Impact on Louisville and Rural Areas of Kentucky State Pension Crisis by Chris Tobe

Christopher Tobe, CFA, CAIA February 6, 2013 CFA Trustee Kentucky Retirement Systems 2008-2012

The recent headline in the Courier journal was “Louisville pension
debt near US worst”i, however the pension crisis is much broader
and deeper than that; the state’s overall pension debt is much
worse. This was reflected in a recent headline from the
Lexington Herald Leader “Kentucky’s financial outlook lowered to
‘negative’ because of pension woes”iiand in an editorial. iii To put
the issue in perspective the Louisville portion of the pension debt
is over 20 times the size of the debt for the YUM! Arena.
The depth of the problem is such that serious state financial
solvency issues will trickle down to cuts in spending on education
and transportation which are critical to every Louisville resident.iv
It will also increase borrowing costs for all state entities,
including those in Louisville, like the Airport, the Stadium, and
the University of Louisville. It is also broader than many think,
effecting workers in dozens of Federal, State, and local
Government programs as this pension crisis bleeds across all
these workers and retirees.

The Kentucky Retirement system points out there are direct
pension payments to 14,148 Jefferson County retirees of $268.9
million per year.v

The National Institute on Retirement Security
estimates a total annual economic impact in Kentucky from state
and local public pension funds of $3.5 billion, viwhich should be
at least a $1 billion impact on Louisville. vii Pension costs eat up
about 15 percent of Louisville’s general fund budget — up from 6
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percent seven years ago — and Louisville spends about $72million on
pensions annually.viii

BACKGROUND
Historically public pensions have been thought to be troubled if their
funding ratios dropped below 80%. The recent financial crisis has many
typical state funds dropping to the 60% level. There are a handful of
states where levels have dropped below 50%, like Kentucky and Illinois,
which has horrific state wide effects. I have talked in depth on this
issueix and how it could even lead to state bankruptcy on the cable TV
program Pure Politics.x

The worst funded in the country is the Kentucky Employees Retirement
System (KERS) at 27%. The Kentucky Teachers Retirement System
(KTRS) is troubled at a 50% funding ratio. The County Employees
Retirement System (CERS) is better but still troubled at 60%. All three
of these systems affect Louisville, but differ in their degree of influence.
The most troubled, KERS, includes most of the Frankfort based
employees, but many of these cabinets have offices in Louisville with
employees under KERS as well. The community college system with
major campuses in downtown Louisville and south west Louisville has
hundreds of KERS workers as well. The most troubling may be Seven
Counties a non-profit mental health agency that covers Louisville and is
threatening closure because of pension costs.xi

KTRS covers every teacher and administrator in every Louisville in
primary and secondary schools, and teachers and administrators for all
community colleges. The University of Louisville opted out of KTRS
over 20 years ago and does not provide a defined benefit plan.
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CERS covers every City of Louisville worker and their police and fire
employees. It also covers all non-teaching school employees including
school bus drivers and cafeteria workers and many aids. In addition, it
also covers most special district employees which were highlighted in a
recent audit report.xii

While KTRS and CERS are not in crisis yet from a funding basis, however
the pension costs have been increasing. Jefferson County Schools
have some ways for these costs to flow through to property tax
increases as they make payments to KTRS and CERS, and are the largest
entities state wide in both of these plans. The Metropolitan Sewer
District (MSD) and Louisville Water Company can pass CERS increases
through rate increases, and the Airport and Fair Board with user fees.
Patience may be waning for this as MSD has already passed through
over 100 million in derivatives losses with their investments.xiii
The costs have been more difficult to cover for Louisville Metroxiv which
has limited taxing power as evidenced by their desire to get a local
option sales tax. This has been frustrating because as noted in the Pew
Report , “While the city consistently paid 100 percent or more of its
annual recommended contributions in fiscal years 2007 to 2010, its
pension funding kept losing ground, dropping over that period from 76
percent to 64 percent of liabilities.”xv The main cause of this has been
unfunded COLA’s for retirees forced down by the legislature.
Other Related Issues
Louisville relies on federal government programs as well. It is thought
that the Federal granting authorities may withhold grant money from
non-profits that have large liabilities on their balance sheets. New
accounting rules going into effect in 2014 may cause non-profits like the
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Head Start programs in CERS to be in danger of losing federal funds
which would shut them down. The bigger liability is in the mental
health agencies in KERS; this has already caused a major disruption and
closing in Southeast Kentucky. Xvi

