Abandon ship!

Kentucky’s underfunded public pension system threatens to drown the commonwealth

On March 26 of last year, the most powerful elected officials in Frankfort were effusive in their backslapping and self-congratulations over their bipartisan feat. Kentucky’s General Assembly had just beat the deadline for their session to pass the much debated Senate Bill 2, a public pension reform bill that supposedly cured what ailed the deeply troubled Kentucky Retirement Systems (KRS), and champagne corks were popping.

“The reforms will make Kentucky’s pension system one of the healthiest in the country,” said Gov. Steve Beshear. “I think we have done a heck of a job for the people of this state because it gets a financial burden out of the way.”

Democratic House Speaker Greg Stumbo claimed that “we have brought stability to our system and adequate funding that will ensure a safe and secure pension for those covered,” adding, “we have honored our commitment, we have accomplished our mission, we have solved a huge problem, and we have earned our pay.”

On the other side of the aisle, Republican Senate Majority Leader Damon Thayer called it “one of the greatest policy achievements of this body and this General Assembly in recent memory” that will “avert a fiscal crisis.” Republican Senate President Robert Stivers called it “a shining example of how government should tackle pressing problems facing the state,” proudly declaring, “I’m going to Disney World.”

Eighteen months later, a growing number of critics find those rosy sentiments to be an absurd showcase of denial, as Kentucky is still widely seen by many experts as having one of the worst funded — and most secretive — public pension systems in the country. Collectively, Kentucky’s public pension systems have a staggering $35 billion unfunded liability, half of which comes from KRS alone, which threatens the state with a looming financial apocalypse.


Put away your Mickey Mouse ears

Kentucky’s public pension system includes the Kentucky Teachers Retirement System (KTRS) — serving 140,000 active and former teachers — and the Kentucky Retirement Systems, housing 10 individual pensions and retiree health plans that serve roughly 350,000 active and former employees. The largest two pensions within KRS are the non-hazardous plans for the Kentucky Employees Retirement System (KERS), serving mostly state government employees, and the County Employees Retirement System (CERS), serving mostly city and county government employees.

In theory, those retirement plans are supposed to function by the employees kicking in payments from their paycheck, while the state or county as employer annually contributes a larger amount called the “actuarially recommended contribution” (ARC), which is the amount needed to keep the pension on sound financial footing. This pool of money is then invested by the pension system to increase their pool of assets, while also paying earned benefits out to retired workers. But for more than a decade, Kentucky’s state government has been treating this theory as more of a loose suggestion than a hard rule, choosing to not contribute the full ARC payment for several pension plans and diverting those funds to other budget priorities.

This lack of funding by the state has been most drastic for KTRS and KERS. The state stopped paying the full ARC for KTRS a decade ago, currently paying only 75 percent. KTRS now has a $14 billion unfunded liability and is only 50 percent funded, meaning its total assets are only half of the total liabilities it owes. The underfunding of KERS was even more dramatic, as the state only paid half of its ARC payments each year over the past decade, giving it a total unfunded liability of $8 billion. The KERS non-hazardous plan is now only 23 percent funded, making it the single worst-funded public pension plan in the entire country.

Though supporters of SB 2 and the accompanying House Bill 440 in 2013 claimed the legislation solved this pension crisis, in actuality, the new law barely addressed this issue of chronic underfunding. Instead, it gave a loose promise of a $100 million payment of the ARC for KERS in the following years, and took a large step toward a longtime conservative goal of transforming Kentucky’s pension system from a defined benefit plan into a defined contribution system, similar to 401k plans in the private sector. SB 2 created a hybrid cash balance plan for new hires under KRS, and many Democrats and labor leaders lambasted the new law as gutting workers’ benefits in exchange for vague promises of savings decades from now, while putting a band-aid on an open chest wound of underfunding.

Events over the past year show that despite the optimistic rhetoric surrounding Kentucky’s pension reform bill, its public pension troubles are far from over.

Just four days after the celebration of SB 2’s passage, the Louisville mental health nonprofit Seven Counties declared bankruptcy, specifically blaming the new law. Seven Counties was just one of many nonprofits allowed to enter KRS in the previous decades, but with SB 2 requiring the full employer payment of the ARC in coming years, they could not afford to pay this staggering increase and continue operating. In May, Seven Counties won their case to pull out of KRS, with the judge ruling that the state still had an “inviolable contract” to cover the pension costs of their employees. This ruling potentially opens the floodgates for other nonprofits to pull out of KRS in order to keep their organizations afloat financially, as well as force the state to pick up the tab for their pensions.

