What we can learn from one mayor's pension reforms

Kentucky, home to arguably the most famous annual horse race on the planet, has produced a lot of remarkable turnaround stories over the years.

In May 2009, when the world was mired in a recession, a little-known contender called Mine That Bird had 50-1 odds to win the Kentucky Derby. In a competition that's earned its reputation as "the greatest two minutes in sports," the horse weaved past 18 other thoroughbreds to cross the finish line first.

A lesser-known dark-horse tale happened a couple of years later about 80 miles east of the derby grounds, still in Kentucky's equine country. Instead of a race, however, the odds were on whether Lexington's newly elected mayor would be able to bring the city's mismanaged pension system back from the brink of a crisis.

There was no such thing as a sure bet in this case. And yet the pension reforms that Mayor Jim Gray, a former construction company chief executive officer elected in 2010, has been able to achieve might serve as an example to other U.S. municipalities whose retirement systems are in deep debt.

The Federal Reserve estimates that public pensions in the U.S. are underfunded by about $1.6 trillion. Over the past several years, pensions have been battered by a stock market crash, a recession, and a wave of workers reaching retirement age.

In 2012, Lexington, which uses a joint city-county government system, had a $296 million unfunded liability to its police and firefighter pension plan. An unfunded liability refers to the difference between how much money a pension system needs to meet its obligations vs. how much cash it has on hand and what its invested assets may earn in the future.

For more than a decade the city repeatedly borrowed money to pay into the retirement system, a risky practice akin to using a credit card to pay off debts. The city had sold about $137 million in bonds between 2009 and 2012 for this purpose, financial documents show.

Gray, a 64-year-old who was elected the city's first openly gay mayor, shook things up in a lot of ways. Some were as minor as introducing an open-floor office plan at City Hall. Others were more far-reaching. In his first year the Democrat formed a task force of representatives from the city administration, police and fire unions, and members of the pension board. The city also hired the Philadelphia-based financial advisory company Public Financial Management Inc. as a consultant.

The deliberations between these parties resulted in a set of reforms that required shared sacrifice by both the city and the pension recipients - not an easy accomplishment. What's more, the city is now legally required to pay off its unfunded liability by 2043.

This wasn't the first time a local government had set its sights on fixing a beleaguered pension system. Lots of other municipalities have tried and failed. Illinois, which has the worst credit rating of any state, still owes an estimated $129 billion to its pension, and New Jersey is on the hook for about $115 billion in unfunded pension costs, according to its most recent estimate.

Lexington is one of the best examples of reforms actually working.

The reason public pensions got into this mess is because a lot of what could go wrong did go wrong. Lawmakers in many cases failed to set aside enough money for retirement systems, leaving plans underfunded. The recession caused public pension assets to decline by roughly $1 trillion from the second quarter of 2007 to the same time the following year, the Congressional Budget Office reported in 2008. Some plans have seen investments falter because of bad bets. In other cases, governments increased benefits to retirees without increasing funding. All the while, retirees are living longer, and government payrolls are starting to shrink. That leaves fewer public employees contributing to retirement plans for every retiree receiving benefits.

In 2011, Lexington reached a crisis point after the city had underfunded the police and fire pension for years even as it increased employee benefits. The city faced an $18 million budget deficit and was close to its self-imposed limit on how much more it could borrow to make pension payments. As the costs of maintaining the pension system grew to more than a fifth of the government's general-purpose spending fund, other city services were taking a hit, too. "All the numbers were draconian," Gray says.

Members of the mayor's pension task force set up shop on the 12th floor of the local government building, sometimes working late into the night or bringing their kids along to meetings. After months of negotiating among members of the task force, the group came to a compromise that would require an additional $9 million contribution each year from the city, increased payments into the plan from current employees, and the creation of a minimum retirement age of 41 for active workers. It also enacted new limits on employees' cost-of-living adjustments, which are changes in retirement benefits to account for inflation.

More noteworthy, the city cut cost-of-living adjustments for current retirees-a move almost unheard of in the public pension realm. Some states have protections for pensioners embedded in their constitutions. In 2015 the Illinois Supreme Court struck down a 2013 pension overhaul, saying it violated the state constitution's ban on reducing retirement benefits.

But in Lexington, police, firefighters, and retirees actually approved the plan by a 76 percent vote. Unions and employees were given a voice, and that made a huge difference, says Captain Chris Bartley, president of the local firefighters' union and a member of the task force.

