The Kentucky state House approved legislation on Monday to allow the Kentucky Teacher Retirement System to issue $3.3 billion in bonds to prop up the most underfunded teachers’ pension plan in the country.
The next day, the Kentucky Retirement Systems released a study from its actuary that analyzes how a hypothetical $5 billion bond would buoy its Kentucky Employee Retirement System for non-hazardous state workers, which is currently the worst-funded public pension plan in the country.
It was the first time KRS has so publicly acknowledged an interest in borrowing billions to cover its increasing obligation shortage for the public pension program, which includes more than 123,000 state workers and retirees.
The debate over issuing pension obligation bonds (POBs) is growing around the country, as states and localities consider them as a way to bolster public pension systems that have a large and increasing unfunded liability. Proponents see the strategy as a low-risk option to prevent struggling plans from collapsing, as interest rates are at all-time lows and long-term investment returns are projected to be higher.
Opponents see the strategy as too risky, using new debt to pay off old debt with no guarantee that the economy will avoid another downturn, causing returns to miss expectations. The local governments of Detroit, Michigan and Stockton, Calif., faced such a scenario recently with their POBs and were forced into bankruptcy.
Unlike the teachers’ system, KRS officials have not publicly lobbied for such a bond from Kentucky’s General Assembly, even though the unfunded liability of its KERS plan for non-hazardous workers is much higher — with a 21 percent funding ratio of assets to liabilities. That makes it the worst of any public pension plan in the country.
But records from the KRS board of trustees show that over the past few months, KRS requested that the actuaries at Cavanaugh Macdonald analyze the impact of pension obligation bonds in the amounts of $1 billion, $2 billion and $5 billion on the unfunded liability of KERS over the next 30 years.
On Dec. 17, Cavanaugh Macdonald gave their projections to KRS for the $1 and $2 billion bonds, and despite their considerable amounts, they barely put a dent in the funding ratio of KERS. In the $1 billion scenario, the funding ratio of KERS would jump to 25 percent once issued in 2017 — still dangerously low for any public pension plan — but would not increase to more than 30 percent until 2031. Likewise, employer contributions to the plan — which have skyrocketed to more than 30 percent of salaries over the past decade — would remain in the low 30s for the next 20 years.
In the $2 billion scenario, the funding ratio of KERS increases to 33 percent in 2017, but does not increase to more than 40 percent — still dangerously low — until 2031, while employer contributions remain locked in at roughly 29 percent for the foreseeable future.
At the Tuesday KRS board meeting, Cavanaugh Macdonald’s projections of a 30-year $5 billion bond — a staggering amount for a plan the size of KERS — showed a much more significant effect. The funding ratio of KERS would jump to 58 percent in 2017, more than 70 percent by 2035, and the plan would be fully funded by 2043. The state’s employer contribution rate would fall from a projected 37 percent next year to 20 percent in 2017, slowly declining in each subsequent year, while the debt service payment would be $334 million each year.
In all three projections by the outside actuary, the funding ratio without any pension obligation bonds looks dire for KERS, continuing to drop to under 15 percent by 2022, and not eclipsing 20 percent again until 2030.
After the $5 billion Cavanaugh Macdonald projection was revealed at the KRS board meeting this week, Republican Floor Leader Jeff Hoover released a statement blasting the concept, noting that their investments in the last quarter were flat.
“We stated that the bonding of $3.3 billion for KTRS under House Bill 4 alone could break Kentucky’s budget, and may send us down the same road as Detroit and Stockton, California,” wrote Hoover. “The bill has essentially opened Pandora’s Box given the recommendation to KRS and if they soon come to us with a request for more money. If we attempt to bond both systems, it will lead to a financial ruin of our state’s finances and bonding capacity.”
But KRS executive director Bill Thielen tells Insider Louisville that neither KRS nor its actuary recommended such a bond. Rather, the projection was simply done to have a fuller understanding of the data and to see what its effect would be on the KERS plan.
“We simply wanted to see what the facts were,” said Thielen. “But our board is not asking for the issuance of that or any other amount of bonds at the present time. It’s good to have the data out there so people realize what could be done if it becomes realistic and as a matter of policy the General Assembly were to decide that somewhere down the road.”
Thielen agreed that the projections for the $1 and $2 billion bonds barely put a dent in the unfunded liability of KERS, which is why they requested an additional projection for a $5 billion bond. He said that the positive impact of the $5 billion POB is “dramatic,” just as the projection for KERS “in the next few years — even with 100 percent of the actuarially recommended contribution (ARC) being paid — is going to continue to drop in funding and funding status.”
Without bonding, Thielen said if KERS meets their assumptions, “it won’t run out of money, and it goes back up to the point where it’s fully funded way down the road.” However, those are merely assumptions, and a downturn in the economy could lead the plan to peril.
“That level of funding clearly illustrates that if you have a significant marketplace interruption where we don’t meet our actuarially assumed rate of return — like in 2008 and 2009, when we suffered losses to the asset base — then this fund can’t last very long,” Thielen said. “So it is a significant issue, and we currently have a negative cash flow situation. Now, paying 100 percent of the ARC will help that.”
Asked about the opinion of state legislators including Rep. Jim Wayne, D-Louisville, who suggest the state needs to begin paying more than 100 percent of the ARC to avoid a KERS free fall, Thielen said KRS would obviously welcome it. But he acknowledges the economic reality of the state’s shrinking budget. And he knows the General Assembly issuing such a large bond for the KERS plan in the near future is likely unrealistic for the same reasons, including the significant risk that it poses for the state if assumed investment returns of 7.5 percent do not come to fruition or exceed the 5 percent interest rate on the bonds.
“If we did not make that 7.5 percent, then you’re turned upside down,” Thielen said. “You have a hard debt that you have to pay on the bond debt service, and you still have to pay the ARC, which is increasing, because you’re not making your assumed rate of return. So it is risky.”
Thielen noted that Illinois faced this scenario after issuing $10 billion in bonds for its pension system a decade ago. In addition, the Government Finance Officers Association recently issued a white paper recommending that POBs not be used for public pension plans. However, a recent update of a study by Boston College’s Center for Retirement Research found that while most POBs were in the red in 2009, most are now in the black since the market has recovered post-recession — that is, with the exception of POBs issued just before the decline in the market in the early 2000s and 2008.
House Speaker Greg Stumbo, the lead sponsor of HB 4 to issue $3.3 billion in bonds for the teachers’ pension system, has said he would not approve of such bonds for KRS, as their investment returns have been worse than KTRS. Thielen acknowledged that has been true over the past five to 10 years, although their lower returns are a result of having less funding to invest, which he said is another reason the state must begin meeting its funding obligations.
Meanwhile, the state Senate passed legislation Friday that would cap the state’s debt at 6 percent of its general fund revenue, which would effectively prohibit either of the large KTRS or KRS bonds. Additionally, Gov. Steve Beshear recently told Bloomberg that while he’s “kind of open” to the KTRS bond proposal, he fears it may limit the state’s ability to borrow for other projects.
Last month, Standard & Poor’s reported that it may lower Kentucky’s AA- credit rating — one of the worst in the country — if the finances of KTRS do not improve.