Credit-ratings agencies were not impressed by Kentucky’s new pension reforms, either. In June of 2013, Moody’s ranked Kentucky’s pension system as having the third-worst unfunded liability problem in the country, and Fitch recently affirmed KERS as the single worst-funded public pension sinkhole in the country.

SB 2 also completely punted on tackling the underfunding of KTRS, as the state continues to fail to pay its full ARC payment. WFPL reported last month that a group of teachers in Jefferson County Public Schools plans to sue the state over their pensions’ chronic underfunding, seeking $11 billion.

Last fall, KTRS requested an additional $800 million from the state — which was not met — and they have expressed their wish for the state to issue pension obligation bonds (POBs) in the coming year for $1 billion to shore up their assets. The risk with POBs can be seen by the recent disaster in Detroit, which entered into bankruptcy in 2013. Detroit issued POBs to address their pensions’ unfunded liabilities, but these bonds require a much stricter repayment plan, which they could not meet. On top of this bleak scenario, new federal accounting rules going into effect next year will cause the unfunded liability of KTRS to balloon from $14 billion to $23 billion.

But the largest pensions disaster potentially looming over Kentucky’s horizon remains within KRS. Not only are nonprofits like Seven Counties wanting to bolt out of KERS and KRS, but cities and counties are starting to call for the emancipation of CERS from the sinking vessel of KERS that it is tethered to within KRS, dragging it down to the bottom of an ocean of insolvency.

While the state was allowed to renege on their full ARC payments to KERS for a decade, the cities and counties have been obligated by law to make their full ARC payments every single year. The Kentucky Association of Counties has argued that local entities would be able to dig CERS out of its still-manageable 60 percent funding ratio if it were run independently of the KRS umbrella. Why should cities and counties who have dutifully made their full ARC payment suffer from the state’s dereliction of duties?

The northern Kentucky city of Ft. Wright took this argument to its logical extension in June, suing KRS in order to divorce CERS from KRS, in addition to damages incurred from risky hedge-fund investments made by KRS that produced lackluster returns. Louisville Metro Council is already eyeing such a strategy, as they recently passed a resolution by Councilman Jerry Miller, R-19, advocating the independence of CERS due to poor investment decisions and inflated administrative costs.

According to some experts, Kentucky’s pension system is already entering into a “death spiral,” where more benefits are paid out every year than contributions taken in, while investment returns from a dwindling asset pool are outpaced by increasing costs. One such expert is Chris Tobe, a former KRS board trustee turned Security and Exchange Commission (SEC) whistleblower who last year authored “Kentucky Fried Pensions: A Culture of Cover Up and Corruption,” a book that scathingly documented the financial malfeasance of Frankfort’s leaders over the past decade.

According to Tobe, the unfunded liability of Kentucky’s pension system is growing by $1 billion each year, making the relatively paltry $100 million promise of funding by SB 2 an insufficient amount to get pensions back on sound financial footing.

But where would this extra $900 million come from? Despite many years of harsh budget cuts to education, social services and executive agencies since the 2008 recession, Kentucky still finds itself in a budget crunch, further evidenced by the current $90 million budget shortfall announced two weeks ago. Frankfort Democrats would balk at even more drastic cuts to government programs, and Republicans have been steadfast in their opposition to any tax reforms that raise taxes, or even add additional revenue to spend.

As if this funding dilemma for Kentucky’s pension systems weren’t enough, the Ft. Wright lawsuit highlights another aspect of KRS that has elicited concern: the secrecy of its investment decisions, which a growing number of critics argue allows KRS to make investments that aren’t in the best interest of its members. Since his time on the KRS board battling to shine a light on their investments, Tobe has warned that the lack of transparency within KRS allows powerful Wall Street investment firms to gain undue influence on where and how the pension system chooses to invest its assets, opening up the plans to risky strategies at best, and outright corruption at worst.


The Cloak Room

By 2008, Frankfort’s raiding of funds that were supposed to go toward ARC payments for public pension plans had already turned the asset to liability ratios of KERS and KTRS from 100 percent to 54 and 68 percent, respectively. That year, a cabal of unscrupulous Wall Street banks broke America’s economy when their fraudulent schemes in the sub-prime mortgage industry transitioned the economy into the Great Recession. The investment returns for Kentucky’s public pensions subsequently tanked, and the increased strain on Kentucky’s state budget caused ARC payments to dip even lower.

