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
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
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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 at age 60 under the cash
balance plan, nearly four times as much as they would receive under the traditional plan.
Expected annual cash balance plan benefits for those who separate with 25 years of service and
annuitize their account balances would be $17,900, a quarter more than in the traditional plan.
However, those separating with 35 years of service can expect to receive annual benefits of
$29,200, only about three-fifths as much as they would receive under the traditional plan.
Nonetheless, most of those who end up faring worse in the cash balance will remain financially
secure in retirement, with Social Security and pension benefits replacing much of their preretirement earnings.
Who Wins and Who Loses under the New Cash Balance Plan?
Fifty-five percent of employees hired in 2014 who complete five or more years of service will
accumulate at least as much lifetime pension benefits in the new cash balance plan as they
would have accumulated in the traditional plan. Workers who separate from government
employment with less than 25 years of service and those hired at younger ages are most likely to
gain from the switch to the cash balance. Employees with 25 or more years of service and those
hired at older ages will generally fare worse under the cash balance plan than the traditional
plan. However, nearly three-quarters of vested employees who complete at least five years of
service leave Kentucky government employment before completing 25 years of service, and
three-fifths leave before completing 20 years of service.
More than a third of employees hired in 2014 who complete five or more years of service
would accumulate no pension benefits net of their own required contributions under the
traditional plan. All these employees will gain from the transition to the new cash balance plan,
with half accumulating at least $24,700 more in their cash balance accounts (net of their own
contributions) than they would have received from the traditional plan. However, about another
third of employees with at least five years of service would have received more than $50,000
worth of employer-financed retirement benefits over their lifetimes in the traditional plan, and
almost all of them will fare worse in the cash balance plan. Half of those with 30 or more years
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
v
of service who do worse under the cash balance plan than the traditional plan will lose more
than $180,000 in lifetime benefits.
The new cash balance plan will distribute benefits more equally over the workforce than the
traditional plan. Under the traditional plan, 90 percent of all employer-financed retirement
benefits would have gone to the 25 percent of employees receiving the most benefits. The
remaining 75 percent of the workforce would have received only 10 percent of all employerfinanced benefits. Under the cash balance plan, the top 25 percent will receive only 60 percent
of all benefits. Although the cash balance plan will award a disproportionate share of benefits to
those employees with the most years of service, the distribution will be less unequal than under
the traditional plan.
Conclusions
Kentucky’s new cash balance will provide more retirement security to more state and county
government employees than the traditional plan. Many employees receive few benefits from the
traditional plan. Those hired at age 25 must work 21 years before they are better off collecting
the traditional deferred retirement annuity than simply taking a refund on their contributions.
Traditional plan participants lose money when they take a refund because they receive only 2.5
percent interest on their contributions, much less than the plan actuaries assume will be earned
on plan assets. Thus, these shorter-term employees subsidize the traditional benefits received by
longer-term employees. The cash balance plan distributes benefits more equally across the
workforce, while ensuring that those employees who fare worse than in the traditional plan will
be able to live about as well in retirement as they did when they were working.
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How Will State and County Government Employees Fare
under Kentucky’s New Cash Balance Pension Plan?
On April 4, 2013, Governor Steve Beshear signed legislation overhauling the retirement system
for Kentucky’s state and county government employees. The reforms limited retirees’ cost-ofliving adjustments and required the state to contribute more to its pension funds, which in 2012
covered less than half the expected value of promised benefits. The legislation also replaced
Kentucky’s traditional pension plan with a new cash balance pension plan for general state and
county employees hired starting in 2014. Unlike traditional pension plans, which specify
retirement benefits as some percentage of final average salary for each year of completed
service, cash balance plans express benefits as an account balance that builds 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 workers earn 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. Benefit portability is especially valuable as the workforce
becomes increasingly mobile. In Kentucky, for example, fewer than 3 in 10 general state
government employees with at least five years of service in the state’s traditional pension plan
spend 25 or more years in state employment. Nonetheless, Kentucky’s shift to a cash balance
plan has generated controversy; critics argue that it undermines retirement security for longterm government workers and erodes the state’s ability to recruit high-quality workers, without
saving the state much money (Bailey 2013; Kentucky Public Pension Coalition 2013).
This report examines how state and county government employees in Kentucky will likely
fare under the state’s 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 instead joined the traditional plan that
covers employees hired between 2008 and 2013. Much of the analysis compares benefits for
typical employees earning average salaries over their careers who begin government
employment at particular ages and shows how benefits grow with additional years of service in
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
1
each plan. We focus on employees hired at age 25 but also consider outcomes for typical workers
hired at older ages.
The report also examines outcomes for the entire population of employees whom we project
will be hired in 2014, assuming that they continue to separate from government employment at
the same rate observed by plan actuaries in the recent past. Tabulations compute the share of
new hires who will accumulate at least as much lifetime pension benefits in the new cash
balance plan as they would have in the traditional plan and show how the proportion of winners
and losers varies by years of service, age when government employment began, and the lifetime
benefits they would have accumulated under the traditional plan. The technical appendix details
our methods.
The results indicate that state and county government employees hired at relatively young
ages who remain on the government payroll for no more than about 25 years will accumulate
more benefits in the cash balance plan than the traditional plan. However, many of those with
more years of service and those hired at older ages would accumulate more benefits in the
traditional plan. Overall, 55 percent of employees hired in 2014 who complete at least five years
of service will fare better in the cash balance plan. Compared with the traditional plan, the cash
balance plan will distribute benefits more evenly across the government workforce. More than a
third of employees who spend at least five years in government employment would get nothing
out of the traditional plan other than their own contributions. Most of these employees will
instead receive substantial benefits in the cash balance plan. Long-term employees who would
have received hundreds of thousands of dollars in employer-financed retirement benefits from
the traditional plan will get much less from the cash balance plan. Nonetheless, most of those
who end up faring worse in the cash balance will remain financially secure in retirement, with
Social Security and pension benefits replacing much of their pre-retirement earnings.
How Do the Two Plans Work?
General state and county workers hired before 2014 participate in traditional defined benefit
pension plans. State employees belong to the Kentucky Employees Retirement System (KERS),
and county employees belong to the County Employees Retirement System (CERS).1 Those in
nonhazardous positions hired on or after September 1, 2008, contribute 5 percent of their pay to
the pension plan each period, in return for a lifetime annuity when they retire that pays annual
benefits equal to a percentage of their average salary during their three highest-earning years
multiplied by their years of service. That percentage ranges from 1.1 to 2.0 percent, depending
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on how long they worked.2 Retirees may begin collecting full benefits at age 65 if they have
completed five or more years of service or as early as age 57 if the sum of their age and years of
service equals 87. Retirees with at least 10 years of service may collect early benefits at age 60,
but their annual benefits are permanently reduced 6.5 percent for each year they retire before
age 65. Employees who separate from state or county employment before retirement may either
leave their contributions in the plan and collect their annuity when they reach the retirement
age, or withdraw their contributions with 2.5 percent annual interest. Those who separate before
completing five years of service—the plans’ vesting requirements—are entitled only to their own
contributions with interest. Until the 2013 legislation, retirement benefits were raised 1.5
percent each year to offset increases in the cost of living, subject to legislative approval. These
cost-of-living adjustments were eliminated with the 2013 legislation, but they will be reinstated
once the retirement system’s funding status improves.
