Kansas appears on the verge of borrowing one billion dollars to help fund KPERS, the state’s public employee retirement system. Following, from April 2013, why this is not a good idea.
Borrowing money to shore up the Kansas state employee pension plan is about the worst idea that could come out of Topeka. Legislatures across the country, and counties and cities of all sizes, have shown that government is fundamentally unable to manage the responsibilities of a defined benefit pension plan.
For more about the problems with KPERS, see KPERS problems must be confronted. Newspapers are not helping Kansans grasp the gravity of the problem; see KPERS editorial a disservice to Kansans. Below is a helpful explanation written by Kansas Policy Institute Adjunct Fiscal Policy Fellow Barry Poulson, Ph.D.. He is also Emeritus Professor at the University of Colorado — Boulder.
Public officials in Kansas have proposed using pension obligation bonds to solve the funding crisis in the Kansas Public Employee Pension System (KPERS). In my view this is not a solution to the funding problem and I will discuss what I perceive to be flaws in this proposal.
The rationale for using pension obligation bonds to pay off unfunded liabilities in the pension plan assumes that the state can borrow funds at a low interest rate and then earn a higher rate of return on the proceeds deposited with the pension fund. The flaw in this rationale is the assumption that KPERS will earn a higher rate of return on bond proceeds deposited in the KPERS fund. KPERS assumes an 8 percent return on assets accumulated in the fund. For a number of years, economists and actuaries have questioned this assumed rate of return and the use of this assumed rate to discount liabilities in the plan. The Government Accounting Standards Board has issued new standards, 67 and 68, to be implemented over the next two years, requiring state and local governments to use a lower interest rate, the mortgage bond rate, to discount liabilities in their financial statements.
If we assume that a lower rate of interest, such as the municipal bond rate, is the interest rate relevant in discounting unfunded liabilities in the pension plan then it is not clear that issuing pension obligation bonds will generate returns above the interest cost on those bonds. If the returns fall below the interest cost on the bonds then this introduces an additional risk and could in fact exacerbate the funding problem in KPERS.
A major flaw in the proposed issuance of pension obligation bonds is the lack of nexus between the investment of the bond proceeds and payments for unfunded liabilities in the plan. The experience in other states is that sometimes bond proceeds are earmarked for other state expenditures. The most egregious example of this problem is the state of Illinois which issued $10 billion in pension obligation bonds and then used the proceeds to meet current expenditures rather than to pay off unfunded liabilities in the pension plan.
Even if the state of Kansas would not commit this form of fraud on the taxpayers the fungible nature of state funding makes it impossible to guarantee the nexus between bond proceeds and the payment for unfunded liabilities in the pension plan. If legislators see that additional funds are available to pay off unfunded liabilities in the pension plan they may choose to allocate less general fund money to meet these pension obligations. The state has not allocated the annual required contribution (ARC) to KPERS for several decades and is not projected to do so for the foreseeable future. Legislators continue to promise pension benefits without allocating the funds required to meet these obligations. We should expect this moral hazard to be even greater with the issuance of pension obligation bonds.
Even if the proceeds of pension obligation bonds could be set aside in a lock box and earmarked to pay off unfunded liabilities in the pension plan the state must still address the accumulation of unfunded liabilities in the defined benefit plan. Without fundamental structural change, including shifting public employees to some form of defined contribution pension plan, these unfunded liabilities will continue to accumulate. Legislators should not be diverted from this difficult task by non-reforms, such as the issuance of pension obligation bonds.
Shifting the cost of pension obligations from one generation of employees and taxpayers to the next generation is not a solution to the funding crisis in KPERS. The defined benefit plan offered by KPERS is not sustainable.
I analyze the sources of unfunded liabilities in the plan and explore alternative reforms to solve this problem in an upcoming paper with KPI.