Pensions and Pension Reform

The Lane Report
November 8, 2017

By John Garen

Pension reform is in the air and written about extensively these days. And for good reason. The problem with public pensions in Kentucky has been festering for quite some time and, as is well known, the commonwealth is left with over $30 billion in unfunded liabilities. The governor has announced a pension reform proposal, and it now seems clear that significant legislative action soon will be taken to address this problem.

What also seems clear is that there are two principles that ought to be adhered to in moving forward: (1) honor past promises made; and (2) reform the system to “stop the bleeding” and to prevent such a mess from happening again.

Consider the second point first. To do so, it is worth reviewing how the crisis was created. At the risk of stating the obvious, the basic issue is that more was promised to people in the various pension plans than money set aside to fund those promises. To understand how this came about, let’s consider a little background on pension plans.

The pension plans in question are “defined benefit” plans, i.e., they promise the individual a given monthly income in retirement. The amount rises with years of service, salary in the highest earning years, and a “benefit multiplier” that are combined to calculate the monthly pension.

Defined benefit plans are intended to be pre-funded. This means that the pension payroll deduction from the employee plus the “normal cost” contribution from the employer with each paycheck is enough to fund the future benefit. Determining how much must be contributed is a substantial actuarial task. It depends on the expected length of service of employees, the path of future payrolls, the returns earned on investments, and the longevity of retirees. While it is complicated to estimate each of these with accuracy, there are plenty of actuaries who are able to do a good job with such a task. Moreover, if this is done well, payroll deductions/contributions fully fund the pension and there is no need for an additional Actuarially Required Contribution (ARC).

Unfortunately, there have been errors in the projections regarding investment returns and other actuarial forecasts that have led to underfunding and the need for the additional ARC. However, other factors also played substantial roles. In particular, there were pension benefit enhancements applied retroactively that were not pre-funded. These are the addition of COLA benefits and many increases in the benefit multiplier in the 1990s and early 2000s that raised pension payout promises. These are outside of actuarial error – they raise payouts beyond the original plan and, in the future, require more funds via a legislative ARC even if the actuarial projections are spot on. They created a benefit to the pension recipient and a liability to the pension plan that was not anticipated and not pre-funded.

This cuts directly to one of the chief weaknesses of public, defined benefit pension plans. There is a great temptation for political officials to make big promises today where the bill for those promises comes later. Regarding pensions, it was especially tempting to make greater promises when the stock market was booming and pension fund returns were higher than normal.  The higher unfunded promises made at that time sounded great then and likely made a lot of politicians look good. However, as always, the higher-than-usual returns did not continue and an unfunded liability developed. Now that the bill is due, it’s clear that such unfunded promises were not a good idea and will cause significant difficulties. Though some state governments avoided this temptation, many, including Kentucky’s, did not.

Though it is important that past promises be kept, it is also important that, going forward, we do not fall into the “promise now, pay later” trap again. This is where “defined contribution” plans come in. As is well known, under defined contribution plans, employee and employer make contributions to each employee’s pension fund account that become the property of the employee. Any pension enhancement would be in the form of greater employer contributions and be paid for immediately. No more promise now, pay later. This is critical in avoiding a future shortfall. We no longer tempt politicians to “kick the can down the road” regarding pension funding … We’ve been down that road and it brought us into our present muddle.

Under defined contribution plans, the employee simply gets the value of the contributions plus the investment gains in the account at the time of retirement. Note that this benefit can be as large as that in a defined benefit plan so long as contributions are sufficient. In that sense, a defined contribution plan can be made equivalent to a defined benefit plan. The goal of a defined contribution plan is to make the compensation of public employees and teachers – salary, pension benefits and other fringe benefits – sufficient to compete with the private sector to attract quality workers/teachers. Whatever pension benefit is needed, in conjunction with salary and other fringes, should be what is aimed for. Whether this is as large as the present pension benefit is a question that policymakers must decide, in light of competition for personnel in the labor market.

A key difference in defined contribution plans is that they do not promise a specific pension payout to the retiree. Each retiree has claim on the accumulations in his/her pension account. However, these plans can be made essentially equivalent to a fixed-income payout by investment of one’s funds in annuity products. Whether one does so is up to the individual’s planning and preferences.

Now to the first principle of reform noted above: honoring past promises. This is important and can be done, while shifting to defined contributions plans, in a couple of ways. One is with a so-called “soft freeze.” This is where only recent and newly hired employees are required to be in the defined contribution plan. All other employees (and retirees) retain the present plan as already configured. This is the nature of the proposal presented by the governor … defined contribution plans for the newly hired with the pension benefits of others mostly unchanged. A second approach is a “hard freeze.” This is where all employees’ pension benefits earned to date are frozen at that level and paid out at retirement. Everyone is moved into a defined contribution plan. However, to honor past promises to current employees, the employer contribution to the plan must be sufficient to be comparable to the defined benefit payout. This option, while workable, apparently is not being considered for Kentucky.

Even with the adoption of a reform similar to what has been proposed, the commonwealth’s taxpayers are left with a large unfunded liability. But the bleeding stops, and we avoid the promise now, pay later trap. Paying down the unfunded liability obviously requires more resources be devoted to the pension legacy costs. Just as obviously, this means less state government spending on other things, more tax revenue, or some combination of the two. Note, though, that strong economic growth eases this predicament. With growth, there are more resources available for all uses. Thus, it is important for policymakers to promote growth-enhancing policies. Just as important, though, before asking the taxpayers for more money, is to “scrub the budget” of ineffective and counterproductive programs and improve the efficiency of the rest. We owe it to ourselves as taxpaying citizens of Kentucky to do so.


John Garen is BB&T Professor of Economics at the University of Kentucky Gatton College of Business and Economics