Beginning on January 1, 2014, newly hired general state and county workers enroll in a cash
balance pension plan. For those in nonhazardous positions, employees will contribute 5 percent
of pay each period to the plan while their employer contributes 4 percent. Employee accounts
will be pooled and professionally managed, but benefits will be expressed as individual account
balances. Accounts will earn at least 4 percent interest each year. Whenever average investment
returns over the past five years exceed 4 percent, accounts will be credited with 75 percent of
that excess. Employees can either withdraw their account balances when they separate from
state or county employment, or convert their balances into a lifetime annuity at or after the
plan’s retirement age. Balances left in the plan after the account holder separates earn only 4
percent interest each year, regardless of actual investment returns. Retirement benefits will not
be adjusted for changes in the cost of living.
How Much Will Retirees Receive?
Retirement benefits in the traditional plan rise sharply with years of service. Employees with
limited tenure receive few benefits, whereas those with long tenures receive substantial benefits
(figure 1). For example, employees hired at age 25 who quit after 15 years of service, earn
average salaries over their careers, and begin collecting retirement benefits at age 60 receive
annual payments of only $3,200 (measured in 2014 constant dollars). Those with 25 years of
service receive $14,300, while those with 35 years of service receive $47,900, a more than 200
percent retirement bonus for an additional 10 years of service.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
3
The traditional plan backloads payments late in employees’ careers because the benefit
formula directly ties payments to years of service and the formula multiplier increases as
employees work more (rising from 1.1 percent for those with fewer than 10 years of service to 2.0
percent for more than 30 years of service). Final average salary also generally increases with
tenure, 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 may begin receiving payments because the 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
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,
Figure 1. Annual Pension Benefit at Age 60 under
Kentucky's Pension Plans, by Years of Service
(constant 2014 dollars)
Traditional
$47,900
Cash balance, mean
Cash balance, 25th percentile
$33,200
Cash balance, 75th percentile
$29,200
$21,900
$23,700
$17,900
$15,300
$12,200
$14,300
$12,300
$7,400
$3,200
15
25
Years of service
35
Source: Authors' calculations based on KERS and CERS plan documents and actuarial reports.
Notes: Estimates are for employees in nonhazardous positions who are hired in 2014 at age 25 and earn the average salary
among plan participants for their age and years of service. The plan salary schedule is assumed to increase 1 percent a
year in real terms. Investment returns for the cash balance plan are randomly drawn from a distribution that generates
expected long-term annual returns of 7.62 percent. Future benefits are discounted at 7.62 percent a year. The annual
inflation rate is assumed to be 3.5 percent.
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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 at age 60 under the cash balance plan, nearly four
times as much as they would receive under the traditional plan. Expected annual cash balance
plan benefits for those who separate with 25 years of service and annuitize their account
balances would be $17,900, a quarter more than in the traditional plan. However, those
separating with 35 years of service can expect to receive annual benefits of $29,200, only threefifths as much as they would receive under the traditional plan.
Unlike benefits provided by the traditional plan that are set by the benefit formula, those
provided by the cash balance plan depend on uncertain investment returns. The mean cash
balance plan values reported in figure 1 indicate how much participants would receive on
average, but actual benefits would be higher if plan investments earned more than expected and
lower if plan investments earned less. Adopting the assumptions made by Kentucky’s plan
actuaries about the average investment return and the dispersion of returns around the average
value allow us to quantify this uncertainty.3 For example, there is a 25 percent chance that the
annual payment from the cash balance plan would exceed the 75th percentile of the distribution
of outcomes and a 25 percent chance that it would fall below the 25th percentile of the
distribution; both these values are reported in figure 1.
Under nearly all investment return scenarios, employees hired at age 25 who remain in
government employment for 15 years will receive substantially more benefits under the cash
balance plan than the traditional plan. There is a 75 percent chance that their annual cash
balance plan payments would reach at least $7,400, more than twice as much as their benefits
under the traditional plan, and a 25 percent chance that they would reach $15,300. Age-25 hires
separating after 25 years of service would receive at least as much under the cash balance plan
as the traditional plan under most investment return scenarios. For example, there is a 75
percent chance that the cash balance plan would pay benefits at age 60 equal to at least 86
percent of the corresponding traditional plan benefit, and a 25 percent chance that it would pay
at least 53 percent more than the traditional plan. Employees retiring with 35 years of
government service would receive much higher benefits in the traditional plan than the cash
balance plan under nearly all possible investment outcomes. For example, there is only a 25
percent chance that average-earning employees in the cash balance plan would receive annual
retirement benefits in excess of $33,200, about two-thirds of the traditional plan benefit.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
5
How Much Will Plan Participants Receive over Their
Lifetimes?
How employees fare under each plan depends on how many retirement benefits they receive
over their lifetimes, not in a single year. Figure 2 shows the expected value of lifetime retirement
benefits that employees hired at age 25 and earning average salaries throughout their careers
would receive in the traditional and cash balance plans and how much those lifetime benefits
increase with years of service. These benefits are financed by both the employer and employees.
Lifetime benefits in the traditional plan grow relatively slowly but steadily for the first 22
years of employment. Because the plan multiplier and salary are relatively low up to this point
and employees have to wait years to collect their benefits, employees who quit before completing
21 years of service would be better off taking a refund on their contributions (with 2.5 percent
Figure 2. Expected Value of Total Lifetime Pension Benefits
under Kentucky's Pension Plans, by Years of Service
(constant 2014 dollars)
$700,000
Traditional
$600,000
Cash balance,
75th percentile
$500,000
Cash balance,
expected value
$400,000
Cash balance,
25th percentile
$300,000
Cash balance,
guaranteed
minimum
$200,000
$100,000
$0
0
5
10
15
20
25
Years of service
30
35
40
Source: Authors' calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: Estimates are for employees in nonhazardous positions who are hired in 2014 at age 25 and earn the average
salary among plan participants for their age and years of service. The plan salary schedule is assumed to increase 1
percent a year in real terms. Investment returns for the cash balance plan are randomly drawn from a distribution that
generates expected long-term annual returns of 7.62 percent. Future benefits are discounted at 7.62 percent a year. The
annual inflation rate is assumed to be 3.5 percent.
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interest) than collecting a future retirement annuity. As a result, each year their future
retirement benefits grow only by their own required contributions and interest. Once they have
spent 21 years in the plan (at age 48), they have amassed enough years of service and are close
enough to retirement that the future retirement annuity is worth more than the refund of their
own contributions. Each additional year of service substantially boosts the lifetime value of the
retirement annuity. After 32 years of service, when 25-year-old hires are age 57 and may begin
collecting their pensions, lifetime retirement benefits are worth $553,000 (in 2014 constant
dollars), nearly 10 times what they were worth 10 years earlier. Lifetime benefits grow much
more slowly in later years because employees forfeit a year of pension benefits for each year they
remain at work, offsetting much of the increase in annual benefits that result from additional
years of service. Nonetheless, after 40 years of service lifetime benefits in the traditional plan are
worth more than $600,000.
