The Program Review and Investigations Committee met on Thursday, June 12, 2008, at<MeetTime> 10:00 AM, in Room 131 of the Capitol Annex. Greg Hager, Committee Staff Administrator, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator Ernie Harris, Co-Chair; Representative Reginald Meeks, Co-Chair; Senators Charlie Borders, R.J. Palmer II, Joey Pendleton, Dan Seum, Brandon Smith, and Katie Stine; Representatives Dwight D. Butler, Rick G. Nelson, Ruth Ann Palumbo, Rick Rand, Arnold Simpson, and Ken Upchurch.
Legislative Guest: Sen. Brett Guthrie.
Guests: Mike Burnside, Executive Director; Adam Tosh, Chief Investment Officer; Kentucky Retirement Systems. Gary L. Harbin, Executive Secretary; Kentucky Teachers' Retirement System. Bosworth M. Todd, Jr., Chairman Emeritus; Todd Investment Advisors.
LRC Staff: Greg Hager, Committee Staff Administrator; Rick Graycarek; Jim Guinn; Christopher Hall; Margaret Hurst; Colleen Kennedy; Van Knowles; Jean Ann Myatt; Tara Rose; Cindy Upton; Dana Daughetee, Graduate Fellow; Stella Mountain, Committee Assistant.
Upon nomination made by Sen. Stine, and seconded by Sen. Pendleton, Sen. Harris was nominated for the position of Senate Co-chair.
Upon motion made by Sen. Pendleton, and seconded by Sen. Stine that nominations cease, Sen. Harris was elected Senate Co-chair by acclamation; without objection.
Upon nomination made by Rep. Simpson, and seconded by Rep. Rand, Rep. Meeks was nominated for the position of House Co-chair.
Upon motion made by Rep. Nelson, and seconded by Rep. Simpson that nominations cease, Rep. Meeks was elected House Co-chair by acclamation; without objection.
Sen. Harris recognized the three new committee members: Sen. Brandon Smith, Rep. Reginald Meeks, and Rep. Ken Upchurch.
Minutes of the December 13, 2007 meeting were approved by voice vote, without objection, upon motion made by Rep. Simpson and seconded by Sen. Seum.
Rick Graycarek presented the report Investment Rates of Return, Governance, and Policies of the Kentucky Retirement Systems and the Kentucky Teachers' Retirement System.
Mr. Graycarek stated that the study, which was initiated by the committee in October 2007, has two objectives: describe the investment organization and operation of KRS and KTRS, and examine investment practices, including rates of return.
He said the report has 7 major conclusions. 1) KRS and KTRS operate separate retirement systems with separate boards of trustees. These boards have a fiduciary responsibility to members and beneficiaries. 2) There is a trade-off between risk and return for investments, but no single objective standard for what the trade-off should be. Retirement systems assume different levels of risk, but lower returns do not necessarily mean lower risk. 3) Higher long-run investment rates of return generally come from higher-risk investments. 4) Investment income accounts for between 45% and 72% of additions to KRS and KTRS annual revenues over the past three fiscal years. 5) KRS and KTRS have been changing their asset allocations. In general, they have decreased allocations to domestic equities and fixed income securities, and increased allocations to international equities and other investments. 6) KRS and KTRS use benchmarks to gauge their investment performance but those benchmarks were not always reported or explained in their financial statements. 7) KRS and KTRS have met or exceeded most of their own benchmarks, but their rates of return were mostly below the average returns of comparable retirement systems.
Mr. Graycarek gave an overview of relevant finance and investment principles. The first is that diversification reduces risk by allocating assets to different types of investments. Second, liquidity is the ability to quickly sell an asset without significant loss. Third, both pension funds hold long-term investment views and have been established to operate in perpetuity. Lastly, there is a trade-off between risk and return.
He said that KRS has 316,000 members, who include active, retired and inactive members, in 3 systems: the Kentucky Employees Retirement System (KERS), which consists of state employees; the County Employees Retirement System (CERS), which consists of local government employees; and the State Police Retirement System. KTRS has 119,000 members, who include employees of the public school districts and the Kentucky Community and Technical College System. He noted that KTRS members do not participate in the federal Social Security program, but KRS members do.
