Call to Order and Roll Call
The meeting of the Public Pension Oversight Board was held on Thursday, August 28, 2014, at 2:00 PM, in Room 149 of the Capitol Annex. Senator Joe Bowen, Co-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; Tom Bennett, Michael Bowling, Jane Driskell, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: Russ Wright, Retired; Paul VanWinkle and Stacy M. Roland, Cabinet for Health and Family Services, Department for Behavioral Health, Developmental and Intellectual Disabilities; Richard Beliles, Common Cause Kentucky; Dwight Price, Kentucky Employers’ Mutual Insurance; Lowell Reese, Kentucky Roll Call; Dave Adkisson, President, Kentucky Chamber of Commerce; and Jessica Malloy, Attorney General’s Office, on behalf of Robyn Bender.
LRC Staff: Brad Gross, Greg Woosley, Bo Craycraft, and Marlene Rutherford.
Approval of Minutes
Co-Chair Yonts moved that the Minutes of May 27, 2014, be approved, which was seconded by Representative Linder. The minutes were approved without objection.
Co-Chair Bowen announced the appointment of Alison Stemler, Shelbyville, Kentucky, who is an attorney with Frost Brown Todd. Ms. Stemler will be filling the unexpired term of Ronald J. Harris, Jr., who has resigned. Ms. Stemler was not present at the meeting.
Co-Chair Bowen said the June Monthly Performance Update provided by Kentucky Retirement Systems was contained in the meeting packets. He also provided a summary of the previous meetings and topics the board had reviewed and discussed.
Co-Chair Bowen said that the board will be reviewing legislative proposals for possible recommendations to the General Assembly. There will be a year-end review of financial and actuarial data, and the board will set goals for the 2015 work plan. He encouraged members to make recommendations to be included in the year-end report, such as identifying efficiencies and highlighting any changes recommended for consideration.
Semi-annual Kentucky Retirement Systems Investment Review
Bill Thielen, Executive Director and David Peden, Interim Chief Investment Officer, Kentucky Retirement Systems discussed the investment program of KRS.
Mr. Thielen discussed the current litigation with Seven Counties. The case is on appeal to the U.S. District Court. KRS has asked the court, or the bankruptcy judge, whichever appropriate, to send the case to the U.S. Sixth Circuit Court of Appeals, but no action has been taken. Another lawsuit filed in Kenton Circuit Court by the City of Fort Wright challenges the KRS investment program and its investments in alternatives. A hearing the KRS motion to dismiss has been delayed until September 25. KRS is pursuing action with Bluegrass Mental Health/Mental Retardation, Kentucky River Community Care, and Frontier Housing that is in the discovery process. The KRS Retiree Health Committee will meet September 4, and the KRS Board will meet September 11. KRS will set the rates and plan components for the under-65 retiree health plan and the Medicare eligible health plan for 2015. As a result of the Bank of America settlement, KRS will receive $23 million that will be allocated to the pension trusts based on the losses realized.
Co-Chair Bowen introduced Bo Craycraft, who has joined LRC staff to work with PPOB in an advisory capacity.
Responding to a question by Co-Chair Yonts regarding the Bank of America settlement, Mr. Thielen said KERS hazardous and nonhazardous, CERS hazardous and nonhazardous, and SPRS pension trusts will each receive an allocation from the settlement based on the original investment by each trust and the amount of funds lost. The KERS nonhazardous pension fund will receive about $8.4 million of the settlement, and the remainder will be spread among the other pension funds. The litigation resulted from the actions surrounding the 2008 financial crisis, specifically the private-label mortgage-backed securities and whether they were safe mortgages when investments were made.
Senator Higdon asked, and Mr. Thielen agreed, to place PPOB members on the KRS e-mail notification for KRS meetings.
Mr. Peden discussed asset allocation and fiscal year-end performance of KRS and he provided an update on securities litigation claims. He defined and identified institutional investors, which are banks, insurance companies, pension plans, endowments, and foundations. Managing the investment portfolio of an institution is done in the context of the liabilities. This requires factoring how much money is needed to pay benefit payments each month and how much liquidity is needed to meet those benefit payments. The objective is not simply making the most money; rather, the investment has to be protected on the downside while earning a reasonable return and paying benefits. To determine asset allocation, the first task is to perform an asset liability study, the objective of which is to assist the plan in selecting an efficient target allocation given the plan’s objectives, which are the risk tolerance, implementation constraints, and other factors. Efficient is defined as the lowest risk portfolio given a level of return or the highest return for a given level of risk.