Lifetime benefits grow more smoothly over the career in the cash balance plan than the
traditional plan. Lifetime cash balance plan benefits increase each year by employee and
employer contributions and investment returns earned on the account balance. Employees hired
at age 25 earning average wages throughout their careers can expect to accumulate about
$125,000 in their cash balance plan accounts after 20 years of service, nearly three times more
than the lifetime benefits they would accumulate in the traditional plan. After 25 years they
would accumulate about $186,000 in the cash balance account, on average, about three-fifths
more than the lifetime benefits in the traditional plan. Of course, cash balance accounts depend
on uncertain investment returns, and employees could end up with somewhat more or
somewhat less. But even in the very unlikely scenario that investment returns fell below 4
percent every year that the employee participated in the plan—so the cash balance account was
credited with the guaranteed minimum return of 4 percent each year—the account balance
would reach $84,000 after 20 years of service, about 50 percent more than the value of lifetime
benefits earned in the traditional plan.
Employees with more than 30 years of service would almost always accumulate more
lifetime benefits in the traditional plan than the cash balance plan. On average, the traditional
plan generates more lifetime benefits than the cash balance plan for age-25 hires with 28 or
more years of service. The difference is largest at 32 years of service, when lifetime benefits are
worth 82 percent (or $248,000) more in the traditional than the cash balance plan. (In the
worst possible investment return scenario, lifetime benefits at 32 years of service are worth
more than three times as much in the traditional plan as in the cash balance plan.) The lifetime
benefit gap narrows after 32 years of service. For workers with very long tenures, lifetime
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
7
benefits grow more slowly in the traditional plan and more rapidly in the cash balance plan as
investment returns accrue on ever-larger account balances. After 40 years of service the
expected value of the cash balance account reaches nearly $500,000.
Much of the lifetime retirement benefits that government employees accumulate come from
their own contributions. How much employees gain from their retirement plan depends on the
retirement benefits financed by the employer, since employees could set aside their own
contributions for retirement outside the employer’s plan. Figure 3 shows how the expected value
of lifetime retirement benefits net of employees’ required contributions grows over the career in
each plan for employees hired at age 25 and earning average salaries. Lifetime benefits financed
by Kentucky’s state and county governments are much lower than total lifetime benefits. The
government-financed portion of the average cash balance plan account is worth $129,000 after
34 years of service—about $200,000 less than the total account—and $174,000 after 40 years—
about $300,000 less than the total account. In the traditional plan, government-financed
lifetime benefits peak after 34 years of service at $374,000—close to $200,000 less than total
Figure 3. Expected Value of Lifetime Pension Benefits
Net of Employee Contributions under Kentucky's
Pension Plans, by Years of Service
(constant 2014 dollars)
$500,000
Traditional, expected value
Traditional, 25th and 75th percentiles
$400,000
Cash balance, expected value
Cash balance, 25th and 75th percentiles
$300,000
Cash balance, guaranteed minimum
$200,000
$100,000
$0
-$100,000
0
5
10
15
20
Years of service
25
30
35
40
Source: Authors' calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: The value of lifetime benefits excludes contributions from employees. Estimates are for employees in nonhazardous
positions who are hired in 2014 at age 25 and earn the average salary among plan participants for their age and years of
service. The plan salary schedule is assumed to increase 1 percent a year in real terms. Investment returns for the cash
balance plan are randomly drawn from a distribution that generates expected long-term annual returns of 7.62 percent.
Future benefits are discounted at 7.62 percent a year. The annual inflation rate is assumed to be 3.5 percent.
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lifetime benefits—and fall to $310,000 after 40 years of service. Net lifetime benefits from the
traditional plan fall late in the career because the employer-financed increment to annual
benefit payments that results from additional service years are insufficient to offset the fewer
benefit checks received by employees who remain at work after they are eligible to collect
benefits.
Note that the value of lifetime pension benefits in the traditional plan are less than employee
contributions until age-25 hires have spent 25 years in government employment. Employees
who separate with less than 21 years of service fare better by taking back their required
employee contributions with interest than leaving the contributions in the plan and collecting a
deferred retirement annuity. However, they lose money by participating in the traditional plan
because their contributions earn annual returns of only 2.5 percent, well below the actual return
assumed by the plan’s actuaries. Employees who contribute to the plan for at least 21 years but
less than 25 years do better by taking the deferred annuity, but they could have done even better
by opting out of the plan altogether and investing their contributions elsewhere. These
employees get nothing out of the traditional plan despite their many years of service. The
traditional plan forces them to subsidize longer-term employees who receive very large
retirement benefits.
To this point, the analysis has focused on employees hired at age 25, but many employees
are older when they join Kentucky’s state or county government payroll. Data from plan
actuaries (Cavanaugh Macdonald Consulting 2012b) show that 68 percent of vested employees
join state employment at age 30 or older, including 17 percent who begin at age 50 or older.
Older hires accumulate benefits in the traditional plan more quickly than younger hires because
they do not have to wait as long to qualify for payments. As a result, older hires do not have to
remain in government employment as long to accumulate more benefits in the traditional plan
than the cash balance plan. Those hired at age 40, for example, accumulate more lifetime
benefits in the traditional plan after 21 years of service, and those hired at age 50 accumulate
more after 12 years (figure 4). By comparison, age-30 hires need 27 years of service to fare better
in the traditional plan than the cash balance plan, and age-25 hires need 28 years of service.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
9
Figure 4. Minimum Years of Service for Which Kentucky
Employees Could Expect to Earn More Retirement
Benefits under the Traditional Plan than the Cash
Balance Plan, by Starting Age
30
28
27
24
21
17
12
20
25
30
35
Starting age
40
45
50
Source: Authors' calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: Estimates are for employees in nonhazardous positions who are hired in 2014 and earn the average salary
among plan participants for their age and years of service. The plan salary schedule is assumed to increase 1 percent a
year in real terms. Investment returns for the cash balance plan are randomly drawn from a distribution that
generates expected long-term annual returns of 7.62 percent. Future benefits are discounted at 7.62 percent a year.
The annual inflation rate is assumed to be 3.5 percent.
How Might Retirement Plans Affect Employee Recruitment
and Retention?
The change in lifetime retirement benefits from working an additional year can significantly
affect employee compensation. In addition to their salaries, Kentucky government employees
receive fringe benefits each year, including health insurance and the promise of additional
future pension benefits. Another year of service sometimes substantially increases the value of
lifetime pension benefits, boosting total compensation. Sharp spikes in the growth of lifetime
benefits can create strong incentives for employees to remain on the job until they realize those
rewards, even if the job is a poor match with their skills and they could be more productive
elsewhere. However, working an additional year after the plan’s retirement age can reduce
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lifetime pension benefits because workers forfeit a year of benefits for every year they remain on
the job, cutting total compensation and creating strong incentives to retire.
