Cash Balance Brief - Kentucky Center for Economic Policy

February 11, 2013 Cash Balance Plan Likely to Increase Costs, Impact the Quality of Public Services and Reduce Retirement Security By Jason Bailey While the primary pension challenge Kentucky faces is how to find the revenue to pay back the existing unfunded liability, much of the attention has instead focused on moving new employees to a defined contribution plan or a hybrid plan like the cash balance option included in Senate Bill 2. However, there are a number of reasons to prefer Kentucky’s existing defined benefit design over such a plan. Here, we outline the potential impacts of a cash balance plan on state costs and on Kentucky’s ability to attract a qualified workforce and provide retirement security for workers.

Cash balance plan may be more expensive than the existing plan for new employees. The cash balance plan in Senate Bill 2 may make Kentucky’s pension funding challenge even worse. Analysis of the actuarial statement for the legislation shows that the cash balance plan is projected to increase state costs by $55 million over the next 20 years compared to keeping the existing defined benefit plan for new employees. 1 In fact, additional costs may be even greater than that for several reasons. The actuarial analysis notes that the system’s assumed rate of return of 7.75 percent was used to develop the cost projections. However, the actuary’s model predicted that the cash balance plan would likely credit individual accounts at a higher rate, with a median estimate of 8.1 percent. The analysis notes that “to the extent the actual credit rate is higher than 7.75 percent, the costs of the legislation will be greater than shown in the enclosed tables.” Unpredictable and potentially higher costs are a concern with cash balance plans. In the case of the Wisconsin Energy Corporation, a cash balance plan with a design similar to Senate Bill 2’s plan failed because it ended up being considerably more expensive than originally estimated. 2 Cash balance plans like proposed in Senate Bill 2 can raise costs because while the state must make up for shortfalls in investment returns below four percent, the system benefits from only 25 percent of investment returns above that amount. Under the existing defined benefit system, all returns above the anticipated rate of 7.75 percent are banked by the system to help make up for periods of lower returns. The state will also face additional costs because of the expected increase in employee turnover under a cash balance plan. Cash balance plans don’t reward long-term employees like traditional defined benefit plans, increasing the likelihood that workers will leave earlier in their careers. Greater employee churn and a less experienced workforce will mean more money spent on hiring, recruitment and training. 2 The cash balance plan is also said to reduce risk to the state. But as mentioned above, the design of the plan means that it shares investment risk differently, but not necessarily in a way that will reduce state costs. Traditional defined benefit pension plans are actually well-designed to take on investment risk and absorb fluctuations in the market. They only disburse a...

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