Call to Order and Roll Call
The meeting of the Public Pension Oversight Board was held on Thursday, September 25, 2014, at 10:00 AM, in Room 149 of the Capitol Annex. Representative Brent Yonts, Co-Chair, called the meeting to order.
A roll call was not performed; however, the secretary made note of those members in attendance.
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, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Brian Thomas, David Peden, and Jennifer Jones, Kentucky Retirement Systems; Jason Moseley and David Adkins, Council of State Governments; and Janna Smith, Office of State Budget Director, on behalf of Jane Driskell.
LRC Staff: Brad Gross, Greg Woosley, and Marlene Rutherford.
Approval of Minutes
Co-Chair Bowen moved that the Minutes of August 28, 2014, be approved, which was seconded by Mr. Jefferson. The minutes were approved without objection.
Co-Chair Yonts previewed several bills that could potentially be considered in the 2015 General Assembly. An ad hoc group appointed from the Interim Joint Committee on State Government had discussed several issues and given direction to staff on how to proceed from those discussions on a few bill drafts that may or may not be prefiled. The board will hear comments in the meeting concerning bills that were filed in the 2014 Regular Session, which could be called again in the 2015 Regular Session.
Review of 2014 Regular Session Legislative Proposals
Senator McDaniel discussed Senate Bill 142 and Senate Bill 216. Senate Bill 142 passed out of the Senate and the House Committee on State Government but was not voted on by the House of Representatives. Senate Bill 142 was endorsed by the Kentucky League of Cities, Kentucky State Police, Kentucky Association of Counties, Kentucky Fire Commission, Kentucky Chamber of Commerce, Kentucky Coroners Association, Magistrates Association, County Judges Association, School Boards Association, School Superintendents Association, Jailers Association, Fire Chiefs Association, County Clerks and County Attorneys, Kentucky Association of Professional Firefighters, Kentucky State Police Professional Association, and Teamsters Local 783, which handles fire and ambulance services for Louisville.
Senate Bill 2, which passed in the 2013 Regular Session, addressed the issue of “spiking,” which is an end of career increase in creditable compensation. He said it is important to distinguish between creditable compensation and wages or overtime compensation. Creditable compensation that is “spiked” or increased at the end of a career has not been actuarially accounted for through the course of an employee’s career. Senate Bill 2 provided that a ten percent year over year increase in compensation would result in the full actuarial value being borne by the employer of the employee. Cities and counties have started receiving bills for these increases to creditable compensation, which have varied from several hundred dollars to one in excess of two hundred thousand dollars on one employee. The full actuarial value could add as much as 156 to 352 percent of wages to the employer’s contribution. As employers look at spiking for employees approaching retirement, they will not allow the employees to work those spiked hours, which means employees will not be able to work the hours and collect the wages and will not collect a pension on those spiked hours. Any federal funds associated with the overtime will have to be returned at every level from city, county, and state.
Senate Bill 142 addressed this issue. First, it excluded bona fide promotions and compensatory time from the definition of a “spike.” A bona fide promotion from one position to another allows an increase in wages and is not considered a “spike.” There is no penalty for a “spike” in a year following an employee being off without pay for five or more weeks, or if the employee has workers’ compensation income, unpaid leave under the Family Medical Leave Act, maternity leave, or if the employee has authorized sick leave without pay. Senate Bill 142 allows an employee could continue to work the hours beyond the additional ten percent; however, if an employee went over the ten percent of creditable compensation level, the wages would still be collected, and the employee and employer would pay into the retirement system. Upon retirement, the employee contributions are refunded and the employee is not eligible for a benefit for the “spiked” portion of compensation, but the employers’ contributions remain in the system and are used to offset the unfunded liability. This allows employers to permit employees to work hours beyond the ten percent level and allows the employees to work and earn the overtime pay.
Senate Bill 142 provided an appeals process for employees to protest whether a promotion was a bona fide promotion. The provisions of the bill were prospective in application and only applied to wages earned July 1, 2014 and thereafter, and the bill in 2015 would affect wages earned after July 1, 2015. Senator McDaniel said he had been contacted by countless cities, police departments, fire departments, counties, and sheriff’s departments asking that the language of Senate Bill 142 be filed in the 2015 session because those employers are having to cut back employee hours to avoid the cost of “spiked” compensation. In the case of road crews removing snow in the winter, the time will be limited, and the remainder of the work will be outsourced to a private company.