He said that KRS and KTRS are governed by separate 9-member Boards of Trustees. The members of the KRS Board of Trustees include 5 elected, 3 appointed, and 1 ex officio. KRS also has an investment committee, which is not required by statute, consisting of 5 of the 9 trustees. The KTRS board consists of 7 elected and 2 ex officio members. Its investment committee, which is not required by statute, consists of 2 trustees and the executive secretary of KTRS. He noted that investment expertise is not required for board members. Both systems employ professional staff. He said that about one-half of comparable systems analyzed for the report do not have elected board members. Investment committees generally are not required by statute, but most systems have them. Most comparable systems require one or more board members or investment committee members to have some investment expertise.
Mr. Graycarek explained that KRS and KTRS are funded similarly in that funds come from 4 primary sources: employer contributions, member contributions, interest income and dividends, and net investment appreciation. The last two are reported as investment income. For KRS and KTRS, investment income has been the single largest component of funding over the 3 most recent fiscal years. KRS and KTRS have received one-time General Fund appropriations in recent fiscal years. KTRS received $12 million in FY 2006 and $14 million in FY 2007. KRS received $12 million.
KRS and KTRS each have separate pension and insurance funds. Mr. Graycarek referred to a graph showing net assets for KRS having increased from $12 billion in FY 2002 to about $17 billion in FY 2007. KTRS’s net assets were about $12 billion in FY 2002 and increased to approximately $16 billion by FY 2007. He noted that the KTRS insurance fund has minimal assets. KTRS has borrowed and redirected money from the pension fund in order to pay insurance benefits.
Sen. Harris asked whether other states were similar to Kentucky in having separate pension and insurance funds.
Ms. Hurst indicated that Kentucky was not similar to most other states in this regard.
Mr. Graycarek noted that in order to pay its insurance benefits between FY 1997 and FY 2007, KTRS has borrowed or redirected just over $600 million.
He continued by discussing the investment goals of KRS and KTRS. In general, goals are established as broad principles on which investment policies and procedures are established. KRS’s goal is to preserve capital while seeking means of enhancing revenues and protecting against undue losses in any particular investment area. KTRS identifies two goals, but those appear to be what are usually defined as objectives. They are to attain a 10-year annualized return exceeding the Consumer Price Index by 3.5 percentage points and that the total return should be similar to comparable market indices for each asset class.
He said investment objectives are more specific. KRS’s short-term objective is that managed funds should exceed returns for comparable unmanaged market indices. The long-term objective is to exceed the actuarially assumed rate of return over two market cycles, which is typically 6-10 years. KTRS’s objectives are to invest funds in the sole interest of members and beneficiaries while allowing for reasonable administrative expenses, and to make sure that invested assets provide a reasonable rate of return, with major emphasis on protecting principal. Because "reasonable" was not defined in either objective, KTRS's objectives cannot be evaluated. Recommendation 3.1 is that KTRS should report specific investment goals and measurable investment objectives.
Investment policies provide specific investment guidelines and are, for both KRS and KTRS, approved by their boards. KRS’s policies can also be changed by the board. KTRS’s policies can only be changed by administrative regulation. KRS has fewer restrictions on investments and no specific allocation constraints. KTRS has several restrictions and asset allocation constraints.
Mr. Graycarek said that KRS’s and KTRS’s investment decisions are also affected by system characteristics, which include member demographics. Decisions also depend on decision makers' judgments, such as how much risk to assume and how to divide management of assets internally or externally. Academic research has consistently concluded that asset allocation plays an important role in rates of return for retirement systems.
Mr. Graycarek reviewed target and actual asset allocations for KRS and KTRS. He pointed out that KRS’s target allocations for domestic equity and fixed income were decreasing, whereas the allocations for international equity and alternatives like real estate were increasing. These trends were similar to other retirement systems.
KTRS's targets for international equities have increased and targets for fixed income have decreased.
Sen. Harris asked how this compared to other public retirement systems.
Mr. Graycarek responded that KRS’s insurance fund and KTRS allocated significantly more assets to U.S. equities, 56% and 58% respectively, compared to the average of 41%. KRS’s pension fund allocated similarly to the average.
