Call to Order and Roll Call
The 2nd meeting of the Public Pension Oversight Board (PPOB) was held on Monday, February 24, 2014, at 12:00 Noon, 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; Senator Jimmy Higdon; Representatives Brian Linder and Tommy Thompson; Robyn Bender, Tom Bennett, Jane Driskell, and James M. "Mac" Jefferson.
Guests: Individuals were present but did not sign the “Guest List.”
LRC Staff: Greg Woosley, Karen Powell, Judy Fritz, and Marlene Rutherford.
Chair Bowen announced that the PPOB would not be taking action on the minutes of the January 27 meeting until the March meeting, at which time action would be taken on both the January and February minutes.
Chair Bowen asked that questions be held until the end of the presentation so as not to be disruptive to the agenda presenters.
Review of Kentucky Retirement Systems Investments
Bill Thielen, Executive Director, Kentucky Retirement Systems, and David Peden, Interim Chief Investment Officer, Kentucky Retirement Systems, discussed the investments and investment policies of the Kentucky Retirement Systems (KRS). The PPOB was previously provided the following investment policies of KRS, which were included in the members’ folders: (1) General Statement of Investment Policy, adopted November 20, 2013; (2) Statement of Investment Policy for the Pension Fund; (3) Statement of Investment Policy for the Insurance Fund; (4) Investment Brokerage Policy, approved May, 2011; (5) Manager and Placement Agent Statement of Disclosure Policy, approved August 16, 2012; (6) Securities Trading Policy for Trustees and Employees, approved February, 2012; (7) Securities Litigation Policy and Procedures, approved May, 2011; (8) Investment Proxy Voting Policy, approved May, 2011; (9) Real Estate Investment Policy; (10) Conflict of Interest and Confidentiality Policy, approved August 17, 2006, amended August 18, 2011; and (11) Authentication Token Policy, approved July 5, 2011.
Mr. Thielen began by stating that the KRS website at www.kyret.ky.gov contains a multitude of investment information including performance reports, consultant reports on the investment program, and copies of all the investment policies. The investment function for KRS is given to the Board of Trustees in Chapter 61 of the Kentucky Revised Statutes, and that KRS 61.645 requires the Board of Trustees to establish an Investment Committee, which currently consists of five members, composed of two trustees appointed by the Governor with investment experience, and three appointed by the Chair of the Board of Trustees. Mr. Thielen also pointed out that Representative Yonts was sponsoring a “housekeeping” bill in the 2014 session that includes a proposal to increase the size of the Investment Committee to seven members, since the Board of Trustees was increased from nine to thirteen members with the passage of Senate Bill 2 in the 2013 regular session. The Investment Committee has the authority to implement all the board’s investment policies and to act on behalf of the board, subject to ratification, in all investment related matters including acquiring, selling, monitoring, and managing investments and hiring investment managers. Mr. Thielen also testified that the Chief Investment Officer (CIO) supervises the internal investment decisions on a daily basis and subsequently reports to the Investment Committee. The CIO also reports to Mr. Thielen administratively. KRS has a very qualified investment staff consisting of eight professionals and one administrative assistant, and that the investment staff professionals have advanced degrees and relevant industry certifications.
Mr. Thielen indicated that currently KRS has $15.5 billion worth of assets, and that of this total approximately 81 percent of the assets ($12.5 billion) are invested by external investment managers, and approximately $3 billion by the internal investment staff. He said that in addition to the external investment managers who invest portions of the asset base, KRS hires a number of national investment consultants through a request for proposal (RFP) process. R.V. Kuhns & Associates is the general investment consultant, Albourne is the consultant on absolute and real return assets, ORG Portfolio Management is the consultant on real estate investments, and Altius Associates is the consultant in the private equity area.
David Peden gave a more detailed presentation on the investments and investment performance of the systems. Investment performance is a product of asset allocation and manager selection, and to make decisions in these areas, the Board of Trustees, through the Investment Committee, conducts an asset liability modeling study every three to five years using an independent expert. The first objective in the process of asset allocation is to construct a portfolio that meets the minimum acceptable return, or assumed rate of return, which for all systems in KRS is 7.75 percent. He noted the assumptions that go into the study are known as capital market assumptions, and that the other factors affecting asset allocation are the various constraints and unique circumstances of each retirement system.
