting in Illinois, they tried to push it back down to the districts picking up a bigger portion because districts had ways they could automatically trigger property tax increases to make up that difference.
Well, the irony is, that’s where we’re going to end up, and what they were trying to avoid all those years … to keep from raising taxes, they stole from the public employ pensions.
They were just hoping that the economy turned around so big, the investments would increase and it would bail them out. But we’re just in an impossible hole.
Wait … with the markets turning around, is there a chance we’ll start to see the gap narrow due to the livelier equities market?
Well, CERS, the city and county pension funds, which have been 100 percent funded, will get that impact. But KERS is less than 25 percent funded, So, they have less than one-third of the money at work. So even you have a 15 percent return [on investment], they have the equivalent of only being up 5 percent because they only have a third of the money at work they’re supposed to have. They’re almost in a death spiral because the problem is, even now there is more cash flow going out [to retirees] than there is cash flowing going in [in contributions] to KERS.
The number of people retiring is increasing rapidly, right?
That’s the underlying theme. But that’s true for every retirement plan in the country. We have a double effect of the underfunding compounding all that, and the economy not being so great for a long time … all compounding (the underfunding) so that you have a death spiral.
What you’re saying is, all the changes we’re trying to make … what you’re saying is, “This ain’t going going to work, anyway.” What we should be doing is talking to the Feds about a bailout to get the retirement funds back to zero.
Illinois has publicly talked bout it. Overall their funds are a little worse than our average. We’re in the top two. Individually, the worst state plan in the country is the KERS. Overall, we’re second worst to Illinois if you put all our pension systems together. Here’s the question: If Illinois has talked about going for some sort of federal assistance, would Kentucky join them? It’s a big political question. Would Mitch McConnell go for the pork? The Tea Party is violently opposed to the whole idea bailing out state pensions.
Sen. Jim DeMint has started an entire organization to block federal help for state pensions.
There has to be to be some assumption these pensions are inviolable. Can you go to Jim DeMint and say, “Let’s just deny the pensions to tens of thousands of people. Just let have Social Security and welfare instead of the pensions they thought they’d earned … and paid into.”?
No one knows how it’s legally going to work out.
But taking that political position of saying, “We know we promised you this pension, but tough luck ….” And it’s not like these people going to have a lavish retirement.
Well, there is a top 10 percent who game these systems. I think there are 300,000 people in the Kentucky systems. If you take 10 percent, that’s still 20,000 or 30,000 people who have gotten high gamed pensions. Sylvia Lovely of the Kentucky League of Cities is an example. She’s in the CERS system, but still, they’ve played games and gotten hers up to a six figure level [per year.] There are tons of others. The problem is, the typical pensioner is only making $20,000 per year and we have to something to help and protect those people. That’s the real key. Some teachers don’t get Social Security, so theirs is a little higher. The bulk are reasonable pensions. But there are a lot the make it symbolically seem overly generous. Maybe we’ll just limp along.
Well, “just limp along”only lasts until the pension funds are illiquid.
The state starts defaulting on bonds. You start selling off your state parks.
That’s a little far fetched …
Why is that far fetched? We run out of cash in four or five years in KERS. It’s actually cash-flow negative now. It runs out of cash in five years.
So when people expect their retirement checks, there’s no money?
The second that first check doesn’t come out, there are going to be some angry people marching on Frankfort. It’s an obligation of the government. It’s a higher obligation than paying the interest on municipal bonds. What they’re fighting over in these other states like California is, they’re trying to get bonds ahead of pensions. Right now, pensions are ahead of bonds.
So you’re talking about like in senior secured debt … the hierarchy of claims in a default.
In a regular bankruptcy, earned pension benefits are senior to senior debt. These are earned pension benefits. That’s like salary almost.
Boy, worst case scenario, something else happens and we have trouble servicing muni debt … and then this pension obligation …. a nightmare.
Illinois is $9 billion behind on vendor payments. They’re about a year or two ahead of us. That’s what’s going to happen here in a year or two. If I hear another legislator say, “Well, our problem isn’t as bad as California ….” Our problem is five times worse than California.
States are going to say the expedient thing is to wipe out these obligations ….
The easy stuff we’ve already done. We’ve punished future employees all we can. But it doesn’t matter. Because this is all the earned pension benefits to Baby Boomers. Suits over cost of living increases are in courts now. That’s something you can do. The next thing is cut retiree health benefits. ObamaCare could take care of retiree health care. That’s one option.
The next step would be to put in some kind of Pension Benefit Guaranty Corp. type system that cuts off the top earners. The abusers off the top. Even then, Kentucky is so bad we don’t even have the money to pay the $20,000 and $30,000 a year people.
(Editor’s note: PBGC is a federal pension rescue program, it receives no funds from general tax revenues. Operations are financed from insurance premiums by sponsors of defined benefit plans, investment income, assets from pension plans overseen by PBGC, and recoveries from the companies formerly responsible for the plans.)