Call to Order and Roll Call
The 1st meeting of the Public Pension Oversight Board was held on Tuesday, December 17, 2013, at 1:00 PM, in Room 154 of the Capitol Annex. Senator Joe Bowen, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator Joe Bowen, Co-Chair; Representative Brent Yonts, Co-Chair; Senators Jimmy Higdon and Gerald A. Neal; Representative Brian Linder; Robyn Bender, Tom Bennett, Michael Bowling, Jane Driskell, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: Eric Jarboe, Lear Net; Clyde Caudill, Jefferson Community Technical College System (JCTCS) and Kentucky Association of School Administrators (KASA); Lowell Reese, Kentucky Roll Call; and Marti White, Kentucky Association of School Superintendents (KASS).
LRC Staff: Brad Gross, Judy Fritz, Karen Powell, Marlene Rutherford.
Board Member Introductions
Chair Bowen provided the opportunity for each board member to introduce themselves and provide a brief background personally and professionally. Mr. Bennett, the board designee representing the Auditor of Public Accounts, stated that the Auditor’s Office audits the state-administered retirement systems and that there may be situations in which he will not involve himself in discussions or not cast a vote due to his position and the duties required of the Auditor’s Office. He also stated that an audit of the Kentucky Retirement Systems (KRS) was recently completed on December 11, 2013, by the State Auditor and is available on the Auditor of Public Accounts’ website. This was the first audit completed by the Auditor’s Office since the passage of HB 300 in the 2012 Regular Session, which required the systems’ annual audit be completed by the Auditor’s Office every five years.
Public Pension Oversight Board Duties and Responsibilities
Chair Bowen provided an overview of the duties and responsibilities of the board outlined in KRS 7A.250. The board is charged with reviewing the administration, benefits, funding, and investments of the Kentucky Retirement Systems. Duties include: reviewing laws, regulations, policies, and plan documents of the Kentucky Retirement Systems and making recommendations; completing a review of employee benefits every five years for employees who began participating on or after January 1, 2014, and making recommendations necessary to maintain sustainability of the systems; reviewing investment programs semiannually of the Kentucky Retirement Systems (KRS); reviewing benefits, by-laws, policies, or charters established by the KRS; studying and recommending changes on legislative proposals affecting the KRS as requested by the Speaker and President and report the findings of costs, implications, and whether those proposals are desired as a matter of public policy; reviewing and providing comments regarding administrative regulations issued by the KRS; studying issues related to KRS as directed by the Legislative Research Commission; and publishing by December 1 each year an annual report that will include legislative recommendations, a summary of the financial and actuarial condition of the retirement systems and an analysis the adequacy of funding levels, with the first report being issued in 2014. A work plan is being developed and will be provided by the next meeting of the board. Future meetings will mainly encompass overviews of benefits and funding and a review of investments.
LRC staff members Brad Gross, Committee on State Government and staff the Public Pension Oversight Board provided an overview of SB 2; Frank Willey, Budget Review, discussed the budgetary impact of SB 2; and Jennifer Hays, Interim Joint Committee on Appropriations and Revenue, provided a fiscal analysis of HB 440.
Mr. Gross provided a PowerPoint presentation and noted that he would be providing background information on SB 2 including the funding policies, cost of living (COLA) changes to current employees and retirees, the hybrid cash balance plan for new hires, governance and oversight changes, employer rate projections and values provided by KRS during the 2013 Session with and without the changes by SB 2, and updated employer rate projections by the KRS of the most recent actuarial valuation after the passage of SB 2. The board will be reviewing and discussing the details of benefits, funding, and investments.
