capitolInvestment consulting firm RVK recently delivered a long-term study of the Kentucky Employee Retirement System non-hazardous plan — currently the most underfunded public pension plan in the country — finding that there is no available investment strategy that can significantly improve its financial status without significant risk of further depleting its assets.

At the beginning of the fiscal year last summer, KERS — which includes more than 90,000 current, retired or inactive state workers — was only 21 percent funded, meaning its assets only cover 21 percent of future liabilities, a shortfall of nearly $9 billion. In a memorandum describing the financial status of the plan over the next 20 years, RVK painted a bleak picture that comes from a decade of underfunding by Frankfort.

“By any measure, this is a significant concern for the future of the Plan’s financial health,” wrote RVK. “This study shows that the Plan faces substantial financial challenges over the next 20 years. By this we mean persistent funding shortfalls, elevated contribution levels, unsustainable payout ratios, and, in the worst-case scenario, the potential for complete depletion of the asset base.”

With the assumption that investment returns would be a constant 7.5 percent every year until 2034 with no additional changes to benefits and contributions, the funding ratio of KERS would be expected to drop all the way to 15 percent between 2020 and 2025 — with its unfunded liability approaching $11 billion — only lifting to above 30 percent in 2034. Actuarially required employer contributions — which have already skyrocketed in recent years — are expected to dramatically increase each year from the current $500 million to nearly $1.2 billion in 20 years.

RVK estimates of funding ratio for the KERS non-hazardous over the next 20 years

RVK estimates of funding ratio for the KERS non-hazardous over the next 20 years

The main focus of the RVK study was to present how different investment strategies — ranging from most conservative to most aggressive — could potentially shore up the plan under a range of market environments, but they cautioned that there was no silver bullet on the investment side alone that could lift KERS out of its current dilemma.

“Given the current financial health of the Plan, the results of this study suggest there is no reasonable investment strategy available to KERS-NHPP that would allow the plan to ‘invest its way to significantly improved financial status,'” wrote RVK. “By ‘reasonable’ we mean an investment strategy that offers the probability of substantially higher returns— substantial enough to alone notably improve the KERS-NHPP funding status — without also courting substantial risk to the already diminished asset base of the Plan.”

RVK added that investment returns which might moderately improve the funding status of KERS “can almost certainly only be achieved by taking substantial risk — and that risk, once taken, may lead to those improved outcomes, but also may lead to faster depletion of the Plan’s assets should the investment markets provide a challenging and unrewarding climate for investors.”

Under any investment strategy, RVK noted that KERS will face liquidity constraints in the near future, as they will soon have to use increasing amounts of assets to pay out benefits, leaving less available for long-term investments with more potential for a larger return rate.

“In the event of a payout ratio over 50%, over two-thirds of the liquid portfolio would need to be liquidated to fund benefit payments (assuming they came due at a time when contributions were not coming in),” wrote RVK. “In our view this is unsustainable for long periods of time and may inhibit the Plan’s ability to invest with a long-term focus, reducing the potential return opportunities. In short, a heavy reliance on illiquid investments risks turning even normal asset value declines into disruptive events.”

While the most aggressive investment strategy, focused more on global and private equity, was estimated to have the most potential to rapidly increase the funding ratio of KERS — up to 82 percent in 20 years under the most ideal scenario — it also carried the greatest risk of financial collapse for the plan. Under the worst-case scenario, such a strategy could lead to a one-year loss of the majority of KERS assets, as well as an 8 percent chance of all assets being wiped out by 2034.

The most conservative investment strategy also fared poorly in the RVK estimate, as the KERS funding ratio would not eclipse 33 percent by 2034, even under the best-case scenario for investment returns.

The closest RVK comes to a conclusion on investments is that KERS should have a well-diversified portfolio that focuses on increasing liquidity — eschewing an ultra-conservative approach and recommending that any aggressive strategy not be undertaken without a full recognition of the risks involved. RVK does note that any positive outcome for the financial stability of the KERS plan is “extremely dependent on the contribution policy” set by Frankfort, and that even small changes to benefits policy could have a significant long-term impact.

The dire future of KERS outlined by RVK largely mimicked the findings of Cavanaugh Macdonald earlier this year, as the Kentucky Retirement Systems commissioned the outside actuary to study the difference in KERS’s future with and without a hypothetical $5 billion bond to shore up its funding. While the estimate with the enormous bond showed KERS quickly bouncing back to financial solvency, KRS executive director Bill Thielen told IL that they had no plans to lobby the Kentucky General Assembly for such a bailout.

If the funding ratio of KERS — or the also financially troubled Kentucky Teacher Retirement System — continues to plummet, Kentucky will likely soon face the current political drama of Illinois, which rivals Kentucky in having the worst public pension crisis in the country. Illinois’ state government is fighting over which politically painful solutions to adopt — such as significant tax hikes, dramatic cuts to spending, or decreasing benefits — in order to prop up their $100 billion unfunded liability.