In 2012, the Task Force on Kentucky Public Pensions released the findings of a report by Pew on how to fix the state’s pension crisis, which recommended gutting benefits for future state hires by moving them into the hybrid cash balance system, as well as discontinuing cost-of-living adjustments for the benefits of current state workers. In the following year’s session of the General Assembly, as Republicans such as task force co-chair and state Senate Majority Leader Damon Thayer eagerly pushed these reforms within SB 2, it was discovered that Pew’s report was paid for by the Arnold Foundation.

This foundation is the creation of John Arnold, whom journalist Matt Taibbi referred to in Rolling Stone last year as a “dickishly ubiquitous young right-wing kingmaker with clear designs on becoming the next generation’s Koch Brothers.” In his 20s, Arnold was a trader at Enron, manipulating energy prices, pocketing an $8 million bonus before the company impaled itself on its own fraud and its workers’ pensions disappeared. Soon afterward, Arnold made billions on hedge funds, and his Arnold Foundation now goes from state to state with Pew telling legislators that gutting workers’ benefits is the answer to solving their pension crisis.

As if it weren’t enough that the Wall Street financial services industry imploded workers’ pensions all over the country during the 2008 crash and now seeks to persuade state governments to cut pension benefits even further, the growing trend in America — especially Kentucky — is to move what’s left of public pensions toward risky, expensive and often low-return “alternative investments” of hedge funds and giant Wall Street private equity firms.

State public pension systems used to almost exclusively invest in more traditional stocks and bonds, but in recent years, the percentage of investment going into these high-risk alternative investments has shot up to 22 percent nationally (and 34 percent within KRS), along with the proliferation of investment manager lobbyists and placement agents — middlemen who connect hedge funds with pension plan staff and elected officials — descending upon state capitols. These investment firms prefer to do business in states where their staff, lobbyists and placement agents can negotiate with public pension plans in secret, collecting tens and hundreds of millions of dollars in fees for their firm that bear little to no correlation with the actual performance of their returns.

If that sounds like an environment that is ripe for pay-to-play public corruption, the long list of indictments and perp walks of investment managers and public officials all over the country in recent years shows that this is a safe assumption. Though Kentucky has not seen anyone in handcuffs yet, Tobe has long argued the lack of transparency within KRS, along with the aggressive lobbying by giant investment firms, makes the state a breeding ground for potential corruption.

In “Kentucky Fried Pensions,” Tobe details how even he himself as a KRS board trustee and member of their investment committee was kept in the dark about the nearly $12 million in fees paid to placement agents prior to 2011. One of these placement agents, Glen Sergeon, had a close relationship with former KRS CIO Adam Tosh when he landed a $200 million investment with Arrowhawk Captial Industries, a sham of a hedge fund that closed within two years. Sergeon also delivered a $24 million investment with The Camelot Group, whose managing director now faces criminal charges of using the fund as his own luxury piggy bank.

Tobe became a whistleblower while still serving as a KRS board trustee in 2010, referring allegations of impropriety and illegal actions to the SEC, which still has an open investigation. In 2011, state Auditor Crit Luallen released an audit that appeared to clear KRS of any wrongdoing — and told trustees not to talk about the internal affairs of KRS with the media, as Tobe did repeatedly — which Tobe characterized as a whitewash. To this day, Tobe claims that the power structure of Frankfort — from Gov. Beshear to Attorney General Jack Conway to leadership of both parties in the legislature — are all turning a blind eye to the secretive actions of KRS, as power and money look after themselves.

Though placement agents are currently banned in several states, they remain open for business in Kentucky, despite legislative effort to ban them in recent years. Though KRS claims they currently have no placement agents hired, Kentucky’s database of registered executive branch lobbyists is filled with 68 individuals employed by the 80 investment firms used by KRS. John Steffen, executive director of the Executive Branch Ethics Commission, tells LEO that these individuals may lobby KRS directly, and while placement agents must register on the database, it makes no distinction between placement agents and lobbyists.

Besides the questions of transparency surrounding investment managers within KRS, recent evidence suggests that Kentucky’s growing number of alternative investments perform poorly, despite high fees paid to such firms.

KRS paid $55 million in fees to investment firms last year, the majority of which went to managers of alternative investments. With the stock market booming, the average return on investments for public pensions nationally was 16 percent. However, with its large percentage of alternative investments, KRS only made a 12.7 percent return. John Cheves of the Lexington Herald Leader reported last month that while the returns of KRS from normal stocks and bonds ranged from 18 to 33 percent, returns from their alternative investments only ranged from 9 to 15 percent.

