The Program Review and Investigations Committee met on Thursday, July 9, 2009, at 10:00 AM, in Room 129 of the Capitol Annex. Senator John Schickel, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator John Schickel, Co-Chair; Senators Charlie Borders, Vernie McGaha, R.J. Palmer II, Joey Pendleton, Dan "Malano" Seum, Brandon Smith, and Katie Kratz Stine; Representatives Dwight D. Butler, Leslie Combs, Rick G. Nelson, Ruth Ann Palumbo, Rick Rand, Arnold Simpson, and Ken Upchurch.
Guests: Cathy Hinko, Executive Director, Louisville Metropolitan Housing Coalition. Gary L. Harbin, Executive Secretary, Teachers’ Retirement Systems of Kentucky. Mike Burnside, Executive Director, Kentucky Retirement Systems.
LRC Staff: Greg Hager, Committee Staff Administrator; Rick Graycarek; Christopher Hall; Colleen Kennedy; Van Knowles; Lora Littleton; Jean Ann Myatt; Rkia Rhrib; Sarah Spaulding; Katherine Thomas; Cindy Upton; Stella Mountain, Committee Assistant; Program Review and Investigations Committee Staff. Emily Spurlock; Carlos Lopes; Mike Clark; LRC Staff Economists.
Upon motion made by Senator Seum and seconded by Senator Pendleton, the minutes of the May 14, 2009 meeting were approved by voice vote, without objection.
Emily Spurlock presented the report Housing Foreclosures in Kentucky.
Ms. Spurlock clarified terms used in conjunction with foreclosure. Delinquent means that the loan is past due; default is the point at which the lender determines that the payment is not going to be made, usually 90 or 120 days late; and foreclosure can be initiated by the lender after the borrower defaults. The foreclosure process is the legal proceeding to end the borrower’s title to the home, and force the home to be sold to pay off the mortgage.
She said the foreclosure process varies between states. Kentucky is a judicial foreclosure state; foreclosures are handled by circuit courts. After the lender files the foreclosure case with the circuit court and if the homeowner does not respond to the court, the court typically rules for the lender. The property is referred to the master commissioner to be sold at a public auction. The foreclosure can be halted if any certain conditions are met.
In the fourth quarter of 2008, Kentucky had 7.5 percent of loans past due, compared to 7.8 percent nationally. At the same time, 0.78 percent of loans in Kentucky and just over 1 percent of loans in the nation entered foreclosure.
The number of foreclosure cases referred to Kentucky master commissioners for sale is higher in the middle portion of the state. In 2008, there were almost 17,000 cases referred for sale statewide. As much as 40 percent of the properties referred for sale are withdrawn before they are actually sold.
Data from master commissioners in three counties indicated that the trend in the number of properties sold in recent years varied. In Hardin County and Jefferson County, there was a substantial increase. There was no significant increase in Davies County.
Ms. Spurlock said one of the recent changes in real estate finance, often cited as one of the causes of the increase in foreclosures, has been the growth in subprime lending. A subprime loan is a loan made to a borrower who does not qualify for the best interest rate and loan terms. In recent years, more loans were originated with the intention of being sold, which passes the risk of default from the originator of the loan to the purchaser of the loan. Since the risk does not stay with the originator of the loan, there was an incentive to offer mortgages with riskier aspects such as loans with little or no down payment, or an adjustable rate mortgage with a low initial interest rate that cannot be maintained.
Past due subprime loans started to increase much sooner than prime loans. Subprime loans only make up about 10 percent of the loans for Kentucky; prime loans are about 70 percent of the loans. In the fourth quarter of 2008, about 4.25 percent of prime loans were past due, and about 21.2 percent of subprime loans were past due.
She said changes in interest rates have affected foreclosures. In one survey in 2006, 12 percent of loans in Kentucky had an adjustable rate. Adjustable rate loans adjust based on an index, plus a margin that will be spelled out in the loan documents. Indexes increased significantly, which contributed to many ARMs resetting to a much higher interest rate. Past due adjustable rate loans increased sooner than the fixed rate loans.