KRS and KTRS gauge investment performance against 4 performance measures or benchmarks: actuarially assumed rates, fund benchmarks, asset class benchmarks, and system long-term objectives. KRS and KTRS have met the long-term objectives. Actuarial rates are used in determining the projected unfunded liability. In both systems, their actual returns exceeded the actuarial rates over the 1-, 3-, and 5-year periods, but fell slightly short in the 10-year period. KTRS’s actuarial rate of 7.5% has remained constant over this period. For KRS, the actuarial rate has declined from 8.25% to 7.75%. Most comparable retirement systems reported an 8% actuarial rate, but rates ranged from 7.25% to 8.5%. Over the past 1-, 3-, 5-, and 10-year periods, the KRS pension and insurance funds consistently outperformed their fund benchmarks. Returns for the asset classes in those funds have not always exceeded their asset class benchmarks. In FY 2007, one reported asset class benchmark was met for the pension fund and none for the insurance fund, yet the fund benchmarks were met. The reason for this confusing result is that cash asset returns exceeded the benchmark, but this was not included in the financial statements.
He said that KRS uses a customized fund benchmark, which, according to KRS staff, approximates asset class target allocations. He noted that it would be helpful, therefore, if KRS clarified how its fund benchmarks are calculated.
Recommendation 4.1 is that, subject to reporting standards, the KRS should report investment returns and benchmarks for all classes of assets. Recommendation 4.2 is that KRS should report more detailed information on how its fund benchmarks are calculated.
KTRS met all its asset class benchmarks for 1-, 3-, 5-, and 10-year periods and met its fund benchmark except for the 1-year returns. Not meeting their 1-year fund benchmark while meeting all asset class benchmarks is a function of the timing of KTRS’s calculation of its fund benchmark.
Recommendation 4.3 is that the KTRS should report its fund benchmark, including a description of how that benchmark was calculated. Recommendation 4.4 is that KTRS should report separate U.S. and international equity asset class returns and benchmarks.
Sen. Harris asked whether KRS and KTRS have had standard benchmarks over the years or whether they use different indices each year.
Mr. Graycarek said that the retirement systems’ representatives would be better able to answer that.
Mr. Graycarek said that in comparison to the averages of other states, the KRS pension and insurance fund benchmarks for U.S. equity and international equity are similar, but the fixed income benchmark is lower. KTRS’s equity benchmark is similar to the U.S. equity average for the other retirement systems, but KTRS combines reporting for international equities and U.S. equities.
He explained that the average returns for the other systems exceeded returns for KRS’s pension fund in every period. The KRS insurance fund’s returns exceeded the average in every period except the 10-year period. KTRS’s returns relative to comparable teacher retirement systems were below average over all time periods. He noted that rates of return vary for many reasons such as systems having different investment goals, objectives, and policies, and because of system-specific factors such as number of members, different salaries, asset allocations, and decision makers’ judgments.
Ms. Hurst pointed out that the market values of asset allocations at the beginning of the year may differ from values at the end. KTRS allocates its individual classes based on book value.
Rep. Palumbo asked what the difference is between the goals and objectives as covered on the presentation.
Mr. Graycarek replied that goals are the broad plan, and objectives are how to achieve those goals. In the case of KRS, the goal is to preserve capital, enhance revenues, and protect from losses. That is done through objectives, which are to exceed unmanaged market indices and to have investment rates of return that exceed the actuarial rate.
Rep. Palumbo said that KTRS’s goals and objectives are confusing.
Mr. Graycarek agreed and noted that one of the recommendations in the report is that KTRS should report specific goals and objectives.
Sen. Stine wanted to know whether there was a chart that showed how KRS and KTRS funds performed relative to nonsubjective benchmarks.
Mr. Graycarek responded that KRS and KTRS show in their financial statements how their funds and asset classes performed relative to the S&P 500 index.
Sen. Stine replied that she would like to see that. She said that it seemed as if the benchmark process was almost retrospective and asked whether that was correct.