Meanwhile, returns for KTRS, which devotes much less to alternatives, were 19 percent. The difference between a 12-percent and 19-percent return for KRS would have been approximately $1 billion, a considerable amount for a retirement system with such a large unfunded liability. KRS denied Cheves’ open-records request for the amount of fees paid to each individual investment manager, as the firms would prefer to keep that number secret in order to maintain a competitive advantage.

While Tobe’s warning cries about the woes of KRS to public officials and many in the media were ignored for years, a growing number of leaders are beginning to move his ideas forward. The Ft. Wright lawsuit to divorce CERS from KRS, as well as the Metro Council resolution advocating the same, is basically a mirror image of the argument Tobe has made for years. So, too, is HB 546, a bill sponsored by state Rep. Jim Wayne, D-Louisville, in this year’s session of the General Assembly calling for a ban on placement agents and requiring full disclosure of investment fees paid by KRS.

While these people are listening to Tobe, some still say his opinions are off base and that Kentucky’s pension reforms have placed the state on a sustainable path.

“While Wayne and Miller are stars, I still think most of the power structure is still trying to cover up these issues,” says Tobe, who adds that while media scrutiny on this topic has increased, it is still sparing.

 For those who have faith that Tobe is the Ghost of Kentucky Insolvency Future that is ignored at our own financial peril, unfortunately those who disagree with his prescription have a great deal more power, so this remains an uphill fight.


The County Line

Councilman Jerry Miller tells LEO that if the judge in Ft. Wright’s lawsuit against KRS allows the case to move forward, he will strongly advocate that Metro Government intervene as a party in the case to do the same. Miller – who is currently a strong favorite in his race for a state House seat this fall — says that if CERS ditched the bloated administration, bad alternative investments and the toxic KERS plan of KRS, Metro Government would wind up saving $10 million a year. But KRS likely won’t go down without a fight.

“That’s why KRS will fight to the death to keep CERS in KRS until the bow breaks off like the Titanic, because that’s all that’s keeping them afloat,” says Miller.

However, KRS Executive Director Bill Thielen tells LEO that such a tactic would do nothing to help counties and cities, as CERS and KERS funds are not commingled.

“We do not use money from CERS to shore up KERS or pay benefits or costs with any other plan,” says Thielen. “Investments are handled separately, even though we might put moneys from each of the plans together in a single investment.”

In statements provided to LEO, both Gov. Beshear and Attorney General Conway – who is running for governor next year and would make KRS appointments if successful – said that CERS and KERS funds are not commingled, echoing the assertion of Thielen that separating CERS would only increase their administrative costs with no tangible benefits for municipalities.

Sen. Stivers declined to comment due to the pending Ft. Wright lawsuit, and Sen. Thayer declined to respond to any of LEO’s questions about Kentucky’s pension system.

Tobe disputes the claims of Thielen, noting to LEO that KRS does not report separate investment returns for KERS and CERS, just a commingled amount, and that despite having only a third of the administrative costs as KRS, KTRS was able to produce much better returns on their investments.

Though Rep. Wayne’s HB 546 advocates studying the proposal to separate CERS from KRS, he tells LEO he is not yet on board with this plan of action, fearing that a splintering of KRS without accompanying reform and funding will only hasten its implosion.

Miller was quick to note that while Metro Council passed his CERS resolution by a 25-0 vote, Mayor Greg Fischer has been notably absent from the debate, saying his “silence is deafening.” When asked why he thought that was, Miller replied, “The mayor’s bag man is the chair of KRS.”

The “bag man” Miller refers to is Tommy Elliot, a key fundraiser for Mayor Fischer, who besides being chair of the KRS board of trustees, is also chair of the KRS Legislative and Budget Committee and serves on the Investment Committee.

Fischer tells LEO that while pension obligations have grown to 15 percent of the Metro budget, he is “in the beginning stages” of forming an opinion on divorcing CERS from KRS.

“Obviously we’re interested in this class action that has involved Ft. Wright,” says Fischer. “The county attorney who represents us is looking at that vehicle; we’re looking at other vehicles as well. But we can’t be passive on what the pension issues are with us.”


Let the sunshine in

Rep. Jim Wayne’s HB 546 seeks to tear down the walls built up around KRS so we finally have a detailed view of how it operates.

“When you have things that are done clandestinely, you cannot guarantee security for that money,” says Wayne. “And that’s the system we have now. There is much that is done behind closed doors with people who are jockeying for advantage to manage this money, and there’s not full accountability.”