The other objective is to measure or understand the range of possible investment return outcomes that the portfolio faces over various timeframes and the associated risks. Asset allocation is the output of the asset liability study, and it is a tool intended to capture the expected return, risk, and correlation to other asset classes over the long term in order to select a portfolio that best meets the needs of the plan. Mr. Peden said that it is important to understand that asset allocation explains 90 percent of the performance of the portfolio. Information was contained in the overview reflecting the funded ratio percentages for all five plans for both the pension and insurance for the five year asset/liability study period beginning in 2009 and ending in 2013. This information will be updated for fiscal year 2014 as KRS begins its next liability study with the consultant, RV Kuhns. The results should be available in early 2015.
In response to a question by Co-Chair Bowen as to why the funded ratios are not the same across the different plans under KRS, Mr. Peden said that the plans have different cash flow streams from the different employers and different liability profiles. Mr. Thielen said that each of the plans has a different benefit structure, and therefore, different liabilities, and that the money contributed over the last 20 years has differed greatly between the KERS and CERS plans. CERS employers have paid 100 percent of the actuarially required contribution (ARC), whereas other employers have not. The liabilities are different, the cash flows are different, and the age of the workforce is different. Mr. Thielen said that historically KRS has had the same asset allocation for each plan but began to diverge in 2009 because the funding level of KERS nonhazardous had gotten low and, along with other factors, KRS has begun to create different asset allocations for each plan to reflect differing liabilities.
Mr. Peden discussed some of the factors for determining risk tolerance for a pension plan. One factor is the health of the plan. An institution is less able to take risk for a plan that is more poorly funded. Another factor is the age of the workforce. A young workforce plan can take more risk, while an older plan needs to take less risk. The state workforce age is at an all time low, one that has not been seen in four decades, and the ratio of retirees to current workers dictates that KRS take less risk. The plan sponsor’s ability and willingness to pay is another factor that determines risk, as well as how correlated the revenue generating ability of the state, cities, and counties are to the economy. If the economy goes down, investments potentially go down, and KRS will need more money at a time when the employers have less ability to contribute to the system. This is another factor that suggests KRS take less risk.
Mr. Peden discussed different types of risk. The main measurement of risk when investing is standard deviation, also called volatility, or the uncertainty of the expected return. The next risk to consider is the investment shortfall, or the risk of not meeting the minimum acceptable or necessary return. There is also drawdown risk, which is the risk that the portfolio drops in value, such as a rapid, violent drop as in October, 1987 or the financial crisis of 2008. Business risk is the risk that a money manager fails and has to return money to investors because of poor skills running the business, or having key employees leave, or having an owner buy an existing manager. Business risks are important to understand because, although it is a part of the relationship with every external manager, this risk is more prevalent in the hedge fund area.
Responding to a question by Co-Co-Chair Bowen concerning the timeframe for drawdown risk and its impact, Mr. Peden discussed the time it takes for a market to recover. The stock market is well above where it was in 2007 at its peak and before the beginning of the downturn, but the NASDAQ only got back to its high point a couple of years ago. Each asset class of the KRS portfolio has its own risk. The objective is to guard against drawdown risk of each asset class to prevent an overall portfolio drawdown, since it still has to earn the assumed 7.75 percent rate of return. As an example of drawdown risk, Mr. Thielen said that KRS suffered a 17 percent loss in 2008-09 of almost $2 billion.
Mr. Peden said that the other risk factor is the inflation risk, which is the diminished real value of the investments.
The capital market assumptions are the backdrop of asset allocation, which he defined as the expected return and expected standard deviation, or risk, of each asset class, and the correlation of those asset classes to one another. Capital market assumptions are developed using a combination of economic expectations going forward in combination with historical returns, while factoring in return to the mean.
The different asset classes perform differently in the business cycle, and KRS is attempting to construct a portfolio that will perform well throughout the entire business cycle. Public equity is the best way to participate in upside economic growth of the economy. It does well when the economy is expanding and poorly when the economy is slowing. Although this asset class is often thought of as safe, it is one of the most risky asset classes because of its volatility. Fixed income has subsets that perform differently in different phases of the business cycle. For example, treasuries do well in recessions, high yield does well in all parts of the cycle except recessions, and investment grade credit does better in recessions than high yield but has more interest rate sensitivity and is subject to losing money when rates rise late in expansion. Although fixed income is the least risky asset class as a whole, it also has the lowest return.
