The Kentucky General Assembly’s annual session starts Jan. 5 and runs through April 12.

Kentucky legislators are expected to consider issuing bonds among other strategies to shore up the state's pension burden next year, as they manage spending and attempt to protect the state's credit ratings.

The state faces funding requests of more than $2.2 billion in the next biennium just for the teacher's pension plan, according to a state panel overseeing the plan. Pension bonds should be considered to address the shortfall in teacher's benefits, the Kentucky Teachers' Retirement System Work Group appointed by former Gov. Steve Beshear said in its final report earlier this month.

"Pension obligation bonds may have a role to play, if the issuance of the bonds is part of a more comprehensive plan to address pension funding shortfalls," the group advised.

A top lawmaker said that he plans to file a bond bill in the upcoming session, although other legislators have cast doubt on the strategy.

Kentucky operates several pension plans for employees, teachers and others. Some reform measures have been enacted, though not for KTRS.

The state still has the second-lowest pension funding ratio of any state behind Illinois, and the third worst if Puerto Rico is included, according to Atlanta-based Asset Preservation Advisors, which specializes in managing municipal bond portfolios.

The state's overall pension funding ratios for its plans have dropped steadily over the past decade, to 44.94% from 82.2% , APA said in a June white paper called "Kentucky: The Next Illinois?

The state's actuarial accrued pension liability was $43.6 billion in fiscal 2014, up from $25.7 billion in 2005, APA said, recommending that investors remain "highly selective" when purchasing Kentucky's bonds.

In November, Moody's Investors Service said only Illinois and Connecticut had relative adjusted net pension burdens that were greater than Kentucky's, whose liability as a percent of revenue was 193%, based on fiscal 2013 figures.

As the General Assembly's session begins on Jan. 5, a great deal of focus is expected to center on the KTRS, the worst-funded of the state's plans.

Gov. Matt Bevin, a Republican who took office on Dec. 8, has said he favors moving new employees and teachers into a 401(k)-type plan, though he hasn't detailed his plan to address unfunded liabilities. His office didn't respond to requests for comment.

Bevin also hasn't taken an official position on the plan by the KTRS Work Group, a panel of lawmakers and stakeholders appointed by Beshear to offer recommendations to keep the defined-benefit plan covering 48,576 retired members and 73,407 active members solvent.

The fact that current members aren't covered by social security and their benefits are protected by state law could complicate reform efforts.

Under new accounting guidelines, the teachers' plan has unfunded liabilities totaling $24.4 billion for a funded ratio of 42.5%.

State officials have studied pension funding a number of years, and enacted reforms for other state benefit plans that also have funding shortfalls.

A solution for the teachers' benefit plan remains elusive.

The KTRS Work Group said it could not reach a consensus around specific solutions, suggesting a series of actions resembling policy guidelines for lawmakers to consider.

However, the group recognized that doing nothing endangers the state's credit ratings further.

"The current underfunding of the Kentucky Teachers' Retirement System is negatively affecting the Commonwealth's credit and bond ratings," said the group's 18-page final report released Dec 4. "Lack of action to fund the system during the 2016 legislative session will do further harm to the Commonwealth's credit and bond ratings."

Standard & Poor's already cut the state's issuer credit ratings to A-plus from AA-minus citing the state's lack of action.

"The downgrade reflects our view of Kentucky's substantially underfunded pension liabilities that are the result of chronic underfunding and that we view as placing long-term pressures on the state's finances," S&P analyst John A. Sugden said Sept. 3.

At the same time, S&P downgraded other state ratings, lowering the appropriation-backed debt and state-aid intercept programs for schools and universities to A from A-plus, while dropping ratings to A-minus from A on various lease debt issues.

Moody's Investors Service, which assigns the state an Aa2 issuer rating, warned on Nov. 9 that "continued lack of meaningful progress on reform in the legislative session starting January 2016 will weigh negatively on the state's credit quality."

Dealing with the funding burden is likely to be a challenge. The annual required contribution has not been fully funded for years, partly because of a statutory funding formula in which the state contributes a fixed rate of 13.1% each year based on teachers' payroll.

The formula doesn't prevent higher contributions from being made in line with the actuarially determined ARC, though the state hasn't provided additional funding above the fixed rate since 2009.

