DALLAS - The revival in pension obligation bond issuance creates new risks for retirement systems that do not resolve chronic structural problems, rating analysts said.
In a worst-case scenario, pension bonds represent deficit financing that creates a higher annual fixed-cost burden and higher liabilities than would otherwise exist, according to Fitch Ratings.
"In all cases, POBs raise timing and investment risks as they are betting that investment returns will exceed the cost of debt service," Fitch analyst Douglas Offerman wrote in an Aug. 13 report.
With a $1 billion pension bond deal that priced Aug. 12, Kansas raised the volume of POBs this year to $1.67 billion.
That is more than five times the volume of pension bonds issued in all of 2014, according to data from Thomson Reuters.
With coupons of 4.927% on maturities of 2045, the Kansas Development Finance Authority barely cleared the legislatively mandated rate of 5%. In authorizing the taxable bonds, the legislature assumed a return on the bond proceeds of 8%, making the deal theoretically beneficial for the state.
Pat Conroy, executive director for the Kansas Public Employees Retirement System, points out that the average return on KPERS investments over the past 25 years is 8.5%.
Jim MacMurray, vice president for finance at KDFA, said demand on the long end of the deal was the weakest but that the bonds managed to clear the market.
"We saw the heaviest demand on the short end of the curve and were able to tighten 15 basis points in the first five maturities of 2017-2021," MacMurray said.
The taxable bonds from the Kansas Development Finance Authority priced through book runner Bank of America Merrill Lynch & Co. with maturities of 2017 through 2045.
The bonds were rated Aa2 by Moody's with a stable outlook and AA-minus by Standard & Poor's with a negative outlook.
Poor investment returns after the 2008 recession sharply increased unfunded pension liabilities, analysts said.
"However, those market losses are not the only cause of weakened pensions," Offerman said. "The majority of plans lowered benefits and/or raised contributions in response. Fitch expects slow improvements in funded ratios for most plans as reduced benefits usually apply only to new workers and stronger contribution practices accrue in the form of larger pension investment portfolios."
POBs are supposed to help issuers such as Kansas to recover some of the ground lost during the recession. For the Sunflower State, the funded portion of the Kansas Public Employees Retirement System is expected to improve to at least 66% from the previous 62%.
Kansas's pension problem is based on 1993 legislation that limits growth in pension contributions to about 1.2% of payroll annually. Actuarially required contributions, or the contributions that would result in full pension funding over time, frequently grow by more than 1% of payroll.
As a result, the state's statutorily permitted contributions have been lower than actuarially determined contributions for years, according to Moody's Investors Service. Since 2001, the state on average has made 72% of its actuarially determined contributions, Moody's says.
"Even if the state's pension bonds work as designed, contributions must rise in order to address growing unfunded liabilities," Moody's analyst Dan Seymour wrote in an Aug. 12 report. "Contribution requirements (in dollars) will still rise by 4% annually, if all assumptions hold, due to the increasing payment structure used by the pension plan."
Standard & Poor's took a similar view.
"We view the sale of the pension bonds and the decrease in general fund contributions as an incremental investment risk and a possible indication of reduced commitment to funding future ARC payments," S&P analysts led by David Hitchcock wrote. "To the extent that the state pension fund does not meet its relatively aggressive 8% rate of return assumption, or further delays increases in employer contribution levels in future years, projected funded levels will be worse than the state's current projection of a 100% pension funded level in 20 years."
The 2014 POB issuance of $380 million in 2014 was the lowest volume in 21 years, according to Thomson Reuters. The peak issuance of $17.8 billion came in 2003, with the second-highest total of $10.3 billion coming in 2008.
