Call to Order and Roll Call
The meeting of the Public Pension Oversight Board was held on Monday, December 15, 2014, at 1:00 PM, in Room 149 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, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Lowell Reese, Kentucky Roll Call; Russ Wright, Retiree; and Representative Arnold Simpson, among others.
LRC Staff: Brad Gross, Bo Cracraft, Terrance Sullivan, Greg Woosley, and Marlene Rutherford.
Co-Chair Bowen reviewed the items in the members’ folders, including the October KRS investment update, the KRS 2014 Actuarial and Audit Report, a KRS meeting schedule for 2015, a fund fact sheet prepared by LRC staff, and copies and summaries of pre-filed legislation. He stated the board would discuss three reports: 1) an actuarial valuation; 2) an experience study; and 3) the annual audit of KRS. The purpose of the actuarial valuation is to provide data on the funds’ funding levels and unfunded liabilities and to determine the actuarially required contributions (ARC) that should be paid in the upcoming budget cycle to insure solvency of the funds. The experience study analyzes past assumptions of future economic events such as inflation, wage growth, and demographics and compares them to actual results in those areas. The annual audit of KRS summarizes the financial condition of the system at the end of a fiscal year, including the contributions and investment returns received and the benefits paid out during the year. He stated the board would also act on the draft PPOB report to be submitted to the LRC and discuss research topics for 2015. Co-Chair Bowen reiterated that the PPOB meetings in 2015 would be held on the fourth Monday of each month.
Approval of November 24, 2014 Minutes
Mr. Bennett moved that the minutes be approved. Co-Chair Yonts seconded, and the minutes were approved without objection.
Kentucky Retirement Systems Investment Update
David Peden, Chief Investment Officer of KRS, discussed the preliminary November investment update with an estimated performance report, since the board previously received the audited report for the month of October. For the month the portfolio was up seventy basis points, which was right on the benchmark. The U.S. equity markets were the best performers, with mid-cap equity leading and mid-cap growth up 3.3 percent and mid-cap value up 1.75 percent, while large cap equity was up 2.5 percent and small cap stocks were flat. The developed non U.S. equity was up about one percent and emerging markets were down about one percent, while fixed income was up slightly with interest rate sensitive fixed income up seventy basis points and high yield income flat. Mr. Peden noted that while the KRS performance was flat, the benchmark was down about seventy five basis points. Real return was negative thirty basis points for the month due to lack of inflation and the strengthening dollar, and absolute return strategies were down about forty basis points. For fiscal year to date, the performance is slightly positive, up about ten basis points, but basically flat with the positive contributors being U.S. public equity both large cap and mid cap, interest rate sensitive fixed income, real estate, private equity, and absolute return. The negative contributors to performance are U.S. small caps, non U.S. public equity, credit oriented fixed income, which is being impacted by the oil and energy related companies that are negatively affecting high yield bonds, and real return or inflation sensitive assets that are being negatively impacted by a lack of expected inflation and the strengthening dollar. For the fiscal year to date relative to the benchmark, assets are under performing by forty basis points because active management is under performing passive management and a large part of the portfolio is dedicated to active management. He also noted the general trends that larger cap stocks are outperforming smaller cap stocks, growth stocks are outperforming value stocks, interest rate sensitive fixed income is performing better than credit focused fixed income, and real return is not performing well so far this year, which are all factors that contribute to the forty basis points under performing for the fiscal year.
Responding to a point of clarification by Co-Chair Bowen, Mr. Peden indicated that performance for the fiscal year is basically flat.
In response to a question by Co-Chair Yonts concerning the flat rate of return and what affect that has on cash flow, Mr. Peden stated that the benefit payments will have to be paid through principal sales and contributions. He said that in the KERS non hazardous plan over $900 million in benefits are paid out annually and that the contributions of both employees and employers are about $400 million. He also pointed out that even with a 15.5 percent return last year KRS had to sell $180 million in assets above what was generated, and that if it continues this year the portfolio would go down about $500 million out of $2.5 billion in assets. He said that the assumptions were changed based on consultation with the investment consultant and the actuary. He said that the investment consultant deals with capital market assumptions going forward and the actuary looks at past performance.