Ms. Spurlock said changes in house prices were a factor. Kentucky did not experience the dramatic increase or decline seen nationally, but some metropolitan areas in Kentucky did experience a decrease in the house price index. As house prices decline, it becomes more difficult for homeowners to sell their house for enough to pay off their mortgages and avoid foreclosure.
She said the third and most recent contributing factor to foreclosures is employment. As problems in the housing market spilled over into the rest of the economy, employment suffered and the unemployment rate increased. Kentucky’s unemployment rate has historically been higher than the U.S., and in recent months, the unemployment rate for both has risen rapidly.
Ms. Spurlock said foreclosures impact borrowers, lenders, neighborhoods, and government. Borrowers who are involved in a foreclosure lose their homes, may lose any equity they had in their home, and they may have a more difficult time obtaining credit in the future. Borrowers who are not directly involved in a foreclosure may still be impacted by credit being harder to obtain, stricter underwriting standards, and higher interest rates.
Ms. Spurlock said losses to lenders vary, depending on contracts between lenders, servicers, and investors. Actual costs from the foreclosure depend on how long the process takes, and the condition of the property. One local source estimated that foreclosures cost the lender about $25,000 to $30,000 per property.
She said one of the most visible effects of foreclosures is on neighborhoods. An increase in foreclosures can cause a decrease in surrounding property values. The most impact occurs when multiple foreclosures occur in dense, urban areas. One example of this is West Louisville, where 22 neighborhoods have experienced net declines in total assessed property values of almost $240 million.
Ms. Spurlock said impacts on government from foreclosures come in two forms. The first is the cost to governments to maintain vacant housing. The second cost is from real property tax revenues because of delinquent payments or changes in property tax assessments.
State real property tax revenues are growing, but at a slower pace because total state property assessments are growing slower, delinquencies are expected to increase, and less new properties have been added to the tax base.
Ms. Spurlock said government responses to increased foreclosures have come at the federal, state, and local level. Federal responses include a moratorium on foreclosures for some loans. The federal loan workout program has two components: a loan modification program aimed at helping borrowers modify their loan payment, and a loan refinance program. The “Neighborhood Stabilization Program” provides money to states and local governments to purchase and redevelop abandoned properties. Kentucky recently received almost $35 million through this program; Louisville received an additional $7 million.
She said at the state level, Kentucky has implemented the Homeownership Protection Center, which helps homeowners facing default. In total, 25 states have enacted laws in the last two years that deal with foreclosure issues covered in the Program Review report. A program implemented by the Jefferson Circuit Court earlier this year is the Residential Foreclosure Conciliation Program, which is aimed at encouraging a conciliation conference between the borrower and lender.
Senator Schickel asked whether any research had been done on the relationship between an amount of a down-payment and the frequency of foreclosure.
Ms. Spurlock said that down-payments have been small in recent years and the median was about 4 percent. With a low down-payment, it is possible that when house prices decline, the mortgage amount is higher than what the house is actually worth.
Senator Seum said it seems that Kentucky is faring better than other states.
Ms. Spurlock said that the impact in Kentucky has been much less than in other states.
Senator Seum asked what the foreclosure rate was before this crisis started.
Ms. Spurlock said in the mid-1990s the percentage of loans entering foreclosure was about 0.2 percent of loans in the survey.
Senator Seum stated that the increase in Kentucky was from 0.2 percent to less than 1 percent. He asked for details on the survey that was used.
Ms. Spurlock said this survey included about 440,000 loans in Kentucky, which is about half of the loans in Kentucky. Nationwide it covers about 80 or 85 percent of all loans. It probably covers about half of the loans in Kentucky.
Senator Seum asked whether local PVAs are required to lower assessments to reflect the new price if properties are losing value.
Ms. Spurlock said PVAs are required to set the fair cash value of the property based on surrounding property sales.
Senator Seum said he had a rental property that sold for much less than the assessed value and that no homes in that neighborhood were close to the assessed value of the property. He wondered if shortages were covered by over-assessing some properties.
Representative Simpson mentioned that Kentucky is a lien theory state, which in many instances leads to a higher bankruptcy rate. He asked whether staff knew of states that changed from a lien theory state to a title theory state to negate deficiency judgments.
Ms. Spurlock said she was unaware of any states that changed.
