The Rebellion in Kentucky?
Last Thursday night, the Kentucky legislature passed a pension-reform bill that promises to gut teacher benefits. Poignantly for many teachers, the 291-page bill was surreptitiously included in a larger piece of legislation concerning sewage services. In response to the bill’s rushed passage, the state’s attorney general vowed to sue Gov. Matt Bevin should the governor sign the bill into law. The Kentucky Education Association labelled the process by which the bill was passed “shameful,” and called for the rally that saw thousands of teachers flood the capitol.Last October, I warned you that Kentucky lost its pension mind, and this tweet from Gov. Bevin confirms my worst fears:
All of this was the latest in what many educators view as a war on public education occurring nationwide. A successful strike by West Virginia teachers last month has inspired fervent organizing across the country. Ten days after West Virginia teachers agreed to a deal, Jersey City teachers struck, and now Arizona teachers are threatening to do the same. In Oklahoma, teachers began yesterday what may well be a full-blown strike. And on the same day, thousands of teachers in Kentucky rallied at the capitol in protest of the pension-reform bill and the possibility of cuts to public education that may come in the state-budget bill which will be unveiled this week.
While the Kentucky bill does not include some of the most odious proposed cuts — such as a reduction in cost-of-living allowances for teachers — it limits the impact of sick-leave benefits for retirement and introduces a system in which new hires will enter a “hybrid” pension plan, a change that will also affect many newly hired city, county, and state employees. Because public-school teachers in the state don’t receive Social Security benefits, changes to teachers’ pensions provoke widespread outrage.
“My three-and-a-half-year-old son was born just after I started my job,” said Byron Gary, one such employee who expects to lose the guaranteed pension return he was promised when he took his job in the air pollution control board in Louisville. He added that while he is concerned about his own retirement, he’s more worried about what the two-tiered system for teachers’ pensions will mean for his son’s teachers. “Any teachers he has won't have the same pension plan, so that might affect people's’ decisions of whether or not to take teaching jobs,” he said. “He might not have the same quality of teaching or if he does, his teachers will have to constantly worry about their own future. My concern is not just for myself, but for the future of the state.”
Kentucky has one of the most poorly funded pension systems in the country, a product of underperforming investments, persistent underfunding, and the use of hedge-fund investment managers by Kentucky Retirement Systems, the agency in charge of the fund. Teachers acknowledge the severity of the pension crisis, but disagree with how the legislature wants to close the gap in funding. Teachers who spoke with The Outline suggested closing corporate tax loopholes, legalizing marijuana, or otherwise taxing luxury services, many of which are stand untaxed in the state, Gov. Bevin’s preferred approach is demanding further austerity from the public sector. Despite sneaking the bill through without time for an actuarial analysis, even its cuts are estimated to provide only a few hundred million in funding, nowhere close to closing in on the state’s $41 billion shortfall.
Teachers in the state do not have much hope that Gov. Bevin will have a change of heart and not sign the pension-reform bill into law (following the bill’s passage on Thursday, Bevin tweeted that “Anyone who will receive a retirement check in the years ahead owes a deep debt of gratitude” to lawmakers who passed the measure). On Friday, thousands of teachers held a “sick out” in protest of the bill’s passage, causing twenty-six counties to shut down schools for the day, and on Monday they rallied at the capitol in hopes of pressuring their representatives to reject the most drastic cuts being proposed to the state’s budget.
The cuts of greatest concern to teachers include those to Family Resource and Youth Service Centers (FRYSCs), which was described to me as a sort of “social worker in the school” and a critical source of support, especially in high-poverty eastern Kentucky. The other is cuts to transportation which, beyond being a basic necessity for students, is used in cities like Louisville to bus students to schools which would otherwise be socioeconomically segregated. As a result of this bussing, Lousiville-Jefferson County ranks as one of the most integrated school districts in the country. Cuts to public universities are also on the table.
“FRYSCs are where we send backpacks of food home with children on Fridays so they can have food throughout the weekend,” said Dustin Robinson, a school counselor in Carter County. Although her school is on spring break this week, she said that teachers had delivered kids backpack meals on Easter Sunday to ensure those in need would have enough food to last them through the week off.