At Kentucky River Community Care in Jackson, for example, the agency
last year fired “almost its entire staff,” more than 400 employees who
had been eligible for state pensions that required employer
contributions, according to a lawsuit filed by KRS. The agency
immediately rehired them through a company it had formed months
earlier, Go-Hire Employment and Development, and Kentucky River
continues to direct their daily activities, according to the suit. Go-Hire
offers the employees 401(k) defined-contribution retirement plans, but
it’s not part of KRS and does not provide state pensions. ……..Kentucky
River left about 70 retirees in the system when it quit. They are entitled
to pensions and health care coverage for the rest of their lives.xvii This
crisis could easily be repeated in Louisville with Seven Counties
according to their Executive Director. xviii
The new GASB and FASB accounting rules will require all of these
Jefferson County entities to disclose their full pension liabilities, which
will hurt their ability to borrow money in the municipal markets.xix
NACUBO, which represents public universities, is fighting the GASB rule
since forcing these liabilities on the university balance sheets will limit
their ability to borrow. xx A current SEC investigation into the Kentucky
Retirements Systemxxi could result in more impediments, similar to
investigations in New Jersey.xxii Just this week a rural county health
department defaulted on its pension payments to CERS. xxiii
The threat of Illinois-like corporate tax increases could cause businesses
in border areas to leave. Indiana has an active effort luring Illinois
business currently and could easily translate that into a Louisville.
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However, additional tax revenue will probably be needed to save KERS
and to keep the state’s credit rating from slipping more, so legislative
leaders will need to be prepared for tough choices picking the lesser of
two evils on economic development.
The Kentucky Retirement Systems has invested over $1 billion in venture
capital and other private equity. Private Equity funds have huge
concentrations in California and a handful of other states. For this
reason many state and municipal funds target a small amount in
investments in their state.xxiv As a Trustee I informally floated a modest
$200 million venture capital program for Kentucky using around 1% of
pension assets, but there was no interest.
Metro Louisville has made a major commitment toward sustainability. xxv
Many cities have done the same by putting their pension dollars to work
in sustainable ways. Groups like Council of Institutional Investors (CII)xxvi
and CERES xxvii help cities and states make sustainable investments. As a
Trustee of KRS we had mandatory legal educational requirements. I
tried to get involved with educational opportunities with CERES and CII,
but KRS staff was openly hostile toward these organizations and refused
to pay.
Is a Divorce of CERS from KRS a Solution?
As a trustee of KRS I became gravely concerned with the transparency
and accountability at the Kentucky Retirement Systems which is an
umbrella agency that comingles 10 different plans including KERS the
worst funded at 27%, and the best funded CERS at 60%. As a trustee of
KRS I felt that this comingling made it impossible to do my fiduciary duty
around investment issues and I commissioned an outside counsel
report.xxviii I became very concerned with currency losses being moved
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from KERS onto CERS, and for CERS bearing a disproportionate share of
administrative costs.
The Kentucky Association of Counties, or KACO, already has been
advocating for Kentucky’s County Employee Retirement System
secession.xxix LaRue County Judge Executive Tommy Turner, KACO chairman, provided this testimony to the General Assembly in August:

Separate CERS as a stand-alone governing board. County governments
have been consistent in paying 100 percent of the contribution amount
required of us. We ask that you review the possibility of allowing CERS to
be governed by their own board. CERS can reach the 80 percent funding
threshold at a much faster rate than KERS. The viability of CERS is not in
jeopardy with it currently having a funding level of around 63 percent
and it will not encounter a cash flow problem. In fact, under the
provisions instituted in HB 1, the contribution rates for CERS will begin to
fall in the future for participating agencies. Allowing CERS to having its
own governing board would ensure CERS members benefit from the 100
percent participation payments that have been contributed. Under its
current makeup, the Kentucky Retirement System must operate with
decisions based on … the most poorly funded program in the system,
which is Kentucky Employees Retirement. Comparatively, the other plans
in the system are relatively well funded. With a separate board, CERS
would be in a better position to adjust investment options and maintain
less liquidity than the current system must keep on hand to pay out
benefits.xxx
The 2012 investment performance confirms that CERS has been harmed
by comingling investments with KERS. xxxi Overall, the combined
performance for 2012 of all KRS investments in pension and insurance
was under its benchmark by $109 million. xxxii Since 2012 KRS
benchmarks were high at 13.57% any liquidity needs would harm
performance. The insurance funds which are lower funded had lower
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returns but still over 12%. If you assume KERS needs the same liquidity
as the insurance funds, you can calculate that CERS subsidized KERS by
$29 million in 2012 by giving them liquidity.
Pew also blames the shortfall on investment losses at Kentucky
Retirement Systems. xxxiii Superior or even adequate long term
investment results cannot be achieved when KRS is mired in investment
scandals.xxxiv As reported in the Independent Counsel Report, the State
Auditor has refused to adequately address the investment scandal.xxxv
While the Legislature in HB 1 in 2008 put forth new laws to help
investment returns, so far the Attorney General has refused to enforce
any of the laws. xxxvi
Metro Government, by way of Metro Council, sent Kentucky Retirement
Systems a $10 million check to go into CERS without consulting an
actuary.xxxvii I share the opinion of the “Ville Voice”, the leading
Louisville Political blog that, “Because it’s entirely possible that the KRS is
anticipating that $10-$11 million windfall from Metro Government in
CERS (County Employee Retirement System)… and that’s why $5 million
was shifted to shore up KERS by the distribution of currency losses.”xxxviii I
also share this other opinion, “Most everyone we speak with in Frankfort
believes operating costs and other expenses are being unfairly put on the
back of CERS. xxxix“
Louisville seriously needs to consider leading a divorce from CERS
especially as this situation deteriorates.
Steps to Solve the Issue?
What can leaders in Louisville Kentucky do to work through this issue?
They cannot bury their heads in the sand, and let Frankfort handle it.
The first is to become aware of the problem so that they can better
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react to it. Kentucky River may be the first of many non-profits killed by
the pension crisis but it will not be the last. Leaders need to have back
up plans to help keep the Federal funds flowing through these programs
to the people in Louisville programs. Even though the mayor and
council will be tempted to lobby for payment reductions, this is in reality
just a high cost loan at the 7.75% assumed rate of return, and will only
lead CERS down the insolvency route of KERS. There is no real legal
way to lower the CERS payment (see appendix 1), in the current
structure.
CERS and KERS have very different problems and different solutions and
leaving them comingled only allows the problem to fester. Even the
non-government entities in CERS and KERS have very different issues,
and the continued comingling makes their problems worse. The
comingled structure by having CERS prop up KERS allows the “can to be
kicked down the road” longer on truly fixing these pensions and puts an
unfair burden on local governments. My recommendation is for
Louisville to demand that the legislature to make the full ARC payment
for KERS immediately and to indentify specifically the funding source. If
they fail to do this I think they should pressure the legislature to allow
CERS to carve out its own plan and run it separately so it is not sucked
down with it. If this does not work they must consider legal action.
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About Chris Tobe
Chris Tobe, CFA, CAIA has over 25 years of experience working with
complex investments as a consultant, money manager, trust officer and
regulator. His firm Stable Value Consulting reflects a specialty in
401(k)’s that had him quoted in the Wall Street Journal, Barron’s and
Market Watch, and working on expert witness cases and with Public
DC plans in Maryland and Texas. He recently completed a 4 year term
2008-2012 as Trustee and Investment Committee member for the $13
billion Kentucky Retirement Systems and serves on the investment
committee of the Delta Tau Delta Foundation. From 2008-2009 he
served as a Sr. Consultant for New England Pension Consultants
(NEPC) and worked with a number of public pension plans including
Oklahoma, St. Louis & Amtrak. While at AEGON 2001-2008 he worked
with Public Plans such as Montana, Pennsylvania, LA Louisville, Cook
Louisville, Chicago, Ohio, Vermont, & Memphis. While at Fund
Evaluation group 1999-2001 he worked with Public University
Endowments at Purdue, U.of South Carolina, Indiana State and U. of
Memphis. From 1997-1999 he worked with Kentucky State Auditor Ed
Hatchett and published a 40 page report on the investments of both the
Kentucky Retirement Systems and the Kentucky Teachers Retirements
Systems. In the mid 1980’s Tobe worked as a campaign coordinator to
Congressman Lee Hamilton, and as his intern to the Joint Economic
Committee of Congress. Tobe has published over 30 articles on
investing and has spoken at over 25 national conferences. He holds
a BA in Economics from Tulane University, and an MBA in Finance from
Indiana University – Bloomington. He is the past president of the CFA
Society of Louisville and has taught the MBA investment course at the
University of Louisville. As a public pension trustee in 2010 he
completed the Program for Advanced Trustee Studies at Harvard Law
School and in 2011 he completed Fiduciary College held at the Rock
Center at Stanford University.
Stable Value Consultants – Pubic Pension Series