Representative Simpson asked what other conclusions staff reached on the process of changing from a lien to a title theory state.
Dr. Clark said that moving to a lien theory would tend to reduce the cost to the borrower and increase the cost to the lender. He said a law that tends to provide consumer protections essentially increases the cost to the lender because they will have to bear a greater portion of the cost.
Ms. Spurlock said studies show that any state laws that make it more difficult to foreclose and favor the borrower, are going to increase costs to the lender and those costs are going to be passed on in less available real estate credit, higher interest rates, and more fees.
Representative Simpson said that would also make lenders more diligent in the process of providing loans.
Ms. Spurlock said that may be one of the contributing factors to less available real estate credit.
Representative Simpson asked whether the Jefferson County PVA actually decreased the assessments of those properties that decreased in value.
Ms. Spurlock said that was correct. Those 22 neighborhoods in Louisville were the only neighborhoods where the entire neighborhood value declined.
Representative Butler asked about the status of the Neighborhood Stabilization Program in Kentucky.
Ms. Spurlock said the Neighborhood Stabilization Program has two rounds; the first round of funding has already been allocated and the state received $35 million and Louisville received $7 million. The second round of funding is a nationwide competitive grant process that is still being allocated and the application process is open until the middle of July.
Representative Butler asked what the cities or groups are doing with this money and what the restrictions are.
Ms. Spurlock said the money has to be used for the purchase and development of abandoned foreclosed homes. Usually these organizations purchase homes, fix them up, and resell them to possibly lower income families.
Representative Butler asked whether staff looked at the effects of short sales on properties or how difficult those were to deal with.
Ms. Spurlock said that some banks are allowing short sales and the difficulty varies, depending on the lender.
Representative Butler said that in his experience it is very difficult to deal with these loan companies, especially the out-of-state ones, and that might be something to look at in the future.
Senator Stine asked whether staff were able to determine what the effect on the SEEK formula was, and when schools would see increased SEEK allotments as a result of the decline in property values.
Ms. Spurlock said they did not specifically look at the impact on the SEEK formula. However, school districts are allowed to change tax rates and set them to a compensating tax rate that would provide as much revenue as was produced in the previous year or up to 4 percent.
Senator Stine said she would be interested in the impact on the SEEK formula if staff have an opportunity to look into that. Northern Kentucky is adversely affected by foreclosures and that is also the area that is most hurt by the way the SEEK formula operates.
Representative Palumbo asked how long a bank has to wait to put a property into foreclosure.
Ms. Spurlock said the point of default is spelled out in the loan documents. At the point of default, the lender would determine whether or not to go ahead and file the foreclosure case or to wait. At the moment many lenders are waiting and attempting to work out a loan modification or to see if any type of plan can be arranged with the home owner. Some of the master commissioners have a considerable backlog of filed cases due to the high volume of property sales. In Lexington, it takes about 3 or 4 months from when the property is received for sale to when it would be actually sold.
Representative Palumbo asked why they have this backlog and whether they are only allowed to sell a certain number of properties per day.
Ms. Spurlock said the master commissioner follows the rules of the local circuit court, and the sales dates are set by the local rules.
Senator Schickel asked about the correlation between foreclosures and down payment in Kentucky compared to those nationally.
Ms. Spurlock said she was not aware of available down payments rate by state data.
Rep. Simpson asked whether the study included bank foreclosures as well as foreclosures by tax liens and entities.
Ms. Spurlock said this study included only bank foreclosures on residential properties for first lien mortgages. In the case of property tax bills, usually the lender will file the foreclosure before the county has a chance to.
Representative Simpson said that was not necessarily the case. There are many properties where people have paid off mortgages and quit paying taxes. In these cases, the county, the cities, or third party purchasers will file foreclosures.
Senator Schickel asked Cathy Hinko, Executive Director of the Louisville Metropolitan Housing Coalition, to discuss foreclosures.
Ms. Hinko said the coalition has been studying foreclosures since 2003 when it became apparent that Kentucky was experiencing a large number of foreclosures. Foreclosures in Jefferson County are no longer only in targeted neighborhoods; they are everywhere. In 2003, thousands of households were already losing their homes. In 2008/2009 school year that just ended, in Jefferson County, almost 9 percent of all public school students were homeless at some point during the school year, and this is believed to be an underreported amount. That trend has increased by 75 percent from 5 years ago.