Funding of benefits are made up of three sources: employee contributions fixed by statute as a percentage of employee pay, employer contributions that vary based upon the results of the annual actuarial valuations, and investment returns. The individual employer contribution rate for a system is made up of two parts: the “normal costs,” which is the on-going costs of the plan or how much the actuary has determined needs to be budgeted to pay for benefits earned during the year based on upon plan assumptions and the “unfunded liability payment,” which is an amount needed to pay off the unfunded actuarial liability typically over a 30 year period. SB 2 incorporated most of the 2012 Public Pensions Task Force recommendations that were established by HCR 162 in the 2012 Regular Session, and other changes and revisions added through the legislative process. SB 2 did not impact the Kentucky Teachers’ Retirement Systems (KTRS). One of the biggest issues in developing SB 2 was paying the full actuarially required employer contribution rate to the Kentucky Employees Retirement System and the State Police Retirement System which had been reduced in past years, mostly since FY 2002-03. SB 2 removed the provisions of HB 1 passed in 2008 that established a phase-in schedule to incrementally increase the employer contribution to reach the full actuarially required contribution (ARC) over time for those two systems and replaced it with a policy to begin fully funding the ARC in FY 2014-15. When the full ARC is not paid, additional unfunded liabilities are created that leads to higher employer contribution rates. Unfunded liabilities have grown in recent years and as a result the payments for financing the unfunded actuarial liabilities (UAL) over the 30 year period (provided by statute) have also increased. Part of SB 2 was to reset the amortization period for financing the unfunded liabilities which will reduce the employer contributions in the short term but will require additional cost in the long term.
Another major change in SB 2 related to the retiree COLA that ended the annual automatic COLA but included language that authorized a 1.5 percent adjustment if the retirement system is 100 percent actuarially funded and legislation authorized surplus funds to provide the COLA or if funds are appropriated to prefund the COLA by the General Assembly in the year provided. Mr. Gross said these same provisions were also amended for the legislative and judicial plans in SB 2 and noted that the COLA for KRS and the legislative and judicial plans had already been suspended for the 2012-2014 biennium in the current biennial budgets passed in 2012. Another major benefit change is the benefit modification for new hires, which established a hybrid cash balance plan for new KRS participants beginning on or after January 1, 2014. The cash balance plans are a type of defined benefit plan but have characteristics of a defined contribution and defined benefit plan because it is an individual account that pays benefits based upon an account balance of employee and employer contributions (or credits) and investment returns, but provides guaranteed level of investment return with investments that are managed by the systems instead of the employee and allow the employee to annuitize the balance upon retirement into a monthly benefit.
The hybrid cash balance plan after passage of SB 2 has the same employee contribution and employer contribution policy however the pension benefit calculation is based upon an individual account balance that includes employee contributions (5 percent nonhazardous and 8 percent hazardous duty), employer credits (4 percent nonhazardous and 7.5 percent hazardous duty), and a guaranteed 4 percent annual investment return plus 75 percent of the five year average investment returns above 4 percent. In the hybrid cash balance plan, the employee is able to annuitize the account balance into monthly benefit payments for life. The same unreduced retirement eligibility provisions in place prior to SB 2 still apply to cash balance participants with a nonhazardous member being able to retire under the Rule of 87 (age plus years of service) or age 65 with five years’ service and with hazardous members being able to retire at any age with 25 years of service or at age 60 with five years’ service, except that reduced retirement eligibility provisions were eliminated for hybrid cash balance participants.
The disability and death benefits are essentially the same with certain modifications to incorporate the cash balance plan. Retiree health benefits remain the same for members of the hybrid cash balance plan as are currently provided to new hires, but the level of benefits for new hires is different from most of the KRS employee and retiree membership due to legislative changes made for new hires in 2003, 2004, and 2008. Individuals who began participating in KRS prior to July 1, 2003, still receive a percentage of the premium based upon service credit with the full premium paid for the individual at twenty years of service with additional premium payments being made for the spouse and dependents of hazardous duty participants based upon their hazardous service credit. As it relates to inviolable contract for the cash balance plan effective January 1, 2014, it is limited to the benefits accrued, which is essentially the account balance in the cash balance plan. The portability of the cash balance plan allows vested employees to withdraw their account as a lump sum, including employee and employer contributions and earned interest, or leave the account with the retirement system to access upon retirement age. The employee contributions and investment return are immediately vested but the employer contribution and investment returns are vested after five years.
Governance and oversight changes made in SB 2 increased the KRS board structure from a nine member board to a thirteen member board and established the thirteen member Public Pension Oversight Board.
