How Will State and County Government Employees Fare under Kentucky's New Cash Balance Pension Plan?

How Will State and County Government Employees Fare under Kentucky’s New Cash Balance Pension Plan? RICHARD W. JOHNSON AND BENJAMIN G. SOUTHGATE A PUBLIC PENSION PROJECT REPORT APRIL 2014 Copyright © April 2014. The Urban Institute. All rights reserved. Permission is granted for reproduction of this file, with attribution to the Urban Institute. Cover photo © 2011. Associated Press/Rich Pedroncelli. This report was completed under contract to the Pew Charitable Trusts. The authors are grateful to David Draine, Gregory Mennis, and Aleena Oberthur at Pew and Barbara Butrica, Owen Haaga, and Gene Steuerle at the Urban Institute for valuable discussions and comments on earlier drafts. They also gratefully acknowledge editorial and production assistance from Fiona Blackshaw. The Public Pension Project examines the cost and financing of retirement plans provided to government employees, assesses their impact on retirement security and employee recruitment and retention, and evaluates reform options. It is a joint effort by the Urban Institute’s Program on Retirement Policy and State and Local Finance Initiative. The Urban Institute is a nonprofit, nonpartisan policy research and educational organization that examines the social, economic, and governance problems facing the nation. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders. Contents Executive Summary iv How Do the Two Plans Work? 2 How Much Will Retirees Receive? 3 How Much Will Plan Participants Receive over Their Lifetimes? 6 How Might Retirement Plans Affect Employee Recruitment and Retention? 10 Will Retirees Remain Financially Secure under the Cash Balance Plan? 12 Who Wins and Who Loses under the New Cash Balance Plan? 15 Conclusions 18 Technical Appendix 20 Notes 25 References 26 About the Authors 27 iv The Urban Institute Executive Summary Like nearly all states, Kentucky had enrolled its state and county government employees in a traditional retirement plan that paid a lifelong pension to retirees based on years of service and how much they had earned near the end of their careers. Beginning in 2014, however, newly hired state and county employees will enroll in a new cash balance plan that expresses benefits as an account balance that grows over time with employee and employer contributions as well as accumulated investment returns. Kentucky’s recent reforms, which included a commitment to increase funding as well as a change to benefits, are a potential model for states and municipalities looking for ways to improve the fiscal health of their pension plans and bolster retirement security for employees. Employer costs are more predictable in cash balance plans than traditional plans, and the retirement benefits earned by workers in cash balance plans accumulate more evenly over their careers, so those who separate from government employment before they retire do not forfeit most of their employment-based retirement savings. At the same time, Kentucky’s shift to a cash balance plan has raised concerns about the financial security of future government retirees. This report examines how Kentucky’s state and county government employees will likely fare under the new cash balance plan. It calculates the annual and lifetime retirement benefits that employees in nonhazardous positions hired in 2014 will earn in the cash balance plan and the benefits they would have earned if they had joined the traditional plan that covers employees hired between 2008 and 2013. How Much Will Retirees Receive? Retirement benefits in Kentucky’s traditional plan rise sharply with years of service. The traditional benefit formula directly ties payments to tenure, and the formula multiplier increases as employees work longer. Final average salary also generally increases with service years, so the earnings base partially replaced by the plan grows as employees work longer. Future retirement benefits erode over time when employees separate from Kentucky employment before they can receive payments, because the cash benefit is not adjusted for inflation or interest forgone while waiting to collect. Retirement benefits in the cash balance plan do not increase as sharply with years of service. Cash balance plan benefits are based on career-average salary, which rises more slowly than How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan? v final average salary. The account balance continues earning investment returns while plan participants wait to collect payments, even after they leave the employer. As a result, employees with limited years of service would receive more benefits in the cash balance plan than the traditional plan, whereas those with many years of service would receive less. For example, employees hired at age 25 who earn average salaries and separate with 15 years of service can expect to receive annual payments of $12,200