"The 2007 Kentucky legislature's House Bill 418 is designed to change elements of pension calculations for retiring state employees. It also offers state employees the ability to invest a portion of their retirement funds in a privately managed separate account. An amendment to this bill proposes that the commonwealth issue up to $800 million in "Pension Fund Bonds" to add money to the state employees' and teachers' retirement systems. In case you forgot or never studied public finance 101, issuing bonds means borrowing money. It has to be paid back.
This is like an individual taking out a mortgage on his house to fund his IRA, not only for this year, but past years. As a financial advisor, it would be irresponsible for me to suggest this strategy to my clients.
There are at least a couple of things driving this proposed strategy by our legislators. The first may be the recent pension bond issues by General Motors and Ford Motor. These bonds were issued for the same purpose as the bonds our legislators propose — to shore up the pension funds of these companies. The difference is that corporations can declare bankruptcy, and states cannot.
The second consideration is the assumption that the pension funds will earn more through investment of the proceeds of the bond issue than the interest that will have to be paid on the bond issue. Certainly, stocks have outperformed bonds on average by a wide margin over the last fifty years, but the returns have been uneven. There have been periods of years where the stock indices barely moved at all. The interest on the bond issues must be paid every six months, just like a mortgage. Returns on stocks are not guaranteed. Do we really want to take out a twenty-year margin loan hoping that the market beats our interest rate?
A lot of the chatter surrounding these proposals is misinformed. Gubernatorial candidate Jonathan Miller sent a letter to "Friends" dated March 6 that condemns the parts of House Bill 418 that actually make sense — that is, giving employees the ability to invest part of their retirement into a separate account. He calls it a "reckless privatization scheme akin to the Bush Administration's failed proposal to privatize Social Security." He goes on to say that defined benefit plans (pensions) are more cost effective than defined contribution plans (separate accounts). If that is so, why have most corporations dropped them?
Other parts of Miller's letter show that he does indeed care about public employees, but he has his facts wrong. It makes no sense, other than political sense, to attack "privatization," because the entire pension system is "privatized." Why? It invests the pension money in common stocks! These are issued by private companies, and only private, shareholder-owned companies have provided the returns over time that the pension funds' actuaries depend upon to make the numbers work. However, those returns haven't been linear, and that is where the legislative proposal to borrow money to bet on these returns is dangerous.
The editorial board of the Herald-Leader gets it wrong also. In their March 11 editorial, they suggest that allowing employees to invest their own money is "almost sure to increase the number of poor retired public employees for decades to come." They are disturbed that Kentucky Senate leader David Williams wants to "cut guaranteed pension benefits" in order to replace them with a separate account solution. But are these benefits really "guaranteed" if their returns come partially from common stocks? In reality, the only guarantees will come from the taxpayers of the commonwealth if the pension investments don't work.
Here's an idea. Instead of using the bond money to fatten the retirement system coffers, use it to offer the state employees a buy out of the commonwealth's future pension obligations. In other words, allow the employees a lump sum in lieu of their pension so that they can invest the money themselves in an IRA rollover account. This gives the workers a potential inheritance to leave heirs, as well as capital to produce income. A pension expires at the death of the recipient or their beneficiary.
In our experience, about 80 percent of workers would rather have their own money to invest anyway. A buyout also gets the taxpayers of the commonwealth off the hook for a constantly expanding pension obligation into the future. The financial effect of that is truly frightening.
Tom Dupree, Jr. is the principal shareholder of Dupree Financial Group which clears securities and investment advice through Raymond James Financial Services. You can reach him at tdupree@dupreefinancial.com.