Figure 5 shows how the annual increment to the expected value of lifetime pension benefits
net of employee contributions changes over the career under the traditional and cash balance
plans, for employees hired at age 25 earning average salaries. The traditional plan reduces total
employee compensation each year until employees have completed 21 years of service.
Employees with less tenure are better off taking back their required plan contributions instead
of waiting for the deferred retirement annuity, but they still lose money because their refunded
contributions are credited with only 2.5 percent interest, much less than what their
contributions could have earned outside the plan.
In the years that immediately follow, however, the value of future pension benefits grows
rapidly in the traditional plan, significantly augmenting employee compensation. The growth in
Annual increment as percentage of current salary
Figure 5. Annual Increment to the Expected Value of
Lifetime Pension Benefits Net of Employee Contributions
under Kentucky's Pension Plans, by Years of Service
100%
80%
60%
40%
20%
Cash
balance
(mean)
0%
-20%
-40%
Traditional
-60%
0
5
10
15
20
25
Years of service
30
35
40
Source: Authors' calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: The value of lifetime benefits excludes contributions from employees. Estimates are for employees in
nonhazardous positions who are hired in 2014 at age 25 and earn the average salary among plan participants for their
age and years of service. The plan salary schedule is assumed to increase 1 percent a year in real terms. Investment
returns for the cash balance plan are randomly drawn from a distribution that generates expected long-term annual
returns of 7.62 percent. Future benefits are discounted at 7.62 percent a year. The annual inflation rate is assumed to
be 3.5 percent.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
11
future pension benefits from a year of service equals at least half of salary for 25-year-old hires
who have been employed by state and county governments between 27 and 32 years, peaking at
83 percent of salary at 30 years of service. However, remaining employed for more than 32 years
substantially lowers the value of lifetime benefits net of employee compensation, reducing the
total compensation paid to government employees. For example, the loss in future lifetime
benefits from working an additional year equals 25 percent of salary at 35 years of service, 35
percent of salary at 37 years, and 40 percent of salary at 40 years.
By contrast, the value of lifetime retirement benefits grows relatively smoothly over time in
the cash balance plan. Aside from the spike in benefits after five years of service when benefits
vest, the annual growth in retirement benefits rises gradually as a share of salary, increasing
from 5 percent at 6 years of service to 10 percent at 40 years of service.
The cash balance plan seems better positioned than the traditional plan to help state and
county governments meet their employee recruitment and retention goals. The traditional plan
offers little to younger workers who do not plan to stay with a single employer for their entire
careers and prefer the flexibility to accommodate family obligations and changing work
opportunities. The cash balance plan should be more appealing to these employees.
Additionally, the cash balance plan augments compensation for older workers instead of cutting
it, promoting work at older ages. This is an increasingly important goal as the nation’s
population ages and the availability of younger workers stagnates. Finally, the sharp spike in the
lifetime value of traditional retirement benefits around the time employees qualify to begin
collecting payments locks mid-career employees into their jobs even if they are not good fits.
The cash balance plan makes it easier for these employees to separate and work more
productively elsewhere.
Will Retirees Remain Financially Secure under the Cash
Balance Plan?
A key objective for any retirement plan is to promote financial security at older ages. A common
way of measuring retirement income security is to compare pre-retirement earnings to
retirement income. The larger the share of pre-retirement earnings that can be replaced in
retirement, the more financially secure retirees will be. Exactly what share of pre-retirement
earnings is necessary to maintain pre-retirement living standards is difficult to determine,
depending on such factors as homeownership and insurance coverage. Nonetheless, a 70
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The Urban Institute
percent replacement rate is often used as an adequacy rule of thumb, assuming that spending
declines in retirement, especially since retirees do not pay payroll taxes or save for retirement. 4
Figure 6 reports simulated replacement rates for Kentucky state and county government
workers in the traditional and cash balance plans. We consider retirement income only from
Social Security and the Kentucky pension plans, although many retirees derive income from
other types of savings. The calculations assume that employees are hired by the Kentucky state
or county governments at age 25 in 2014, earn average wages throughout their careers, and
retire and begin collecting Social Security and pension benefits at age 65. We consider five
different employment-history scenarios. One scenario assumes that employees remain in their
original jobs for the full 40 years. Other scenarios assume that they leave Kentucky government
employment before age 65 but are immediately reemployed elsewhere, where they receive the
exact same salary they would have received at their Kentucky government jobs and participate
Figure 6. Percentage of Pre-Retirement Earnings
Replaced by Social Security and Kentucky Pensions by Employment
History, Traditional (T) and Cash Balance (CB) Plans
Social Security
110%
Employer pension
100%
90%
80%
70%
73%
60%
40%
52%
51%
50%
36%
25%
43%
55%
55%
56%
29%
29%
29%
57%
30%
20%
10%
29%
29%
29%
29%
29%
29%
29%
0%
T
CB
Four 10-year jobs
T
CB
Two 20-year jobs
T
CB
One 15-year job,
one 25-year job
T
CB
One 10-year job,
one 30-year job
T
CB
One 40-year job
Source: Authors' calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: Estimates are for employees in nonhazardous positions who begin state and county employment in 2014 at age
25 and earn the average wage among plan participants for their age and years of service. After each employment spell
they are assumed to begin a new job with the same salary schedule and retirement benefits. In all cases, then,
employees work for 40 years and receive the same salaries. They collect their pension and Social Security benefits at
age 65. The analysis compares Social Security and pension income at age 65 to average annual earnings received at ages
60 to 64. Investment returns for the cash balance plan are randomly drawn from a distribution that generates expected
long-term annual returns of 7.62 percent. Future benefits are discounted at 7.62 percent a year. The annual inflation
rate is assumed to be 3.5 percent.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
13
in retirement plans identical to the one offered by Kentucky. In all scenarios, then, employees
receive the same salaries and are covered by retirement plans with the same terms for 40 years.
The scenarios differ only by time spent in a single plan.
Social Security provides an important base of retirement income for Kentucky’s publicsector retirees, but for our hypothetical workers it replaces only 29 percent of average annual
earnings received at ages 60 to 64. Social Security benefits would have been 15 percent higher if
our hypothetical workers began collecting at age 67—their full retirement age—instead of 65.
(Social Security replaces a larger share of earnings for retirees with shorter employment
histories and lower salaries, because it offers a higher replacement rate to those with relatively
low lifetime earnings.5)
The traditional plan provides much lower benefits to employees who hold a series of
pension-covered jobs than those who hold one long-term covered job. For example, the
traditional plan replaces only 25 percent of earnings received at ages 60 to 64 for retirees who
hold four 10-year jobs, and only 36 percent of earnings for retirees who hold two 20-year jobs.