Kentucky Retirement Systems 2014 Actuarial and Audit Report
Bill Thielen, Executive Director of KRS, discussed the 2014 actuarial valuation report and the audited financial data, which were presented to the KRS Board at its December meeting. Mr. Thielen began by identifying the basic funding equation for retirement benefits which is Contributions + Investment Income = Benefits Paid + Expenses or administration (C + I = B + E). He said that all pension and insurance plans with the exception of the KERS non hazardous pension plan and SPRS plan increased in funded status from June 30, 2013, to June 30, 2014. As of June 30, 2014, the KERS non hazardous plan was 21 percent funded and the insurance plan was 27.9 percent funded, for a combined funded level of 22.1 percent. The pension plan dropped from 23.2 percent at the end of June 30, 2013, to 21 percent at the end of June 2014. The SPRS pension plan also decreased during the fiscal year from 37.1 percent to 35.6 percent.
All other pension plans increased for the same period. He noted that all the insurance plans are doing well. He also stated that most public pension plans that pay insurance benefits are on a pay as you go basis and rarely pre-fund the insurance benefit. Mr. Thielen also highlighted comments made by the actuary based on the pension valuations, with the most significant being that the market value investment return was greater than anticipated for all funds. He also noted the actuarial value investment return was greater than expected for all plans, and he reiterated there was an increase in funded ratios for all plans except the KERS non hazardous and SPRS plans. He said that each August KRS provides the actuary a large database of information that is used to perform the actuarial valuation. The KERS non hazardous assets have steadily decreased in value over the last eight years from about $5.6 billion in market value in 2007 down to $2.56 billion as of June 30, 2014. The largest drop in assets was in 2009 and 2010 during the major recession, when all plans lost about $2 billion dollars, and in 2012, the investment rate of return was zero. While the pension plan assets are at $2.56 billion dollars, in 2014 KRS paid out over $914 million in benefit payments, refunds, and expenses from the KERS non hazardous plan. He also said that the actuary has indicated the KERS non hazardous plan funded ration will continue to go down for the next two to four years and they expect, if the investment rate of return is met along with other assumptions, that it will decline to 14.92 percent funded. However, if the ARC is funded at 100 percent and the assumptions are met, it is expected that the plan will be at 32.4 percent funded in twenty years. The KERS hazardous plan and the CERS plans also showed a loss in 2008 and 2009, but they have increased since and as long as 100 percent of the ARC is paid and the assumed rate of return is met, it is expected that these plans will continue to see their funded status increase.
In response to a question by Co-Chair Yonts, Mr. Thielen indicated that before House Bill 1 it was projected that the KERS non hazardous plan funded status would decrease to somewhere around nine percent; however, that projection has increased because of additional ARC payments and changes to the plans.
Mr. Thielen discussed the pension funding contained in the actuarial valuation. The normal total cost portion of the contribution rate for KERS non hazardous is 8.4 percent, which is the cost of benefits earned in the year the valuation is performed. In other words, if there was no unfunded liability and a pension plan was begun on July 1, 2013, this would be the cost of the benefits earned in that year. The member portion of that 8.4 percent cost is five percent and the employer normal cost is 3.4 percent of payroll, which if the 0.7 percent administrative expenses were added would give an employer cost of 4.1 percent. The portion of the rate required to amortize the unfunded liability is 29.47 percent. The total employer contribution rate based on the 2014 valuation is 33.57 percent for the pension plan. He noted that the insurance funding is separate and that both the pension and insurance plans are added together that results in the total rate. The unfunded accrued liability is $9.1 billion with a 21 percent funded ratio, and the amortized period, which was reset by Senate Bill 2, is 29 years. The total employer contribution rate for the KERS non hazardous plan rose from 30.84 percent in fiscal 2013 to 33.57 percent in fiscal 2014, which is not the rate set in the budget bill.
An analysis of the gain or loss of the 2014 KERS non hazardous pension plan with an assumed rate of return at 7.75 percent and an earned rate of 15.55 percent resulted in an actuarial gain of $129 million in investment income. An actuarial gain of $69 million was also seen when the assumed rate of payroll increase (4.5 percent) was compared to the actual flat payroll for the fiscal year, because although contributions were not increasing, there was also no additional accrued liabilities. Mr. Thielen said that that assumptions are made on service retirement at normal retirement age, but if an employee retires earlier, an actuarial loss occurs and that over the last few years there have been actuarial losses in terms of service retirement, which for this fiscal year amounted to $229 million. The analysis was basically the same for the other plans, including both the non hazardous and hazardous plans.