Ms. Hinko cited statistics from the Greater Louisville Association of Realtors that home sales and prices in Louisville have decreased. There are variations within Louisville; prices are up in some areas and down in others.
Ms. Hinko said the 0.78 percent of loans entering into foreclosure in one quarter is a very disturbing rate if one looks at the cumulative effect of homes that are in jeopardy. She cited statistics on how foreclosures in surrounding counties increased by 3 percent to 333 percent from 2002 to 2007. She also pointed out that between 2000 and 2007, the median income adjusted for inflation nationally went down 7 percent but the median rental cost went up 7 percent.
Ms. Hinko mentioned a study that shows the impact on African-Americans of the use of high cost mortgages. In Lexington/Fayette County, 38.51 percent of the mortgages issued in 2006 to middle- and upper-income African-Americans were high cost, compared to 19.49 percent of the mortgages issued to white households. Studies attribute at least 25 percent of homeless children to foreclosures.
Ms. Hinko said there are many scams in which someone claims to be from the federal government. She said the Attorney General’s office is looking into this. She said not many people are refinancing under some of the new federal mortgage products.
Representative Simpson said if Ms. Hinko had a proposal to protect homeowners from predators, he would be very supportive. He said the issue of foreclosures is not really a legislative problem; it is a financial problem and a problem with the banking industry. Proposals are needed to better educate consumers to stay within the level of their means and to purchase homes responsibly. He asked Ms. Hinko whether she had any comments or proposals.
Ms. Hinko said House Bill 552 defines high cost loans for Kentucky well and her opinion was that an even more aggressive definition of high cost loans is needed. She agreed that education is important but nobody had ever seen such exotic loans and products before and could not have been educated on them beforehand. Education, funded through the state housing finance agency, KHC, would be wonderful. She felt that financial education in the schools, starting in junior high school, is important.
Representative Simpson said education is really the challenge and that no legislative solution is needed other than trying to advance those educational components.
Ms. Kinko said the Jefferson County Circuit Court has a new program, a conciliatory conference, which parallels the foreclosure. In Philadelphia they use this conciliatory conference and have diverted about 25 percent of the actual foreclosures that have been filed in court into some sort of resolution. She commends that system and hopes that it will be implemented in all circuit courts.
Representative Simpson commented that these conciliation conferences would be very useful to help keep homeowners in their homes and, more importantly, exclude the option of bankruptcy, which has a very high rate in Kentucky.
Senator Seum asked how many mortgages there are in Jefferson County.
Ms. Hinko said she did not know.
Senator Seum asked how they have come up with these percentages if the total number of mortgages is not known.
Ms. Hinko said the best data available would be the 2000 Census. She said that the Office of Financial Institutions may have a more accurate number of people with mortgages.
Senator Seum expressed concern about the property evaluation administrators adjusting their taxes fairly. He asked whether the property assessments for neighborhoods that lost 49 percent of the value of their homes also went down by 49 percent.
Ms. Hinko said she did not know.
Senator Seum said the Louisville Metropolitan Housing Coalition may want to look into the matter to make sure that home owners pay the correct amount of tax.
The report Housing Foreclosures in Kentucky was accepted by roll call vote upon motion made by Senator Seum and seconded by Representative Simpson.
Greg Hager followed up on the report Investment Rates of Return, Governance, and Policies of the Kentucky Retirement Systems and the Kentucky Teachers’ Retirement System, which the committee adopted last year.
Mr. Hager updated the committee on the investment returns for the time periods of 1 year and 10 years for Kentucky Retirement Systems, the Kentucky Teachers’ Retirement System, and retirement systems comparable to each. Returns updated to include FY 2008 were down significantly for both Kentucky systems and the average comparable system.
Mr. Hager also updated the committee on how the systems had implemented the 5 recommendations made in the report. KTRS’s long-term investment goal is still unclear based on the 2008 Comprehensive Annual Financial Report, but otherwise the recommendations have been implemented by both systems.
Representative Simpson asked what the actual dollar amounts are compared to the national benchmarks.
Mr. Hager said he did not have that calculation.
