In the words of Governing magazine, Kansas took a “big, scary gamble” last week when it issued $1 billion in pension bonds. Here’s hoping the bet pays off – because if it doesn’t, the state’s budget problems could go from bad to worse.
The state issued the bonds to help shore up the Kansas Public Employees Retirement System. The idea is that KPERS will earn more from investing the bond proceeds than the state will have to pay in bond interest costs over the 30-year life of the debt.
Lawmakers set a 5 percent cap on the interest cost of the debt. Last week’s sale came in just under that, at 4.68 percent.
KPERS doesn’t have much to lose, as it gets $1 billion to invest and the state has to pay back the bonds plus interest. But from the state’s perspective – including its taxpayers – borrowing money to invest is a risk.
If the stock market drops, the state could end up paying more in interest costs than what KPERS earns in investment income.
“They’re buying stocks at what may be the top of the market,” warned Matt Fabian of Municipal Market Analytics Inc., which has described pension bonds as “always the wrong choice.”
A spokesman for Moody’s Investors Service said that Kansas is “essentially placing a wager.”
Governing magazine cautioned that “such schemes tend to end poorly for governments that can’t afford the risk that the pension investment can sour.” It noted that debt tied to pensions played a role in the bankruptcy of Stockton, Calif.
The Wall Street Journal reported earlier this year that this is “a corner of the municipal-bond market most states have come to avoid because of its risk.”
State leaders downplay the risk. They point out that KPERS has averaged an 8.5 percent return during the past 25 years (though only 3.8 percent for the past 12 months ending in June). Also, the state borrowed and invested $500 million in 2004, and it has so far beaten its spread.
“This isn’t a crap shoot on the part of the state,” Sen. Jeff King, R-Independence, told the Lawrence Journal-World.
But even short-term investment fluctuations could squeeze the state’s budget. That’s because, as Moody’s warned last week, the state is exchanging a “soft” liability (unfunded pensions) for a “hard” one (appropriation debt) by issuing the bonds.
“Debt represents an inflexible fixed cost that cannot be renegotiated or modified without defaulting,” Moody’s said.
Moody’s also concluded that KPERS will remain “poorly funded, even with this bond deal.” And it noted that the state is scaling back its employer contribution to KPERS this fiscal year and next to achieve short-term budgetary relief – an indicator “that the state is having trouble balancing its budget.”
Such a sign of distress might lead to another credit downgrade for the state, which would be costly.
But, like it or not, the state has committed to this fiscal gamble. The only thing to do now is hope it wasn’t a bad bet.
For the editorial board, Phillip Brownlee