Treasury bonds should protect in recessions, but they lose money when interest increase. Absolute return, also known as hedge funds, is not really an asset class, but is rather a group of various strategies that generally have statistical commonalities, such as low correlation with the equity and fixed income markets, low standard deviation, or risk, and high Sharpe ratios, or return per unit of risk. KRS does not use hedge funds to out earn equities; instead, hedge funds are used because KRS wants to have the best chance of earning 7.75 to 8 percent return with a fixed income level of risk, and they are part of the mix to accommodate that goal.
Real return as an asset class contains strategies and security types with one commonality: all real return investments should do well in inflationary or rising interest rate environments. The strategies range from Treasury Inflation Protected Securities (TIPS), to hard assets such as real estate, timber, or drug royalties. Not all real return strategies are considered alternative investments, with TIPS as one example. Investments in this category may also include strategies where KRS loans money to individuals, as a bank would, in the agriculture or mining industries, and has the underlying asset (such as crops, equipment, land, minerals) as collateral for the loaned funds.
Private equity is an asset class where the investor collects an illiquidity premium over private equity. If the illiquidity premium does not exist, KRS would not invest in private equity. A secondary benefit of private equity is access to smaller companies or companies that are too small to go public, but that have $25 to $50 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) or revenue.
Venture capital is also an available asset class, but it does not fit the profile for KRS of consistent returns with low risk. Other strategies in private equity are debt-related strategies, such as where a company is in distress and the debt is purchased in order to gain control of the company for rehabilitation, and private debt, which is when the investor essentially replaces the bank when it has abandoned making certain loans, such as loans to the agriculture or mining industry.
Mr. Peden discussed a histogram of asset class characteristics showing a dispersion of monthly returns from July 1, 2004, to June 30, 2014. The histogram shows the riskiness of an asset class. The wider the dispersion may be, the more risky the asset class. He contrasted the tight pattern of fixed income investments with low volatility, and asset classes that have widely variable returns, or high volatility. He reviewed the return profile of hedge funds and said that visually it looks much more like the aggregate bond index than it does the S&P index, at least from a risk perspective.
When different asset classes are added that are uncorrelated with one another, the standard deviation is decreased for the total portfolio. This diversification is mathematically based. It is important to understand that correlation is measured from negative one to positive one. Negative one means two assets are perfectly negatively correlated, so that when one goes up the other goes down by the same amount. When two assets are perfectly correlated or positive one, they move exactly the same, so there is no benefit to having both asset classes in a portfolio because they are adding the same exposure to the portfolio. The ideal situation is to have all asset classes and all investments in the portfolio with a correlation of zero, which would indicate that they are bringing unique exposures to the portfolio. Standard deviation is not the weighted average of two assets. It is possible to have two risky assets in combination and result in a low risk portfolio if the correlation between the two assets is negative or low.
Mr. Peden said that consistency of return is important: the lower the standard deviation, the higher the geometric average. It is the goal of KRS to have consistent returns, which in the long term will result in the highest average return. Consistent returns are important especially for the KERS nonhazardous plan because more funds are paid out in benefits than contributions are received. The more asset classes and investments added to a portfolio that are uncorrelated with one another the greater the risk is driven down without affecting the targeted return of the portfolio.
The annualized data for asset class characteristics and the correlations were provided for the past five and ten years and since 1990. The average return for the S&P 500 since 1990 has been 9.6 percent and the risk has been 14.8 percent. Mr. Peden discussed the KRS return experience in hedge funds since KRS began building out the hedge fund program in September 2011 and thru June 2014. The return in hedge funds has been 7.65 percent annually, which is at 7.75 percent or 8 percent target. However, the standard deviation has been 3.19 percent, which is close to the performance of fixed income since 1990. The correlations to high yield indexes, S&P 500, and treasuries have exceeded expectations allowing hedge funds to perform exactly as intended, with targeted rates of return with low risk. During this same three year period, the S&P 500 has returned 24.5 percent with a standard deviation of 7.44 percent, but since 1990 it has returned 9.6 percent with a 14.8 percent risk. This suggests at some point that public equity is going to revert to the mean, or long-term average, and experience both lower returns and greater risk. KRS is trying to build a portfolio that will perform over an entire business cycle and to factor in all the risk profiles of each asset class given the status of a pension plan with a relative inability to take on a large amount of risk.