Mr. Graycarek replied that the systems do not change their benchmarks throughout the year. They cannot know the values of their benchmarks until the year is over, which is standard for all systems. He said that asset class benchmarks are based on a variety of indices, and fund benchmarks are based on targets or actual allocations.
Sen. Stine asked, regarding governance and those individuals carrying huge fiduciary duty, what code of ethics governs their actions and who reviews their actions.
Ms. Kennedy replied that the board has the ultimate fiduciary responsibility.
Sen. Stine asked about there being any legislative oversight or any kind of governmental oversight or federal oversight.
Ms. Kennedy replied that there is no oversight committee. The board members have the powers and privileges of a corporation.
Sen. Stine asked who these individuals on these boards are and how they are chosen.
Ms. Kennedy replied that for KRS, 5 members are elected by representatives of the different constituencies of the members; 3 are appointed by the governor; and 1 is an ex officio member. For KTRS, 7 members are elected by the membership; 2 are ex offico.
Sen. Stine asked when elections are held and how they are done, including which entities vote for members. She asked for the names of the board members and their qualifications.
Ms. Kennedy responded that there are no statutory qualifications. Terms are 4 years with provision for re-election and re-appointment. Ms. Kennedy said she would provide details on terms and elections and information on board members.
Sen. Stine commended the committee for focusing on this topic. It is very important that safeguards are in place to ensure that funding is invested in the best possible way.
Sen. Seum asked for clarification regarding the $600 million transferred from KTRS’s pension fund to its insurance fund.
Mr. Graycarek replied that some funds have been borrowed and some have been redirected, which are not a debt owed to the pension fund. The insurance fund received about $624 million from the pension fund between FY 97 and FY 07.
Sen. Seum asked for details.
Sen. Harris said that could be clarified by KTRS representatives.
Rep. Rand asked whether the benchmark is a goal where the systems want to be in a particular year or future years.
Mr. Graycarek replied that the benchmarks are related to their investments. The benchmarks are a way of gauging their performance of how particular classes of investments perform.
Rep. Rand asked if they anticipated what benchmarks are projected to be next year or in 5 years or in 10 years.
Mr. Graycarek said that both KRS and KTRS have long-term objectives, which generally are and include, for example, the objective to exceed the actuarial investment rate of return. By year, their benchmarks are not a specific projected number. They are based on how the indices perform that are used as benchmarks.
Rep. Rand asked why KRS members pay into the federal social security system but KTRS members do not.
Mr. Graycarek replied that in the 1950s retirement systems had an option to opt into the federal Social Security system or not. KTRS decided not to opt in. The benefit for members is not having to pay the tax. The disadvantage is not getting Social Security benefits. Contribution rates are higher for KTRS members than for KRS members.
Rep. Rand asked whether someone retiring from KTRS goes onto Medicare or whether the state insurance is primary.
Mr. Graycarek said he did not know and deferred to KTRS to answer that question.
Rep. Meeks asked whether staff found any different governance models that included a requirement for trustees to have experience in investments.
Mr. Graycarek replied that for most comparable systems, board or investment committee members were required to have some investment expertise.
Rep. Meeks asked for clarification that this was not a requirement in Kentucky.
Mr. Graycarek replied that neither KRS nor KTRS has a statutory requirement that its board or investment members have investment expertise.
Rep. Meeks asked about the amounts of funds other states appropriated to their retirement systems and the amounts of net assets in comparable systems.
Mr. Graycarek said that staff did not look at general fund appropriations for other retirement systems. He said net assets varied among the comparable systems. For public employee retirement systems comparable to KRS, the average net asset value was $25 billion and the median was about $20 billion. For the comparable teacher retirement systems, the average was $15.7 billion and the median was about $12 billion.
Sen. Borders asked Mr. Graycarek whether in their investigations they had any reasonable qualms with the actuaries used and with their numbers.
Mr. Graycarek replied that staff did not evaluate the appropriateness of those actuarial rates. They did report in the study that KRS and KTRS actuarial rates are within the range of what most other systems use.
Rep. Simpson noted that the report mentioned administrative expenses. He asked whether staff compared administrative expenses of both pension systems to other states.