Traditional pension plans, then, provide little financial security to retirees who spend no more
than 20 years with a single employer, even if they spend a full working life in covered
employment. Retirement security is more likely for retirees who spend 30 years in a single
traditional plan, which when combined with a 10-year spell in another traditional plan replaces
55 percent of their earnings. Combined with Social Security, these retirees are able to replace 84
percent of their pre-retirement earnings. Retirees who spend all 40 years with a single employer
replace 73 percent of their earnings through the traditional plan. Adding Social Security raises
their replacement rate to 102 percent.
Retirees who participate in cash balance plans for a full working life can expect financial
security in retirement, regardless of the number of jobs they hold. For example, the cash balance
plan replaces, on average, between 51 and 57 percent of pre-retirement earnings for those who
spend 40 years in covered employed, even if they hold multiple short-term jobs. These retirees
would be able to replace between 70 and 86 percent of their pre-retirement earnings through
Social Security and the cash balance plans. Although the relatively few retirees who spend 40
years with a single employer would fare better under the traditional plan than the cash balance
plan, the cash balance plan will provide adequate financial security to retirees who participate
for many years, regardless of how often they switch employers.6
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The Urban Institute
Who Wins and Who Loses under the New Cash Balance Plan?
Fifty-five percent of vested employees projected to be hired in 2014 will accumulate at least as
many lifetime pension benefits in the new cash balance plan as they would have accumulated in
the traditional plan (table 1). Workers who separate from government employment with fewer
years of service and those hired at younger ages are most likely to gain from the switch. For
example, 84 percent of those who complete five to nine years of service will fare at least as well
in the cash balance plan, as will 69 percent of those with 10 to 14 years of service, 66 percent of
those with 15 to 19 years of service, and 52 percent of those with 20 to 24 years of service. Nearly
three-quarters of vested employees (72 percent) leave Kentucky government employment before
completing 25 years of service, and three-fifths leave before completing 20 years of service.
Employees with 25 or more years of service and those hired at older ages will generally fare
worse under the cash balance plan than the traditional plan. For example, 82 percent of
employees with 25 to 29 years of service, 96 percent of employees with 30 to 34 years of service,
and 85 percent of employees with 35 or more years of service would have earned more pension
benefits in the traditional plan.
Half of vested employees hired in 2014 will receive at least $5,800 more retirement benefits
over their lifetimes (measured in constant 2014 dollars) in the cash balance plan than they
would have received in the traditional plan. The median gain in lifetime benefits among those
who will fare better in the cash balance plan is $19,500, and the median loss in lifetime benefits
among those who will fare worse is $65,600. More than a third (36 percent) of vested employees
hired in 2014 would accumulate no pension benefits net of their own required contributions
under the traditional plan. All these employees will gain from the transition to the new cash
balance plan; half accumulate at least $24,700 more in their cash balance accounts, net of their
own contributions, than they would have received from the traditional plan. Another 14 percent
of vested employees would have received some employer-financed pension benefits in the
traditional plan but no more than $15,000 over their lifetimes; 87 percent of them will
accumulate more in the cash balance plan. However, 36 percent of vested employees would have
received more than $50,000 worth of employer-financed retirement benefits over their lifetimes
in the traditional plan, and almost all of them will fare worse in the cash balance plan. Among
this retiree group, the median loss exceeds $100,000. Among those who complete 30 or more
years of service and do worse under the cash balance plan than the traditional plan, half will lose
more than $180,000 in lifetime benefits.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
15
Table 1. Change in Lifetime Value of Expected Pension Benefits when Switching from Kentucky's Traditional
Pension Plan to the Cash Balance Plan
All vested workers
Final years of service
5–9
10–14
15–19
20–24
25–29
30–34
35 or more
Vested
workers (%)
100
Those accumulating
at least as many
benefits under the
cash balance plan (%)
55
Median Change in Expected Lifetime Benefits, Net of Employee
Contributions ($2014)
All vested
Those doing at least as well Those doing worse under
workers
under the cash balance plan
the cash balance plan
5,800
19,500
-65,600
28
18
14
12
10
8
10
84
69
66
52
18
4
15
9,500
20,900
31,100
4,300
-89,500
-184,600
-161,800
10,600
26,900
46,000
56,700
41,300
51,600
89,200
-3,000
-12,200
-21,000
-46,300
-106,500
-188,400
-184,300
Starting age
Younger than 25
25–29
30–34
35–39
40–49
50 and older
13
19
19
13
19
17
69
64
59
55
49
37
13,700
12,800
10,800
9,200
-1,700
-2,500
26,200
29,500
29,400
23,700
14,000
4,600
-188,600
-190,100
-169,200
-102,900
-34,600
-7,100
Value of lifetime benefits net of
employee contributions under
the traditional plan
Negative or zero
$1–$15,000
$15,001–$50,000
More than $50,000
36
14
14
36
100
87
39
6
24,700
9,100
-2,800
-99,000
24,700
10,700
14,200
18,200
N/A
-1,800
-7,100
-109,200
Source: Authors’ calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: Estimates are for the cohort of employees in nonhazardous positions expected to join the state and county payroll in 2014 and remain employed for at
least five years, assuming they separate from state and county employment at the same rate as employees have in the recent past. Employees earn the average
salary among plan participants for their age and years of service. The plan salary schedule is assumed to increase 1 percent a year in real terms. Investment
returns for the cash balance plan are randomly drawn from a distribution that generates expected long-term annual returns of 7.62 percent. Future benefits are
discounted at 7.62 percent a year. The annual inflation rate is assumed to be 3.5 percent. All financial amounts are expressed in constant 2014 dollars.
16
The Urban Institute
Many employees who would have accumulated some retirement benefits net of their own
contributions in the traditional plan will receive significantly less in the cash balance plan. Just
over half of this group will lose more than 25 percent of their retirement benefits, and nearly a
third will lose more than 50 percent (table 2). About half of those who would have received more
than $50,000 worth of employer-financed traditional retirement benefits will receive less than
50 percent as much in the cash balance plan. However, about three-quarters of those employees
who would have received no more than $15,000 worth of traditional benefits net of their own
contributions will receive at least 50 percent more in the cash balance plan.
The new cash balance plan will distribute benefits more equally over the workforce than the
traditional plan. Under the traditional plan, 90 percent of all employer-financed retirement
benefits would go to the 25 percent of vested employees receiving the most benefits (figure 7).
The remaining 75 percent of the vested workforce would receive only 10 percent of all employerfinanced benefits. The top 5 percent would receive 27 percent of all payments. Under the cash
balance plan, the top 25 percent will receive only 60 percent of all benefits, and the top 5 percent
will receive 19 percent. Although the cash balance plan will award a disproportionate share of
benefits to employees with the most years of service, the distribution will be less unequal than
under the traditional plan.