As was the case for last month’s strikers in West Virginia, Kentucky’s union history, particularly in the eastern part of the state that has long been home to coal mining, informed many of the teachers rallying to defend what they see as the future of their communities. “My dad was a United Mine Worker, and I grew up seeing him come home from the picket line, bullet holes in his truck and him in jail for fighting on the line,” said Nema Brewer, a Fayette County school-district employee and one of the co-founders of KY 120 UNITED, a Facebook group inspired by similar efforts in West Virginia. In a state in which just about everyone has a teacher in the family, this feeling of a united community defending what is often the sole remaining public space in town — the school — was not unique. “I’m a fourth-generation teacher, and that’s not that uncommon,” said Dustin Robinson “In eastern Kentucky, the school is the rallying point for the community. It’s where people host baby showers. The whole community revolves around the school, and the most well-respected people in the community are the teachers.”
This broad support for their actions is what Kentucky teachers, like their counterparts in West Virginia and Oklahoma, are relying upon as Gov. Bevin continues to vilify them (late last month, he said teachers were “selfish and sort-sighted” for not supporting his reforms). “They do understand what’s going on, and they do support us,” said Brewer in reference to the families affected by school closures.
Although the pension reform seems almost guaranteed to be signed into law, teachers aren’t defeated. They spoke of the dozens of educators running for office, many of whom are challenging legislators who voted in favor of the bill. As to what comes next, Brewer seemed unbowed. Acknowledging that “we’re likely to get our asses handed to us in the budget,” she said that teachers, in a way, had already won. “We've won because we didn't let ourselves be run over, we stood up for ourselves like Kentuckians do, and I hope people don’t forget that. Complacency is not an option.”
Tonight 49 members of the Kentucky House and 22 members of the Kentucky Senate voted not to keep kicking the pension problem down the road— Governor Matt Bevin (@GovMattBevin) March 30, 2018
Anyone who will receive a retirement check in the years ahead owes a deep debt of gratitude to these 71 men & women who did the right thing
It's clear the man is totally clueless about pensions and building a sound, sustainable retirement system which benefits everyone: teachers, the state, taxpayers, and most importantly, current and future students.
The rebellion in Kentucky is just the beginning. When the real pension storm strikes (never mind 2008, that was a walk in the park), I foresee a massive uprising from public-sector unions fed up with politicians looking to dismantle public pensions.
Teachers all over the US are fed up of being underpaid, overworked and now they're getting the pension shaft to add insult upon injury? No way, Jose.
Scores of public school teachers in Kentucky and Oklahoma braved chilly temperatures to demonstrate over school resources, pension changes. https://t.co/P5XoYTcFs5 pic.twitter.com/5sB9fCDsWa— ABC News (@ABC) April 3, 2018
I keep telling people if you want to understand where the world is headed, stop reading finance and economics textbooks, you need to read Hegel who believed in a kind of philosophical version of Newton's Third Law of Motion: for every action, there is an equal-and-opposite reaction.
One thing about teachers, they're very organized, very smart and if you mess with their pay and pensions, they will take you down, quite literally.
I mean it. Gov. Bevin's days are numbered, he will not survive this latest rebellion.
And the irony in all this? As teachers across Kentucky, Alabama, Arizona. Oklohoma and other states strike to protest lousy pay and cuts to their pensions, the fat cats on Wall Street are seeing their compensation soar as they squeeze public pensions dry to make Forbes' list of rich and famous.
The big squeeze is one of the reasons why so many chronically underfunded public pensions will never get back to fully-funded status.
There are a lot of reasons and I'm not going to say public-sector unions in the US aren't part of the problem. They most certainly are, demanding a high discount rate based on rosy investment assumptions so they don't have to pay more into their pensions and refusing to accept some form of risk-sharing (like conditional inflation protection) to shoulder the burden when their pensions are in trouble.
But state governments are equally at fault, failing to top up pensions in good and bad years, and failing to manage public-sector pensions properly by incorporating Canadian-style pension governance.
In an op-ed published by the Lexington Herald Leader, Olivia Gonzalez and Nolan Gray report, Ky.’s pension crisis isn’t just a funding problem — it’s a management one:
For years, Kentucky’s looming public-pension crisis has followed the five stages of grief.Now, I want to be very careful here, because while I agree with the authors that Kentucky's pension woes aren't only about funding, there are structural problems, I don't agree that indexing will be the cure-all they claim.
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.
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?
Importantly, indexing is an attractive strategy to implement, especially after a major crisis, but it's not the way to add value over the long run.
In Canada, large public pensions operate at arm's length from governments, they hire smart people to add value across public and private markets, and pay them properly to carry out these duties in-house, foregoing many fees and only using external managers when needed.
