Frequently Asked Questions

How many state-run public pension systems are in Kentucky?

Three. The Teachers’ Retirement System (TRS), Kentucky Public Pensions Authority (KPPA) and Kentucky Judicial Form Retirement System (KJFRS). All three are separate pension systems with different boards, administrators, beneficiaries and investments.

What makes TRS unique?

TRS is Kentucky’s largest single pension system and includes public school teachers and administrators. It’s important because of the large number of participants and retirees, and the fact that teachers don’t receive Social Security. As of June 30, 2020, TRS has only 58.4% of the funds needed to pay for the promised obligations.
TRS has an 11 member board consisting of the following:
  *  Kentucky education commissioner
  *  Kentucky state treasurer
  *  Two Governor appointees with required investment expertise
  *  Four active TRS participants elected by TRS members
  *  One retired TRS participant elected by TRS members
  *  Two individuals from outside the teaching profession elected by TRS members
The board is responsible for hiring an actuary.

What makes KPPA unique?

KPPA is comprised of three separate systems that provide retirement income to retired state and local government employees, non teaching staff of local school boards and universities, and state police officers.
*  KERS – Kentucky Employees Retirement System
   Non Hazardous
*  CERS – County Employees Retirement System
   Non Hazardous
*  SPRS – State Police Retirement System
Within both KERS and CERS, the pension funds are segregated into two categories to more accurately reflect the characteristics of “hazardous” and “non hazardous” employees.  This results in five separate pension funds within KPPA (KERS hazardous, KERS non hazardous, CERS hazardous, CERS non hazardous, SPRS).
Each of the five pension funds also has a separate insurance trust fund.  
CERS is governed by a 9 member board of trustees made up of three elected members and six others appointed by the governor.  This board was created on April 1, 2021.  
KERS and SPRS are governed by a separate KRS Board of Trustees also consisting of 9 members.  
KPPA also has an 8 member board of trustees made up of members from the CERS and KRS boards.  
The board is responsible for hiring an actuary.

What makes KJFRS unique?

KJFRS is by far the smallest and most well-funded of the commonwealth’s pension systems. It provides retirement benefits for judges who serve on the Supreme, Appeals, Family and District courts.

However, it also allows sitting legislators to spike their pensions by taking another position in state government and then using that salary in the calculation of their legislative-pension benefits.

The practice is known as “reciprocity” and was implemented in 2005 by the General Assembly. It continues to this day.

This policy has resulted in part-time legislators getting appointed to lucrative full-time positions within state government such as a judgeship or seat on the Public Service Commission – jobs which often pay much higher (often six-figure) salaries than they made in the General Assembly – and then using that salary to dramatically spike their pension benefits for a lifetime.

So what’s the problem?

None of the state-managed pension funds have enough money in reserve to pay for the promised retirement benefits for state employees.

Just how bad is it?

The official deficit is approximately $40 billion; however, some believe the total is closer to $60 billion. Contrast this with the General Fund budget for the current fiscal year, which is about $12 billion and it’s clear: the problem is substantial.

What is a defined benefit pension system?

A pension fund, often called a “defined benefit plan,” is a pool of money similar to a trust fund which provides a fixed amount of income to retirees on a monthly basis for the rest of his or her life. TRS and KRS are both defined benefit pension systems.

How is a healthy and successful defined benefit pension system supposed to work?

Actuaries determine the cost each year of the future retirement benefits for current state employees (this is called the Normal Cost).

Working employees then contribute a percentage of their paycheck each pay period into the pension fund.

Employers (in this case the state of Kentucky and its taxpayers) then make a required contribution of a certain percentage of payroll into the same pension fund.

For pension funds that don’t have enough money set aside to pay future benefits, an additional catch-up payment might also be required.

The money paid into the pension fund doesn’t just sit there. It’s invested in stocks, bonds and other investment vehicles, causing it to grow over time with an investment-return goal set by each pension system’s board called the Assumed Rate of Return (AROR).