"We had a seat at the table, unlike most people," he says. "That's why the plan works. There's sacrifice by all but to the benefit of the community, taxpayers, and police and firefighters." The police and fire pension was more than 77 percent funded as of July 2017, 11 percentage points higher than it was when Gray took office in 2011, according to the pension's latest actuarial report.

The political pressures to keep pensions intact are high: Governments often use the promise of a generous retirement as a way to recruit employees who could likely make more money in the private sector. "When you talk about issues like pensions, to employees they're not math problems," says Vijay Kapoor, who was a consultant at PFM, the company Lexington hired to help with reforms. "They really go to the heart of people's financial security."

At the time, there was no template for how Lexington might approach the overhaul, Kapoor says. He says he focused on acting as a referee between employee groups and local officials. "Cops and firefighters are very solution-focused," he says. "If you talk to a cop or firefighter, they say, 'I have to put the fires out' or 'I have to save the person.' They don't have time to be, like, 'On the one hand' or 'On the other hand.' Put them in a room and say, 'We've got a problem we've got to solve it together.' "

Kapoor now runs his own consulting company in Asheville, North Carolina, and after his stint in Lexington, he's since worked on pension reforms in Chattanooga and New Orleans using a similar approach. It wasn't always a "kumbaya" effort, he says, but groups working on pension reform ultimately came to an agreement.

In Chattanooga the police and fire pension was about half funded in 2013, after having been almost fully funded in 2000. The city came to an agreement with employees in 2014 that would require certain police officers and firefighters to contribute more of their pay into their retirement system and enacted new restrictions on cost-of-living adjustments.

Chattanooga Mayor Andy Berke, who started working on pension reform during his first year in office in 2013, has developed a wry sense of humor about the painful process: "I definitely want to do that again - that was really an enjoyable experience." Berke says there were uncomfortable weeks when he couldn't go to the grocery store without someone approaching him to ask why he was trying to hurt firefighters and police officers. "I promise you that didn't feel very good," he says. But by the time an agreement was reached, people would congratulate him for taking a stand for the city, he says.

Chattanooga also lowered the return assumptions for the pension plan's invested assets, which Berke says will help make meeting its funding targets more realistic. It also means the pension's funding status, which incorporates expectations for future returns, hasn't budged much in recent years: It was 57 percent in 2017. The pension doesn't have a target year for fully funding the plan yet, but the city is focused on getting the plan on the right track, says Katrina Abbott, fund administrator for the Chattanooga Fire & Police Pension Fund.

Some states have made an effort to rein in pension costs. Rhode Island lawmakers passed the Rhode Island Retirement Security Act of 2011, which increased the retirement age and suspended cost-of-living adjustments. State Treasurer Seth Magaziner says the reforms are saving the state and cities about $300 million per year, and he estimates that Rhode Island will be fully funding the pension by 2036. "The challenges facing public pensions systems in America did not arise overnight, and they're not going to be fixed overnight," he says. "The longer they wait to do something, the more painful it's going to be."

Other states haven't seen overhauls to pensions pay off at all. Former New Jersey Gov. Chris Christie oversaw several reforms to the state pension but failed to contribute the amount recommended by actuaries examining the retirement systems. New Jersey still ranks as one of the worst-funded systems in the country.

Alaska, Illinois, and other states whose constitutions protect pension benefits may have the hardest time digging themselves out of a debt hole, says Flick Fornia, president of Pension Trustee Advisors, a consulting company in Greenwood Village, Colorado, that has worked with retirement plans, governments, and labor groups. Most state pensions are protected by contracts, though the extent to which they're protected differs, according to the Center for Retirement Research at Boston College.

"If you haven't paid for something, it's hard to fix it by promising less in the future if you haven't paid for the past," Fornia says. Cities and states that do attempt reforms need to show there is shared sacrifice among all stakeholders involved or else it won't work, he says.

Politicians who make tough decisions-especially on touchy matters such as retirement benefits-rarely get rewarded. Lexington Mayor Gray is happy to be an exception. He says he hasn't been punished for the changes he's enacted in his city. One day, when he was going through airport security, he says, a retired firefighter thanked him for fixing the pension. Gray says it's a reaction he gets a lot now.

Voters gave Gray the OK on the changes, too, re-electing him as mayor in 2014, for his final term. This year he was looking to run for Congress, saying pension reform prepared him for prickly federal issues including Social Security reform and the opioid crisis. Gray lost the Democratic primary on May 22. Still, that doesn't take away what Lexington was able to achieve. "It was thorny and turbulent, and there was no clear road map for it," he says. "We really created and blazed that trail, but it was done with a lot of talented people. There was no 'me' in this."

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Adapted from Bloomberg Markets magazine.