Co-Chair Yonts asked Brian Thomas, General Counsel of the Kentucky Retirement Systems, to comment on any of the bills discussed, but Mr. Thomas said he would defer to Bill Thielen, Executive Director, who was not in attendance.
In response to a question by Co-Chair Bowen concerning the limit of ten percent growth in creditable compensation earned during the last five years of employment, Senator McDaniel gave an example of an employee in hazardous duty who is four years from retirement and whose retirement is based on the employee’s highest three years of salary. In the last three years of employment, the employee cannot exceed more than a ten percent per year increase in creditable compensation and receive a retirement benefit on the amounts over the ten percent increase, although the key feature of the bill is that the employee can still work and be paid for those hours.
Responding to a question by Senator Higdon, Senator McDaniel explained how “spiking” in Senate Bill 2 relates to Senate Bill 142. Under Senate Bill 2, when an employee exceeds the ten percent creditable compensation growth amount, the employer pays the same actuarially required contribution for the employee up to the ten percent level, but then the employer is responsible for the full actuarial value of the retirement cost for any amounts above that level. In various scenarios, this value is an additional amount between 156 percent and 352 percent of wages.
Responding to a question from Co-Chair Yonts as to how this would affect the inviolable contract, Senator McDaniel stated that a Maryland court opinion several years ago made clear that changes that are prospective in nature, as in Senate Bill 142, do not affect any benefit that has been earned or accumulated to date, and that consequently the provisions of the bill would likely not be a violation of the contract.
Senator McDaniel also discussed Senate Bill 216. Senate Bill 216 passed the Senate in the 2014 Regular Session and was discussed in the House Committee on State Government. After an agency begins participating in the KERS or CERS, it is required to continue participating, except in limited circumstances. For example, an agency’s participation in CERS may be terminated for failure to comply with the retirement laws, such as not paying the employer contribution rate, or by seeking a legal remedy, as in the case of the Seven Counties Services bankruptcy proceedings. One issue that affects agency participation is the increasing employer contribution rates, which have increased over the years from 5.89 percent of pay in 2001-02 to 38.77 percent in the latest budget for the KERS nonhazardous plan. Also, the federal government has been reviewing who should and should not be eligible to participate in government retirement plans and may render an opinion as to the eligibility of some agencies, such as nonprofits, to participate in those types of plans. KRS has had on-going litigation with agencies over the failure to pay employer contributions on groups of employees, with the bankruptcy proceeding in the Seven Counties case being a prime example.
Senate Bill 216 establishes a process where certain agencies defined by the bill may voluntarily discontinue participation in KERS or CERS, provided they pay the actuarial costs for no longer participating. The bill also provides a consistent process across KERS and CERS whereby an agency may be required by the KRS Board to discontinue participation if it is determined to no longer be eligible to participate in a governmental plan or if the agency fails to follow the requirements established for participating agencies under state law, such as the failure to pay employer contribution rates. Under the bill, if an employer wants to voluntarily discontinue participation in KERS or CERS the employer would have to: (1) submit a request to the KRS to discontinue participation; (2) pay for an actuarial study to determine the costs of the agency’s discontinuation of participation; (3) pay the full actuarial costs for discontinuing participation in the system through a lump sum or by installments if KRS allows the employer to do so; and (4) establish a qualified retirement plan for the benefit of its employees. If installment payments are permitted, the installment period can be up to thirty years, with the interest rate not to exceed the assumed rate of return, and the required collateral and security for the installment payments are determined by KRS.
Senate Bill 216 identifies those entities that can or cannot discontinue participation in KERS and CERS, with mental health agencies, most quasi-state agencies, and other agencies that are nonprofit, nonstock corporations under KRS Chapter 273 being permitted to voluntarily discontinue participation. Under SB 216, if an agency ceases participation, employees hired by the agency after the agency discontinues participation would not participate in the retirement systems. Employees of the agency participating on the date the agency discontinues participation will cease participation going forward, but those employees would retain all benefits that the employee had earned to date. If an employee of an agency that discontinued participation then transitioned to a new employer that still participated in the systems, the employee would continue to accumulate service credit and any benefits under the retirement system applicable to the new employer. No employee will lose any earned benefit. There have been three legal opinions outside the system, as well as a letter from the KRS, that indicate the provisions of Senate Bill 216 do not violate the inviolable contract.
