Politics & Government

Kentucky's underfunded pensions: Are bonds the answer?

Kentucky lawmakers are debating whether to borrow nearly $1 billion to plug a hole in the Kentucky Retirement Systems, which provides lifetime pensions to state and local government retirees.

The money would come from "pension obligation bonds" sold to the public, with the proceeds invested financially at KRS. At present, KRS is $12.3 billion short of what it expects to need in coming years to honor its pension obligations, to say nothing of its health insurance commitments. KRS hopes that investing extra money on Wall Street now will help cover the future shortfall.

However, even proponents of bonds say they're risky, not unlike taking out a loan to gamble that a stock tip will pay off. Other states, including Illinois, have gotten burned on pension obligation bonds when market returns fell short of their obligatory bond payments. And Kentucky's debt rating is negative with analysts because the state has borrowed so much money, ranking it as one of the worst-run states fiscally.

"It's the principle of taking on debt to pay more debt," said state Sen. Damon Thayer, R-Georgetown, co-chairman of a legislative task force studying the state pension system. "I'm not enamored of that approach."

But here's the kicker: Kentucky already is doing it.

With scant public notice, Gov. Steve Beshear and the legislature in 2010 ordered the state to begin issuing $888 million in 10-year pension obligation bonds to assist another ailing system, the Kentucky Teachers' Retirement System, which covers more than 110,000 active and retired schoolteachers. In part, the bonds are replenishing teacher pension funds that the state had redirected to pay for retiree health care.

The final bond in that series, for $152.4 million, will be issued next year. By Fiscal Year 2014, including interest and fees, the state's General Fund will pay nearly $125 million a year to retire the debt, or more than four times what it spends on the state parks.

Thayer's task force is now discussing whether to issue $780 million in pension bonds for KRS, the other major pension fund, an idea put on the table last month by consultants from the Pew Center on the States. That could roughly double the state's repayment obligation. Kentucky would be spending more to repay its pension bonds than it does on most of its state universities.

Critics say pension bonds would be a desperate Hail Mary pass by lawmakers who fumbled pensions for many years. The General Assembly repeatedly sweetened retirement benefits for public workers while failing to set aside enough money to keep the systems solvent, they say. Last year, despite knowing of the looming problem, the legislature contributed only 51 percent of the recommended sum to the pension fund for most state workers.

"Before you go borrowing money at whatever interest rate to try and shore up a system that's broken, why don't we identify what's broken and fix it? Meaningful pension reform must happen first," said Phil Moffett, a Louisville businessman and one-time Republican gubernatorial candidate.

Moffett is working with others in Louisville, including investments adviser Chris Tobe, a former KRS trustee, to oppose more pension bonds.

"People wouldn't borrow money for their own retirement investments," Moffett said. "They either save more money or they accept fewer benefits. The only reason it's palatable for our legislators to borrow money like this is because they won't have to pay it back if the stock market doesn't work out for them. They can just pass the bill onto taxpayers."

Behaving badly

Experts say few states do a worse job than Kentucky in managing public pensions.

"The notion that all public plans are in trouble is simply not correct. Before the two financial crises of the past decade, most plans were in reasonably good shape. And in the wake of the crises, plan finances have begun to stabilize," Alicia Munnell wrote in her new book State and Local Pensions: Now What? Munnell, an economist, is director of the Center for Retirement Research at Boston College.

"Sponsors of seriously underfunded plans, such as those in Illinois, Kentucky, Louisiana, New Mexico and Pennsylvania, have behaved badly. They either have failed to make their required contributions or used inaccurate assumptions so that their contribution requirements are not meaningful," Munnell wrote. "Pension funding is simply a story of fiscal discipline."

Kentucky's public pension systems markedly have withered.

The KRS fund for most state workers has $3.7 billion in assets and $11.1 billion in liabilities, making it only 33 percent funded. Experts say anything less than 80 percent is worrisome. KTRS, the teachers' fund, has $11.9 billion in assets and $24.3 billion in liabilities, making it 57 percent funded.

Even the legislative pension system is drooping. (Legislative pensions are separately managed and better funded; lawmakers have resisted calls to merge their pensions with those of other state employees.) The part-time lawmakers have boosted their retirement benefits in several ways, promising six-figure annual payouts to the luckier retirees among them. That helped shrink their funding level to 58 percent by 2011. Until a few years ago, the legislative pension system enjoyed a funding surplus.

Matter of timing

Faced with staggering pension deficits and no cash to spare in their budgets, state and local governments around the country have turned to pension bonds — with mixed results.

In 2009, Lexington began issuing $137 million in bonds to shore up its underfunded police and fire pension system, with $34 million more in bonds budgeted for next year. Debt service is costing the city $10.8 million a year, though the expense so far has been manageable.

On the other hand, Illinois sold many billions of dollars in pension bonds over the past decade, losing much of the proceeds in the 2008 stock market crash, so it's now in worse shape than it started. The state must pay $1.6 billion, or 5 percent of its annual budget, just for the interest owed on pension bonds, according to the Illinois Civic Federation, a nonpartisan analyst of public spending in that state.

In California, auditors say the city of Oakland lost $250 million from a 1997 pension bond when its subsequent investments failed to pay as much as it owed on the bonds. Nearby, the city of Stockton filed for bankruptcy this year, blaming in part its debts owed on pension bonds that didn't work out.

Pension obligation bonds "have the potential to be useful tools in the hands of the right governments at the right time. Issuing a POB may allow well-heeled governments to gamble on the spread between interest rate costs and asset returns or to avoid raising taxes during a recession," Boston College's Center for Retirement Research wrote in a 2010 study.

"Unfortunately, most often POB issuers are fiscally stressed and in a poor position to shoulder the investment risk. As such, most POBs appear to be issued by the wrong governments at the wrong time," the researchers wrote.

Kentucky could win by acting now, state officials say. Interest rates are at historic lows, making it cheap to borrow, and the stock market seems to be recovering from the recession.

"I'm not ordinarily a fan of pension obligation bonds, but I think they're a smart move in this case," said Gary Harbin, executive secretary of KTRS, the teachers' retirement system.

The two bonds issued so far for KTRS promise interest rates in the range of 3 to 4 percent, and their proceeds are earning returns at 12 percent, Harbin said.

"Whenever you borrow money to invest, your timing has to be right or else you're just doubling down on your debt," Harbin said. "We were fortunate to get out of the gate at just the right time."

Falling short

Pension system 2011 assets 2011 liabilities Funding level
Kentucky Retirement Systems (funds for state, county, state police) $11.9 billion $24.3 billion 49%
Kentucky Teachers' Retirement System $14.9 billion $25.9 billion 57%
Judicial Retirement Fund $178 million $311 million 57%
Legislative Retirement Fund $38 million $66 million 58%
Source: Pew Center for the States
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