Also, indexing won't work in a bear market, that's a proven fact. The reason why you pay fees to external managers is to properly manage risks. We can debate whether public pensions should follow Japan’s GPIF and put the squeeze on fees to their external managers, but shifting exclusively to an indexing strategy is not a winning strategy over a long period because investment returns will be volatile and so will the funding costs.
And the problem now is that passive investing has gotten way too popular and poses risks in and of itself to the overall market as everyone piles into low-cost index funds (too much of a good thing can poison your portfolio).
Lastly, and quite disturbingly, John Cheves of the Herald-Leader reports, KY pension agency might join suit claiming deception in $1.5 billion hedge fund deals:
The Kentucky Retirement Systems Board of Trustees is debating whether to join a lawsuit that says the state’s pension agency was cheated on up to $1.5 billion in hedge fund investments by several wealthy corporations, with blame to be shared by some of its own current and former trustees and officials.Whether or not this suit goes the distance in court remains to be seen but there are some very serious allegations being made here and it certainly doesn't look good for the hedge fund and private equity moguls named in the suit or the former KRS board of trustees.
At stake is whether KRS can recover part of its estimated $27 billion pension shortfall from out-of-state billionaires rather than the state budget, which is being bled dry for pensions at the expense of schools, social services and other programs. KRS is responsible for providing pensions to about 365,000 past and present employees of state and local governments.
“There are only two known ways for KRS to avert the imminent collapse of its plans: a massive taxpayer bailout and/or the success of this lawsuit,” attorneys for plaintiffs in the case wrote in a court filing earlier this month.
A special subcommittee of the KRS board met in closed session Tuesday to discuss the suit.
“We have not yet made a decision,” said John Farris, KRS board chairman and president of Commonwealth Economics in Lexington.
“All of the actions discussed in the lawsuit happened before I joined the board and before most of the current members of the board joined,” Farris said. “So we’re having to go back and recreate a time-line and decide what the board was doing when it invested in these funds. So far, we’re looking at 37,000 pages of documents.”
The suit was filed Dec. 27 in Franklin Circuit Court by eight public employees whose pensions are held by KRS, organized by Michelle Ciccarelli Lerach, an experienced financial class-action litigator in San Diego. The plaintiffs — including a circuit court judge in Clark and Madison counties, a former assistant Jefferson County attorney and a retired Kentucky State Police captain — say they seek damages on behalf of public employees and state taxpayers.
The suit alleges that, starting in 2011, KKR & Co., Prisma Capital Partners, The Blackstone Group and Pacific Alternative Asset Management sold KRS hedge fund investments that were “extremely high-risk, secretive, opaque, high-fee and illiquid vehicles.” The hedge funds produced “excessive fees … poor returns and ultimately losses,” saddling Kentucky with a crippling debt that should be repaid by the hedge fund dealers and their owners, the suit alleges.
The “impenetrable spider web of fees” charged by the hedge fund dealers were impossible for any outsider to calculate, and deliberately so, the suit alleges. It cites a 2015 report from the nonprofit Roosevelt Institute in Hyde Park, N.Y., that found public pension systems pay an estimated 57 cents in fees to hedge fund managers for every dollar in net return.
And a report prepared for KRS by CEM Benchmarking found that its actual investment costs in 2014 were $126.6 million, or more than 100 percent higher than the $62.4 million it had publicly disclosed, the suit alleges. Most of this money was fees paid to investment managers.
The “hedge fund sellers … knew if the true nature and risks of these high-risk/high-fee vehicles were disclosed in the KRS annual reports, an uproar would have resulted and the unsuitable ‘investments’ could have been terminated, costing the hedge fund sellers millions and millions of dollars a year in fees. Hedge fund sellers let the deception continue because it served their selfish economic purposes,” the suit alleges.
Among the 30 defendants named in the suit are the hedge fund dealers that sold investments to KRS and some of the nation’s wealthiest investors, including Henry Kravis, co-founder of KKR & Co., and Stephen Schwarzman, chairman and chief executive office of The Blackstone Group. The estimated net worth of just those two men is about $15 billion. The suit also targets KRS’ fiduciary and actuarial advisers.
Meanwhile, the suit alleges, KRS trustees and officials with no expertise in complicated financial matters dithered as the pension system turned the $2 billion surplus it enjoyed in 2000 into its current state of near-insolvency. The largest pension fund for state workers today has just 13 percent of the money it’s expected to need to pay future benefits. The largest pension fund for local government employees is 53 percent funded.