Rural Economic Effect of the Kentucky
State Pension Crisis
Christopher Tobe, CFA, CAIA February 1, 2013
Rural Kentuckians may see the pension crisis as a Frankfort
problem, or a problem of the 3 metro areas around Frankfort,
but it is much broader and deeper than that. The depth of the
problem is that it could cause serious financial solvency issues
for the entire state, which will most likely trickle down to cuts in
spending on education and transportation which are critical to
every rural county.i It is also broader than many think effecting
workers in all 120 counties. Rural counties depend on Federal,
State, and local Government programs for a higher percentage of
income than most urban counties, and this pension crisis bleeds
across all these workers and retirees.
The Kentucky Center for Economic Policy points out there are
documented direct pension payments of $30 million into Pulaski
County and $10 million into Graves County.ii A good portion of
that money is spent locally in stores, restaurants and doctors’
offices. The National Institute on Retirement Security estimates a
total annual economic impact in Kentucky from state and local
public pension funds of $3.5 billion,iiiwhich should be at least a
$1 billion impact on rural counties. iv
Media coverage of these issues has been spotty in Kentucky but
there has been some national coverage.v I have talked in depth
on this issuevi and how it could even lead to state bankruptcy on
the cable TV program Pure Politics.vii Historically public pensions
have been thought to be troubled if their funding ratios dropped
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below 80%. The recent financial crisis has many typical state funds
dropping to the 60% level. There are a handful of states where levels
have dropped below 50%, like in Kentucky and Illinois, which have
horrific state wide effects.
The worst funded in the country is the Kentucky Employees Retirement
System (KERS) at 27%. The Kentucky Teachers Retirement System
(KTRS) is troubled at a 50% funding ratio. The County Employees
Retirement System (CERS) is typical but still troubled at 60%. All three
of these systems effect rural counties, but differ in their degree of
influence.
The most troubled, KERS, includes most of the Frankfort based
employees. In addition, it also includes state highway garage workers in
every county, prison guards, and state park workers. What is not
broadly known is that it also includes the non-teaching employees of
many universities, like Morehead and Murray in rural counties, and nonprofit
mental health agencies that cover every county.
KTRS covers every teacher and administrator in every county in primary
and secondary schools, and teachers and administrators for all
community colleges and the Regional Universities in rural areas.
CERS covers every city and county worker and their police and fire
employees. It also covers all non-teaching school employees including
school bus drivers and cafeteria workers and many aids. In addition, it
also covers most special district employees which were highlighted in a
recent audit report. The Bluegrass Institute, a Kentucky think tank, has
reported that are over 1,701 agencies participating in the Kentucky
Retirement Systems, I estimate that over 1000 could be nongovernment.
viii
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While KTRS and CERS are not in crisis yet, they have large membership in
every county. In most counties the school district is the largest
employer with teachers and administrators in KTRS and support staff,
cafeteria workers and school bus drivers in CERS. Local government is
most likely a top 5 employer in every county, as every local police officer
and fireman (State Police have own system) is in CERS. Every county
and city worker is in CERS. Thousands of workers in non-profits are in
CERS as well
Rural Counties in general also rely on federal government programs as
well. It is thought that the Federal granting authorities may withhold
grant money from non-profits that have large liabilities on their balance