Mr. Thielen stated that the actuarial comments on the insurance plans valuations were basically the same as with the pension plans. There was greater than expected investment returns with all funded ratios increasing for 2014. The normal cost of insurance benefits earned in 2014 was 2.71 percent of payroll minus the member rate of 0.24 percent, and the employer normal cost rate was 2.47 percent with a 0.05 percent administrative expense. The rate to amortize the unfunded liability is 5.22 percent, resulting in a total employer contribution rate of 7.74 percent. The total employer contribution rate for both the KERS non hazardous pension and insurance plans based on the 2014 valuation is 41.31 percent (combining the 33.57 percent pension rate and the 7.74 percent insurance rate). Mr. Thielen pointed out that the combined rate for the pension and insurance plans in 2013 for CERS non hazardous was 18.10 percent, and 35.70 for hazardous; however, after the insurance phase-in, which was extended to ten years in House Bill 1, the rate for insurance was reduced slightly to 17.67 for non hazardous and 34.31 percent for hazardous in 2014, and the rate will drop again next year from 17.67 percent to 17.06 percent for non hazardous and from 34.31 percent to 32.95 percent for hazardous, which will result in several million dollars in savings in fiscal year 2016. He said the contribution rates established by the valuation recommended by the actuaries and adopted by the KRS board will become effective for CERS beginning July 1, 2015, or the 2016 fiscal year. The KERS and SPRS rates set in House Bill 235 in the 2014 Session will be the rates applied for both years of the biennium.
Responding to a question from Co-Chair Bowen concerning the funding portion for the insurance plan, Mr. Thielen stated that there has been a decrease in the healthcare cost inflation rate over the past three years and the KRS board decided to move from a self-funded health plan to a fully insured health plan provided by Humana, which decreased the unfunded liability about $2 billion and brought the insurance rate down. Mr. Thielen stated that the under 65 retirees receive health insurance through the Kentucky Employees’ Health Plan and the over 65 retirees are Medicare eligible and now have a Medicare Advantage option provided by Humana, which will continue through the 2016 calendar year and that requests for proposals will be submitted for years beyond 2016. He said the 2003 changes in the health benefits had a significant impact over the last few years on the contribution rate for health insurance.
Responding to a question by Ms. Driskell concerning the increase in rate to amortize the unfunded liability from 26.71 percent in 2013 for the KERS non hazardous plan to 29.47 percent in 2014 and what is included in the “other” category on the pension gain or loss analysis, Mr. Thielen stated “other” is made up of a number of scenarios and situations such as tweaks to the actuary’s software and the timing of certain situations, such as when monies are paid into the system, and the actuary has to account for those situations. Mr. Peden noted that it is assumed that all cash flows in and out of the systems occur at the midpoint in the year, but in reality they occur throughout the entire year.
Co-Chair Bowen recognized Representative Arnold Simpson in attendance.
Mr. Thielen indicated that the impact of the 2014 valuation and the rates recommended and adopted by the KRS board will become effective July 1, 2015 for CERS, and that KRS would be notifying all participating employers what the new rates will be.
In response to a question by Ms. Stemler as to why the contribution rates are decreasing, Mr. Thielen said that the liabilities have gone down as a result of Senate Bill 2 because there is not an unfunded cost of living adjustment (COLA), and because the losses in 2008 and 2009, which were “smoothed” in over the last five years in order to dampen the volatility in the employer contribution rate, have been taken off the books. In years prior to the 2014 valuation, KRS was recognizing over $1 billion in losses each year for those five years, and the changes made by Senate Bill 2 over the long term have reduced the benefit levels. He said that if the investment returns remain flat for the remainder of fiscal year 2015 it will have a negative impact in the next valuation.
Mr. Thielen discussed the experience study which was completed in late spring, 2014 and was presented to the KRS board at its May meeting. A study of all pension and healthcare funds were reviewed comparing what actually occurred during the study period from July 1, 2008 through June 30, 2013 with what was expected to happen, and assumption changes were recommended if the actual experience differed significantly from what was expected to occur. The actuaries have recommended a small reduction in the expected payroll growth assumption, but a larger reduction was not recommended because it is expected that payrolls will grow over the next few years.