Responding to a question by Co-Chair Yonts concerning adequate security to ensure payment of the costs of terminating participation, Senator McDaniel stated that KRS has no security by ignoring the problem. As organizations are reviewed, the KRS will have to define the mechanics of how security will be provided, but at the least there are assets for many of these agencies, such as the on-going contracts from the state in the case of Seven Counties Services. Senator McDaniel said the bill addresses the issue of adequate security more robustly than what is currently provided; a $90 million unfunded liability financed over a 30 year term will reset the clock for an organization, which will reduce the amount the entity is paying for the retirement benefit. Co-Chair Yonts said that the bill may require some reference to other provisions of law for the enforcement of security and that the security interest must be better defined for the state to be fully protected since the future is unknown. He said that 30 years for repayment was problematic.
Responding to a question by Co-Chair Bowen concerning any potential bankruptcy, Senator McDaniel stated that it could be argued that currently the state is assuming more risk without an orderly exit mechanism and no security at all. He said that these recommendations are unchartered waters by working through the issues of agency participation to strike a balance of honoring commitments to employees while allowing essential services to be provided on behalf of the Commonwealth.
In response to questions from Representative Linder regarding the federal government’s review of entities eligible to participate in a governmental retirement plan, Senator McDaniel stated that it would depend on the conditions, how the federal government views different types of agencies, and how it views the obligations of the employers of the Commonwealth. He deferred to KRS for other thoughts. Senator McDaniel stated that there is no timeline for the federal government to provide a review.
Brian Thomas, General Counsel, and Jennifer Jones, Assistant General Counsel, Kentucky Retirement Systems, discussed House Bill 324, a housekeeping bill that was sponsored by Co-Chair Yonts in the 2014 Regular Session and that did not pass. Co-Chair Yonts said the bill would provide flexibility to the KRS and provide for efficiencies that would reduce overhead and costs to the systems. Co-Chair Yonts asked that any changes that may have come about since the 2014 session that should be included in the housekeeping bill be brought to LRC staff’s attention.
Mr. Thomas stated that the bill would allow KRS to comply with federal law and both save substantial administrative costs and improve the experience of the members in the administration of their retirement benefits. Regarding trustee elections, KRS would like to pursue the possibility of conducting the elections electronically. The cost of CERS elections is between $105,000 and $120,000, which is due to creating the ballots and mailing. The bill would allow KRS to conduct the elections electronically, thus reducing some of the costs of printing and mailing ballots by as much as fifty percent, which is a significant savings for each election. He also noted that the additional CERS trustee position that was created by Senate Bill 2 is not in sync with the other CERS elected trustees, requiring an additional CERS election with added costs, and the bill would allow for this additional position to be elected at the same time as the other trustees. The bill would also authorize the use of debit cards in place of paper checks for payment of benefits. The statute was amended in 2000 to require retirees to sign up for electronic funds transfers (EFT) or direct deposit unless the member did not have a bank account or their bank did not participate in the EFT process. Mr. Thomas stated that the majority of retirees utilize EFT; however, there are still approximately 7,500 paper checks mailed each month at a cost of approximately $35,000 per year. KRS believes that debit cards could be utilized in place of paper checks and that members would receive their benefits faster and be more secure.
Additional changes in the bill were included to address “tier 2” members who began participating in the retirement system from September 2008 through December 2013, as a result of House Bill 1, passed in 2008, and Senate Bill 2, passed in 2013. These members are traditional pension benefit structure members; however, the creditable compensation definition that applies to this group only allows a calculation of benefit if those members have five complete years of service. The experience of KRS is that some members have more than five years of service but do not meet the definition and cannot have a benefit calculated for their service and are only eligible for a refund, which KRS does not believe was the intent of House Bill 1. Mr. Thomas said that Senate Bill 2 increased the number of trustees on the KRS board. The number of members on the investment committee is set by statute, whereas the number of members on the remaining subcommittees of the KRS board are set by the board itself, and as a result of the increase in the number of trustees the number of members on the subcommittees have increased and therefore the housekeeping bill would allow an increase in the number of investment committee members from five to seven members.