When an employee retires, they receive a monthly check for the rest of their life.

What’s an actuary?

an actuary?

Actuaries are hired by the pension systems themselves to analyze the data related to the current employees, investment returns, growth in the amount of employee payroll, retirees’ lifespans and numerous other important factors. Through this process they determine how much money must be set aside each year so there will be enough to pay future retirees’ benefits.

Problems can arise if actuaries use faulty data or intentionally manipulate information in order to provide the pension systems (their employers) with information that makes the health of the system look better than reality. This can include using inaccurate data regarding how long retirees will live, the growth or decline of the payroll for current employees and failing to account for the impact of changes to employee benefits.

What’s the Normal Cost?

The present-day cost of the predicted future retirement benefits earned in a particular year that must eventually be paid to current state employees when they retire. This dollar amount should be paid in full into the pension system each year.

What’s the Assumed Rate of Return (AROR)?

Each pension system sets a goal for their annual investment returns. This is a long-term goal since returns may fluctuate drastically from year to year. For a pension system to be healthy, the AROR must be achieved annually over the long term.

Severely underfunded pension systems typically have lower ARORs than fully funded systems. The investments within underfunded systems are more conservative since a prolonged economic downturn and losses in the stock market could make matters even worse.

Underfunded pension systems often are forced to sell investments earlier than preferred in order to pay benefits, which further hinders the potential for returns.

What does a higher AROR goal mean?

An assumption of higher investment returns means the funds set aside in the pension system are expected to grow faster and earn higher investment returns, thus decreasing the amount needing to be contributed by employees and employers to pay future benefits.

However, an AROR that’s too optimistic and unreachable could result in pension funds not having enough money to pay future retirees.

Fully funded pension systems benefit most from “compound interest”

It’s important to have pension funds as close to fully funded as possible because of the impact of “compound interest,” which really is “interest earning interest.”

  • For example, consider a fully funded pension system with $10 million in assets earning 5% (or $500,000) in its first year. During the following year, that fund will earn another 5% interest on $10.5 million, which will add another $525,000 to the account and so on year after year enabling the fund to grow even larger.

Underfunded pension systems miss out on the powerful impact of compound interest as there’s a smaller amount of “interest earning interest.”

Underfunded pension plans can materialize through one or a combination of the following:

  • Employee retirement benefits are more expensive than anticipated.
  • Investment returns did not reach AROR goals.
  • Employers and employees failed to contribute the amount which actuaries determine is needed to maintain a healthy system.
  • Actuaries used inaccurate or manipulated data.

Why does a lower Assumed Rate of Return (AROR) matter?

Higher investment returns in pension funds mean more money will be available to pay retirement benefits.

Conversely, lower returns translate into fewer dollars available for benefits.

If the AROR is lowered but promised benefits don’t change (as recently happened in 2018 at KRS), then employers will need to contribute more to cover the Normal Cost.

When expectations are lowered for the future amount of money generated from investment gains, more funding is then required from the employer if benefit levels are to remain the same.

Isn’t the problem in Kentucky caused by investments failing to perform well?

The current AROR for TRS is 7.5% while the 30-year return for the investment portfolio was 8.49% as of December 31st, 2020. Investment performance by the TRS managers has been excellent over the years and did not cause the underfunding problem in the pensions systems.

The five plans within KPPA have ARORs ranging from 5.25% to 6.25%. The 30 year returns for these plans range from a low of 7.41% for KRS Non Hazardous to a high of 8.4% for KERS Hazardous as of December 31st, 2020.

While performance over the last decade has lagged due to a reliance on underperforming investments, investment returns are only a small contributor to the current deficit.

Wasn’t this deficit caused by exorbitant investment fees paid to outside investment managers?

No. TRS has been managed very efficiently since inception and costs continue to be very low.

Fees paid by KPPA did increase over the past decade due to an over-reliance on hedge funds. Total fees paid, however, make up only a very small portion of the entire unfunded liability. KPPA has been actively lowering investment allocations to high-fee hedge funds in recent years.