Mr. Thielen pointed out that KRS is not in competition with other public retirement systems, and that each retirement system is different in terms of cash flow needs, maturity of its membership, etc., and that the goal of KRS is to outperform the assumed rate of return of 7.75 percent – it is not to be the best invested retirement system in the nation in terms of total numbers.
Mr. Peden stated it is important to note that each system has its own portfolio, and that despite the fact that investments of the five systems (KERS, KERS Hazardous, CERS, CERS Hazardous, and SPRS) are often made with the same money manager or asset, KRS knows exactly how much each system owns in each asset and has a customized asset allocation for each of the five systems for both pension and insurance. Mr. Peden then further discussed capital market assumptions. Working with R.V. Kuhns, three components have been developed for these market assumptions: (1) the expected return for each asset class in which the systems are invested; (2) agreement on what the expected standard deviation or price volatility is for each asset class; and (3) the correlation or co-movement of two asset classes in relation to one another.
These factors are used to set the expectations and indicators for what asset classes need to be combined together to reach the 7.75 percent assumed rate of return. He also said another factor that goes into asset allocation are constraints, and that the constraints for many of the systems inside KRS are the willingness to make the actuarially required contributions, the ability to make the actuarially required contributions, and the age of the plan. In other words, the asset allocation question looks at the level of assets that are being paid out in benefits versus the amount of contributions that are being received. Mr. Peden noted that these constraints contribute to the risk that can be taken compared to peers, and that every public pension plan has different constraints that must be factored in to the asset allocation modeling.
Mr. Peden said the second most important process that determines the outcome of investment performance is the KRS investment manager process. He pointed out that KRS continuously performs the equivalent of an RFP process because staff conducts 200 face to face meetings, and 400 phone interviews, with investment managers every year, and that it is incumbent upon asset class specialists, or directors of each asset class, to continuously monitor both the performance of current managers, as well as track and maintain a database of any potential managers that might be utilized in the future.
Mr. Peden noted the first stage of the due diligence process is to develop and maintain a pipeline of managers, which requires constantly taking meetings and knowing who the best managers are in any given asset class. He said that further due diligence may be needed to replace an existing manager who is not performing to expectations, or there could be a new asset allocation that includes an asset class not previously utilized. Additionally, unique strategies occasionally present themselves as an opportunity that KRS would want to pursue, which would require a new manager position to be filled. KRS concentrates on a couple of areas in the due diligence process: (1) investment performance, or what the investment manager or asset class is expected to accomplish; and (2) investment fit, which is how a manager fits in with the current roster of managers, and if the manager will add or contribute expertise not already included in the portfolio.
Mr. Peden also noted that the other side of manager due diligence is an evaluation of the business or operational aspects of the firm, especially when investing in managers on the “private” side, such as private equity or hedge funds, because there is not only risk in the investment but in the business as well. One aspect of the business characteristics that are evaluated are fees, and these are evaluated at an early stage in the process as to whether the fees are reasonable based on the strategy being evaluated and the size of the investment that KRS is looking to place with a particular manager. Mr. Peden asserted that because of this evaluation, a formal RFP process is not needed to make sure KRS is getting the best fee available. He said after staff has conducted a comprehensive due diligence process in conjunction with the consultant in the respective asset class specialties, a comprehensive memorandum is written and a formal recommendation is presented to the Investment Committee by staff, which sometimes includes a presentation by the investment manager being considered for hire. The Investment Committee then either approves or disapproves the investment, and if approved, there is a final due diligence process, consisting of a legal review and contract negotiation with the investment manager. The final due diligence includes both internal and external counsel to complete the process.
Mr. Peden stated that the KRS pension fund has had good performance on a year-by-year basis, with the poor years commensurate with the overall difficulty seen in the market. He noted trends in the KRS returns were reflective of the overall markets in the 2000-2001 periods, as well as during the significant downturn in 2008-2009. He also noted that the performance in 2011 and 2012 was a period where non-U.S. equity and emerging market equity had a poor return period, and that this period was during a period of time referred to by economists as a risk-on and risk-off cycle, which made it difficult to identify trends occurring in the market. However, he noted that over time the pension fund has met or exceeded the 7.75 percent assumed rate of return.