In response to Co-Chair Bowen’s question concerning inclusion of language in the bill that reflects that any savings derived from or identified by efficiencies should be applied to the unfunded liability, Mr. Thomas stated that any savings would ultimately be applied to the unfunded liability because a proportionate amount is taken from each trust to pay for the elections and any savings derived from the housekeeping bill would benefit each trust proportionately.
Responding to a question by Co-Chair Yonts, Mr. Thomas stated if KRS implemented a debit card type system rather than a paper check that some individuals would choose EFT directly into a bank account. Also, KRS would look at the current language of the bill to make it clear that retirees have the option to elect EFT if they do not want a debit card when switching from a paper check.
In response to a question by Senator Higdon about whether a requirement that retirement system employee pay increases be the same as other state employees pay increases should be included in the housekeeping bill, Mr. Thomas said he would defer that decision to the executive director of KRS or the chairman of the board.
For clarification and responding to a question by Mr. Jefferson, Mr. Thomas said that the Social Security Administration requires EFT of benefits but also allows a debit card. With regard to why the standards of qualification for serving on the KRS Board and investment committee and the Public Pension Oversight Board (PPOB) are different, Mr. Thomas stated that House Bill 1 amended KRS 61.645 and required some investment expertise for particular members of the board of trustees, but he could not address the standards of qualification for the PPOB. Mr. Jefferson said that there is a difference in the statutory language. If a statute was going to be changed with respect to investment committee members, it may be beneficial to look at the statutory differences between investment experience for serving on the PPOB and being a trustee of the KRS Board, which might assist the trustees in financial oversight. Mr. Thomas said KRS would review that issue. Co-Chair Yonts said that Section 15 of House Bill 324 may address some of the Mr. Jefferson’s concerns relating to investment experience.
Co-Chair Yonts discussed House Bill 323 and House Bill 389, which he sponsored and were introduced during the 2014 Regular Session. The bills passed the House and were referred to the Senate Committee on State and Local Government and saw no further action. House Bill 323 gave jurisdiction over the Legislators’ Retirement Plan, Judicial Form Retirement System, and the Teachers’ Retirement System to the PPOB as to the benefits, administration, investments, and funding. The bill removed the prohibition on members and retired members from serving in appointed positions and modified the date for the annual report due from the PPOB to the Legislative Research Commission from December 1 to December 31 each year. Co-Chair Yonts stated that it is a policy issue of whether the legislature should require that all state-administered retirement systems be under the PPOB. He asked for discussion from PPOB and attendees.
In response to a question by Co-Chair Bowen as to how the oversight of these additional systems would function, Co-Chair Yonts stated that he did not believe there would be a need for any additional scheduling or additional meeting days. However, he the length of the agendas may increase, but PPOB would review the same strategies, assumptions, goals, investment returns, problems, and issues, and there would be some regularity of reporting by the systems to PPOB.
Co-Chair Yonts said House Bill 389 required state retirement systems to conduct an actuarial experience study at least once every five years, instead of the current ten years. From discussions, it was recommended that the study mandate be shortened and that a copy of the report on the experience study be provided to the Legislative Research Commission, and specifically to the co-chairs of PPOB.
In response to a comment by Senator Higdon regarding the individuals or firms that conduct the experience study not being the same as the actuary, Mr. Thomas stated that KRS utilizes the same actuary because it is familiar with the data. The actuary is usually changed every five or six years.
Co-Chair Yonts asked whether an actuarial audit could be cross-referenced with the experience study for accuracy or viability of the study and whether this would be beneficial. Mr. Thomas said that to his knowledge this had never been done. Co-Chair Yonts asked Mr. Thomas to look into whether an audit of the experience study would be beneficial and report back to PPOB.
Mr. Bennett said the Auditor’s Office had consistently found, in the eighteen audits of school systems, that auditor rotation is an issue. When the same set of eyes is looking at information year after year, there is a tendency to miss items that may be a problem. The board may want to discuss at a future meeting.
