On our recent show, we reviewed the perilous state of pensions today, especially those right here in Kentucky. The Kentucky Retirement System (KRS) provides retirement benefits for a wide array of state employees. Many of these individuals are relying on their pension to fund a significant amount of their retirement dreams. However, after years of lackluster management, the Kentucky state pension is commonly cited as being among the worst funded within the country. As the headlines range from slightly sensational to apocalyptic it’s important to break down some of the key facts retirees, employees, and taxpayers need to know.

1) The pension invests in non-traditional investments

The pension relied on by over 40,000 Kentucky retirees looks much different than a typical 401k plan used by many Americans. Instead of being simply diversified into a global mix of stocks and bonds the pension is invested in a wide range of investment types and strategies in a hope to maximize returns while keeping fluctuations minimal.1 This is how pension holders became owners of things like timberland, real estate, and private equity deals. Unfortunately, these alternative options have done little to provide the hoped for returns and are far more expensive than a simple 401k-style strategy. In fact, the 0.87% annual management fees in the fund is nearly 4x higher than other local pensions pay, such as the Kentucky Teachers Retirement System at around 0.28%.2

2) The math the plan uses is sound

One of the easiest targets when it comes to talking about the success or failure of a pension system is the people doing the math. They run the numbers to figure out things like life expectancy of members, return assumptions for investments, funding levels, and future economic outlooks. So, did the people doing the math here simply fall asleep at the wheel and allow the pension to drive headlong towards a cliff? Well, not exactly. The fact is, much of the math and calculations surrounding the plan are quite sound. Take the return assumptions for instance. At a 6.75% assumed annual rate of return3 the pension is assuming they’ll receive a similar long-term return to an average 70/30 portfolio, simply invested as one might do in their 401k. So, it’s not the math that’s way off the mark.

3) The State has often neglected its end of the bargain

The KRS pension program relies on two important sources of funding for future payments. The first is employee contributions, this is the amount withheld from each employee’s check to support the pension promises. The other key piece is the employer (or state) contribution, this is the amount the state pays into the pension to cover future payments. While employees don’t have an option as far as their contributions go, the state has a lot of wiggle room on whether or not it decides to make its payment. This means that over the past couple decades, when the state budget was tight, lawmakers simply abdicated their responsibility to pay their full portion into the pension. This would be the equivalent of your employer telling you you’re getting a 401k match and never making it. The problem with this strategy is that every year of neglected  contributions misses out on more and more of the compounding interest to help the pension meet its long-term obligations. So, the hole gets deeper with every missed payment.

4) The pension no longer collects as much as it pays out

A pension system can, at times, contribute less than the recommended amount for a short period of time and still succeed. However, to do so the pension would need significantly more people paying into the system (current employees) than are withdrawing from it (retirees). This is because a pension acts as a pay-as-you-go system which means the current employees’ payments into the system are used to pay retirees first and the extra is saved for the future. It’s how every pension (including social security) typically works. However, when the number of retirees grows larger than the currently employed it’s natural that the amount paid out becomes more than what’s paid in. This is where KERS portion of the pension stands today. With slightly more retired versus employed members the pension can no longer rely on current employees to help keep it afloat.4

5) The amount needed to shore up the pension is big

A pension system runs on a mathematical calculation to figure out how long it’s current assets will last given what it can expect to receive from current employees, pay out to current retirees, and the rate of return it can receive in its investments. What starts to sound the alarm is when the pension requires more assets in the bank now to make these future payments even if its investments perform as expected, this is considered a “unfunded liability.” As it stands the state pension has around $30-billion less than it needs if the current 6.75% rate of return was factored in. However, some lawmakers have called for using a lower assumed rate since the investments have done so poorly lately. If this lower rate of around 2.70% were used the pension would be around $80-billion short. Now, that doesn’t mean much without context. So, take into consideration that the entire state budget for Kentucky is around $11-billion and you can begin to see the scale of the crises. The money to cover this difference can’t simply be “created,” it will have to come from someone, whether that be retirees or taxpayers.

 

When it comes to public pensions, issues are hardly just the concern of the pension holder. The state of pensions today means that both pensions holders and taxpayers are going to be required to make large sacrifices in the near future. It’s not out of the question for future retirees to see benefit cuts or for taxpayers to be left footing the bill. This is why it’s critical, if you plan to retire with a pension, to talk with an investment advisor, run your numbers, and review your plan. Even if you don’t have a pension your advisor can help you think through the implications of higher taxes and other issues you may face if your state is staring down a pension in peril. If you’ve not taken the time to layout your personal financial plan yet there’s never been a more important time to do so, the math will not simply wait.

 

1 https://kyret.ky.gov/Investments/Manager%20Fees/Managersfeesupdatedfor12.31.15.pdf
2 http://www.kentucky.com/news/politics-government/article97211242.html
3 Kentucky Retirement Systems 2016 Annual Report p. 6 (https://kyret.ky.gov/Investments/Financial%20Statements/2016-financial.pdf)
4 Kentucky Retirement Systems 2016 Annual Report p. 14-15(https://kyret.ky.gov/Investments/Financial%20Statements/2016-financial.pdf)
Image Credit: Copyright Alexey Stiop