Gary Harbin, Executive Secretary of the Teachers’ Retirement System of Kentucky, updated the committee on KTRS.
Mr. Harbin said when compared to the 58 major state-wide pension plans reporting in the Pension Fund Data Exchange as of March 31, 2009, KTRS ranked in the top 9 percent over the past year, the top 19 percent over the past 2 years, and the top 31 percent over the past 3 years. Compared to the 10 pension plans that KTRS was compared to in the LRC study, KTRS has outperformed 9 out of 10 of these plans through March 31, 2009. In a larger universe of all pension plans, both public and private with a billion dollars or more, KTRS ranks in the top 24 percent. He said the reason that KTRS has outperformed other pension plans is that other pension plans were taking more risks.
Mr. Harbin said KTRS has changed its asset allocation from only large cap stocks and fixed income to 4.1 percent of the portfolio in mid-cap stocks, 2.6 percent of the portfolio in small cap stocks, and about 11.6 percent in international stocks. Fixed income is about the same as it was in 2000; the amount in cash has been reduced, and the amount in real estate has increased. KTRS’s goal is to have 5 percent of its assets invested in alternative assets, a new investment class.
Mr. Harbin said the Board of Trustees has voted to expand the Investment Committee to seven members: 5 trustees, 2 of whom are investment experts, and 2 nontrustees who are investment experts.
Mr. Harbin said KTRS has developed a Web-based training system for members of the KTRS Investment Committee. Additionally, each member of the Investment Committee participates in continuing education on an annual basis, consistent with the investment consultant’s recommendations of best practices in the pension industry.
Mr. Harbin said an investment consultant and actuary are conducting an asset liability modeling study to match the investments of the system to its liabilities. This study will be the basis of future asset allocations. KTRS has a fixed employer contribution rate coming from the state, out of which it has to pay for retiree health care. This situation has to be resolved for KTRS to remain actuarially sound into the future. The investment consultant is consulting with KTRS regarding best practices and a report to the board will follow. To date, the most significant item discussed with KTRS has been to eliminate the statutory requirement that investment policy be included in administrative regulation.
Mr. Harbin reported that KTRS has no issues related to “pay to play.” They have been very diligent in this area and their investment manager contracts prohibit payment of fees be paid to obtain the contract without KTRS’s written consent. The KTRS Board of Trustees has adopted a policy that prohibits investment managers, investment consultants, staff, Investment Committee members and Board members from having conflicts of interest, and all those individuals associated with investments have signed conflict of interest statements to that effect.
Mr. Harbin said KTRS acted on all recommendations made by Program Review. Their primary goal is to earn the required return over the long-term with minimal volatility to provide sound actuarial funding of member benefits. KTRS’s current actuarial assumed rate of return is 7.5 percent.
Senator Stine asked Mr. Harbin to elaborate on alternative assets.
Mr. Harbin said they include private equity, bench shore capital, timberland, and other alternative assets, and investing directly in companies, usually small companies.
Senator Stine asked whether the same level of safeguards and protections are in place that might apply to other types of investments.
Mr. Harbin said there is more risk but higher reward involved in these types of investments.
Senator Stine asked how the advisors are chosen and how frequently.
Mr. Harbin said the investment advisors were chosen through an RFP process. He said typically they want to obtain the services of a good investment advisor, keep the advisor for a long period of time because they are long-term investors, and review the work on an annual basis. KTRS would keep an advisor 10 years or more.
Senator Stine asked how they decide to change their advisor.
Mr. Harbin said it is time to change the advisor when the advisor is no longer able to take the investments of KTRS to where they want to go, or the advisor has changed or lost this focus.
Senator Stine asked what the penalty was for violating the conflict of interest agreement that everyone signs.
Mr. Harbin said that if it is a vendor, KTRS will stop doing business with the vendor. If it is a staff person, that person will be fired. If it is a member on the Board of Directors, the manager who violated the conflict of interest agreement with the board member will be discharged.
Senator Stine asked whether there are criminal consequences.
Mr. Harbin said there are no criminal consequences related to the policy that the board has stated. There are criminal consequences if there is “pay to play” going on.
Senator Stine asked whether KTRS has rejected investors who have used placement agents.