Mr. Thielen pointed out that KRS uses an actuarial “smoothing” method adopted by the board, where gains and losses are smoothed in over a five year period of time, which dampens the volatility of the employer contribution rate determined each year. As an example, he noted the employer contribution rate would have skyrocketed following the substantial losses in 2008-2009 but for the smoothing of investment returns, and he stated that 2013 was the last year that KRS recognized the substantial losses from that period.
Mr. Peden stated the data for investment performance reflects that, despite the poor performance during the financial crisis, KRS is close to the 7.75 percent assumed rate of return for the latest ten year period, and the five year return, which no longer includes the financial crisis numbers, is well above the assumed rate. He said that as of July 1, 2013, KRS is able to report the rate of return on a system-by-system basis for KERS, CERS, and SPRS, as a result of a change in custodians, noting that KRS has always been able to track each systems’ assets, income, and expenses, but prior to this date had not been able to calculate a rate of return for each system. He noted that this data is also now included in the monthly updates.
Mr. Thielen pointed out that the performance and allocation data includes a since inception date number (ITD), which reflects the return over an approximately thirty year period. For the pension plan, the ITD number is based on a 1984 inception date, and for the insurance plan, it is based on a 1987 inception date.
Mr. Peden testified that the total Kentucky based investments by KRS is approximately $50 million, and that the number reported includes companies and bond issuers that are headquartered in Kentucky. Mr. Peden indicated that if the PPOB would like KRS to incorporate in the data firms that have significant exposure in Kentucky, such as Ford or Toyota, the PPOB would need to provide a list to KRS as to which companies to include or the criteria to use to categorize a company as a Kentucky based business. Mr. Thielen noted that the KRS Board is always looking for opportunities to invest in Kentucky based firms, but that the foremost obligation is to maximize the return to the fund.
Mr. Thielen then provided an illustration between the operations under House Bill 1 and Senate Bill 2 for the KERS nonhazardous plan. The illustration began with the actuarial values at the end of the 2011 fiscal year, which was $3.7 billion, and the end of the 2013 fiscal year, which was $2.6 billion, under the funding schedule of House Bill 1. During this period, liabilities increased approximately $200 million, and the funded ratio of the plan dropped from 33.3 percent at the end of FY 2011 to 23.2 percent at the end of FY 2013, on an actuarially funded basis and taking into account the “smoothing” method of returns. On a market value basis, at the end of FY 2011 the funded ratio was 31.7 percent and at the end of FY 2013 it was 24.1 percent. He said that House Bill 1 set a plan for increasing funding to the system over a period of years, but that projections indicated for many years the system continued to be underfunded until approximately 2026, with current annual payouts of around $900 million and an asset value that was projected to decline to below $1.5 billion in 2020. However, he noted that enactment of Senate Bill 2 increased the projected asset value of the KERS nonhazardous plan by an approximate $850 million difference by 2021 – showing that the plan is projected to be much better funded under the 100 percent funding level of Senate Bill 2.
Mr. Peden indicated that on a five year basis the KRS annualized return is average with the peer group, but that KRS is taking less risk than the average of the peer group. He reiterated that KRS is not seeking to compare or compete with the peer group, especially on a one year basis, but that KRS does evaluate how the risk weighted return, or sharp ratio, compares with the peer group on a longer five or ten year basis. The comparison shows that the annualized return over a five year term is consistent with the peer group, but that KRS is taking on less risk. On a ten year term, the annualized return is below the average return, but the KRS investments take on less risk, and that based on the constraints of KRS, the risk and return outcome is favorable. Mr. Peden also compared the 7.75 percent actuarially assumed rate of return to the peer group and noted that 7.75 percent is a common return assumption by various pension plans, with 7.50 percent and 8.00 percent being the next two most common assumed rates of return. However, Mr. Peden stated that if the 7.75 percent return is lowered, the unfunded liability will increase, and that a longer term view needs to be taken on the assumed rate of return rather than increasing or decreasing that rate on a year-to-year basis. Further, Mr. Peden noted that the real rate of return is the total return minus an inflation expectation.
