- Funding reforms and conservative assumptions are a step in the right direction, but progress will take time to undo Kentucky's poor past funding discipline.
- Negative rating pressure is likely for local governments lacking the ability to make budgetary adjustments for increasing pension costs.
- Other postemployment benefits (OPEB) at the state level are better funded than most state plans; however, risks remain due to the volatility of health care costs.
For years, the Commonwealth of Kentucky used aggressive assumptions and methods that led to contributions not generating pension funding progress. As a result, the funded ratios for the major pension plans in the commonwealth are weak. Recently, the plans have made changes to assumptions and methods, most of which we view as positive adjustments. However, these adjustments will require larger contributions that could create budgetary pressure.
Pension Funding Cost To Increase For All Sectors
Commonwealth of Kentucky
Kentucky has one of the poorest funded pension systems of U.S. states, with an aggregate funded ratio of 44% as of fiscal 2019. In part due to recent reforms, pension costs will likely increase to fund the deficiency, in some instances significantly.
Local governments participate in the poorly funded County Employees Retirement System (CERS, Hazardous and Nonhazardous) a cost-sharing multiple-employer statewide plan, and we expect the payment stress from this plan will rise for local governments. This will pressure their credit quality, as local governments cover all payments and hold the liability.
For the teaching staff, the costs associated with the cost- sharing multiple-employer statewide Teachers' Retirement System (TRS) are paid by the commonwealth and are not a liability of the school districts. For the non-teaching staff, pension contributions to CERS are a minimal part of the budget, and are expected to remain so even as costs for CERS are projected to increase.
State universities and community colleges
Some universities and community colleges participate in the Kentucky Employees Retirement System (KERS) pension and OPEB plans, as well as the TRS pension and OPEB plans. Pension pressures at the state level have caused required contributions to increase. In July 2019 the commonwealth passed legislation that freezes required pension contributions at 49.5% of covered payroll and allows quasi-governmental entities, including universities and colleges, to remain in the plan or to pay their net pension liability and exit the plan by the start of fiscal 2021. Despite rising costs, many quasi-governmental entities have elected to remain in the plan, as the costs to exit are not economical for all.
Updated Assumptions And Reforms Are A First Step, But Reversals Will Take Time
In the past 20 years, Kentucky did not consistently make the full actuarially determined contribution (ADC) to its pension systems and used aggressive assumptions and methods, which led to funding levels deteriorating to some of the lowest in the country. Starting in 2017, the systems implemented more conservative assumption and method changes, leading to higher contribution requirements, and the state made budgetary adjustments to pay the full ADC to its plans (chart 2). Even with these changes, poor funding levels will likely persist for years as the plans' funded ratios remain extremely low.
With the recent contribution changes, the 2020 contributions to KERS Hazardous, KERS Nonhazardous, and SPRS were greater than static funding, indicating these plans reduced unfunded liabilities if all else is held equal--though KERS Hazardous was the only plan to meet our minimum funding progress metric that indicates what we consider significant progress(chart 3). Contributions to CERS Hazardous, CERS Nonhazardous, and TRS remain short of static funding, indicating that, if this continues, unfunded liabilities will rise.
Starting with new hires in 2022, TRS, currently a traditional defined-benefit plan, will shift to a hybrid defined-benefit/defined-contribution plan for new members. This change will reduce new benefit accruals, but meaningful savings will take time to materialize, given the current size of the plan's unfunded liabilities.
Plan Summaries And Potential Credit Impacts
The commonwealth is responsible for KERS, TRS, and SPRS liabilities, while counties and cities are responsible for CERS liabilities. While the Kentucky Retirement System (KERS plans and SPRS) and TRS have made some positive adjustments to assumptions and methods, and improved funding discipline in recent years, in July 2020 the comparatively better funded CERS plans separated from the Kentucky Retirement System by transferring the governance of the plans to a separate nine-member board of trustees. This board will have control over the actuarial assumptions that determine the ADC and influence future payments.
County and city plans (CERS)
Current contributions for CERS plans are insufficient and if these trends persist, the unfunded liabilities will rise. Before 2018, local governments were required to pay the ADC, but aggressive actuarial assumptions were consistently not met, leading to poor funding levels. However, following the 2017 actuarial assumption changes, the cost increases to achieve ADC for CERS were not manageable for most local governments. Increases in CERS contributions for local governments are capped by law with annual increases of no more than 12%, and the legislature implemented a 0% increase in 2021 to provide pandemic-related relief. The commonwealth intends to ramp up CERS contributions to match actuarial recommendations before the end of 2028.
We believe there is a high likelihood the new board of trustees will alter CERS assumptions and methodologies. Currently, CERS amortizes unfunded liabilities as a level percentage of assumed payroll rather than on a level-dollar basis after the ramp-up period. We view this as a form of deferring pension costs because this funding method implies progressively larger payments through the amortization period, pushing increasing contributions to future years and adding risk of faster-than-expected increases if payroll growth falls short.
Cities and counties with small tax bases or relatively high costs will likely face budgetary pressure due to mounting pension contributions, potentially pressuring ratings. Local governments do not have control over CERS contribution levels or actuarial assumptions of the pension plans. Furthermore, without segregated accounts, each entity does not have the option to increase funding. Many counties in the commonwealth do not report their pension liabilities in their financial statements, indicating governing bodies might not be fully aware of the magnitude of these unfunded liabilities. We incorporate the governance risk associated with this into our ratings.