For years, KRS knowingly kept in place an unrealistically optimistic set of assumptions about investment returns, government payroll growth and inflation that made the pension funds’ numbers look better than they should have, the suit alleges. And as the pension system lost billions of dollars during one of the greatest extended bull markets in the nation’s history, KRS trustees and officials made desperate bets on hedge funds while they claimed in public statements that they were being cautious with taxpayers’ money, the suit alleges.
“Trustees, with the knowing assistance of all the other defendants, chose to cover up the true extent of the KRS financial/actuarial shortfalls and take longshot imprudent risks with KRS funds to try to catch up for the funds’ prior losses and deceptions,” the suit alleges. “They misled, misrepresented and obfuscated the true state of affairs inside KRS from at least 2009 forward.”
Focusing on those who allegedly had a direct hand at KRS in investment decisions, the suits’ defendants include current trustees William Cook and Vince Lang; former trustees Randy Overstreet, Timothy Longmeyer, Bobbie Henson, Thomas Elliott and Jennifer Elliott; former chief investment officers David Peden and T.J. Carlson, former executive director William Thielen; and former director of alternative investments Brent Aldridge.
The suit also alleges certain conflicts of interest in the hedge fund deals.
For example, Cook, who was appointed to the KRS board by Gov. Matt Bevin in June 2016, retired a year earlier as a senior portfolio manager at Prisma and continued to have a financial interest in the company and a “close personal” friendship with Prisma CEO Girish Reddy, the suit alleges.
While Cook was still at Prisma, the company created and sold the Daniel Boone Fund as an investment for KRS, the suit alleges. As the $500 million fund started to lose money, Cook and others helped arrange for a Prisma executive to work inside the KRS offices in Frankfort for two weeks every month, helping with the system’s investment portfolio, the suit alleges. In 2016, even as KRS began to pull out of other hedge funds, citing their weak performances, it put an additional $300 million into Prisma’s Daniel Boone Fund, the suit alleges.
KRS’ chief investment officer at the time was Peden, who worked at Prisma himself a decade earlier, the suit alleges. The suit quotes Peden as telling interviewers that bringing the Prisma executive into the KRS offices was “like having a free staff member.” Peden said Prisma offered KRS the use of its executive when it learned the pension system could not find a qualified candidate to help with its hedge fund investments, the suit alleges.
Neither Cook nor Peden returned calls seeking comment this week. Cook is still on the KRS Board of Trustees and serves on its investment committee, according to the KRS website.
The defendants have filed individual responses to the lawsuit denying wrongdoing and asking Judge Phillip Shepherd to dismiss the case. Among their defenses, the hedge fund dealers say the plaintiffs have shown no evidence that they misrepresented their products or committed any other bad acts. Current and former KRS trustees and officials cite sovereign immunity, the legal shield that generally covers people working in public service.
In his response, Cook called the conflict of interest allegations against him “without merit on their face.” Cook said he has recused himself from every KRS board decision involving Prisma because of his past employment at the company. He said he also recuses himself from any business involving KKR, which acquired Prisma in 2012. And when KRS made the decision in 2016 to invest an additional $300 million in Prisma’s Daniel Boone Fund, Cook said that was after he retired from Prisma and before he joined the KRS board, so he had no role in the deal from either end.
Not surprisingly, to avoid a public spectacle, hedge fund firms want to seal evidence up, much like Trump wants to do with Stormy Daniels.
Of course, Yves Smith of naked capitalism is lapping all this up as it fits into her cliche comments on how evil Blackstone, KKR and private equity funds and hedge funds are.
For his part, Ted Siedle likes the thought of jailing people for abusive hedge fund and private equity extortion rackets.
For me, all it does is confirm my belief that there is a serious governance issue impacting KRS and other US public pensions that quite honestly aren't being managed properly, leaving them open to abusive practices.
But in order to manage public pensions properly, you to need to hire qualified people and in order to do that, you need to get your compensation right. And that's never going to happen in the US where politicians use public pensions to dole out goodies to their Wall Street campaign contributors.
The system is corrupt. Period. And it's intentionally corrupt and nobody is doing a thing about it until it rots away and years of mismanagement fester and expose serious vulnerabilities.
It's time US public pensions ask some very important questions like who's taking care of pensioners and their needs, not just private equity and hedge funds on Wall Street.
Below, a couple of clips of Kentucky teachers rallying at the state capitol in Frankfort to protest last-minute changes to their pension system.
Like I said, you don't want to mess with teachers and their pensions. Gov. Bevin will have plenty of time to read Hegel when he's booted out of office.
For the rest of you looking to dismantle public pensions while enriching your ubber wealthy Wall Street campaign contributors, take note, this is coming to your state sooner than you think.
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