Mr. Thielen stated that currently the actuaries are conducting an experience study for KRS that will be reported to the Board of Trustees at the May quarterly meeting, and based on that experience study and the recommendations of the actuary, the board will adopt assumptions going forward, including the rate of return assumption on investments, the salary growth rate, healthcare cost inflation assumptions, etc., and that this is a practice done at least every ten years, and by recent practice, every five years. In the experience study, the actuaries will be looking at whether the current assumptions are adequate for future projections.
In response to a request by Senator Bowen for clarification of the current KRS organizational structure, Mr. Thielen stated that KRS is governed by a thirteen member board. The board comprises eight different committees, broken down by subject matter, and the Investment Committee is one of these committees, which consists of five members of the board. In response to a second question, Mr. Thielen stated that placement agents are hired by investment managers, not by KRS, and that KRS has never paid or hired a placement agent directly and has not invested any assets where a placement agent has been used for about five years. Mr. Thielen further described the organizational structure to say that under the board and committees is the KRS staff, consisting of approximately 257 staff members, of which nine members are in the investment division, with various educational qualifications, and that those staff members report directly to the Investment Committee.
Senator Bowen asked Mr. Thielen to provide insight into the various newspaper reports of the problems that resulted in the $100 million Arrowhawk investment and the more than $24 million investment with the Camelot group, and what was the chain of command for the oversight of those investments. Mr. Thielen stated that both Camelot and Arrowhawk are outside investment managers, and that staff followed the process of evaluation previously detailed. Also, representatives from those groups appeared before the Investment Committee and made presentations, and the Investment Committee decided to invest funds in both of those groups. Mr. Thielen stated that a little less than $25 million was invested with Camelot, and Mr. Peden indicated that $100 million was invested in Arrowhawk, with $50 million invested initially, which was followed by a second investment of $50 million. The Camelot investment was approved in May, 2009, and the Arrowhawk investment was approved with a special Investment Committee at the end of September, 2009. The Arrowhawk investment was the last investment made by KRS where a placement agent was used.
Mr. Thielen said that placement agents are marketers that are hired by small investment managers that do not have their own marketing staff. The placement agents will talk with public and private pension staff to generate interest in investing money in the fund, and those placement agents are paid by the investment managers, not by KRS. KRS has done a study of its investments over the years in which placement agents were involved, and the results of the study show that there is no difference in the returns that KRS has received overall and that the costs that were paid to the investment managers of those investments were in line with what would be expected in the marketplace.
Mr. Peden reiterated that placement agents are third party marketers and that it is important to note that just because someone uses a third party marketing firm does not mean they are spending more or less on the marketing effort because internal marketing staff is a very expensive aspect of an investment management group. He said that the Auditor of Public Accounts (APA) 2011 report, located on the KRS website, is a good introduction into placement agents, and that from the report recommendations were made that have been adopted by KRS, one of which is the placement agent disclosure document. The recommendation and adopted practice requires that when a manager is presented to the Investment Committee, the completion of a disclosure document is required by the manager, which includes a question as to whether a placement agent was used to introduce the investment to KRS. Since 2009, the answer to that question has always been no; however, the board has not prohibited placement agents from being involved, and neither has the General Assembly, although third-party marketing firms or an internal marketer at a fund must report and describe themselves with the Executive Branch Ethics Commission, who in turn determines whether that person should register as a lobbyist.
Senator Bowen asked whether passage of Senate Bill 2 alleviated the concern of reaching a “pay as you go” situation – i.e. that the fund would not have enough money to pay benefits from existing assets. Mr. Thielen stated that KRS is on a better path than previously, and as long as the General Assembly appropriates 100 percent of the actuarially required contribution, the projection is that the fund will not reach that point. However, he also noted that there are still major concerns that in the event of another recession, or if KRS fails to meet the actuarial assumptions, the plan could be in jeopardy. He stated that the systems are a long way from being solidly funded, given that the rating agencies use 80 percent as being solvent and well-funded.