Mr. Jefferson stated that frequently there is a bias to adjusting an assumption in a meaningful amount unless there was obvious evidence to warrant otherwise and the value of having a second set of eyes, whether it is an audit of the actuarial report or a different firm conducting the experience study, may improve the soundness of the fund. It would be a valuable resource to trustees to have another expert review of the assumptions. Even though there would be an additional cost for this additional review it could be a worthwhile exercise. As to the frequency of the actuary reports, he suggested that the statute set forth when the reports are produced and that information be shared with the General Assembly prior to a budgetary session so that information could be acted upon in the budget process, if necessary, and that KRS may have to provide the report a year earlier in order to comply. Currently, the report is generated in the summer following a session, which Mr. Thomas stated is due to the report coinciding with the end of the fiscal year in June.
Responding to a question by Representative Thompson as to whether there is a manner to measure the performance or the accuracy of an actuarial report, Mr. Thomas stated that this was the purpose of the experience study, which reviews the last five years to determine what the system has actually experienced as to benefits paid, the number of retirements initiated, and the new members into the system. All this information is compared to what was assumed to determine if the assumptions need to be adjusted.
Monthly Investment Update
David Peden, Chief Investment Officer of the Kentucky Retirement Systems, provided an investment update. At the outset, in reference to the earlier discussion concerning auditing, Mr. Peden stated that the Public Auditor’s Office performs an audit of KRS at least every five years, which is a check of the auditor utilized by the KRS.
Mr. Peden said that in July every asset class was negative except for hedge funds, which resulted in a slow start for the fiscal year of negative eighty-three basis points. The U.S. equity markets had a sizable loss on the last trading day of July, losing two percent, which also had a substantial impact on the monthly return. In August every asset class was up except for hedge funds resulting in the total fund being up 1.39 percent versus the benchmark of 1.28 percent. U.S. public equity was up 4.3 percent, and fixed income was also up, so both interest rate sensitive assets and credit sensitive fixed income were positive. Real return was led by master limited partnerships, such as oil and gas pipelines, and toll roads, which performed well in August, being up eight percent as an investment class for the month. In the current fiscal year, KRS investments are up fifty-five basis points and are slightly trailing the benchmark set at seventy four basis points.
Update on Seven County Services Court Case (deferred from August meeting)
Greg Woosley, LRC Analyst assigned to the Committee on State Government and PPOB, gave an update on the Seven Counties Services court case and a summary of two other court cases with recent activity.
On May 30, 2014, the judge in the U.S. Bankruptcy Court issued an opinion in the retirement systems’ adversary proceeding in which KRS asked the court to find Seven Counties Services was not eligible for a Chapter 11 bankruptcy. The judge provided an analysis of what it means to be a “person” eligible for Chapter 11 and not a “governmental unit” that would not be eligible for a Chapter 11 bankruptcy. The court found that Seven Counties Services was not a governmental unit and was therefore eligible to continue participating in the filed Chapter 11 bankruptcy. A governmental unit under the Bankruptcy Code is defined as including the Commonwealth and any department, agency, or instrumentality of the Commonwealth. The court determined that because Seven Counties Services was organized as a nonprofit corporation created by private citizens without government action, and not administered by individuals directly responsible to public officials, that it was not a department of state government.
The court also determined that Seven Counties Services did not qualify as an agency because community mental health centers were intended to be an alternative to the use of direct state agencies, and that through their creation and the manner they were handled by the state they were treated separate and apart from state government. The court was swayed by the fact that Seven Counties Services’ employees were not under the state merit system and were not governed by the salary schedules applicable to state employees, and there were no personnel regulations governing those employees. The court also determined that Seven Counties was not an instrumentality, relying on the case of Las Vegas Monorail, because Seven Counties did not have any of the three features normally found in a governmental entity: (1) the power to tax; (2) the power to exercise eminent domain; and (3) sovereign immunity. The court said that there was a low level of state control over Seven Counties Services’ operations and that it operated independently from state government, even though there was some cabinet oversight.