Table 2. Change in Expected Lifetime Benefits When Switching from Kentucky’s
Traditional Pension Plan to the Cash Balance Plan, among Workers Who Would
Accumulate Employer-Financed Benefits under the Traditional Plan (%)
Lose more than 50%
Lose 50% or less but more than 25%
Lose 25% or less but more than 10%
Lose 10% or less but gain less than 10%
Gain 10% or more but less than 50%
Gain 50% or more
Percentage of all workers
Value of Lifetime Pension Benefits Net of Employee Contributions
under the Traditional Plan
More than
All
$1–$15,000
$15,001–$50,000
$50,000
30
0
2
53
25
2
30
32
9
6
20
7
7
8
15
4
7
11
13
3
21
72
20
1
65
14
14
36
Source: Authors’ calculations based on KERS plan documents and actuarial reports.
Notes: Estimates are for the cohort of employees in nonhazardous positions expected to join the state and county
payroll in 2014 and remain employed for at least five years, assuming they separate from state and county
employment at the same rate as employees have in the recent past. Employees earn the average salary among plan
participants for their age and years of service. The plan salary schedule is assumed to increase 1 percent a year in
real terms. Investment returns for the cash balance plan are randomly drawn from a distribution that generates
expected long-term annual returns of 7.62 percent. Future benefits are discounted at 7.62 percent a year. The
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
17
Figure 7. Percentage of Employer-Financed Pension Benefits Going to
the Plan Participants with the Highest
Lifetime Benefits under Kentucky's Pension Plans
90%
Traditional
Cash balance
60%
49%
32%
27%
19%
Top 25%
Top 10%
Top 5%
Participants with the highest lifetime benefits, net of employee contributions
Source: Authors' calculations, based on KERS and CERS plan documents and actuarial reports.
Notes: The value of lifetime benefits excludes contributions from employees. Estimates are for the cohort of employees
in nonhazardous positions expected to join state and county employment in 2014 and remain employed for at least five
years, assuming they separate from state and county employment at the same rate as employees have in the recent past.
Employees earn the average salary among plan participants for their age and years of service. The plan salary schedule is
assumed to increase 1 percent a year in real terms. Investment returns for the cash balance plan are randomly drawn
from a distribution that generates expected long-term annual returns of 7.62 percent. Future benefits are discounted at
7.62 percent a year. The annual inflation rate is assumed to be 3.5 percent.
annual inflation rate is assumed to be 3.5 percent. All financial amounts are expressed in constant 2014 dollars.
Columns do not always total 100 because of rounding.
Conclusions
The majority of Kentucky’s state and county employees will fare at least as well in the state’s new
cash balance pension plan as in the traditional pension plan that covers employees hired
between 2008 and 2013. The cash balance plan will provide at least as many lifetime benefits as
the traditional plan to 55 percent of vested employees. Employees with limited years of service
will gain the most from the new plan, but even most of those with as much as 20 to 24 years of
service will fare better.
Most employees who complete more than 25 years of service and many of those hired at
older ages would accumulate more benefits in the traditional plan. Pension losses for some
workers will be substantial. For example, those who complete 30 or more years of service will
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The Urban Institute
receive about $180,000 less in the cash balance plan than in the traditional plan. Nonetheless,
the new cash balance plan will continue to provide financial security in old age to these
employees. Bear in mind that long-term employees make up a relatively small share of the
public workforce, though their experiences often dominate discussions of retirement security.
Only 28 percent of Kentucky state employees with five or more years of service remain in
government employment for 25 or more years.
Many state and county government employees receive little retirement security from the
traditional plan. More than a third of vested employees get nothing from the plan other than
their own required contributions plus interest. Employees hired at age 25 must work 21 years
before they are better off collecting the deferred retirement annuity than simply taking a refund
on their contributions. Traditional plan participants lose money when they take a refund
because they receive only 2.5 percent interest on their contributions, much less than the plan
actuaries assume will be earned on plan assets. Thus, these shorter-term employees subsidize
the traditional benefits received by longer-term employees. The cash balance plan distributes
benefits more equally across the vested workforce. Half of vested employees who would receive
no employer-financed benefits from the traditional plan will gain at least $24,700 from the plan
change.
The new cash balance plan is better suited to the 21st century labor force. Traditional plans
that provided generous benefits to employees with 30 or more years of service but little to
anyone else might have once been appropriate when workers changed jobs less often. Plans that
penalized work at older ages might have made sense when employers were eager to hire young
baby boomers surging into the labor force. Today, however, it is hard to justify these plan
structures. As the labor force becomes more mobile, plans must offer benefits to shorter-term
employees in order to attract recruits. As the workforce ages, it is becoming increasingly
important that plans reward work at older ages instead of encourage employees to retire early,
especially as younger workers become relatively scarce. Kentucky’s new cash balance plan
promotes the state’s recruitment and retention goals while providing more workers with
retirement security than the traditional plan once offered to state and county workers.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
19
Technical Appendix
Our analysis compares outcomes under the traditional plan that covers general state and county
employees in nonhazardous positions hired between 2008 and 2013 and the cash balance plan
that covers their counterparts hired after 2013. We calculate the retirement benefit that
employees hired in 2014 will earn in the new cash balance plan and the benefit they would have
earned if they had instead joined the traditional plan. In all cases we assume that retirees receive
their traditional plan benefits as single life annuities, forgoing survivor benefits for any spouses.
Except as noted, the computations use the plan actuaries’ assumptions on macroeconomic
conditions, plan performance, and employee behavior (Cavanaugh Macdonald Consulting
2012b). For example, we assume an annual inflation rate of 3.5 percent and annual long-term
nominal investment returns on plan assets of 7.62 percent. All financial amounts are expressed
in constant 2014 dollars.
Outcomes under the cash balance plan are uncertain, depending on variable investment
returns. We account for this uncertainty by simulating benefits under 1,000 different
investment return scenarios and examining how outcomes vary under those alternative returns.
The random investment return for each scenario is drawn from a normal distribution with a
mean of 8.25 percent and standard deviation of 12.14 percent, which generates an expected
long-term annual return of 7.62 percent. Under this distribution of investment returns, expected
employer costs for the cash balance plan equal expected costs for the traditional plan. We report
the mean value from the full distribution of cash balance plan outcomes, which indicates how
much employees can expect to receive from the plan. We also report values at the 25th and 75th
percentiles of the distribution of benefit outcomes. There is a 25 percent chance that cash
balance plan benefits will fall below the 25th percentile of the distribution and a 75 percent
chance that they will fall below the 75th percentile. (Alternatively, there is a 75 percent chance
that cash balance plan benefits will exceed the 25th percentile of the distribution and a 25
percent chance that they will exceed the 75th percentile.)
The report compares the annual and expected lifetime benefits under each plan for workers
who earn average salaries over their careers given their years of service and starting ages.
Average salaries are provided by the plan actuaries. However, because much of our analysis
shows how accumulated benefits grow as years of service increase, we adjust the actuaries’
salary estimates so they better reflect experiences over time for long-term employees. We cap
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The Urban Institute
annual nominal salary growth at 7 percent for employees with between 11 and 29 years of
service, and we set annual nominal salary growth at 3 percent for employees with 30 or more
years of service. Thus, salaries are assumed to grow more slowly than inflation near the end of
employees’ careers. These adjustments eliminate discontinuities in employees’ salary histories.