The most common approach to portfolio construction is Mean Variance Optimization (MVO), which is the mathematical method of determining allocation mix using the capital market assumptions of return, risk, and correlation for each asset class to target the highest possible return for a given level of risk or to find the allocation mix that offers the lowest level of risk for a targeted return.
Mr. Peden emphasized that KRS does not build its portfolios to chase returns and is constantly aware of risks, and KRS must be self-sufficient because it does not have the luxury of an entity coming in and bailing it out. The choice of asset classes is mathematically based using the projected return targets and the goal of minimizing risks. Alternatives have an important role in achieving that goal and allowing KRS to keep standard deviation low and exposure to drawdown risks at a minimum.
In response to a question by Co-Chair Bowen concerning the mathematical equation and asset allocation decisions between different plans under KRS management, Mr. Peden said that this is a part of the asset allocation process. KRS knows that the liability profiles, or what is known will need to be paid out in benefit payments, for the KERS nonhazardous and hazardous plans are different from one another, and when going through the asset liability study the amount of contributions made and the benefit payments paid are factored in by the consultant and that profile factors into what asset allocation KRS can comfortably have for each system. The KERS nonhazardous plan this year will have a different asset allocation than the other systems because of its funding status and cash flow constraints.
Mr. Peden stated that any problems with the KERS nonhazardous plan do not affect the ability to manage the assets for CERS. CERS’ performance is a result of the asset allocation for CERS and that the KERS funding status has played no role in CERS’ performance. KRS had good performance for the 2014 fiscal year, and there were no negative performing asset classes. Performance was led by public and private equity and performed at 22.45 percent and 22.71 percent respectively. This year was the first year after the financial crisis that private equity has reached its stride and started returning the performance numbers that were expected, and more importantly cash flowing back in terms of companies being sold, money returning to investors, and venture capital with companies going public. High yield fixed income and core fixed income performed well, even with a negative performance in May/June because of rising interest rate fears. Absolute return/hedge returns performed very well with an approximate 8 percent return with low risk, but real estate returns were disappointing. This is partly because KRS’ assets are young, whereas the index contains more mature assets.
Responding to a question by Co-Chair Bowen, Mr. Peden stated that KRS does not anticipate which asset class will perform the best over a 1, 2, or 3 year period of time and jump in and out of asset classes. Rather, because KRS always has its funds invested, the goal is to build a plan that will consistently make the returns expected in any market environment. However, the capital market assumptions that go into the models change, and this is reflected in the asset allocation over time.
In response to a question by Representative Linder as to how losses are balanced against the pay out for benefits and whether it is measured against future pay outs based on the benefits offered today, Mr. Peden said that this is factored into the liability calculations, so that the net current value of the assets versus the net present value of future liabilities results in the funding ratio. Actuarially, KRS knows the projections that are factored into the asset liability study to get an understanding of cash flow needs, and that the 7.75 percent benchmark rate of return comes from the calculation of those future obligations. Mr. Thielen said that the investment consultant works with the actuary and the actuarial assumptions that are developed to model asset allocation, and if those assumptions are met, the necessary funds will be available to pay the liabilities for the future, amortized over a 30 year period.
In response to questions by Senator Higdon concerning return on investment when dealing with the state, Mr. Peden said he has spoken with local public and private sector entities that have real estate development needs and discussed the possibility of financing or partnering to build a facility. KRS feels this is a good investment and will consider a way to safely invest in those types of projects. Mr. Thielen stated it was his understanding that in the late 1970s or early 1980s, KRS invested directly in real estate, lost a lot of money, and subsequently got out of that type of investment. By lowering the assumed rate of return there is increased pressure on contributions that need to be made by the employers to meet benefit payments and expenses. Each year the actuary performs a valuation looking at the experience of KRS and where the assets stand in relation to liabilities given the benefit structures created and the demographics of participants. The unfunded liability changes every year depending on the experience in the previous year. If the assumed rate of return is exceeded that will help decrease the unfunded liability. If more employees retire than expected and benefits will need to be paid out over a longer period, this will have a negative impact on the unfunded liability.