The court stated the manner in which the state had designated and treated Seven Counties Services over the years suggested it was not an instrumentality of the state and that the state treated them separate and apart from the state. Applying the definitions, the court determined that Seven Counties Services was not a governmental unit and therefore could continue with the bankruptcy. Mr. Woosley said that a side holding of the court was there was an executory contract between Seven Counties Services and KRS, and that Seven Counties Services could reject the contract in a bankruptcy proceeding and seek to terminate its obligations under the contract. The judge expected that Seven Counties Services would follow the normal process of proceeding through a Chapter 11 bankruptcy, leaving open the possibility that some type of plan for determining how Seven Counties Services removes itself from the contract would be formulated. The KRS board had voted to appeal the decision, and the judge did not object to KRS’ request to move the appeal directly to the U. S. Sixth Circuit Court of Appeals. KRS is waiting to see if the Sixth Circuit accepts the appeal.
In response to a question by Co-Chair Yonts, Mr. Woosley said there was no clear guidance on when the Sixth Circuit would make the decision on whether it would review the case.
Co-Chair Yonts pointed out that since the bankruptcy proceedings some of the contracts of Seven Counties Services had been vetoed by the Government Contract Review Committee, which were sustained by the Governor, it is possible that other contracts may be terminated under the 30 day cancellation clause included in the standard government contracts.
Responding to a question by Co-Chair Yonts concerning the allocation of funds by the secretary of the Cabinet for Health and Family Services to the boards for mental health organizations, Mr. Woosley stated that the court was careful to analyze what the degree of state control was over Seven Counties Services and determined even in light of the statutory framework that it was a low level of control. The court noted that the state did not have the power to seize assets owned by the private corporation, but it took note of the statutory scheme. The court was not swayed by the scheme of oversight to determine that Seven Counties Services was a governmental unit. If the state exercised the scheme, it would show that the Commonwealth has some degree of control over certain aspects of the operation.
Mr. Woosley updated the Board on the Bluegrass Oakwood and Oakwood Community Services court case. The case was scheduled for oral argument at the Court of Appeals in September, but the arguments were cancelled by the Court and the case had not been rescheduled at the time of the meeting.
He also summarized an agency participation case that was filed last fall by Frontier Housing, Inc. and Housing-Oriented Ministries Established for Service, Inc. Both entities provide housing assistance for low and moderate income families in eastern Kentucky, east central Kentucky, and southeast Kentucky. The organizations requested to be participants in CERS in 2002 and were admitted by the KRS Board. In the fall of 2013 the organizations filed a petition for declaration of rights in Franklin Circuit Court and argued they are nonprofit corporations that do not meet the definition of a county contained in KRS 78.510(3), which is a prerequisite for participation in the CERS. KRS filed a motion to dismiss, which was denied by the court, and the case will now proceed through discovery.
The last case update was for a case involving the City of Ft. Wright, which filed a class action lawsuit against the KRS Board in Kenton Circuit Court. The City of Ft. Wright asserts that the CERS is investing in assets not approved by the statutes, KRS 78.790 and KRS 386.020. The city is requesting declaratory and injunctive relief. The petition was filed in June 2014, and a motion to dismiss was filed in July by KRS. The case was set for a hearing on the motion to dismiss at the end of September, but the hearing was rescheduled to October 2, 2014.
The next meeting of the PPOB will be October 23, 2014, unless there are conflicts. Co-Chair Yonts said that potential items for discussion will be suggestions for recommendations to be included in the annual report to be filed with the Legislative Research Commission on December 1. Potential discussion might include KRS discussion on issues, input from interest groups such as the Kentucky League of Cities, Chamber of Commerce, Kentucky Associations of Counties, Public Retirees, Government Retirees, Kentucky Education Association, and Transportation Cabinet employees discussing the “spiking” bill.
Co-Chair Yonts asked that suggestions on topics to be discussed in the next couple of months and items that need to be included in the annual report be shared with staff, and that an analysis as to why they should be included be provided along with pros and cons. The November meeting will be devoted to finalizing the report due December 1.
Co-Chair Bowen stated that he believed the Board was making strides in addressing the issues and encouraged the members to be creative in their thinking and to submit any ideas or suggestions to Co-Chair Yonts or himself.
Without objection, the meeting was adjourned at approximately 11:42 a.m.