Mr. Harbin said that was correct.
Senator Stine asked whether they have accepted any investors who had used placement agents.
Mr. Harbin said they have not. KTRS has no contracts with anyone who has made a payment to get the contract at KTRS.
Senator Stine asked whether that is in written policy.
Mr. Harbin said it was.
Senator Stine asked about the anticipated 7.5 percent rate of return, and what the actual rate of return is for this year.
Mr. Harbin said currently the actual rate of return for this year is about minus 14 percent.
Senator Stine noted that that is a significant difference and asked whether the anticipated amount should perhaps be more realistic.
Mr. Harbin said of the anticipated amount, 7.5 percent were long-term investors. They are investing over decades, not years, and over the long-term, they are confident that they can achieve a 7.5 percent return, given historical performance in all those asset classes.
Senator Stine said that her concern was how this affects the ARC [actuarial required contribution] increase because it would appear that they should put more money in if they are not performing to the level that they anticipate.
Mr. Harbin said typically with pension plans that is the case, that they have a direct impact on the ARC whenever there is a decline in the market value of the investments. KTRS has a fixed employer contribution rate by statute since its inception which needs to be increased.
Representative Simpson asked whether KTRS reports annually to one of the standing committees.
Mr. Harbin said they do not present a report but they do submit their CAFR annually as well as a report about their investments, especially in the investments made in Kentucky.
Representative Simpson said he thought that every year KTRS appears before State Government or a committee that monitors their progress on investment.
Mr. Harbin said they do not present an annual report verbally. They do present annual reports but in the written form.
Representative Simpson asked whether a 1 percent change in a 12 billion of assets is $120 million.
Mr. Harbin said a 1 percent change is about $120 million.
Representative Simpson asked what KTRS’s annual employer contribution is and how much the Commonwealth gives them to augment the retirements of the teachers.
Mr. Harbin said they match it, and teachers contribute 9.855 percent.
Representative Simpson asked how much that is in dollars.
Mr. Harbin said it is roughly $360 million, and then the state matches that plus a 3.75 percent overmatch, so roughly $400 million.
Representative Upchurch asked whether there is any kind of compensation package for the board members.
Mr. Harbin said they are reimbursed at the rate of $90 per meeting, $90 per day.
Representative Upchurch asked how much the state and employees pay into this system each year, and how much is paid out.
Mr. Harbin said the employees and the state pay into the system about $750 million to $800 million a year, and KTRS pays out about $1.5 billion.
Senator Seum asked who receives the annual report, the Legislative Research Commission or the State Auditor.
Mr. Harbin said both.
Mike Burnside, Executive Director, Kentucky Retirement Systems updated the committee on KRS. He explained how KRS has implemented the recommendations made in the report. He said the benchmarks used are industry standards and are calculated by their custodial bank at the beginning of the year based on their asset allocation model and what they project as targets for those asset allocations. Benchmarks do not change throughout the year, but their asset allocation does. He showed how they calculate the benchmark and showed their target and average for the year. The KRS Pension Fund and the KRS Insurance Fund generally did meet their benchmarks throughout the year; some months they were slightly below, some slightly ahead.
Mr. Burnside said the KRS compares its performance to its peers in the Pension Fund Data Exchange. As of March 31st, KRS was in the top 24 percent of all pension funds reporting to the Pension Fund Data Exchange, in the top 26 percent for the trailing year, and the top 36 percent throughout the third year. In the current quarter, their performance is negative 6.86 percent, and they are in the top 55 percent of all pension funds reporting to the Pension Fund Data Exchange. This is not a reason to be alarmed because for long-term investors, one quarter is far too short a term to judge ones pension or investment performance overall.
Mr. Burnside said most of those reporting to the Pension Fund Data Exchange do not report on insurance funds. Looking at the different asset classes for the KRS Insurance Fund, he said KRS performed well against its peers, but when one compares the insurance fund overall to the universe of peers for the Pension Fund Data Exchange, KRS did not fare well.
Mr. Burnside compared KRS Pension Fund and Insurance Fund asset allocations to the median fund in the Pension Fund Data Exchange. Generally, their allocations are very close to the median fund. The Insurance Fund has invested heavily in domestic and international equity. Because there is no fixed income in the Insurance Fund, it has a larger than median allocation to the Treasury Inflation Protected Securities.