Responding to questions and comments by Mr. Bowling, Mr. Thielen said that the actuaries had not reviewed the experience of the funds since 2008, and based on the experience over the period 2008 through 2013, recommendations were made as to how KRS should change the assumptions. For instance, one of the assumptions is payroll growth, which is currently set at 4.5 percent, but because that growth has not been realized over the experience study period, a reduction in the payroll growth assumption was recommended. Changes in other assumptions have also been recommended, but none of the recommendations has yet been adopted by the KRS board.
In response to questions by Mr. Jefferson regarding the asset liability study and the experience study, Mr. Peden said that the asset liability study is conducted every five years. Mr. Thielen stated that the experience study is required by statute to be conducted once every ten years, but KRS has chosen to have one performed at least every five years. An experience study was done after only three years following the 2008-2009 financial crisis. Responding to a follow up question as to why KRS does not wait to conduct the asset liability study until after the board resolves the question of assumption changes, Mr. Thielen stated that there had been discussion of putting off the asset liability study, but that KRS would take into account the actuarial recommendations in the study. Mr. Peden stated that the board is looking for more information on the investment side before making a determination on the recommendations.
In response to questions by Mr. Jefferson regarding investment experience for the Board of Trustees, Mr. Thielen said the obligation to appoint persons with investment experience lies with the Governor. KRS has no role in approving or checking the background of any appointee. The current board structure includes a banker and an economics and finance professor.
Responding to a question by Co-Chair Bowen whether the 7.75 percent assumption rate decreasing to 7.5 percent was industry standard or unique to Kentucky, Mr. Thielen said that the average of public pension plans in the nation in terms of the assumed rate of return is about 7.62 percent.
Mr. Peden discussed the benchmarks of each asset class and noted that each is an industry standard, publicly available and indexed benchmark. The total fund benchmark is the weighted average of all the respective asset class benchmarks, which requires additional data to calculate.
He discussed the securities litigation policy and stated that if there is a potential claim less than $10 million, KRS follows the normal process and files a claim to participate with the broader class action. These policies are set by the KRS board in conjunction with legal counsel. If a potential claim is over $10 million, KRS seeks outside counsel. If it is determined that the claim is worth pursuing individually, a second outside legal counsel will be sought, or the Attorney General’s Office will be consulted, to pursue the claim.
Co-Chair Yonts asked about the Bank of America settlement and the amount of loss. Mr. Peden stated that the $23 million settlement made KRS whole. Ms. Malloy indicated she had participated in the lawsuit for the Attorney General and that the loss was $21.7 million.
Responding to questions by Ms. Driskell and Ms. Malloy concerning monitoring class action suits, Mr. Peden indicated that there is a contract for those services with the KRS custodian and a third party servicer, Riskmetrics. Mr. Thielen said that all external advisors are hired after an RFP process. Reinhard, Boerner, VanDeuren has been used for assistance with claims over $10 million for the last three years. Typically, the contracts are for three years with three annual renewal periods. Mr. Peden indicated that Riskmetrics has been the monitoring provider since 2008-09 and receives an annual fee for the service. Since 1997, there have been 918 total claim recoveries with a total recovery of over $25.5 million.
Discussing fees by asset class, Mr. Peden stated that KRS has historically disclosed the asset management performance fees in total in the Comprehensive Annual Financial Report (CAFR). Through a series of open records requests earlier this summer, KRS determined that it could break down the fees by asset class and give that information out publically, as well as in the CAFR going forward, which shows total fees by each respective asset class. The data shows there has been an increase in fees, but this is because the total value of the assets has increased: the greater the amount of assets under management, the more fees will be paid. Another factor driving increasing fees is diversification. About ten years ago, KRS had approximately ten asset managers. As more money is given to an asset manager, the fee rate will be lower because managing the fund requires the same amount of work for a portfolio. Because more recently KRS has begun diversifying its portfolio, the amount of assets given to any single manager is smaller, and therefore the overall fee rate has increased.
Mr. Peden discussed the use of performance fees in certain asset classes, which can produce higher fees when the manager’s performance exceeds certain targets and both KRS and the manager are “sharing” the “profit” or upside performance of an asset. These performance fees create an alignment of interests, where the manager is incentivized to create greater returns to capture the performance fees, but overall this type of fee results in the asset class costing more money to manage. For every investment manager brought to the investment committee, the fee for that manager is disclosed both in the memorandum and verbally in the committee and is part of the decision for selecting a manger. While there has been a lot of misinformation about fee disclosures and accusations that information is being withheld from the board by KRS staff, the fees are always disclosed. The board knows exactly what the fees will be for an investment manager. The investment committee factors in the fee information when it decides to hire a manager.
