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Pension Spotlight: Kentucky

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Pension Spotlight: Kentucky

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.

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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

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.

School districts

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.

Chart 2

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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.

Chart 3

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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.

Appendix

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.
Amortization Method:
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;
jessica.akey@spglobal.com
Todd D Kanaster, ASA, FCA, MAAA, Centennial + 1 (303) 721 4490;
Todd.Kanaster@spglobal.com
Joseph Vodziak, Chicago + 1 312 233 7094;
joseph.vodziak@spglobal.com
Secondary Contacts:Geoffrey E Buswick, Boston + 1 (617) 530 8311;
geoffrey.buswick@spglobal.com
Jane H Ridley, Centennial + 1 (303) 721 4487;
jane.ridley@spglobal.com
Helen Samuelson, Chicago + 1 (312) 233 7011;
helen.samuelson@spglobal.com

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