BRADENTON, Fla. — As taxable fixed-income rates remain near all-time lows, Kentucky is one of several states eyeing pension obligation bonds to deal with unfunded retirement obligations.
Lawmakers there are considering a bill that would allow the state to issue $3.3 billion in pension obligation notes for its underfunded teachers' pension plan. It would be the state's largest-ever bond issue if approved.
Pension obligation bonds have also been discussed among some Pennsylvania lawmakers, while Kansas Gov. Sam Brownback has proposed borrowing $1.5 billion to reduce that state's annual contributions to the Public Employees Retirement System.
Jacksonville, Fla. is also considering pension bonds as police and fire unions bargain over long-term benefit reforms proposed by the city.
The Kentucky Teachers' Retirement System would receive $3.3 billion in pension note proceeds if the state's lawmakers authorize the financing this year.
Industry skeptics say pension obligation borrowings are often a sign that an issuer has failed to manage finances properly or fund required pension contributions.
KTRS has $14 billion in unfunded liabilities, a concern often cited by analysts in the state's rating reports. One rating agency warned this year that the state could be downgraded if lawmakers fail to address pension reform and funding.
The state's annually required contributions to KTRS have been short of full funding for the past eight years, according to Fitch Ratings. In fiscal 2014, the state's contribution was 68.4% of the ARC, leaving a gap of roughly $260 million, Fitch said.
House Speaker Greg Stumbo, D-Prestonsburg, is the sponsor of House Bill 4 proposing the pension obligation notes. He told the House Appropriations and Revenue Committee last week that he has opposed bonding in the past but current market conditions changed his mind.
"The interest rates at this point in time have dropped to 50-year lows and that makes this window of opportunity that we have so attractive to do something to shore up our pension fund," he said.
Generally, the pension obligation bond strategy is not good for most issuers, according to Lisa Washburn, a managing director at Municipal Market Analytics.
"It's almost never a good idea to place bets with public money," she said.
Washburn also said that there are times when the borrowed money is not spent for the intended purpose, increasing the pension liability further for taxpayers.
"In theory, it's a tool for a very well managed organization to use but often the reason why an issuer is using pension obligation bonds is because they haven't managed their finances as well as they should have, and they have a large looming problem," she said.
On the performance side, five years of economic recovery have improved the results of POBs, which on average produced a real internal rate of return of 1.5%, according to a July 2014 report by the Center for Retirement Research at Boston College.
"While POBs could potentially be a useful tool under the right circumstances, evidence to date suggests that the jurisdictions that issue POBs tend to be the financially most vulnerable with little control over the timing," the center's report concluded.
Stumbo, who said he has opposed pension bonds in the past, said inaction by the state now would further jeopardize the teacher's pension fund, and allow its funded status to erode further.
For most retired teachers, the state pension is their only retirement income as teachers are not eligible for Social Security benefits.
Issuing pension notes to supplement KTRS' investments would make the system "solvent and guarantee all these folks will get the pension funds we promised as a state to deliver to them," said Stumbo.
The state can sell pension bonds at an all-in 4.5% interest rate or a 3-point spread, he said, adding that the state's assumed actuarial rate of return is 7.5%.
Stumbo said KTRS has seen positive results from its investments. In fiscal 2014, the system's one-year rate of return was 14.1%. Over three years the rate of return was 11.3%, the 10-year rate was 7.2%, and the 20-year rate of return was 8.2%.
"I think that one can conclusively say that they have managed their investments well and that they've done a good job to date," he said. "I don't think it's improper to consider giving them more money to shore up these funds."
Since 2012, most POB issuers saw their deals price well below 4%, except for some maturities around 2032 that got rates around 5%, according to information supplied to The Bond Buyer by Interactive Data.
Two pension bond borrowings this year saw interest rates range from 0.35% for a maturity in June to 4.11% on a maturity in 2028.
The most recent sale was on Jan. 16 by the Marion and Polk County School District in Oregon. The district's $50.14 million in taxable general obligation bonds were rated Aa2 by Moody's Investors Service with an Aa1 enhanced rating due to the Oregon School Bond Guaranty Program, which pledges the state's credit to guarantee the debt service when due.
The Oregon school district saw yields of 0.35% on bonds maturing on June 30, to 3.03% in 2025, to 3.81% on a $20.7 million of term bonds maturing in 2034, Interactive Data said.
While it is not clear if Kentucky would win the most favorable interest rates if it sold pension notes, rating agency analysts have long cited the state's outsized liabilities.
Standard & Poor's maintains a negative outlook on the state's AA-minus issuer credit rating, and warned Jan. 26 that the state could face a downgrade.
"The negative outlook reflects our view of Kentucky's substantially underfunded pension liabilities and the long-term pressures the state faces unless these are managed," said S&P analyst John Sugden. "We are looking to the legislative session, which began in January and extends through March, to determine what, if any, steps the commonwealth takes to address the KTRS pension liability."
S&P is maintaining its negative outlook beyond the typical two-year horizon to incorporate actions that lawmakers take during this year's session, Sugden said.
"In the absence of meaningful pension reform, we could lower the rating," he said.
Stumbo's bill proposes that the bonds be issued by the Kentucky Asset Liability Commission, which has split ratings notched lower than the state in part because its notes are subject to payments through lease financing agreements and biennial appropriation by the General Assembly.
Commission notes, which are limited to 20-year maturities, are rated A-plus by Fitch and S&P, and Aa3 by Moody's.
If Kentucky borrows $3.3 billion for the teachers' retirement system, Stumbo said its funded status would increase to 72.4% in fiscal 2035.
"It's a window of opportunity that will close soon," he said.
Robert "Beau" Barnes, general counsel for the KTRS, told the budget committee the pension fund found it difficult to see any other option for the state to deal with the unfunded liability.
Barnes described various revenue streams that could be dedicated or repurposed to pay debt service on the notes. He also said that HB 4 provides a permanent statutory mechanism to ramp up funding for the state to pay the full actuarial contribution over eight years.
Rep. Mike Denham, D-Maysville, said the unfunded liability could impact the state's ability to borrow money and its ratings.
"The additional debt that we would show on the books would be more than offset by the responsibility we show by doing this to shore up the [pension] fund as far as our future bond ratings are concerned," Stumbo said.
Rep. Steven Rudy, R-West Paducah, asked about the contingency plan if the market goes bad.
Stumbo said a black swan event could affect returns on the pension notes. However, he said, much of the bond proceeds would preserve assets now held by the system, and would "help us ride out such an event."
The committee passed the bill, and sent it to the full House for a vote.
So far, four amendments have been proposed. One would reduce the authorization for pension obligation notes to $520 million.
Other amendments would gut the bond authorization and suggest various ways to fund the annual required contribution. One lawmaker's proposed change to HB 4 would have the state issue funding notes to make the ARC payment.
