Kentucky State Capitol Building

By Daniel Desrochers | Lexington Herald-Leader

In New Jersey, officials turned to the state lottery. In Illinois, they raised taxes. In South Dakota, they lowered their cost-of-living adjustments.

Kentucky has one of the worst-funded pension systems in the country, but it isn’t alone. Following the Great Recession, about 75 percent of state pension funds have undergone some kind of reform since 2009, according to a study by the Center for Retirement Research at Boston College.

But the most common reforms — switching to a hybrid retirement plan, freezing cost-of-living adjustments and increasing employee contributions — have already happened in Kentucky. Those efforts, though, have done little to help a funding crisis that directly affects about 14 percent of Kentuckians.

“We’ve done pension reform and we still are where we are because none of it was designed to affect the unfunded liability,” the more than $37 billion that Kentucky eventually owes public employees but hasn’t set aside, said Jason Bailey, executive director of the liberal-leaning Kentucky Center for Economic Policy.

That leaves lawmakers without much of a blueprint as they try to overhaul Kentucky’s struggling pension systems in coming months.

Hybrid pension plans

Both before and after the recession, several states began switching to hybrid retirement plans, in which employees can choose between a 401(k) investment account or a pension, or have a little bit of both.

Kentucky was one of those states. In 2013, the legislature passed pension reform that moved new hires to a cash-balance pension plan, in which participants are promised a certain benefit at retirement but that benefit is stated as a 401(k)-style account balance rather than a monthly income stream.

Making such changes for future hires is easier politically and will help reduce costs several decades later, but it does little to address the cost of pensions already promised to Kentucky’s public workers.

“You can always screw new employees because they don’t exist,” Bailey said.

Kentucky’s hybrid pension plan, though, won’t save enough money to salvage the state’s financially strapped pension funds, according to PFM, the consultant group hired by Gov. Matt Bevin’s administration to recommend changes to the pension systems. Instead, PFM is encouraging lawmakers to freeze the pension plans of most state workers and switch them to a 401(k) investment account that comes with a defined contribution by the state, not a defined monthly benefit.

Still, such a change would only increase the state’s spending on retirement plans in the near future, as it would have to invest in the new 401(k) accounts while still continuing to fund the pensions that workers have already accrued. Any savings would come decades later.

Only two states have switched to mandatory 401(k) retirement plans for government workers: Alaska and Michigan.

Michigan adopted its defined contribution plan for new hires in 1996, when the pension system was fully funded. Since then, the state’s pension debt has grown to $6 billion. Critics of the change say it caused the debt, but proponents say the debt would be worse had the state not switched.

Alaska’s debt also grew after the state adopted a defined contribution plan. In every legislative session since 2012, lawmakers have unsuccessfully proposed bringing back a hybrid pension system, in which employees could choose between a traditional pension or an investment account. If given the choice, Alaska estimates that about 80 percent of state workers would choose the pension plan.

Changing the rules

The most obvious way to cut Kentucky’s unfunded liability quickly without a huge influx of cash is to change the pension rules for current workers and retirees.

The most common way states have done that is to raise the amount employees must contribute to the pension system.

Kentucky has already done that, too — kind of.

In 2008, the state raised the contribution rate for new hires in state and local government to 6 percent of their salary, which is the national average. But those newer employees are still only contributing 5 percent of their paycheck to the pension system, just like their more senior colleagues. The other 1 percent goes to health care.

That means state workers still contribute a little less than the national average to the pension system, and the average is likely to increase. The Center for Retirement Research projects that the national average for employee contributions into pension systems will soon be 7 percent.

In its report, PFM did not recommend making existing or future public workers put more of their salaries into pension funds.

Another quick way to slice the size of future pension obligations is for states to raise the retirement age. About 4 percent of states did this for current employees between 2009 and 2014, according to the Center for Retirement Research.

In Kentucky, the PFM report recommended lifting the retirement age for most government workers in Kentucky to 65.

These changes often end up in court.

For example, state workers sued Rhode Island when it changed retiree benefits. The two parties came to an agreement in 2015, resulting in a hybrid pension plan that requires employees to take more risk.

Illinois, which also faces a pension crisis, lost its court battle over changes to retiree benefits. Following the court ruling, the legislature opted to raise taxes to help pay for the ballooning cost.

Clawing back benefits

Perhaps the most significant way to decrease the unfunded liability is to “claw back” benefits already granted to existing retirees.

A state’s ability to do this, though, depends entirely on the strength of laws that protect worker benefits, according to the Center for Retirement Research. In Kentucky, most benefits are protected by an “inviolable contract,” making it difficult legally for the legislature to scale back benefits that were promised when a worker was hired.

One benefit that appears to have fewer protections under the law is cost of living adjustments — the annual pay raise given to many retirees to make up for inflation. These adjustments have become a target for state legislatures.

Researchers at Boston College found that 9 percent of state plans made reductions to cost of living adjustments between 2009 and 2014, including Kentucky. In the 2013 pension reform bill, Kentucky froze cost of living adjustments for retirees at 2012 levels, ensuring the state wouldn’t take on an even larger debt to pay for them.

But just freezing cost of living adjustments does little to reduce the current unfunded liability. That is why PFM made its most drastic recommendation: rolling back cost-of-living adjustments that were granted to government workers from 1996 to 2012. The change would decrease the paychecks of many retirees by 25 percent or more.

There has been little enthusiasm for that recommendation among lawmakers, and groups representing retirees have already said they would challenge any such move in court.

Paying up

With few politically feasible options to deal with the unfunded liability, most states have been forced to find more money to pay down their obligations.

In Kentucky, state budget director John Chilton said this week that lawmakers will have to find $1 billion more in the budget to put toward the pension system next year.

Earlier this year, New Jersey, a state with a pension crisis rivaling Kentucky’s, dealt with their unfunded liability by shifting $1 billion in lottery money to help fund its ailing state worker pension fund.

Kentucky would have a hard time copying New Jersey. The state gets about $240 million annually from lottery proceeds, but that money is already earmarked for popular college scholarship programs.

Illinois, which faces more than $100 billion in unfunded liability, chose to address its financial woes by raising the state’s income tax.

Bailey recommends this route for Kentucky lawmakers. He has some support from Democrats in the legislature, but Gov. Matt Bevin and Republican leaders have said repeatedly they oppose raising taxes to pay for state pensions.

William Smith, a member of the conservative-leaning Bluegrass Institute’s pension reform team, said rather than raise taxes, he thinks the state needs to reform its existing defined-benefit pension plans, offering lower benefit accrual rates that are more closely tied to the plan’s investment performance. Making those changes, though, would be difficult, he acknowledged.

“My concern is that the legislature doesn’t have the expertise or time to make a proper defined-benefit plan work,” Smith said.