One provision of SB 2 is to charge an employer for “pension spiking.” This provision requires an employee’s last participating employer to pay the actuarial cost for increases in compensation greater than the ten percent earned annually by the employee during the last five years of employment. This was to address the issue of increases in an employee’s salary in the last five years to increase the retirement benefit when calculating the five high years. Exceptions for the employer “spiking” charge are bona fide promotions or career advancements and lump-sum payments for compensatory time at retirement.
Relating to employer cost projections, the retirement systems are required by state law to provide an actuarial analysis of all pension related bills. They also have their actuaries perform a 20 year projection of employer contribution rates once the annual actuarial valuation is completed. Both sets of projections assume the plan meets all economic and demographic assumptions over the long term. The actuarial analysis from SB 2 for the KERS non-hazardous plan shows that without any changes the employer contributions rate as a percentage of payroll was anticipated to grow from the current budgeted amount of 26.79 percent in 2014 to 64.59 percent by the year 2032. With the changes from SB 2, the actuarial analysis anticipated the employer contribution rate growing from 26.79 percent of payroll in 2014 but leveling off over time to 40.19 percent by the year 2032. Without the provisions of SB 2, KRS projected the total dollar value of employer contributions for the KERS non-hazardous plan would grow from $460 million in 2014 to $2.1 billion by the year 2032. With the passage of SB 2, the dollar amount was projected to grow from $460 million to $1.3 billion by 2032.
The employer contribution rate projections completed after the 2013 actuarial valuation results and after passage of SB 2 were also provided. As a percentage of payroll, there is a projected increase initially from 26.79 percent to 38.77 percent from 2014 to 2015 for the KERS nonhazardous plan, but then decreasing over time to 33.82 percent by 2032. In terms of dollars, KERS nonhazardous employer contributions are anticipated to grow from $450 million and increase steadily to $1.3 billion by 2032. It was noted that the employer contribution rate has a pension contribution fund and a retiree health funding component. CERS nonhazardous projections from the SB 2 actuarial analysis indicated a growth in employer contributions as a percent of payroll ranges from 18.89 percent in 2014 to 25.88 percent in 2032 without the changes from SB 2. With the changes from SB 2, the actuarial analysis showed a decline in CERS hazardous employer contributions over this same time period, reaching 16.49 percent by 2032. The 2013 actuarial valuation projections completed after the passage of SB 2, reflects the current 18.89 percent employer contribution rate as a percent of payroll in 2014 falling to 13.32 percent in 2032. However, the dollar value continues to go up due to the expectation of a growing payroll. The CERS hazardous duty projections were also provided and discussed.
Jennifer Hays discussed the changes to the tax statutes in 2013 HB 440. This is the funding mechanism to help fund the actuarially required contribution (ARC). The discussion on SB 2 during the session identified approximately $100 million additional General Fund dollars would be required to fund the higher employer contributions. HB 440 contained the provisions that would create these additional dollars. The changes were made to the individual income tax totaling $62.5 million, a personal credit and a limit on itemized deductions that will be lower than the federal limit; corporation income tax totaling $15 million by amending disclosure requirements to require the same disclosure for management fees required for intangible expenses and interest expense; amendments to the sales and use tax laws that generated $16.4 million by increasing compensation for retailers with sales in excess of $1,000 and by requiring retailers with sales from a location outside this state for consumption in Kentucky to notify the purchaser of the state sales tax due; and an administrative provision relating to a suspension of certificates or licenses of delinquent taxpayers that would generate $6.0 million.
Ms. Hays indicated that the Road Fund tax was also modified in HB 440 that would allow a new car trade-in allowance credit on motor vehicles purchased on or after July 1, 2014, decreasing the motor vehicle usage tax by approximately $34 million. This fiscal impact relates to the 2015-16 fiscal year because tax provisions take time for a full implementation to occur and achieve the highest dollar amount. The $30 million individual income tax revenue generated with respect to the limit on itemized deductions was the result of inaction of the General Assembly and the definition of the Internal Revenue Code (IRC) and how Kentucky relates to the actions of the federal government for individual income tax because Kentucky’s income tax code applies to the end of the federal tax code; therefore, federal income tax is calculated and then Kentucky’s individual income tax is calculated; that Kentucky has not updated reference to the IRC since 2006 and still operate under that code. The limit on itemized deductions was in the code adopted in 2006 and as the deduction was expanded Kentucky expanded also. In 2012, the expanding limit on itemized deductions for federal purposes was changed, and Kentucky fell back to the Code in effect in 2006, which results in a limit of federal purposes that is higher than the itemized deduction limit now in effect for state income tax purposes.