In response to a question by Co-Chair Bowen if a fee ever stopped the process of hiring an investment manager, Mr. Peden stated that staff had been asked to try to negotiate a lower fee. If an investment manager had a fee outside the norm for a particular asset class, staff would not bring it before the investment committee for consideration. Each manager fee begins at the market fee for the asset class. KRS attempts to negotiate a lower fee from that point for each investment in the portfolio.
Responding to questions by Co-Chair Yonts and Co-Chair Bowen on the impact of a requirement for the disclosure of the individual fees, Mr. Peden stated that if KRS is required to publicly disclose the fees paid, KRS will lose the ability to negotiate lower fees, or at least would have a diminished ability to negotiate lower fees. This is because a manager would no longer have an incentive to give KRS a lower fee than to anyone else because it will re-price its book of business to all other clients. Mr. Thielen said that there is a “most favored nation” clause in most of the contracts, which requires that if a lower fee is given to someone else, then that lower fee must be given to KRS. This is likely true for many other pension plans. Mr. Peden said KRS may piggyback off other plans in the country that have better negotiating power than KRS in getting special deals with certain managers. Disclosure on an individual manager or investment basis could impair the ability to utilize this strategy.
In response to a follow-up question by Co-Chair Yonts, Mr. Peden stated that if full disclosure is required, the cost of investing will increase and the benefits returned will decrease at an annual cost of $17 million dollars in increased fees to the systems. Mr. Thielen stated that KRS would disclose more fee information if required by the General Assembly. Mr. Peden said that some people have called for KRS to invest with the lowest fee managers, but KRS only invests in managers in the top quartile of performers because, while fees are important, it is more important for a manager to deliver the performance expected for an asset class or investment. Ultimately, there would be no reason to invest at a fee discount if the savings were overwhelmed by negative performance or negative performance versus the benchmark.
In response to questions by Senator Higdon concerning fee percentage, Mr. Peden said that the total fees divided by assets resulted in a fee of about 34 basis points, which represents the amount paid to investment managers. The only investment expense netted from the gross return is the cost of consultants. Every other expense is part of the KRS administrative budget.
Responding to a point raised by Co-Chair Bowen, Mr. Peden said that if greater disclosure is required on an on-going basis, some managers will not want to work with KRS, some availability of certain asset classes will be diminished, and other managers would charge a higher fee. However, the current roster of managers would probably not be affected because they would likely not terminate existing contracts on the basis of new fee disclosure requirements. As new managers are chosen, the greater fee disclosure and potential increased fees would be felt.
Responding to a question by Ms. Mattingly, Mr. Peden said that the investment manager contracts are confidential. Mr. Thielen said that confidentiality clauses exist in most of the contracts KRS has with investment managers, but a stated exception to the open records law would prevent those contracts from being disclosed.
In response to a question by Ms. Driskell as to how other states handle the disclosure issue, Mr. Peden stated it was 50/50 as to how fees are disclosed based on what the entity feels is in the best interest of the system, retirees, and taxpayers. Mr. Bowling asked LRC staff to look into how other states disclose pension system fees.
Mr. Thielen said that, with the passage of 2008 House Bill 1, there are additional transparency requirements. There was a clause included in KRS 61.645 that specifically states that KRS can retain the confidentiality of this type of information if disclosure will interfere with the ability to negotiate fees in the investment program.
Ms. Malloy asked about the affect of disclosure on asset management. Mr. Peden said he had not researched the issue but was fairly confident about how it would affect KRS. He offered to research how other states’ disclosure requirements have or have not impacted or affected their pension systems; however, he said it would be difficult to make a judgment as to impact unless there is data on the particular plan’s fee costs before and after disclosure requirements were implemented.
Richard Beliles, Common Cause of Kentucky, stated that the Kentucky Teachers Retirement System has no fund managers but had better returns on investments than KRS had with fund managers.
