For years, Kentucky’s looming public-pension crisis has followed the five stages of grief.
State legislators have denied the problem, thrown their hands up, bargained using half measures, and given in to depression.
But now, a rare alignment of the political stars is forcing the General Assembly to take action on Kentucky’s troubled public-sector pensions. While most coverage has focused on fully funding the program, it is equally important going forward that we get management of the state’s pension fund right.
Here are a few lessons Kentucky policymakers can learn from other states.
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Kentucky should shift investment toward index funds, away from managed funds, which are generally riskier, since they involve making bets on specific hedge funds, managers, companies, and real-estate developments. Index funds, on the other hand, track the ups and downs of the economy. As the economy grows, investors receive steady returns. They’re also less risky.
Heavily managed portfolios can be seductive to fund managers, since they are high risk and high reward, but in many cases financial projections plan for the unlikely high-reward scenarios to paper over funding issues.
Yet even in “high reward” scenarios, much of these additional returns are eaten up by exorbitant management fees, producing returns that are often equal to or below index funds.
As a recent Herald-Leader investigation showed, this effectively acts as a transfer from Kentucky workers to Wall Street managers.
The beauty of index funds is that they require relatively little expertise and minimize risk without sacrificing much in the way of returns. Shifting pension dollars toward index funds also reduces opportunities for politicization in fund management.
Political interference may seem like a small issue, but in states like New York and California, the politicization of investing has led to over $1 trillion in losses. Part of this loss is explained by the fact that both states must employ large numbers of in-house employees and depend heavily on Wall Street managers to administer their investments.
In Nevada, fund managers are taking a different approach. As a Wall Street Journal profile of Nevada’s chief investment officer Steve Edmonton recently revealed, Nevada’s shift to index funds has “reduced complexity, risk, and cost.”
Nevada’s fund regularly outperforms the smartest guys in the room, including the heavily managed Harvard endowment fund. Ignoring the benefits of index funds means leaving valuable returns on the table—returns that could help the state get out of its funding problem.
Getting investment risk right is especially important given Kentucky’s continuing use of defined benefit plans. When higher discount rates are used to assume plans will perform well, the size of the future liability decreases, meaning policymakers can get away with paying less into the system.
This helps to explain why so many states like Kentucky make risky investments and are overly optimistic in their return assumptions: because it gets them off the hook for funding pensions by papering over funding shortfalls.
Kentucky’s fiscal year 2015 pension liability, for example, balloons from $30.68 billion to $91.52 billion when using realistic assumptions about returns. Defined benefit plans incentivize this kind of risky behavior. This is one reason why — in addition to getting smart on management — more states are considering switching to defined contribution plans for public workers, which eliminate the potential for policymakers to underfund long-term liabilities.
Kentucky’s pension crisis isn’t just a funding problem — it’s also a structural problem. Simply increasing funding within the current structure ignores the political factors that will inevitably push us toward another pension crisis down the road. Policymakers need to address the factors that make underfunding so attractive. That means shifting toward an investment strategy that relies more on low-cost index funds and less on risky investments.
One surefire way to reduce our appetite for those kinds of risky investments is to switch future employees over to a defined contribution system. We’ve accepted the short-term funding problem. But will we remain in denial about the long-term structural problem?
Olivia Gonzalez is an economics Ph.D student and researcher at George Mason University. Nolan Gray is a writer and policy researcher originally from Lexington.