The state of Kansas, in an effort to reduce the annual payments its cash-strapped treasury must make into the state employee pension fund each year, is turning to a risky bond market bet — one that has paid off for the state in the past, but that was also used by the cities of Detroit, and Stockton, California, before they were forced to declare bankruptcy.
The Kansas Public Employees Retirement System is currently funded at less than 60 percent of the level necessary to pay full benefits to current and future retirees. The state has been working to bring the fund to the 80 percent level by the middle of the next decade, but tax cuts pushed through the legislature by Gov. Sam Brownback have left the state chronically short of revenue, making those pension payments more of a burden than they used to be.
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Brownback is pressing the state legislature to approve the issuance of between $1 billion and $1.5 billion in so-called “pension obligation bonds.” The revenue from the bond offering would be immediately invested in the state pension fund, boosting both its bottom line and its capacity to produce investment returns. Brownback, who was reelected to a second four-year term in November, inherited a chronically underfunded pension system when he took office in 2011, though the funding levels initially fell further early in his first term.
The state will pay the bondholders from general revenue, not from the pension fund. But proponents insist this is a good deal for taxpayers, because they assume the earnings from the new money injected into the pension fund will be higher than the interest rate the state has to pay on the bonds. That means that the pension fund will stay on track to meet its growth target while the legislature, on net, spends less money to make that happen.
The catch, of course, is that this is essentially a bet. Kansas taxpayers, and possibly its retirees, would lose big if the spread between the interest rate on the bonds and the pension fund’s investment returns isn’t wide enough or goes negative.
Kansas, because of its revenue problems, was downgraded by credit ratings agencies Moody’s Investors Service and Standard & Poor’s last year. Even after those downgrades, the state should be able to sell bonds offering an annual rate below 5 percent. Backers of the bond offering estimate that the state pension fund will earn 8 percent annually.
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While it’s a bet, it’s probably a safe one, and it has worked for Kansas before. A smaller debt offering in 2004 went off at 5.4 percent, and officials say that the average return from the fund since then has been 7.45 percent.
However, investment professionals tend to look askance at pension obligation bonds, both because of the risk they represent and because they have historically been used primarily by states and municipalities under significant financial strain, suggesting further trouble ahead.
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