Thursday, February 26, 2015

The Public Pension Gamble in Kansas and Kentucky: Borrowing

The Public Pension Gamble in Kansas and Kentucky: Borrowing

Rolling the dice is a bi-partisan practice when it comes to pension financing.  In Kansas, Governor Sam Brownback (R) is behind a proposal to issue $1.5 billion in municipal bonds to bolster the state pension plan, which is about 60% funded.[1]  In Kentucky, Governor Steve Bashear (D) is pushing a proposal to issue $3.3 billion in municipal bonds to inject into the Kentucky Teachers’ Pension, which is 54% funded.[2]  In 2012, Kentucky supposedly reformed their public pension system, but the fixes were insufficient.[3] 



Here’s the idea in brief.  The states can borrow at a rate of about 5%, inject the bond proceeds into the pension plan, and hope that the money earns at least 7.5% (Kansas) to 8% Kentucky.  They will narrow their pension deficit over the next two or three decades if their returns exceed their borrowing costs, and they don’t further reduce their contributions or increase their liabilities.

In theory, this is a reasonable bet.  The pensions ought to be able to generate more than the cost of borrowing the money.  But given the political realities and fiscal practices of both states, this is probably a very risky undertaking.  Both states got into this mess by underfunding their pensions.  Like New Jersey and Illinois, which also issued pension obligation bonds, Kansas and Kentucky have kept taxes artificially low and now face a budget and pension crisis.  In researching the fiscal policies of both states, there’s precious little evidence that they have the financial discipline to make this work.

As usual, two groups will be big winners from this undertaking.  The politicians will be okay.  By enacting this proposal, they will push the pension crisis out far enough so they won’t be in office when the problem resurfaces. Wall Street will also do very well.  In addition to underwriting $4.8 billion in bonds, money managers will get the proceeds to invest in stocks, bonds, real estate and private equity.  Here’s the back of the envelope math on issuing a combined total of $4.8 billion in bonds.  The underwriters would make about $24 million selling the bonds.  Over ten years, money managers would take home $280 million in fees, and the pensions would earn about $1.2 billion in extra returns, assuming a 2.5% spread between investment returns and borrowing cost.  The Kansas and Kentucky plans have $23.7 billion in unfunded liabilities (Kansas $9.7 billion, Kentucky Teachers $14 billion).  If the borrowing works, it will put a modest dent in the pensions’ unfunded liabilities.

It’s a win-win, except for the two groups that count most: taxpayers and pension beneficiaries.  Taxpayers have to hope that their politicians suddenly learn financial discipline and that the bond proceeds are invested wisely.  If I were a taxpayer in Kansas or Kentucky, I’d be worried.  Beneficiaries have to hope that the pension deficit shrinks.  Otherwise, they’ll be overwhelming pressure to substantially reduce benefits.

Kansans and Kentuckians need only look northeast toward New Jersey, where pension obligation bonds have done little to reduce the retirement deficit.  Moreover, Governor Chris Christie failed to keep up his end of a retirement reform package passed in 2012, and a New Jersey court has ordered him to make the promised contributions.  New Jersey is being forced to go through another round of reform, which will effectively destroy the pension plan for many public employees.[4]

Democrats and Republicans have different approaches to government.  However, when it comes to solving problems, they both prefer the easy solution: borrowing.