What is meant by the phrase “just pay the ARC”?

The ARC means “Annual Required Contribution.” It’s the combination of the Normal Cost (cost of future benefits attributed to the current year of service) along with an additional payment meant to “catch up” the system to fully-funded status. The catch-up payment is typically amortized over 30 years.

ARC = Normal Cost + Catch-Up Payment

Why don’t we just pay the ARC and reach fully funded status over time?

The ARC means “Annual Required Contribution.” It’s the combination of the Normal Cost (cost of future benefits attributed to the current year of service) along with an additional payment meant to “catch up” the system to fully-funded status. The catch-up payment is typically amortized over 30 years.

ARC = Normal Cost + Catch-Up Payment

Ensuring that benefits offered to state workers are affordable is vital to ensuring each year’s ARC is fully funded.

What’s a COLA?

A cost-of-living adjustment known as a COLA is the annual increase in the pension amount given to retired employees as a way of keeping up with the inflation.

Isn’t this just all about underfunding?

Underfunding has taken place in past years, especially during the Beshear and Fletcher administrations, which did contribute to the problem. However, underfunding is not the primary cause of the current deficit.

An inefficient and costly benefit structure along with retroactive benefit enhancements is primarily to blame.

What’s a Retroactive Benefit Enhancement (RBE)?

State employees are promised a specific retirement benefit for each year of service. The cost is calculated and then contributions are required for the employee and the employer (Normal Cost).

It was common in the past for Kentucky legislators to increase the promised retirement benefits for state workers and apply the increase retroactively back to the first day of employment. This resulted in the original Normal Cost being too low as it underestimated the future costs to the state and taxpayers.

If legislators would have left past benefits untouched, the contributions would have been sufficient. By increasing benefits and applying them retroactively, however, the original amount contributed into the system was not nearly enough.

What’s an example of a benefit enhancement?

Increasing the benefit factor applied to an employee’s benefit calculation.

What’s a benefit factor?

A benefit factor is used in the calculation to determine how much money an employee will receive annually as a retirement benefit. It’s typically multiplied by an annual income amount close to the salary of earned by the employees during their last year of service. The amount is then multiplied by how many years that same employee has worked.

For example, consider a state employee who worked 30 years, had an annual salary of $60,000 during their last year of employment and had earned a benefit factor of “2%.”

    • $60,000 (final salary) x 30 (years of service) x 2% (benefit factor) = $36,000 (annual pension retirement income)

Increasing the benefit factor even a small amount can result in much-larger incomes for retirees. For example, here’s the same calculation with a benefit factor of 2.5% instead of 2%:

    • $60,000 X 30 x 2.5% = $45,000

By increasing the benefit factor to 2.5% from 2%, the increase in pension payments to the retiree increases by a whopping 25%.

Increasing the benefit factor applied to the pension-income calculation was a frequent occurrence resulting in higher-than-anticipated benefit payments.

What’s the “inviolable contract”?

the “inviolable contract”?

The “inviolable contract” protects retirement benefits earned by employees.

Each state has its own such contract containing the rules pertaining to what can be changed regarding employee compensation and benefits. Some states’ contracts are more flexible than others.

In Kentucky, it’s clear that benefits already earned are protected. What’s unclear is whether future unearned benefits are protected from changes going forward.

So what’s the answer?

The commonwealth and taxpayers must honor the retirement benefits already earned by state employees. This will be a large sacrifice and will result in an outsized percentage of the state budget allocated to the ARC for quite some time. In recent years, as much as 15 cents of every $1 in the current General Fund budget has been dedicated to funding public pensions.

Increased funding is not the silver bullet, however. The future benefit structure and liabilities must be changed and streamlined to ensure that what led Kentucky to this point never happens again. Simply keeping the current employee benefit structure in place and only increasing payments to fund the ARC won’t solve the problem.

Last updated 10/6/2020

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