sheets. New accounting rules going into effect in 2014 may force nonprofits
like the Head Start programs in CERS covering every county to be
endanger of losing federal funds which would shut them down. The
bigger liability is in the mental health agencies in KERS; this has already
caused a major disruption and closing in rural Southeast Kentucky. ix
At Kentucky River Community Care in Jackson, for example, the agency
last year fired “almost its entire staff,” more than 400 employees who
had been eligible for state pensions that required employer
contributions, according to a lawsuit filed by KRS. The agency
immediately rehired them through a company it had formed months
earlier, Go-Hire Employment and Development, and Kentucky River
continues to direct their daily activities, according to the suit. Go-Hire
offers the employees 401(k) defined-contribution retirement plans, but
it’s not part of KRS and does not provide state pensions. ……..Kentucky
River left about 70 retirees in the system when it quit. They are entitled
to pensions and health care coverage for the rest of their lives.x This
crisis while it may appear to be in Frankfort has already spread and has
done damage to rural counties.
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The new GASB and FASB accounting rules will require all of these
entities to disclose their full pension liabilities. Many Kentucky cities
and counties fear it will hurt their ability to borrow money in the
municipal markets.xi NACUBO, which represents public universities, is
fighting the GASB rule since forcing these liabilities on the university
balance sheets will limit their ability to borrow. xii A current SEC
investigation into the Kentucky Retirements Systemxiii could result in
more impediments, similar to investigations in New Jersey.xiv
The threat of Illinois-like corporate tax increases could cause businesses
in border areas to leave. Indiana has an active effort luring Illinois
business currently and could easily translate that into a Kentucky
strategy. Rural counties could lose business especially to Tennessee in
addition to Indiana and others. However, additional tax revenue will
probably be needed to save KERS, so legislative leaders will need to be
prepared for tough choices picking the lesser of two evils on economic
development.
What can leaders in rural Kentucky do to work through this issue? The
first is to become aware of the problem so that they can better react to
it. Kentucky River may be the first of many non-profits killed by the
pension crisis but it will not be the last. Leaders need to have back up
plans to help keep the Federal funds flowing through these programs to
the people in these rural counties. Even though mayors will continue
to complain, avoid any payment holidays, or CERS will be heading down
the same dark road as KERS.
The next is get their legislators to demand transparency and
accountability at the Kentucky Retirement Systems which is an umbrella
agency that comingles 10 different plans including KERS the worst
funded at 27%, and the best funded CERS at 60%. As a trustee of KRS I
felt that this comingling made it impossible to do my fiduciary duty and I
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commissioned an outside counsel report.xv I became very concerned
with currency losses being moved from KERS onto CERS, and for CERS
bearing a disproportionate share of administrative costs.
My recommendation is for the legislature to make the full ARC payment
for KERS immediately, if they fail to do this I think they should allow
CERS to carve out its own plan and run it separately so it is not sucked
down with it. CERS and KERS have very different problems and
different solutions and leaving them comingled only allows the problem
to fester. Even the non-government entities in CERS and KERS have very
different issues, and the continued comingling makes their problems
worse. The comingled structure by having CERS prop up KERS allows
the “can to be kicked down the road” longer on truly fixing these
pensions and puts an unfair burden on local governments.

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