You may have heard the old story about a man who started a watermelon business. He secured a deal to purchase watermelons for $1 each and unwisely decided that he would sell the watermelons for 95 cents each. Confused at why his business continually failed to make money, he lamented “if only I could sell more watermelons.”
What he thought was merely a volume problem was in fact a structural problem.
This might as well be the story of Kentucky’s pension system, and those who have claimed that merely pumping more money into our broken system are playing the role of the failing watermelon salesman.
Our existing structure is irreparably broken, and this is not merely because of a failure to pay in enough money. This is thanks to the defined-benefit model, which has proven unreliable and forced taxpayers to assume the totality of risk for worker retirement.
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The first problem is the structure of benefit obligations themselves. The way that an employee’s pension is calculated, which has gotten lost a little in this discussion, is a formula that, for example, might provide 2 percent of a person’s salary multiplied by their years of service. So, if a person begins their career making $35,000 but spends their final five years making $100,000, retires after 27 years, their pension payment for the remainder of their life will be $54,000. It is possible for a person to spend more years drawing a pension than they spent paying in, drawing a higher salary than they averaged over the course of their career.
No one would design a retirement system in this way, and the private sector has wisely moved away from it.
Some of these problems can be effectively absorbed so long as more people are paying into the pot than taking out. For a long time, even as mistakes were made, this was one of the things that insulated our system. Today, there simply aren’t enough state workers to offset the mistakes. Consider Kentucky’s pension system compared to the federal Social Security system, When Social Security was implemented, there were 17 workers for every one person drawing from the system. Today, there are only three workers per Social Security retiree, which causes a great deal of anxiety for policymakers.
In 2008, Kentucky’s pension system had about 1.5 workers per retiree. For this and other reasons, then Senate President David Williams had been warning of the system’s impending collapse for years. Today, we have 0.89 workers per retiree. Our system is officially upside down.
Though it is theoretically possible for a system like this to still work, few places have managed it successfully. The failure is, in part, due to actuarial assumptions which are the centerpiece of the model, but often don’t come to fruition. Approximately 22 percent of our funding problem comes from actuarial backloading, and another 15 percent comes from market underperforming. In situations where the market underperforms, or when miscalculations are made, it’s the taxpayer who assumes the entirety of the risk, forcing public money, that would have otherwise gone to roads or education, to be used to correct these mistakes. That’s the situation we’re in now, but one that we can avoid in the future.
The best example of these structural shortcomings comes from the County Employee Retirement System. Even as the system paid in the full contribution, which it is required to do by law, the unfunded liability increased. In 2005, the system was 94 percent funded. Today the system is 59 percent funded.
The single most important thing we can do at this point is ensure that we solve this predicament once and for all by moving away from our broken structure, and move into a defined-contribution system. A defined contribution system promotes the common good by protecting the citizenry from assuming the risk for employee retirement and provides fairness and flexibility to government employees by providing them the same retirement that is available in the private sector.
What we can’t afford is to merely put a Band-Aid on the system and continue digging a deeper hole. As the old saying goes, we have kicked the can down the road for a long time, and we have run out of road. The structural changes proposed by the legislature last week help secure a stable future and can provide a wonderful example for other states facing this challenge. Legislators are doing the right thing by making this critical change. Taxpayers should support them.
Jordan Harris is executive director of the Pegasus Institute in Louisville.