Kentucky Retirement Systems Investment Update
Brad Gross, Committee Staff Administrator, Public Pension Oversight Board, updated the board on peer comparisons of returns and asset allocations. For the period ending June 30, 2014, the rate of return for the KERS nonhazardous fund, net of fees, was 15.6 percent. The desire of KRS is to meet or exceed the rate assumption over the long term and the investments have done so over the one, three, and five year periods, while over the ten year period, including the 2008-2009 market decline, the returns were slightly less than the assumed rate of return. For the one-year term, they have exceeded their policy benchmark in the pension fund and are slightly below that benchmark in the insurance fund. One of the questions that arises is how KRS compares with other public pension funds. LRC staff is looking at the other states. As of June 30, 2014, out of 50 state plans, 22 have reported individual one, three, five, and ten year returns. Compared to the 22 states that have reported, KRS is below the median average. KRS returns fall below the returns in a peer comparison from RV Kuhns, the KRS investment consultant, which has 67 plus plans. Bank of New York Mellon has 106 plans for which numbers are available, and the average rate of return is 17.2 percent for one year. He said that the comparison for KTRS is a preliminary number and is gross of fees, whereas KRS has a net of fee number reflected. For the one year ending June 30, 2014, KTRS earned 18.1 percent on a gross of fee basis and outperformed its benchmark.
Mr. Gross said that asset allocation has changed over time, with public pension plans shifting the types of funds invested in. Historic asset allocation for public pension funds have been in domestic and international equity, fixed income, cash, and alternatives such as real estate, private equity, real return, and hedge funds. Looking at historical data, he said that a 2012 pension and investments study indicated the average allocation of pension assets in alternative asset classes was about 19.4 percent. This is part of a larger trend. In the 1990s the equity allocations increased and transitioned from domestic to international equities. There has also been a trend away from equities into alternative portfolios. There are other studies showing similar trends, such as a 2014 Cliffwater Research study that reported an average allocation of 25 percent in alternatives at the end of 2013. PEW and Wilshire have studies on average allocation that report similar numbers for asset allocation trends.
KRS has followed a similar trend and began with private equity in 2001, added hedge funds in 2009, and recently allocated funds to real return and real estate. The alternative allocation has 10.38 percent in hedge funds, 9.96 percent in private equity, 3.86 percent in real estate, and 10.06 percent in real return. Related to peers, KRS has 34.3 percent as of June 30, 2014, in alternative assets. Real estate is considered an alternative asset for the comparison, but this asset has been present for some time, and some plans differ on whether it is an alternative asset class. Staff will continue to update the peer comparison data comparing KRS with the LRC peer, Cliffwater, and KTRS comparisons. Overall, KRS is slightly below allocation on the equity side but has a comparable fixed income and cash component and an above average alternative asset class.
Mr. Gross provided information on the KRS and KTRS return comparisons for one, three, five, ten, and twenty year comparisons. KTRS out performs KRS on the one, three, five, and ten year returns, but KRS out performs on the twenty year basis. KTRS has a higher exposure to equities, which have performed well the last few years.
KRS fees for 2013 were $45.6 million or 41.4 basis points. Compared to the KRS fees for 2013, KTRS had $31.6 million in investment fees or 19.6 basis points. One of the differences is that KTRS manages more of the portfolio internally, about 40 percent, with 60 percent managed externally, and has a substantial portion in domestic equities and some fixed income bonds that are managed internally versus KRS, which manages 14 percent internally. The asset allocation for KRS is higher in alternative assets, which typically have higher fees for investment, and in public equity and fixed income, while the allocation to alternatives is lower for at least the one year period examined.
Co-Chair Bowen asked members to study the information provided by Mr. Gross for further discussion and follow up questions at the September meeting.
Co-Chair Bowen indicated that the update on the Seven County Services lawsuit would be deferred to the September meeting.
Dave Adkisson, President of the Kentucky Chamber of Commerce, said the public pension issue is significant to the business community and important to the taxpayers. In 2006, the Chamber, the Kentucky League of Cities, and the Pritchard Committee began speaking out about pensions. The Chamber has been pleased with the progress and reforms, which have been critical in bending the curve in the out years. KTRS has suggested that it needs an additional $400 million per year to be whole, a 4 percent increase in the state’s budget. The Chamber is willing to assist and partner with the board in a constructive exercise to move forward and has offered some suggestions as to resource expertise.
Ms. Driskell said she wanted to share the most recent Moody’s Investor Service article about affirming Kentucky’s bond rating, the discussion on the Seven Counties case, with the board and would provide it to staff for distribution.
Co-Chair Bowen asked Mr. Thielen to share the board’s concerns with KRS board members.
A motion to adjourn was made by Co-Chair Yonts and seconded by Mr. Bowling. The meeting adjourned at about 4:25 p.m.