It appears that any solution to the state pension crisis will be unacceptable to public employees and taxpayers with perhaps no winners.
Under the letter and spirit of the law, public workers are entitled to generous pension benefits that shouldn’t be renegotiated. It may appear that teachers and other public servants would have nothing to gain and a lot to lose in any pension reform.
However there are a few lurking dangers for anyone with a public pension. The legislature cannot easily dispense with promised pensions but can counter the pension’s realized benefits by halting cost of living increases (COLAs), taxing pensions like ordinary income and switching new employees to defined contribution plans.
Even without the legislature taking counter measures to lower the net costs of pension benefits, these pensions are at significant risk from inflationary spikes. Although the United States has experienced low, single-digit inflation since the early 1980’s, this trend may be bucked in the coming years.
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If the U.S. were to experience double-digit inflation for even a few years this could effectively destroy a third of a pension’s lifetime value. The legislature is currently under no obligation to go above the 1.5 percent COLA.
A challenge to funding our public pensions is that the promised benefits are based on relatively high investment expectations that can only be achieved with a significant investment in volatile assets.
Furthermore pension benefits are based on the highest years’ earnings, which can be out of line with career earnings. Each of these pension designs invites trouble both at the micro level with benefit “spiking” and at the macro level with under-performing markets.
How can we move forward with uncertain investment performance and inflation risks? A guiding principle is that both the state and state workers should honor the letter and the spirit of the law. Kentucky should maintain a defined benefit retirement system for its workers with concessions made on both sides.
Workers should not be allowed to include any supplemental pay in their benefit calculations. An ideal system is that workers are immediately vested in the plan with contributions and benefits tied to each year’s salary, not a few high years. There are over 50,000 former teachers retirement system employees who didn’t work long enough to gain any retirement benefits.
Pension funds should invest in the Kentucky economy through Kentucky-based businesses and municipal projects. Fund performance could be tied to an index of growth in the state’s output. This hovers around 3 to 4 percent but is steady and, importantly, is part of what our state workers are impacting with their public work. Pension benefits could be tied to the Consumer Price Index to float with any high inflation episodes. State workers should have the opportunity for their pensions to grow if they do not take them at the earliest eligible age. This would allow teachers to stay in their current positions rather than having to find new jobs or retire early.
The combined impact of these policies would be that workers receive guaranteed pensions that are robust despite investment and inflation swings. This reworked system would require longer careers and likely some pension reductions.
The state would have a defined benefit plan that was synced with the state economy, eliminating investment risk and solvency issues. For those public employees who think the status quo is better, they could be grandfathered and take their chances that inflation doesn’t thrash their pension benefit.
Paul V. Hamilton is an associate professor of economics at Asbury University.