🔒Policymakers consider ‘lockbox’ approach for pensions

There's been much talk since last year about a constitutional “lockbox” to prevent future legislatures from pilfering transportation funds for other purposes. The matter may make it onto the voting ballot as early as November.

Now, some policymakers are weighing a similar approach for the state's pension system, which remains among the most underfunded in the country thanks, in part, to past legislatures foregoing annual required contributions (ARC) in lean budget years.

In a recent interview, State Comptroller Kevin Lembo said he wouldn't necessarily support a constitutional amendment, but he's not opposed to other tactics that could force legislators to keep up with annual pension payments, including borrowing money in the form of a pension-obligation bond (POB) with restrictive bond covenants.

The state teachers' pension system used a similar strategy in 2008, issuing a $2 billion POB with covenants that require the state to pay its full ARC each year, which it has done.

The strategy could be replicated for the state employee pension system, known as SERS, which is currently underfunded by $14.9 billion, Lembo said. Such a borrowing would likely be in the range of several hundred million dollars.

Lock the legislature out

“So in the years when the legislature needs $100 million, they would realize pretty quickly” that they couldn't forgo the pension payment to create budget savings, Lembo said. “We can lock them out of that. I'm open to talking about it because of the value it has in locking in good behavior.”

Asked for her opinion, State Treasurer Denise Nappier said she is in favor of at least discussing a POB, but that it would require an analysis of whether the returns on invested bond funds would meet or exceed the cost of debt.

“We also must consider the impacts of such a transaction on the state's credit rating and debt levels,” Nappier said. “That said, a modestly sized and prudently structured transaction could be a powerful tool if it includes a bond covenant to improve fiscal discipline going forward — as was done with the POBs issued for the Teachers' Retirement Fund in 2008.”

Some states, which can usually attract favorable interest rates, have also used POBs as a sort of arbitrage play, investing the borrowed funds and hoping for a higher return in the markets. Lembo and state budget director Benjamin Barnes, however, are cool to that market-timing strategy.

The POB talk comes amid heightened attention on the state's $25.7 billion unfunded pension obligation and the increasing risk of annual retirement contributions swamping the state budget in the not-so-distant future.

Changes to pension funding

Malloy has proposed changes to pension funding that would smooth annual payments but lengthen the payoff schedule. Lembo and Nappier have also released new funding strategies, and they plan to meet with the governor to reach consensus on a path forward.

Lengthening the payoff schedule would mean higher near-term costs. A POB could help the state get over that hump, Lembo said.

While past legislatures failed to sock away enough to meet rising pension costs, the Malloy administration has been making the required ARC payments, which is calculated by actuaries. The annual cost is $1.5 billion, but it's rising thanks to overly optimistic assumptions about stock market returns, lower-than-required contributions and early retirement incentives provided in past years, and a backloaded payoff structure.

Of course, there is a deterrent currently in place if the state fails to make the ARC payment in a given year: It could hurt Connecticut's bond rating, driving up interest rates on state borrowing.

While that is a disincentive for legislators who might want to use some of the money for other programs, Lembo said the POB could be an additional way to build a fortress around the pension funds.

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