Putting KTRS on firmer footing over the upcoming biennium would require more than $2 billion from the state budget, according to Robert "Beau" Barnes, the pension system's deputy executive secretary of operations and general counsel.

In addition to fixed statutory payments of $369.6 million for fiscal 2016 and $405.4 million in 2018, another $730 million and $710 million would be necessary over the biennium to maintain the pension fund on an actuarially sound basis, he said.

"At this point, KTRS is seeking a commitment by the Commonwealth to fund the ARC, beginning with the upcoming budget that will be developed in the 2016 session," Barnes told The Bond Buyer on Monday. "There has been discussion of a four-year phase-in given the size of the additional funding needed."

The additional funding is needed to address the system's unfunded liabilities, which are greater under new reporting requirements of the Governmental Accounting Standards Board, according to a financial presentation Barnes gave to the Public Pension Oversight Board on Dec. 17.

Under GASB 67, pension plans must report assets and liabilities as of the fiscal year end to "reduce the lagged nature of reported funding progress," Moody's said in a report earlier this year.

KTRS' liabilities were $31.1 billion using traditional accounting standards based on the most recent actuarial valuation date, according to Barnes' presentation.

The unfunded liabilities totaled $13.9 billion, equaling a funded ratio of 55.3%.

The plan's liabilities rise to $42.47 billion and the shortfall increases to $24.4 billion for a funded ratio of 42.5% under the GASB 67 accounting method.

Pension obligation bonds may be considered as one way to address some of the shortfall.

Earlier this year, a bill sponsored by House Speaker Greg Stumbo, D- Prestonsburg, would have authorized the issuance of up to $3.3 billion in pension obligation bonds. The measure passed the House, although the financing was stripped out of the bill by the Senate, where it ultimately died.

Stumbo, who was a member of the KTRS Work Group, has said that he plans to propose another pension bond bill during the upcoming session.

"Last year's legislation provided for a bond of up to $3.3 billion to leave room for any necessary downward adjustments that may have been required due to changing interest rates, etc.," Barnes said. "If the bill is re-filed, I wouldn't be surprised if it contained some such similar language."

If the Legislature approved bond financing in the upcoming session, the strategy could cost the state more in borrowing costs with its credit ratings in doubt and the Federal Reserve raising its target for the federal funds rate by 25 basis points on Dec. 16.

"KTRS has not run projections to reflect current market conditions, but with the recent rate increase the cost of the bond would likely be greater," Barnes said.

Since the Fed's rate increase was modest, Municipal Market Analytics managing director Lisa Washburn said it probably won't affect most investment returns significantly.

Returns likely will be affected more as pension funds reduce their risk profile by lowering investment return expectations, she said.

Washburn also said her view about pension bonds has not changed since telling The Bond Buyer earlier this year that the strategy is not good for most issuers, especially those with "a large looming problem" and whose finances have not been managed well.

"In my opinion they are a risky type of transaction for [taxpayers] that would have to pay for any shortfalls and those reliant on the system for future benefits at the promised levels because deteriorating performance of a pension fund will reasonably lead to the possibility of benefit reductions/negotiations," Washburn said in an email Monday.

Using pension bonds is favored for some politicians because it allows them to obtain at least a short-term boost in pension funding status, although it leaves the debt and future contributions for future administrations to deal with if investment returns don't pan out, she said.

"It is much more politically palatable than raising taxes now to fund pensions, cutting services, or taking on significant pension reform," she said.

Some Kentucky lawmakers have already said they oppose the use of bonding to address the teacher's pension funding needs, pointing to problems encountered in Illinois, New Jersey, and Detroit.

While the KTRS Funding Work Group said it could not reach consensus, it urged legislators to treat the pension problem as a high level budget priority using a multi-faceted approach that includes sharing responsibilities between the state, school districts, and KTRS members.

"POBs as a phase-in or bridge to ARC funding should allow the retirement system to move to 100% funding more quickly and at lower cost than relying solely on increased contributions," the panel's final report said.

It cautioned, "The Commonwealth will only realize any savings from pension obligation bonds if the returns earned on the money invested exceed the interest paid on the money borrowed."

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