Mr. Graycarek replied that staff considered this, but that reporting of expenses in other systems was inconsistent and it was often unclear what expenses were.
Rep. Simpson asked whether they compared the administrative expenses between the two Kentucky systems.
Mr. Graycarek replied that staff had some difficulties with that as well because of differences in how both retirement systems report their expenses.
Rep. Simpson said that it is important for this or another committee to look at that issue. There is a danger if reported expenses are so complicated that they cannot be ascertained.
Sen. Harris commented that this was an excellent point. He reminded members that this report would be revisited through the usual follow-up process. He asked for clarification that Kentucky’s retirement systems have a variety of investment areas, such as domestic and international stocks, and with each of those investment areas there are certain indices that are more appropriate.
Mr. Graycarek said KRS and KTRS mostly use standard indices or benchmarks for their asset classes. There are some benchmarks in both systems in which indices may be combined or they use their own type of index.
Sen. Harris asked whether these were generally accepted industry-wide indices.
Mr. Graycarek answered yes.
Sen. Borders commented that given the unfunded liability of the systems, there should be legislative oversight, working in conjunction with the retirement boards.
Sen. Stine asked whether the amount that is required to be contributed for the ARC [actuarially required contributions] is related to how well the investments are performing.
Mr. Graycarek replied that, all else equal, if investment returns go up, the unfunded liability goes down.
Mr. Burnside said there were 2 recommendations in the report that pertain specifically to KRS and both of those dealt with information that is in the Comprehensive Annual Financial Report (CAFR). One recommendation is to increase the amount of information provided on how benchmarks are developed. The other was to include a full list of the asset classes in the CAFR. He said they would implement those recommendations as they prepare their 2008 CAFR.
Mr. Burnside discussed the importance of investment for any retirement system and that KRS needs to optimize every dollar. He said that KRS would be working with the governor’s pensions task force.
He noted that the report says that KRS’s investments contributed between 64% and 72% of the annual net additions from 2005 to 2007. According to the U.S. Census Bureau, on a nationwide average, investments have added 64.9% of the net value of the fund over that same time period, so KRS has been at or above the national average for this measure.
Mr. Burnside followed up on an earlier question about the pension fund being better funded than the insurance fund. For KERS non-hazardous, the pension fund is at 56.9% funding. The insurance fund is 11.9%. For KERS hazardous, the pension fund is at 83.6% funding; the insurance fund is at 49.8%. CERS employers are required by statute to contribute the full actuarial amount. That system is funded at 82% for the non-hazardous pension fund and the insurance fund is at 28.8%. GASB [Government Accounting Standards Board] standards now require that pension systems report the full actuarial value of the liability for health insurance benefits projected to 30 years. In past years, systems may have been able to report pay-as-you-go funding for insurance.
Mr. Burnside said that systems in many other states do not offer health insurance benefits, or offer a much scaled-back health insurance benefit compared to Kentucky.
Mr. Burnside said that in 2004 the General Assembly changed health insurance benefits for new employees and this will help over time with the cost of benefits.
Mr. Burnside referred to an earlier question about actuarial rates and the expertise of the actuary. KTRS and KRS use Cavanaugh Macdonald as their actuary. It is a nationally recognized firm from Atlanta that works with many retirement systems across the United States. The firm has a reputation nationwide as being very fair and very competent.
Mr. Burnside said the level of benefits for current employees is projected and investments are projected using an assumed growth rate of 7.75%. This is different than a benchmark. There has been recent discussion among investment professionals as to whether states’ actuarial rates are too high.
Mr. Burnside said that KRS’s administrative costs are on page 31 of the actuarial analysis in their annual financial report. In 2007, KRS had $27.8 million in administrative expenses.
Mr. Burnside commented on the actuarially required contributions. He agreed that the better investments do, the lower the required contribution is, but it is not realistic to expect that investments can make up all the unfunded liability.
The report Investment Rates of Return, Governance, and Policies of the Kentucky Retirement Systems and the Kentucky Teachers' Retirement System was adopted upon motion by Sen. Pendleton and seconded by Sen. Seum, without objection by roll call vote.