Mr. Burnside said the fixed income portfolio of the pension fund as of May 31 overall is negative 1.24 as opposed to a benchmark of a plus 3.5. To correct that, they have hired a new director of fixed income and are in the process of replacing underperforming managers with money managers who are more able to match their goals and take KRS where it needs to be in the fixed income market.
He said the insurance fund has performed very close to its benchmarks, negative 23 percent year-to-date as opposed to a performance benchmark of negative 23.23 percent.
Mr. Burnside said the markets are very uncertain. There was no way of knowing how the markets were going to perform, and there is no way of predicting exactly where the markets are going. The best approach for KRS is to stick to a long-term strategy and try to position itself in a way to come out of this with the best returns possible.
Mr. Burnside said KRS’s investment expenses include security lending fees, common stock commissions, contractual services for their consultants, investment advisors and the custodial bank. Their biggest expense is in securities lending fees in paying interest on the collateral earned, known as broker rebates. The securities lending income is higher than the broker rebates so they are making a profit.
Mr. Burnside said the operating expenses of the KRS will be about $26 million for this year, which includes operating the fund and salaries and benefits for 250 employees.
Mr. Burnside said they do not have a written policy on placement agents in place right now. A draft policy is going to be presented to the Investment Committee at its next meeting in August. The policy on placement agents is aimed at increasing transparency, and decreasing or eliminating the possibility of a conflict of interest. KRS requires conflict of interest statements to be signed by all board members, all investment committee members, and everyone doing business with the system.
In conclusion, Mr. Burnside said KRS has decreased from a $16 billion fund last year to about a $12 billion fund, a decrease of almost 25% in market value which has had a significant impact on the system. They are in a negative cash flow situation. Their annual required contribution is not set by statute; it is set by the budget process through the legislature. He said next year the annual required contribution that they recommend in the budget cycle will be larger than it was before. To make up this shortfall and to make ends meet, the employers will have to pay a higher fee and live up to the funding schedule that was set forth in House Bill 1. He said the negative cash flow situation is beginning to impact their ability to invest.
Senator Stine said that KRS can adversely affect the entire state’s budget. She expressed concern about the system being significantly under the actuarial projections and that they will have to come up with a large amount of money. She asked when information for FY 2009 would be available.
Mr. Burnside said the custodial bank has to value the fund and give them an audited statement, which should take another 2 weeks.
Senator Stine asked if there are any criminal penalties for anybody violating their conflict of interest contracts.
Mr. Burnside said he was not aware of any criminal penalties for the conflict of interest.
Senator Stine asked to receive a copy of the policy on placement agents as soon as it is available.
Senator McGaha asked what percentage contribution is paid by the employee.
Mr. Burnside said nonhazardous employees pay 5 percent pre-tax; hazardous employees pay 8 percent; and employees hired after September 1 of 2008 pay an extra 1 percent for the health insurance contribution.
Senator McGaha asked who sets that contribution rate.
Mr. Burnside said the contribution rate for employees is set by statute; the employers’ is set through the annual required contribution recommendation.
Senator McGaha asked how much a 1 percent raise would be on employee contribution.
Mr. Burnside said they have 5 different systems and they would have to add up what the employee contributions were to come up with a figure.
Senator McGaha said he would be interested to see what 1 percent equates to.
Mr. Burnside pointed out that, because of the inviolable contract, employee contribution rates cannot be raised without a corresponding increase in benefits.
Representative Simpson asked why KRS has different investment models for the pension and insurance funds.
Mr. Burnside said the insurance fund is a younger fund; its asset liability model is different because they wanted more growth potential and a more aggressive fund to increase its funding standard.
Representative Simpson said he does not see why they would be more aggressive with one fund as opposed to the other.
Representative Simpson suggested that staff share the Housing Foreclosure Report with the Banking and Insurance Committee staff so they can review it in preparation for possible legislation for the next session.
Senator Schickel directed staff to also share it with the State and Local Government Committee staff.
He said the next meeting is scheduled for August 13.
The meeting was adjourned at 12:25pm.