Frank Willey discussed the funding for the full implementation of the ARC. He noted that the 20 year employer projection values based on the 2013 actuarial valuation results includes a group of employers that participate in the system that are outside the state budget system and that the actuarial valuation includes all employers; that in staff discussions the numbers will include those employers covered by the state budget or appropriations made by the General Assembly. The actuary does not consider the source of funds, and LRC is extremely concerned from a budget standpoint because the monies are General, Tobacco, or Agency Restricted Funds. A difference in numbers also occurs because the actuary uses a 4.5 percent payroll growth; that using this assumption for active member valuation data over the last five years has not materialized and the percent payroll growth on the average salary has resulted in an annual average pay as of June 30, 2008, of $38,221 to an average salary of $38,943 as of June 30, 2013, therefore very little payroll growth as a result of annual increment policy and a decrease in the number of active employees during this period for non-hazardous employees participating in the KERS. Therefore, the actuary is not accounting for the loss of employees in the system but at the same time is accounting for an increase in payroll. Assuming the payroll growth occurred during the five years the average salary would be at $49,773 as of June 30, 2013.
Mr. Willey also discussed the additional cost of the full ARC implementation of the affected retirement systems. The total of all fund sources for FY 2013-14 is $184.4 million and $198.8 million in FY 2015-16 for all three branches of government. He stated that in order to fund the direct state employees there would need to be $71 million in General Fund. In order to fund non-state employees providing state services such as county and non-prosecutorial employees, the amount needed would be $1.1 million of total funds, mental health and mental retardation boards would be $20.2 million, and local health departments would be $18.3 million, and rape crisis and child abuse centers would be $845,000. These agencies provide a direct service through contracts with the state; regional universities, the Kentucky Employer Mutual Insurance (KEMI) agency, and other quasi-organizations, although not providing a direct service to the state, would need $19.4 million. All of these participants, a portion, or selected participants may be funded.
In response to question by Chair Bowen concerning “spiking,” Mr. Gross indicated this was an issue brought up during the Public Pensions Task Force in 2012 and is a situation where an individual takes a different job in the last couple years of employment or works a large amount of overtime during the last couple years of employment to increase retirement benefits by inflating their last high three or five years of compensation, known as final compensation, which is a part of the benefit calculation. The magnitude of “spiking” and its impact on unfunded liabilities are unknown because it is not typically tracked by the retirement systems. SB 2 included a provision that if compensation was increased in the last five years increased by more than ten percent per year then the last participating employer would be responsible for paying the additional actuarial costs over that period. The retirement systems have implemented this provision by looking at situations in the last five years where the compensation increased more than the ten percent and, if so, then it is categorized as a “spike” and then look at the benefit that would have otherwise been paid without the “spike” and the benefits paid with the increase and calculate that amount over the course of a lifetime to produce a dollar that the employer would be responsible.
Responding to a question by Representative Yonts with regard to routine overtime such as firefighters and police personnel, Mr. Gross indicated that the only two exceptions written in the bill, one was an exemption for bona fide promotions and salary advancements and another was lump-sum payments for compensatory time and that the statute does not address directly situations of emergency nature. These other types of payments have been an issue as the Kentucky Retirement Systems develops administrative regulations. In response to a comment from Representative Yonts, he noted that final compensation does not typically include accumulated sick pay but rather sick leave is most often converted to additional months of service credit at retirement.
Ms. Hays responded to a question by Representative Yonts regarding the collection of the sales and use tax on on-line and catalog retailer transactions, stating that Richard Dobson in the Department of Revenue participates in the streamlining or simplification of sales tax law committee that is working toward implementation of changes to the state’s sales and use tax law in the event the Marketplace Fairness Act is enacted by Congress; that Kentucky will be ready to move forward immediately with any changes that need to be adopted to implement collection of the sales tax on transactions by remote sellers. She said that from voluntary retailers the state is currently collecting approximately $20 million in taxes and that according to projected data if these collections are mandatory the state would collect approximately $225 million per year.
