A golden opportunity to manage the risk of pension underfunding issues

Much has been written about the underfunded pension plans challenging Lexington and the state of Kentucky and the negative long-term implications of not addressing these problems sooner than later. The numbers are worrisome and also large.

Lexington has a reported pension deficit of approximately $585 million and the state of Kentucky, depending on whose numbers you use and which numbers you actually count has a reported pension deficit of anywhere from $12 billion to $20 billion. These are big numbers, but before anyone panics, first appreciate that these are long-term obligations, payable over the next 30 to 40 years.

For instance, Lexington’s $585 million deficit is actually equal to approximately $16.5 million a year, if one evaluates it by amortizing it over 35 years. This is approximately 6 percent of Lexington’s 2011 general fund revenues of $281 million, but almost 94 percent of the city’s $18 million of property tax revenues for 2011.

Pension plans are generally designed to have funding contributions made annually, and for these contributions to be invested in long-term risk-oriented assets earning about 6-8 percent annually. While poor investment results can create problems for a plan, generally these are short-term phenomena corrected by time — i.e., 2008 stock market valuations vs. 2012 valuations.

Most pension plan problems I have witnessed in my career are a result of entities failing to make the necessary contributions. This exacerbates problems for these plan because when those neglected contributions are ultimately made, the contributor also will need to compensate the plan for the additional 6-8 percent of lost annual earnings. When contributions are not made, it means the plan is missing a vital earnings component necessary to meet future funding requirements.

Today, interest rates are at lows not seen in over 100 years and institutional investors (especially life insurers) are desperately looking for high-quality, long-term (20- to 30-year maturities) investments. Both Kentucky and Lexington have high-quality “AA” ratings, and I believe they both have the financial wherewithal to borrow much of the money necessary to meet the actuarial requirements for these plans, which are significantly less than the pure underfunded numbers.

I believe our leaders today shouldn’t focus on the mistakes of the past; they should instead focus on implementing the correct measures to fix the future. Today, the state and the city of Lexington can probably borrow 10-, 20- and 30-year money (with multiple maturities) with an average cost of less than 4 percent. The long-term projected average annual inflation rate is expected to be 3-3.5 percent annually. Any time one can borrow money at a rate close to the inflation rate, it’s a gift. The 50-year average rate on the 10-year U.S. treasury is 5 percent. This is the long-term “normal rate.” Today this rate is 1.61 percent. Any debt sold today to eliminate these pension deficits will be a financial gift to everyone’s future.

Lexington and the state of Kentucky should finance as much as practical for their current pension deficits. This isn’t an interest rate call, it’s a risk-management approach.

Both entities have the ability to lock in a funding cost today that should be less than their actuarial assumptions used in the plan. In addition, the long-term projected earnings on the funded monies should be in excess of both entities’ funding cost. While some may question how the additional debt will affect our ratings, I think our leaders should recognize that the rating agencies and investors dislike uncertainty and that by implementing a funding approach today, they can stabilize and begin to take control of both entities’ future pension cost exposure. If this isn’t done, rating agencies and investors may view both entities negatively.

In my career, I have seen many businesses wait too long to address a problem. Usually they don’t raise more capital when times are good, because they are afraid of negatively impacting their shareholders. Ford and GM both entered the financial crisis with different balance sheets. Ford, early in the crisis, leveraged every unsecured asset it had and entered the crisis with several billions of dollars of cash on its balance sheet. GM waited and then became a victim of the markets and had to go through bankruptcy. These examples will be played out in business schools for years. Why did Ford make it and GM didn’t? Lexington and the state may be facing a similar decision today: “Should we borrow now in order to protect our future from financial uncertainty?”

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