In response to questions by Senator Higdon, Mr. Thielen said that the drop in funded status is a result of a number of factors, which were discussed at the last meeting, including the shortfall in contributions, the unfunded cost-of-living adjustments, and the investment losses still being factored in over the last five years, which was approximately 17 percent of the asset base due to the 2009 losses. He also noted that KRS expenses and office staff are paid from the budget approved by the General Assembly in the biennial budget, which is currently about $39 million per year, and that by statute this money is paid out of the employer allowance account – where the employer contributions are credited, but that investment staff and consultants, the fund administrative expenses, are paid out of the KRS trust funds. Mr. Thielen also said that the experience study would identify areas that need to be addressed and that the actuaries have to make a significant number of assumptions of what will occur in the future, such as how long individuals will live, how many individuals will terminate before they are vested, and the rate of inflation for healthcare costs.
Responding to a question by Representative Yonts concerning the allegations about the Camelot investment, Mr. Thielen indicated that when KRS learned there was an issue involving Camelot it began taking steps with external counsel to protect the investment. He stated that there is approximately $24 million invested in Camelot, and that losses, if any, are unknown at this time, but that KRS is constantly monitoring the situation to maximize the money KRS might receive back from the fund.
Responding to Representative Yonts concerning what due diligence was exercised in determining how much to invest in a new group, Mr. Peden and Mr. Thielen indicated that the normal due diligence process was performed by KRS. Mr. Peden indicated that the Camelot investment was approved in May, 2009, and that the individual that has been charged had a prior track record for investing that was presented to the Investment Committee. With the benefit of hindsight, he would call into question some of the information that was told to KRS staff and the Investment Committee regarding that track record, and that it does appear that this was the first substantial fund that the individual managed, but that he did have prior investing experience. Further, KRS staff first became aware that there was an issue in June, 2013 when it received a letter from the auditor of the fund, and KRS engaged legal counsel at that time. KRS began working in the fall of 2013 with the Securities & Exchange Commission (SEC) and the Manhattan District Attorney’s Office. Mr. Thielen also indicated that the general investment consultant recommended the investment with Camelot as well, although it was a new fund, and Mr. Peden stated that Strategic Investment Solutions (SIS) was the consultant that had reviewed the fund.
In response to questions from Representative Thompson on the internal versus external management for the pension and insurance funds, and the absolute return class and the real return class, Mr. Thielen stated that there is approximately $15.5 billion in assets for all plans. This total was further broken down in the presentation to show that the $2.6 billion in actuarial plan value is the value of the assets invested in the KERS nonhazardous pension plan. Mr. Peden indicated that absolute return is mostly investments in hedge funds, and that KRS has a fund of hedge funds currently being managed by three managers, Prisma Capital Partners, PAAMCO, and Blackstone. Also, KRS has started building out a direct hedge fund program in order to directly invest in hedge funds and to replicate what an external fund of funds might look like, with the goal being a portfolio that has a low standard deviation and a low correlation to the equity and credit markets. Mr. Peden stated that real return is any assets that are inflation sensitive, which should do well when there is inflation, such as treasury inflation protected securities (TIPS), commodities, infrastructure, and real assets like farmland or timberland investments.
Responding to an additional question by Representative Thompson, Mr. Thielen indicated that about $873 million in benefit payments were paid in the last fiscal year for the KERS nonhazardous plan. He also noted the KERS nonhazardous plan has had a negative cash flow at times, and at one time was selling about $75 million in assets per month to make the benefit payments, and that because of the unfunded liability, among other things, KRS is keeping more money more liquid and therefore there is less to invest for a higher return. This also requires KRS to keep more money in short term investments in order to meet the monthly benefit payments.
In response to a question by Mr. Bennett concerning investments in Kentucky, Mr. Peden stated the Kentucky-based investments include only companies or bond issuers headquartered in the state, and that real estate investments include only physical property in the state. Mr. Peden also noted that KRS contracts with River Road Asset Management out of Louisville to manage a portion of the equity portfolio.