Responding to a question from Senator Higdon concerning the decrease in the investment return assumption from 7.75 percent to 7.5 percent, Mr. Thielen stated there are two major economic assumptions, one being payroll growth, the other investment return. As a result of the experience study the actuaries recommended that the investment return assumption be reduced, and that this assumption be reviewed every biennium. The reason indicated is that it will be more difficult in the next few years to make the assumed rate of return. Mr. Peden indicated that the investment return assumption is a budgeting mechanism and that if the investment assumption is not earned the ARC payment will increase in order to balance the funding equation of contributions plus investment income equaling benefits paid plus expenses, and that by lowering the assumption the actuary is providing a more realistic budgeting assumption based on what they believe will happen in the future. Mr. Peden stated that the investment consultant, RV Kuhn’s, provides capital market assumptions to the actuary to factor into the model. Ms. Driskell pointed out the experience study results will be used to develop the next biennial budget. Mr. Thielen stated that the valuation recommendations will factor into the rates that will become effective July 1, 2015, but the experience study assumption changes will not become effective until the 2015 valuation is performed, which will affect the rates beginning in the next biennium, July 1, 2016. Mr. Peden also noted the investment assumption is important for setting the asset allocation for the plans, and he stated he did not want to add asset classes strictly to attain a higher investment assumption.
The financial impact on the valuation for the KERS non hazardous plan is that if the assumption changes were applied to the valuation it would have increased the unfunded liability from $9.1 billion to $9.7 billion and the funded ratio would have decreased from 20.99 percent to 19.97 percent, which would also result in the employer rate increasing from 33.57 percent to 36.17 percent. The same applies to the KERS non hazardous insurance plan. The unfunded actuarial liability would have risen, the funding ratio would decrease, and the employer rate would increase. The total employer rate for this year is 41.31 percent, and if the new assumptions were used there would have been an increase to 44.80 percent; however, the new assumptions were not applied this valuation and will not be applied to the valuation next year and any impact will not affect the rates until fiscal 2017 and after. Mr. Thielen noted that the rate this year and next year will be 38.77 percent of payroll for KERS non hazardous, which was set in House Bill 235 and the KRS Board cannot change that percentage.
Mr. Thielen discussed the key audited financial data for 2014. He said the asset base of the entire system increased in 2014 by $1.5 billion from $14.68 billion to $16.17 billion, but that the KERS non hazardous plan lost $182.5 million, and therefore the asset increase was in the other plans. The net loss of $182.5 in the KERS non hazardous pension plan was a result of total deductions of $914.7 million compared to the contributions and investment gains of $732.2 million.
In response to questions from Mr. Jefferson concerning recommendations to improve the cash flow situation of the KERS non hazardous plan, Mr. Thielen indicated that KRS will keep the Board apprised of the cash flow situation and work with them to develop a plan to address the issue. He noted the actuaries are completing twenty year projections as well as projections in the event there was an infusion of additional monies in a lump sum and what the impact would be on the KERS non hazardous plan over time. He said that as soon as those projections are available he would provide them to the Board. He also said that another suggestion of the actuaries was a reduction of the amortization period for the KERS non hazardous plan, which would increase the contribution rate and provide more assets to invest that would help with the cash flow problem. However, Senate Bill 2 reset the period from twenty five years to thirty years, and while more funding is being provided in higher ARC payments over time, it will take a long period of time for the impact of the changes made in Senate Bill 2 to be realized.
Ms. Driskell pointed out that an affordable plan was developed to address the retirement system situation and is moving forward and that it will take time to see the impact.
Responding to a question by Representative Thompson concerning the 2014 pension gain and loss analysis, Mr. Thielen stated that under current conditions early retirements will continue and that the actuaries have recommended and the KRS Board has adopted adjustments to those assumptions.
In response to questions by Co-Chair Bowen concerning payroll growth and new hires contributing to a different plan as a result of Senate Bill 2 and whether payroll growth will have the impact that it would have had prior to Senate Bill 2 and the recommendations from the PPOB to the KRS Board, Mr. Thielen indicated the impact would be the same because the employer contribution is calculated the same way for employees participating in the cash balance plan as the defined benefit plan. Mr. Peden pointed out that one of the benefits of Senate Bill 2 is the cash balance plan because from a budgetary standpoint employers are making the same contribution as those in the Tier 1 or Tier 2 plans but the liabilities are not increasing as much as under those tiers. Mr. Thielen said that the recommendations made by the PPOB were very well received by the KRS Board, and KRS is in the process of implementing some of those recommendations, such as the actuarial audit, next year. Mr. Thielen indicated his thoughts were mixed on recent calls for the Auditor to perform an audit; however, he stated that KRS will cooperate fully with whatever the Auditor decides to do with the request from the Chamber of Commerce. He said that State Auditor Crit Luallen performed a comprehensive governance and operations audit of KRS and that most of the recommendations from the audit have been implemented. He also noted that a financial audit was performed that was issued this month, that the LRC Program Review and Investigations Committee has performed two significant examinations of the KRS investment program, both of which resulted in 100 page plus reports, and that the Securities and Exchange Commission performed a two and one-half year investigation of the investment program and any use of placement agents by investment managers. He pointed out that none of those examinations have resulted in any significant findings. He believed that any additional audit or investigation would be redundant and costly.
