After 35 years as a consulting actuary in the private sector, I had the challenging and enlightening experience of working with the legislature and the governor during the past year on the journey that ultimately led to House Bill 1 (HB 1), the public-employee pension reform bill. During this time, I was a contract employee of the House, but hope that I served as an objective advisor whose primary interest was the good of the system.
So, let's discuss some key facts, based upon my observations and professional experience. First and foremost, the greatest design challenge faced by those who worked on pension reform was the constitutional provision that limits reform for current participants. In short, current employees cannot be forced into a defined contribution - 401(k)-type - system.
Those employees must continue in the current defined benefit system at the current level of benefits. This means that the current $26 billion liability cannot be designed away or taken away from the current employees. It can only be dealt with through contributions by the state, investment earnings and savings in health care. Every branch of state government - the Senate, the House, the governor (past and present), as well as the courts - understands this.
Okay. There may be constitutional limits on changes for existing employees. But, what about new employees? Wouldn't a 401(k)-type savings plan work for them? Not for a long, long time. Why not?
Every penny the state contributes for retirement benefits is needed to fund the liabilities of current participants. The state must reach the point where it is funding its required contribution by 2025 and continue to fund at that level every year thereafter. Any dollars that go to a future 401(k) match would be dollars not going to help pay off that $26 billion accrued liability which we have heard so much about. Simply put, any 401(k) solution is more costly than a comparable defined benefit solution and misdirects dollars needed by the current system.
Next, HB 1, the legislation that was enacted, is projected to save more money in the long run than any of the other proposals that were made during either the regular session of the General Assembly or the negotiations that led up to the special session. Those HB 1 design changes will save state taxpayers billions of dollars in the long run. Even for current employees, savings will be made in those areas where it is possible -- "double dipping" and the COLA (cost of living adjustments). Limiting the COLA to 1.5% per year could reduce payouts from the trust funds by $400 million in the five years beginning July 1, 2009.
Defined contribution plan advocates like to point out that 401(k) plans involve employee, as well as employer, contributions. True, but folks in the Kentucky Retirement System have always taken on a big part of the responsibility for their retirement. Current participants contribute 5 percent or 8 percent of pay to the system, depending upon their jobs. New employees will contribute either 6 percent or 9 percent. And the employees have always made their required contributions. Unfortunately, this has not been true of the state.
The current state pension system presents tremendous challenges for those who govern and for generations of our citizens. But, if you think that the private system transition from a defined benefit system to a 401(k) structure is a wonderful model, you should read the page 1 article in the July 13, 2008 Courier-Journal entitled, "Many retirees will run out of cash." The article reports on a study by accounting firm Ernst & Young that "warns of an impeding national crisis" resulting from the transition to 401(k) plans in most of private industry. Retirees would be much better prepared if they had a guaranteed source of retirement income beyond Social Security, the study concluded.
Additional steps do need to be taken to sustain the Kentucky retirement system. The state must stick to the funding schedule contained in HB 1. Health care costs need to be further contained. Maximum investment returns are required from the $30 billion in assets that are in trust to pay future benefits. But, do not think that 401(k) is the answer and do not underestimate the value of the design changes made by House Bill 1's reforms. I've seen the numbers.
Patrick Welsh, an enrolled actuary who advised House leadership on the issues of public pension reform, has been appointed by the Governor to serve on his Pension Funding Work Group.