Wayne’s bill not only bans placement agents and requires total disclosure of investment management fees, but also requires a competitive RFP bidding process for any managers submitting investment proposals — no more secret negotiations. The bill did not receive a hearing in this year’s General Assembly, though it was filed late in the session. When he brings his proposal back next year, he fully expects KRS and investment industry lobbyists to put up an aggressive fight to block its progress.

“If you’re going to open this up, in their minds, it could be that they see this as a shaking up of the system that could threaten either their position or it could threaten the stability of the funds, or it could threaten some relationship they have,” says Wayne.

Thielen maintains that KRS has not directly or indirectly paid a placement agent in “over five years” – though Tobe suspects they could be paid by managers hired by KRS — and defends the practice of negotiating with investment managers in private as a cost-savings measure, despite their fees and commissions being more costly in some cases.

“The universe of potential investment managers out there is very large, and only a few of them do we want to try to invest with or deal with,” says Thielen. “They don’t want everybody else to know the fee that they negotiated with us. And if they had to disclose that, then everybody’s going to end up paying their (higher) standard rate, because they wouldn’t be able to treat some entities differently and negotiate a little better rate.”

Thielen acknowledges their alternative investments underperformed normal stocks and bonds, but says these investments are a safe way to balance their portfolio, as they are better able to weather a downturn in the stock market.

Miller says Thielen’s statements on alternatives defy common sense and may speak to something more unsavory.

“It is either ineptness or corruption that causes them to invest money in illiquid private equity investments,” says Miller. “KTRS used basic investments used by all truly prudent investors to earn their lofty returns, while KRS/CERS used very speculative investments.”

Sen. Stivers declined to comment on Wayne’s bill from the last session, and Beshear says these proposals should be reviewed by the Public Pension Oversight Board created by SB 2. Conway wouldn’t comment on Wayne’s bill, but says “as a general matter, I support transparency and competitive bidding in all areas of government, and that includes the pension systems, subject to any federal or state securities laws that make the disclosure of certain information illegal. Businesses and investment firms who wish to do business with government should realize that transparency is required when being entrusted with public dollars.”

Again, Thayer – who chaired the committee that produced the Pew/Arnold recommendations for SB 2 — did not respond to LEO’s questions. Tobe suggests the fact that Institutional Investor – a trade magazine whose main advertisers are Wall Street hedge funds – recently touted the senator as one of the most influential players in the country on public pensions “sends a clear message to hedge funds that if you want the large secret fees from KRS, then you need to go through Thayer.”

Thielen says KRS is already very transparent and follows the law, and will adapt if the legislature adds more disclosure requirements.

“That’s a decision for the General Assembly to make. If they want us to disclose every single thing and it costs more? Fine, we’ll do that. I’m all for transparency to the extent required, and if that’s what’s required, we’re certainly going to follow the law. But we do want people to know what the impact is going to be.”


Show me the money

While the transparency of KRS is important, Wayne realizes that the most important priority for addressing Kentucky’s giant unfunded liability with its pension system is finding the political will to pass tax reform that raises enough revenue to plug the massive hole left by a decade of neglect by Frankfort.

“That means probably in aggressive fashion paying more than the ARC as pro-rated over so many decades; it means probably playing some catch up initially, and then scaling back to the ARC once we fund the system a lot more,” says Wayne.

If Frankfort does not show enough leadership to step up and do so — and considering the seemingly eternal fear that most in both parties have of raising taxes, this seems likely — Wayne says dark days lie ahead.

“It doesn’t take a prophet from the Old or New Testament to tell you this will lead to destruction in this state,” says Wayne. “Our schools will be underfunded, the pensions will not be properly funded, university tuition will go up, we’ll find different ways that we’ll start to gouge the people who can least afford it to fill in the holes. It’ll continue down the road of Kentucky becoming a Banana Republic.”

Wayne continues to plead with Beshear to use his political capital while he still can to make passage of tax reform his No. 1 priority, but with the Senate firmly in Republican hands, the task would be daunting. Meanwhile, Republicans have their eye on taking back the majority in the House in this fall’s election. If successful, the GOP would be likely to not just cut taxes and prevent budget revenue increases, but attempt the end the defined benefit plan for public pensions and throw government workers to the 401k wolves.

But as the unfunded liabilities in the pension system grow and Kentucky’s boat takes on more water, the Frankfort powers that be continue to tell everyone to relax, because they’ve got this under control.

“We all need to realize that the reforms put in place will take time to show improvement in the financial condition of the system,” says Beshear. “The financial problems in the system did not occur overnight, and the solution put in place won’t solve them overnight.”