Year of Publication

2007

College

Martin School of Public Policy and Administration

Executive Summary

In 2006, an issue of serious concern to state legislatures was the long-term security of the defined benefits that state and local public pension plans promise to current and future retirees (Snell, 2006). Public pension systems are growing in terms of members and the benefits they offer to their members. Part of this group includes the estimated 77 million baby-boomers who will be living the next 20 to 30 years in retirement (Wharton, 2006). These dynamic changes are raising the burden public pension plans place on government operating budgets. Expecting a large number of their employees to retire, public administrators are becoming more concerned about meeting the retirement pledges to their public employees and also maintaining a desired level of public services demanded by their taxpayers (Mattoon, 2006).

In a study of 58 state pension systems, Wilshire Associates found that 84% were under-funded in 2005 by an estimated $157.1 billion (Wilshire and Associates, 2006). The pension unfunded liability problem has been gaining attention in the Commonwealth of Kentucky. During February 2007, Governor Ernie Fletcher passed an executive order to establish a task force that would examine ways to restore the financial health of the state’s two main public retirement systems, the Kentucky Retirement System (KRS) and the Kentucky Teachers Retirement System. As of June 30, 2006 the unfunded liability for KRS was $11.9 billion (excluding the County Retirement systems), $3 billion more than the General Fund operating budget for fiscal year 2007. The unfunded liability is a measure of the degree to which the cost of benefits that have been earned by members to date but not yet paid exceeds the value of the assets available to pay for benefits. These benefits are contractual obligations of the Commonwealth and are protected by statute as well as the state constitution (KRS, 2006).

Several states, including like Kentucky, are trying to address their unfunded liabilities and escalating costs before the real hardships occur. Severely under-funded public pension systems have caused some governments to reduce their provision of public services. Municipal bond ratings and, therefore, government’s potential to borrow funds has also been negatively affected. In addition, if the unfunded liability problem continues to be deferred by policymakers it will raise the employer contribution rates needed to pay for future pension liabilities and consume an even larger portion of their operating budgets increasing the financial burden on future taxpayers. To avoid these negative consequences, public administrators are developing policies aimed at funding their pension systems at actuarially sound levels.

This paper analyzes how the cyclical market affects the funding levels of public pension systems and evaluates funding strategies public pension systems can use to prepare for the future. I analyze the impact of different investment management policies on the KERS Non-hazardous system and the feasibility of issuing pension obligation bonds to pay off the unfunded liability. The first section provides an overview of the structure of public pension plans, describes how these systems are funded, and identifies the factors that can affect their funding level. The next section discusses causes of unfunded liabilities and their implications. The third section discusses potential solutions various states have implemented to address unfunded liabilities and improve the funding of their plans. The fourth section looks at the Kentucky Employees’ Retirement Non-hazardous System's unfunded liability and analyzes the specific conditions that caused it. The fifth section discusses my analysis with the data, methodology and results discussed within each subsection. In the last section, I discuss various policy implications associated with my analysis and offer recommendations for improving public pension funding.

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