Upon being asked by Mr. Bennett questions concerning the percent of employer contributions decreasing but the dollar amount increasing and healthcare costs, Mr. Gross stated there are two parts to the employer’s contribution rate, a normal cost or on-going cost of the plan and the payment to finance the unfunded liability. A significant portion of the KERS contribution rate is being applied to pay off that unfunded liability and that since the unfunded liability is being paid off by a level percentage of payroll and the systems project payroll to grow by 4.5 percent annually, the dollar amount to pay off the unfunded liability increases over time as payroll grows. He also stated that of the 26.79 percent employer contribution in FY 2012-13, 17.29 percent is applied to pension and 9.5 percent is applied to insurance as set by the state budget and that the insurance rate will decrease as a percentage of payroll over time and that by FY 2032-33 it is projected to be about 5 percent of payroll.
Mr. Bowling indicated he was interested in the collections from securities litigation, the type of collections undertaken by all the retirement boards, collection amounts over the years, what is currently being done now and who is collecting the settlements, the coordination between the retirement boards and the Attorney General’s Office to make sure that future pension rights are not being settled, and the results. Mr. Gross pointed out that the retirement systems do have recovery processes and procedures and that staff would be happy to obtain that information from the retirement systems and have their staff testify in the future.
Mr. Jefferson requested a copy of the actuarial report provided by the Kentucky Retirement Systems. Mr. Gross indicated he would e-mail a link available on the KRS website. In response to questions by Mr. Jefferson regarding actuarial assumptions, Mr. Willey indicated that the plan beginning next year will be undergoing a review of assumptions and from that review a determination made if any of the assumptions being used need to be changed and that the retirement board makes that decision, not the actuary; that any changes made at the review effective June 30, 2014, would be made for the next valuation period. Mr. Gross pointed out that the retirement board is required by law to conduct a review of the assumptions once every ten years and typically perform a review every five years and that April is the target date for 2014. He further noted that this upcoming June 30 valuation would impact CERS employer rates the following year but KERS will not be impacted until the following biennial budget period.
Representative Yonts asked about the Kentucky Teachers’ Retirement System (KTRS) situation and indicated that this retirement system could in the future also be impacted and a part of the oversight board’s review. He also asked about the impact of the Seven Counties lawsuit that will be going to trial next spring and how this will affect the many quasi organizations and ultimately the state. Mr. Willey indicated that the unfunded liability would be distributed to the remaining employers in the system, mainly the KERS, and the state’s rate would significantly increase in the next budget cycle but the amount was unknown. Mr. Gross stated the impact would depend on the number of employees and how much of a share of the unfunded liability payment is impacted. If a payroll becomes smaller, the cost of financing the liabilities is shared across smaller payroll. He also noted that there are differences in the statutory features of KERS and CERS. For example, Kentucky Retirement Systems has the ability to stop benefit payments in CERS for noncompliance while in KERS the statute does not allow for those payments to cease.
Chair Bowen asked Mr. Willey to provide explanation on the ramifications of the actuary overstating the annual average compensation of employees. Mr. Willey indicated the oversight board could encourage the KRS board to review those assumptions taking into account past history and make an appropriate adjustment as soon as possible.
In response to a question from Senator Higdon, Mr. Willey indicated that LRC staff receives an annual valuation.
Responding to a question by Mr. Bowling, Mr. Willey stated that there are two major factors influencing the decrease in number of employees. Deaths do not affect those numbers but rather budgetary considerations result in payroll being decreased and employees are not replaced, and agencies have ceased paying the retirement system. Mr. Willey noted that the liability has not changed, only the payroll growth assumptions.
Other Business
Chair Bowen indicated that next month the board would review a plan of benefits and funding that will include a detailed discussion of the 2013 actuarial valuation results. Also, the board will meet during the 2014 regular legislative session on the fourth Monday in the months of January, February, March, and April at the hour of 12:00 noon and an evaluation completed heading into the interim.
Adjournment
The meeting adjourned at 2:50 p.m.