In response to questions by Mr. Jefferson regarding the due diligence process and the lessons learned, Mr. Peden stated that staff believes that the current process is more robust than it was five years ago, and one item in particular that has been improved is the analysis of the business aspect of an investment firm. He noted that one area that was lacking in the Camelot investment was there was an absence of a strong accountant, and there was no chief operating officer or chief controller, and that experience has shown that there needs to be a strong back office to be successful and to be recommended as a worthy investment by staff today. In contrast, and in hindsight, Camelot was dominated by a single individual, rather than having a host of resources and “voices” in the firm, which is important so that one individual cannot control outcomes. He said that KRS has conducted an evaluation of its other investments in light of what has occurred, but that in private equity investment there is only one opportunity to get the investment right because once committed you cannot get out of the fund. He further stated that although there may be investments KRS currently holds that he might not personally recommend today, there are no other funds that KRS is concerned about at this time or that they believe require proactive efforts (to terminate).
Mr. Jefferson also inquired about the commissions and administrative expenses for staff, as well as the external manager operating expenses, and whether KRS tracks the payment of all of these separate fees paid to managers. Mr. Peden indicated that the fees are detailed in the Comprehensive Annual Report (CAFR), although he agreed that tracking and adding all of the fees to get a total fee number is difficult. He also noted that fees are absolutely factored in to the decision to hire a manager, but that they are not the driving force in selecting a fund manager. Instead, the first criteria in selection is to make sure the expected return strategy is sensible and fits in the portfolio, and to make sure KRS is getting the best fees possible that match up with the type of investment strategy. He explained that a strategy requiring many employees and analytical work may justify higher fees, and that one criticism is that fees have been creeping up, but that private equity or hedge funds, which have become an increasing part of the total portfolio, are more expensive than the alternative, which is a more passive equity or index tracking account. Specifically, Mr. Peden noted that in order for KRS to achieve a 7.75 percent rate of return consistently, with a low standard deviation, KRS has to pursue a variety of strategies, and one criticism was that KRS did not have enough private equity or hedge funds in the portfolio. Mr. Peden also indicated that the investment managers are evaluated on a net basis, so while the fees may be higher in some cases, they are being evaluated on the expected return on an after fees basis.
Responding to a further question by Mr. Jefferson concerning private equity and possible declining asset values, which could present a liquidity or cash flow issue, and how often this is updated, Mr. Peden stated that investment staff tracks and projects on a month-to-month basis what cash is needed to make sure there is appropriate liquidity to make benefits payments, but one issue is that KRS is not getting distributions back fast enough from private equity and this portion of the asset allocation has been increasing. To address the situation, the public equity portion of the portfolio is reduced below its target level to offset the overweight of the investment assets held in the less liquid private equity funds. Mr. Thielen pointed out that this is due to private equity assets being tied up for seven to ten years, with the initial seed funding committed for three years and then some returns occurring over the later years as assets are sold off within the funds.
In response to another question by Representative Thompson concerning asset allocation targets and the major shifts in the asset classes, Mr. Peden indicated that prior to the financial crisis, KRS did not have any high yield bonds or global bonds, there was very little non-U.S. equity, no emerging market equity, no hedge funds or absolute return, and there was some real return assets in the form of TIPS but these were included in the fixed income class. KRS has tried to get away from the interest rate sensitive aspects of fixed income and have tried to add global bonds because of a tactical aspect related to rising rates in certain countries. He further stated that the goal of absolute return is to have a consistent return, low volatility asset class, and that real return was added to the portfolio because of the inflation aspect of those assets, and because they tend to rise with inflation the assets help to not only meet the return target but also are a hedge against inflation. Mr. Thielen noted that KRS does an asset liability modeling study every five years and will likely be conducting one next year, which will look at asset allocation and liabilities and will make recommendations on where the KRS funds should be with its allocations.
Senator Bowen said there are still challenges in addressing the pension systems, and that the markets need to perform to achieve the projected returns and meet the benchmarks. He brought to the board’s attention the legislative proposals contained in the members’ packets and announced that the next scheduled meeting will be March 24.
There being no further questions or business, the meeting adjourned at about 1:30 p.m.