Appendix table A1 reports the career salary history that enters our computations for an
employee hired in 2014 at age 25.
Appendix Table A1. Assumed Annual Earnings for Kentucky State and County
Employees ($)
Age
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
Nominal earnings
27,204
30,363
33,751
37,382
41,272
45,437
49,892
54,657
58,757
63,115
67,533
72,260
77,319
82,731
88,498
94,616
101,105
107,988
113,909
120,145
126,711
Earnings in
constant 2014
dollars
27,204
29,336
31,507
33,717
35,966
38,257
40,588
42,960
44,621
46,309
47,875
49,494
51,168
52,898
54,672
56,475
58,308
60,171
61,324
62,494
63,681
Age
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
Nominal earnings
133,625
140,905
149,038
157,618
166,668
178,335
190,819
203,182
217,405
232,623
239,602
246,790
254,194
261,819
269,674
277,764
286,097
294,680
303,521
312,626
Earnings in
constant 2014
dollars
64,885
66,106
67,557
69,030
70,525
72,910
75,376
77,545
80,168
82,879
82,478
82,080
81,683
81,289
80,896
80,505
80,116
79,729
79,344
78,961
Source: Authors’ estimates from KERS actuarial reports.
Notes: Estimates are for employees in nonhazardous positions who begin employment in 2014 at age 25 and earn
the average wage among plan participants for their age and years of service. The plan salary schedule is assumed to
increase 1 percent a year in real terms, and the annual inflation rate is assumed to be 3.5 percent.
Annual benefits under the traditional plan are based on the benefit formula. Because we are
estimating retirement benefits for employees hired in 2014, most of whom will not retire for
decades, we assume that the plan’s 1.5 percent cost-of-living adjustment will be reinstated
before employees begin collecting benefits. When computing annual benefits under the cash
balance plan, we assume that employees who serve until retirement age convert their account
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
21
balances into actuarially fair lifetime annuities offered by the state. Annual payments from those
state-provided annuities are computed using a nominal long-term interest rate of 7.62 percent—
the assumed plan return on assets—and survival probabilities from a unisex life table compiled
by the Social Security Administration’s Office of the Chief Actuary. To facilitate comparisons
with the annual benefits provided by the traditional plan, we assume that the cash balance
annuity provides payments that increase 1.5 percent a year instead of equal benefits every year.
Cash balance participants who separate before retirement may either withdraw their funds
or leave them in the plan, and we assume that job separators choose the option that generates
the largest lifetime stream of retirement benefits. Funds left in the plan earn 4 percent annual
returns until the retirement age, when they are converted into actuarially fair annuities as
described above. Funds withdrawn from the plan earn market investment returns until
retirement, when they are converted into annuities sold by private insurance companies.7 Those
annuities, however, provide less generous annual payments than actuarially fair annuities
provided by the state because those who purchase annuities tend to live longer than average. 8
Additionally, private insurers invest in long-term bonds that earn less than riskier equities, face
higher administrative costs, and must reap a profit on their policies. We assume that the lifetime
value of payments provided by private annuities equals only 78 percent of the value of payments
provided by actuarially fair annuities, consistent with recent evidence on the private annuity
market (Poterba and Warshawsky 2000). These annuity calculations use a nominal interest rate
of 6.2 percent.9
The value of lifetime benefits under the cash balance plan is simply the account balance that
has accumulated by the time workers separate from government employment. We compute
lifetime benefits in the traditional plan as the expected present value of the future stream of
retirement benefits. We sum annual benefits that will be collected from the benefit take-up age
until age 120—the assumed maximum lifespan—but discount future benefits by our assumed
long-term investment returns (7.62 percent) and the probability that retirees will die before
receiving their payments. Employees in the traditional plan may exchange their annuity
payments for a refund of their employee plan contributions, which earn interest at 2.5 percent
each year. We set the value of lifetime benefits equal to these accumulated employee
contributions if that option is worth more than the annuity payments.
We also compute the value of lifetime pension benefits net of employee contributions. This
calculation shows the value of the government’s contributions to the retirement plan. The net
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The Urban Institute
value of lifetime pension benefits is computed as the gross amount minus the value of employee
contributions. Because the investment returns that could have been earned on employee
contributions if they had not been invested in pension plans are uncertain, we show for both the
traditional and cash balance plans the expected value of net lifetime pension benefits as well as
values at the 25th and 75th percentiles of the distribution.
Much of our analysis compares annual and lifetime pension benefits for prototypical
employees who begin government employment at particular ages and shows how much they
grow with additional years of service. We focus on employees hired at age 25 but also consider
outcomes for prototypical workers hired at older ages.
An important measure of retirement income security is how much pre-retirement earnings
retirees are able to replace once they withdraw from the labor force. We estimate this measure
by simulating Social Security income and pension benefits from each plan for prototypical
workers. The simulations assume that employees are hired by the Kentucky state or county
government at age 25 in 2014 and retire and begin collecting Social Security and pension
benefits at age 65. We assume that Social Security rules will not change over time, so retirees
receive only 86.7 percent of their full Social Security benefits (because they begin collecting at
age 62, three years before they reach Social Security’s full retirement age for those born in 1960
and later). One simulation assumes that employees remain in their original jobs for the full 40
years. Other simulations assume they leave Kentucky government employment before age 65
but immediately become reemployed elsewhere, where they receive the same salary they would
have received at their Kentucky government jobs and participate in retirement plans that are
identical to the one offered by Kentucky. In all scenarios, then, employees receive the same
salaries and are covered by retirement plans with the same terms for 40 years. The scenarios
differ only by time spent in a single plan. We examine four alternative scenarios: four 10-year
jobs, two 20-year jobs, one 15-year job followed by one 25-year job, and one 10-year job followed
by one 30-year job.
Retirement benefits are an important component of employee compensation. An additional
year of service sometimes substantially increases the value of lifetime pension benefits, boosting
total compensation. Sharp spikes in the growth of lifetime benefits can create strong incentives
for employees to remain on the job until they realize those rewards, even if the job is a poor
match with their skills and they could be more productive elsewhere. However, working an
additional year after the plan’s retirement age can reduce lifetime pension benefits because
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
23
workers forfeit a year of benefits for every year they remain on the job, cutting total
compensation and creating strong retirement incentives. We compare the workforce incentives
created by each plan by computing the annual increment to lifetime pension benefits as a share
of salary and showing how it varies over the career for prototypical workers.