Mr. Tosh said that KRS pays out about $115 million each month, so investments have to earn at least that much. He noted that there is always room for improvement in KRS’s investments, but that challenge becomes more daunting given the huge unfunded liabilities and unfavorable economic and market conditions.
Rep. Simpson asked Mr. Burnside to discuss board members’ participation levels and expertise on investment issues.
Mr. Burnside said that KRS has a very dedicated board with members who are attorneys, CPAs, people with banking experience, and people with investment experience. Training is provided for investment committee members. The board has an annual retreat for training and discussion, and board members attend conferences.
Rep. Simpson asked Mr. Tosh whether he sees moving toward internationalizing the portfolio as a continuing trend.
Mr. Tosh said that he did. Markets are becoming more global in nature and assets are shifting outside the U.S.
Sen. Borders agreed that investments alone could not eliminate the unfunded liabilities. He said that board members are not being questioned but that legislative oversight is needed.
Rep. Meeks requested that Mr. Burnside provide today’s comments to the committee in writing.
Responding to the report, Mr. Harbin gave an overview of KTRS’s investment history and strategy. He noted that Kentucky is among a minority of states providing health care through the pension plan and that Kentucky is unique in that it is borrowing from the pension plan to fund retirees’ health care. He explained that almost all KTRS members are not eligible for Social Security benefits, which means that employers of members do not make Social Security contributions.
Mr. Harbin responded to Sen. Seum’s earlier question and said that contributions have been borrowed or diverted that otherwise would go into the retirement system to retiree health care. This has been done since 1998 when the law first allowed the board of trustees to take up to 3.25% of the incoming contributions and move them to retiree health care. Up to 2004, the total amount of funds that were transferred was $335 million. KTRS was 98% funded at that time. In 2004, actuaries recommended that this stop, but funds were directed through the budget to continue the process. There has been continued redirection of contributions to the total of $289 million through this fiscal year. Through the next biannual, there will be another $273 million. Those funds are being paid back by the Commonwealth. The actuarial rate (7.5%) is the rate of interest that is being paid on those monies and these payments are included in the current budget.
Sen. Harris pointed out that KRS retirees have the same health care benefits as single employees but in the KTRS this is not the case. He asked Mr. Harbin to elaborate on how KTRS’s health benefit is different.
Mr. Harbin said that in the KTRS a medical plan is required but the health benefit is provided to the level of funding that the board of trustees has available. Since 2004, the board has not had that funding available and it has been provided through the budget process in directing the board to use contributions that would otherwise be in the retirement side to pay for retiree health care.
Sen. Harris noted that KTRS retirees have to pick up some of the cost of their insurance.
Mr. Harbin confirmed that they pick up the cost beyond single coverage. Referring to Sen. Stine’s earlier question regarding improved investment returns lowering the ARC, he said KTRS’s employer contribution rate is fixed by statute and is not dependent upon the investment return directly.
Mr. Harbin said that KTRS’s administrative costs and investment costs are very low compared to other pension plans. He said that KTRS’s investment policy is governed by administrative regulation.
Sen. Harris asked whether KTRS’s hands are tied through statute and regulation.
Mr. Harbin said that KTRS is limited to some extent, but administrative regulations were changed in July 2007. 15% of KTRS stocks can be in international stocks.
Rep. Palumbo asked for examples of international equity and international private equity.
Mr. Harbin responded that international equity is a publicly traded company that may be sold on the exchanges in foreign countries. International private equity is a company that is not on those exchanges.
Rep. Palumbo asked for a specific example of an international public equity.
Mr. Harbin said that Nokia is an international public equity.
Mr. Harbin added that KTRS has been changing its asset allocations in recent years, which includes beginning to invest in international equities and increasing those investments over time. He noted that in comparison to other large plans, KTRS ranked highly as late as 2003 but its rankings were below average beginning in 2004. He indicated that KTRS’s rankings have been improving though and they were in the upper half of the rankings for the most recent quarter.
Mr. Todd presented an overview of investment strategy and investment advice offered to Kentucky Teachers' Retirement System.
Sen. Harris said that the next meeting is scheduled for July 10th.
The meeting was adjourned at 12:55pm.