Our view that many cities and counties will potentially face rating pressure from escalating pension costs is supported by generally unfavorable revenue flexibility, outside of the few areas with high wealth levels. Local governments in Kentucky do not rely heavily on property taxes for revenue; insurance premiums and payroll taxes are the primary source of revenue, and while governments have unlimited flexibility to raise rates, increases can be politically difficult. They do not have the ability to collect a home-rule sales tax; there is a state-distributed sales tax. We believe budgetary pressure caused by rising pension costs will be more difficult for Kentucky local governments given the lack of revenue-raising flexibility many currently deal with. This lack of flexibility already pressures our view of many local governments' creditworthiness and rising pension costs without additional revenue-raising flexibility will likely exacerbate pressure on ratings.
Commonwealth plans (KERS, TRS, SPRS)
KERS Nonhazardous is the largest plan and is, arguably, the lowest funded state pension plan in the country at just 14%, and was on pace to fully exhaust its assets by 2023 before the recent adjustments allowed it to make funding progress. If the state were to backtrack on recent progress to funding full ADCs or market volatility were to reduce the value of the plan's assets, it would result in higher costs and liquidity concerns for KERS Nonhazardous. The commonwealth's 2021 budget includes the full ADC with the new actuarial assumptions and methods and the proposed 2022 budget also includes full ADC for the state plans.
The commonwealth is responsible for the TRS liability, and all contributions are made by the commonwealth to TRS, as a non-employer contributing entity. TRS has aggressive assumptions stemming from its long amortization and high payroll growth, resulting in the plan's ADC being less than static funding.
Exposure To Cost Pressure Remains Despite Partially Prefunded OPEB
Each of the state pension systems also administers OPEB plans for participants. Although the commonwealth has required an ADC be made to the OPEB plans and the funded ratios are higher than OPEB plans in many other states, they remain poorly funded in our view and will likely remain a cost pressure. We expect contributions will escalate, given current health care cost trends. Employees hired before 2003 have a service-based coverage benefit, which is exposed to health care costs that are rising faster than inflation and are harder to predict, in part due to a lack of uniform disclosures of specific benefits they cover. Nonhazardous employees hired after 2003 have a stipend, which is similar to a pension and therefore has reduced claims volatility and escalation risk, compared with service-based coverage benefits, but still carries the same risks as a pension. For more information see: "Retiree Medical Benefits Generate Unique Cost Drivers And Risks For U.S. States," published Sept. 17, 2019.
Given the commonwealth's tiered approach, cuts to the service-based coverage benefits are unlikely to occur. With an aging baby boomer population and current health care cost trends exceeding inflation, we believe budgetary pressure from OPEB is mounting for the commonwealth, even with its efforts to control costs with different benefit tiers.
|Plan Details As Of June 30, 2020, Comprehensive Annual Financial Reports|
|Metric||KERS Nonhazardous||KERS Hazardous||CERS Nonhazardous||CERS Hazardous||TRS||SPRS||S&P Global Ratings' view|
|Funded ratio (%)||14.01||55.18||47.81||44.11||58.27||28.02||Funded ratios below 40% are considered extremely poor and potentially face spiralling effects due to liquidity risk.|
|Discount rate (%)||5.25||6.25||6.25||6.25||7.50||5.25||A discount rate higher than our 6.0% guideline indicates higher market-driven contribution volatility than what we view as within typical tolerance levels around the country.|
|Total plan ADC (mil. $)||1,049||59||555||207||1,134||58||Total contributions to the plan recommended by the actuary.|
|Total actual contribution (mil. $)||949||59||475||168||1,134||59||Total employee and employer contributions to the plan that were made last year.|
|Actual contribution as % ADC||90||100||86||81||100||103||Payments have historically not met ADC but with recent "changes," contributions are now meeting it.|
|Actual contribution as % MFP||77||102||67||61||70||84||Under 100% indicates funding slower than what we view as minimal progress.|
|Actual contribution as % SF||117||134||88||81||91||126||Under 100% indicates negative funding progress.|
|Period||Closed||Closed||Closed||Closed||Closed||Closed||A closed funding period ensures the obligor plans to fully fund the obligation during the amortization period.|
|Length (years)||30||30||30||30||24||30||Length greater than 20 years generally correllates to slow funding progress and increased risk of escalation due to adversity.|
|Basis||Level dollar||Level dollar||Level % of payroll||Level % of payroll||Level % of payroll||Level dollar||Level % explicitly defers costs, resulting in slow or even negative near-term funding progress. Escalating future contributions may stress affordability.|
|Payroll growth assumption (%)||N.A.||N.A.||2.00||2.00||3.50||N.A.||The higher this is, the more contribution deferrals are incorporated in the level percent funding methodology. There is risk not only of market or other adversity causing unforeseen escalations to contributions, but of hiring practices not keeping up with assumed payroll growth leading to contribution shortfalls.|
|Longevity||Generational||Generational||Generational||Generational||Generational||Generational||A generational assumption reduces risks of contribution “jumps” due to periodic updates from experience studies.|
|N.A.--Not available. ADC--Actuarially determined contribution. MFP--Minimum funding progress. SF--Static funding. TRS--Teachers' Retirement System. SPRS--State Police Retirement System.|
This report does not constitute a rating action.
|Primary Credit Analysts:||Jessica Akey, Chicago + 1 (312) 233 7068;|
|Todd D Kanaster, ASA, FCA, MAAA, Centennial + 1 (303) 721 4490;|
|Joseph Vodziak, Chicago + 1 312 233 7094;|
|Secondary Contacts:||Geoffrey E Buswick, Boston + 1 (617) 530 8311;|
|Jane H Ridley, Centennial + 1 (303) 721 4487;|
|Helen Samuelson, Chicago + 1 (312) 233 7011;|
No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted. To reprint, translate, or use the data or information other than as provided herein, contact S&P Global Ratings, Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-7280 or by e-mail to: email@example.com.