The final analyses examine outcomes for the entire population of employees whom we
project will be hired in 2014. Appendix table A2 shows the distribution of 2014 hires by starting
age and final years of service, which we estimate based on data provided by the plan actuaries
(Cavanaugh Macdonald Consulting 2012b). The analysis does not incorporate any behavioral
responses by employees to the plan change. Instead, we assume that employees separate at the
same rate in the two plans. Employees projected to separate before completing five years of
service (when their benefits vest) and those projected to die or become disabled before leaving
government employment are excluded from the analysis. We compute the share of new hires
who would accumulate at least as many benefits under the cash balance plan as the traditional
plan and the median change in the lifetime value of expected pension benefits—net of employee
contributions—when switching from the traditional plan to the cash balance plan. We show how
outcomes vary by final years of salary, starting age, and the value of lifetime benefits that would
have been received in the traditional plan. We also compute the change in expected lifetime
pension benefits, net of employee contributions, as a share of net lifetime benefits that would
have been received in the traditional plan. Our final tabulation shows how the transition to the
cash balance plan will affect the distribution of plan benefits across the vested workforce. For
each plan we compute the share of total benefits going to plan participants in the top 25 percent
of the benefit distribution, the top 10 percent, and the top 5 percent.
Appendix Table A2. Projected Distribution of New Hires in 2014, by Starting Age
and Final Years of Service among Vested Employees (%)
Starting Age
Final years of service
5–9
10–14
15–19
20–24
25–29
30–34
35 or more
All
Younger
than 25
25
15
11
9
7
6
27
13
25–29
23
14
11
9
8
11
23
19
30–34
21
14
12
10
13
20
10
19
35–39
21
14
12
16
24
12
1
13
40–49
22
18
26
24
9
1
-19
50 and
older
56
33
10
1
---17
All
28
18
14
12
10
8
10
100
Source: Authors’ estimates from KERS actuarial reports.
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Notes
1.
In 2012, KERS had 42,479 active members and 42,479 retirees and beneficiaries; CERS had 92,182
active members and 52,182 retirees and beneficiaries (Cavanaugh Macdonald Consulting 2012a,
2012b). State police and public school teachers are covered by separate retirement systems.
2. The percentage factor is 1.1 percent for employees who separate with less than 10 years of service, 1.3
percent for those with between 10 and 20 years of service, 1.5 percent for those with more than 20 but
no more than 26 years of service, and 1.75 percent for those with more than 26 but no more than 30
years of service. For employees with more than 30 years of service, the factor is 1.75 percent on the
first 30 years and 2.0 percent on later years.
3. We assume that investment returns are randomly drawn from a normal distribution with a mean of
8.25 percent and a standard deviation of 12.14 percent, the same assumptions made by Kentucky’s
plan actuaries (Cavanaugh Macdonald Consulting 2012a). This distribution generates expected longterm annual returns of 7.62 percent.
4. See Scholz and Seshadri (2009) for a discussion of replacement rates.
5.
In 2001, the median new beneficiary received monthly Social Security benefits that replaced 42
percent of average indexed monthly earnings (Munnell and Soto 2005). Our estimate is lower because
our retirees have above-average lifetime earnings and we compare benefits to peak earnings, not the
lower lifetime measure typically used in replacement-rate estimates. Additionally, the full retirement
age is 67 for our retirees, compared with 65 or 65 and two months for those who first collected
benefits in 2001. The increase in the full retirement age effectively reduces Social Security benefits for
later generations of retirees.
6. Both the traditional and cash balance plans replace smaller shares of earnings when participants hold
their relatively short-term jobs at the end of their working lives instead of the beginning. For example,
in both plans the replacement rate falls 9 percentage points when participants hold a 30-year job
before a 10-year job instead of holding the 10-year job first. The traditional plan generates lower
benefits when the long-term job comes first because payments from the larger annuity are based on
earnings received between 11 and 15 years before retirement instead of between one and five years
before retirement. Cash balance plan participants receive lower benefits when the long-term job
comes first because they must then annuitize their larger account balances in the less-favorable
private market instead of through the state.
7.
We assume that investors can expect the same 7.62 percent long-term annual return outside the plan
that the state expects to earn on its assets.
8. People who expect to survive to advanced ages tend to value annuities more than those who expect to
die at relatively young ages because they will receive more annual payments. This adverse selection, as
it is known, requires insurers to lower annual annuity payments as the expected longevity of
policyholders rises in order to cover their costs.
9. Real annual returns on long-term government and corporate bonds averaged 2.7 percent between
1926 and 2013 (Morningstar 2014). With the Kentucky plan’s annual inflation assumption of 3.5
percent, this real rate corresponds to a nominal rate of 6.2 percent.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
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References
Bailey, Jason. 2013. “Cash Balance Plan Likely to Increase Costs, Impact the Quality of Public Services
and Reduce Retirement Security.” Berea: Kentucky Center for Economic Policy.
http://www.kypolicy.us/content/cash-balance-plan-likely-increase-costs-impact-quality-publicservices-and-reduce-retirement/.
Cavanaugh Macdonald Consulting. 2012a. “Report on the Annual Valuation of the County Employees
Retirement System.” Kennesaw, GA: Cavanaugh Macdonald Consulting.
https://kyret.ky.gov/Actuarial%20Valuations/2012-valuation.pdf.
––––––. 2012b. “Report on the Annual Valuation of the Kentucky Employees Retirement System.”
Kennesaw, GA: Cavanaugh Macdonald Consulting, LLC.
https://kyret.ky.gov/Actuarial%20Valuations/2012-valuation.pdf.
Kentucky Public Pension Coalition. 2013. “What the Kentucky Public Pensions Taskforce
Recommendations Mean for the State’s Public Employees and Retirees.” Louisville: Kentucky Public
Pension Coalition. http://www.publicpensioncoalitionky.org/wpcontent/uploads/2013/01/KPPC_TaskForceRecommendation_proof3-3.pdf.
Morningstar. 2014. 2014 Ibbotson SBBI Classic Yearbook: Market Results for Stocks, Bonds, Bills, and
Inflation 1926–2013. Chicago: Morningstar.
Munnell, Alicia H., and Mauricio Soto. 2005. “How Much Pre-Retirement Income Does Social Security
Replace?” Issue Brief 36. Chestnut Hill, MA: Center for Retirement Research at Boston College.
http://crr.bc.edu/wp-content/uploads/2005/11/ib_36.pdf.
Poterba, James M., and Mark Warshawsky. 2000. “The Costs of Annuitizing Retirement Payouts from
Individual Accounts.” In Administrative Aspects of Investment-Based Social Security Reform, edited
by John B. Shoven (173–206). Chicago: University of Chicago Press.
Scholz, John Karl, and Ananth Seshadri. 2009. “What Replacement Rates Should Households Use?”
MRRC Working Paper 2009-214. Ann Arbor: Michigan Retirement Research Center.
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About the Authors
Richard W. Johnson is a senior fellow in the Urban Institute’s Income and Benefits Policy
Center, where he directs the Program on Retirement Policy. He writes about economic security
at older ages, especially state and local pension plans, employment and retirement decisions,
and long-term care.
Benjamin G. Southgate is a research assistant in the Urban Institute’s Income and Benefits
Policy Center. His research focuses on older workers and state and local pension plans.
How Will State And County Government Employees Fare Under Kentucky’s New Cash Balance Pension Plan?
27
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