Responding to various questions from Mr. Jefferson as to when the findings of the asset allocation study are expected and published, Mr. Peden indicated there is a lot of sensitivity analysis around the expected return and that the KERS non hazardous plan has a more difficult time being in the asset classes that can generate the same return as CERS and the other plans. He believes that in the next few years the projected funding valuation for KERS non hazardous will be in the teens even if the expected return is made. He said that the KRS Investment Committee has discussed what the appropriate principal balance would be to completely divest and have in cash, with a minimum of one and one-half times benefit payments being a reasonable ratio.
In response to a question by Ms. Mattingly about the timeliness of the contributions, Mr. Thielen said that every employer participating in the system has to submit contributions and a report by the tenth of the month following the month that the contributions are earned, and if that information is not submitted timely the employer is subject to a minimum $1,000 penalty. That said, he noted that most employers pay and file the reports on time.
Final Report to Legislative Research Commission
Next on the agenda was the Board’s approval of the annual report to be submitted to the LRC, which was discussed with the understanding that any technical, clerical, or stylistic changes may be made as the report is finalized, and the Co-Chairs were authorized to approve any of those types of changes.
Ms. Driskell indicated that she had some questions and follow up to the recommendations made at the last meeting and asked how those would be addressed or handled. Co-Chair Bowen stated that unless a member has an objection to Ms. Driskell’s suggestions or recommendations or how those recommendations would change the report, that the report would accommodate those recommendations and incorporate them into the final report. Ms. Driskell, referring to Chapter 4 of the draft report, expressed the concern that the report will be a public report and bill numbers are referenced, but that she believes more detail may be helpful to those reviewing the report, and she stated that she had submitted to staff suggested language to be included. She also noted that the recommendation concerning “spiking” was an either / or recommendation, and it was her understanding that the Board wanted to be supportive of a measure that clearly defined what “spiking” is and that resolved the problems with “spiking” provision, and that the recommendation would be to fix the unintended consequences. In this regard, she noted she had provided language to that effect to staff. Co-Chair Yonts noted that he and Mr. Thielen would be meeting on this very issue after the meeting. The issue is that the original Senate Bill 2 placed the obligation on the employer and last year’s bill shifted that obligation from the employer to the employee, and that based on data or information received an adjustment can be made to the wording of a bill that could reference “spiking” to be under a certain dollar amount rather than a percentage. For clarification of Ms. Driskell’s position, Co-Chair Bowen asked if he was correct in his understanding that she was not endorsing or supporting any particular piece of legislation and that there may be several bills that address “spiking” and the legislature would adopt a bill that will address the issue as defined in the PPOB report. Ms. Driskell indicated that was correct.
Ms. Driskell also commented about one of the points relating to the actuarial experience study about recommending that the KRS Board should move quickly on adoption to insure timely completion and as she stated previously she does not want that action to be in conflict with the budgeting process.
Co-Chair Bowen asked if there were any objections to Ms. Driskell’s additional recommendations and comments and there were none.
Co-Chair Yonts moved that the Board approve the draft report as submitted to the Board with the changes suggested by Ms. Driskell above and to allow for any technical, clerical, stylistic changes that would be necessary in finalizing the report. Mr. Thompson seconded. The motion to approve the draft report, as amended, was adopted without objection.
Discussion of 2015 Research Topic
Co-Chair Bowen mentioned topics that would be reviewed at the PPOB meetings in 2015. The Board is required to review investments twice per year, and that would continue to be done next year. Recommendations adopted by the PPOB last month of studying the cash flow issues facing the system would likely be studied, as well as a study of the KRS administrative expenses and approval process compared to other state systems. The PPOB would likely study the investment oversight and structure of other public pension funds, and the personnel and compensation system of KRS. He stated the PPOB would review and study data on other public pension funds as it relates to investment fees, expenses, and the required disclosure.
There being no further business, the meeting adjourned at about 2:40 p.m.
A copy of the PowerPoint presentation used by Mr. Thielen is on file in the Legislative Research Commission Library.