Call to Order and Roll Call
A meeting of the Public Pension Oversight Board was held on Monday, April 27, 2015, at<MeetTime> 1:00 PM, in Room 131 of the Capitol Annex. Representative Brent Yonts, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator Joe Bowen, Co-Chair; Representative Brent Yonts, Co-Chair; Senators Jimmy Higdon and Gerald A. Neal; Representative Brian Linder; Tom Bennett, Jane Driskell, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Representatives Jerry Miller and James Tipton, among others.
LRC Staff: Brad Gross, Greg Woosley, Terrance Sullivan, and Marlene Rutherford.
Co-Chair Yonts advised that board member Michael Bowling had resigned and that the Speaker’s Office had been advised.
Approval of Minutes
Co-Chair Bowen moved that the minutes of the February 23, 2015, meeting be approved. Mr. Bennett seconded the motion, and the minutes were approved without objection.
Co-Chair Yonts summarized the materials contained in the board members’ folders that would be reviewed and discussed during the meeting.
He noted that the May board meeting falls on Memorial Day and that the meeting would be rescheduled to June 1 unless there are conflicts.
Kentucky Retirement Systems Investment Update
David Peden, Chief Investment Officer, Kentucky Retirement Systems
Mr. Peden discussed the estimated March composite performance summary. The 2014 investment update prepared by LRC staff comparing KRS with its peers is an excellent comparison mirroring what he had presented previously. While most of his previous comments had been negative in terms of the KRS portfolio’s performance in a difficult investment environment, he was pleased to report that February was an excellent month and March was a little better than flat, with a return of about ten basis points. The total KRS portfolio shows a 1.19 percent return versus the benchmark return of 2.40 percent. Fiscal year to date, the asset class performance has seen positive returns, with U.S. public equity up 6.38 percent, real estate up 5.67 percent, private equity up 4.76 percent, absolute return up 2.72 percent, and fixed income up 2.22 percent. With the exception of U. S. public equity and fixed income, the others are alternative asset classes and are performing well. So far, the month of April has an estimated performance of 3.00 percent, and although the fiscal year to date is below the 7.5 percent return target, with February being a good performing month, KRS is catching up. The first part of the fiscal year had been a challenging environment, but in February the market began to change, and because the dollar is not rallying like it was earlier in the fiscal year, this is helping the non-U.S. equity portfolio. The markets in Europe and Japan have started to perform favorably, and the quality and value of European assets has helped the non-U.S. equity asset class become a good contributor.
Responding to a question by Co-Chair Yonts of the effect the turmoil occurring in Greece, Germany and China has had on non-U.S. equities, Mr. Peden indicated that it would not be as negative of an impact as it was a couple of years ago because KRS has minimal exposure to Greece, and China will be a major driver in the foreign market going forward. The problem with China is the comfort level with the type of information coming out of the country and whether investors can have confidence in economic reporting. Outside the U. S., Japan is the largest holder of U.S. treasuries.
Representative Miller asked Mr. Peden to define absolute return versus real return. Mr. Peden stated that absolute return is commonly known as hedge funds, which have provisions relating to liquidity, and that absolute return portfolios are made up of stocks, bonds, loans, cash, and some derivatives. Real return are assets that are tied to or are impacted by inflation and that real return as an asset class has performed poorly recently because there has just been no inflation.
Responding to Co-Chair Bowen about the ten-year rate of return compared to the peer group return for the same period and the assumed rate of return, Mr. Peden indicated that the 7.5 percent target rate of return is really a 20-year plus number that KRS believes it can attain. However, there is no easy answer as to what the assumed rate of return should be and how the portfolio should be judged against that assumed rate because it comes back to the timeframe used to judge the actual rate of return earned. Since 1984, the rate of return has exceeded the 7.5 percent return target, but with the situation the KERS non-hazardous plan is in, it may make it more appropriate to about a realistic return target over a shorter time period. He also noted the average public pension plan uses a 20-year term to set the expected rate of return.
Responding to a question by Representative Miller as to why KRS should not mimic KTRS in managing money, Mr. Peden said that KTRS has outperformed KRS because 60 percent of its assets are allocated to the U.S. equity market that has done well in the last couple of years. However, that asset class is as risky as any, and KRS has a long term strategy that it believes will eventually catch up to those returns. KRS asset allocation is set based on the asset liability modeling study. In short, given the funded status of the plan, KRS does not feel comfortable taking more equity risk and deviating from the standard set in the overall portfolio as KTRS has done.
Kentucky Retirement Systems Personnel and Compensation System
Bill Thielen, Executive Director, Kentucky Retirement Systems
Mr. Thielen advised that the KRS board at its April meeting made a selection for actuarial auditing to begin May 1. The contract was awarded to the Siegel Company. The final report will be due to KRS on August 1, and a “Level 2” audit will be performed by Siegel. The results of the actuarial study or report should be available to PPOB at its September meeting. The asset liability modeling study will be provided to the KRS Board at its May meeting and will be available to PPOB at the June 1 meeting.
Mr. Thielen discussed the benefits of the three systems administered by KRS for both pension and health insurance. The systems administered by KRS are more unique and complex than other pension plans around the country, with a total membership in the three systems of over 348,000. Since 2008, the active membership has been reduced relative to the number of retirees and the number of inactive members, meaning there are fewer individuals making monthly contributions to support the system.
Membership is broken down into three tiers. Tier 1 consists of members participating prior to September 1, 2008; Tier 2 covers September 1, 2008, through December 31, 2013, which was established by House Bill 1; and Tier 3 is the hybrid cash balance plan established January 1, 2014.
Mr. Thielen said that the internal legal department has ten staff attorneys, two paralegals, and two support staff. These employees perform hearings, review legal documents and re-employment requests, and conduct conferences, among other things. Most of the court cases involving KRS are handled in-house, but there has been $2.4 million spent in 2014 on external counsel, which is up from 2013 and is mainly related to the Seven Counties bankruptcy case.
There are 122 employees in the benefits section, which over the last two years has handled approximately 250,000 calls per year. Additionally, there have been over 5,000 in-office visits 2014, and there was a spike in October and November due to open enrollment for health insurance. There were over 10,000 pre-retirement audits in 2014, down slightly from 2013, and over 4,000 retirement recalculations and audits, up from 2013. There are over 107,000 monthly benefit recipients. KRS staff also conducts events and enrollments for retiree health care each year, with almost 26,000 Kentucky Employees Health Plan enrollments and over 48,000 Medicare eligible enrollments. KRS has attempted over the last few years to increase outreach to members through publications, social media, field visits, and webinars.
Some of the challenges for KRS are plan funding, the Seven Counties and other litigation, administration of pension spiking, budget and staff constraints, and investment performance. Mr. Thielen also pointed out that one-third of the KRS staff will reach retirement eligibility in the next five years, and that recruiting and training replacements for those employees is a challenge.
Responding to a question by Co-Chair Yonts as to staff turnover, Mr. Thielen said the main reasons that employees are choosing to leave or retire are due to furlough days and lack of pay raises, but there have been terminations for personal and other reasons. KRS has been trying to recruit individuals and get them trained to replace those who will be retiring in the next five years, and KRS is trying to address inefficiencies as it replaces personnel.
Overtime hours have decreased from 2012. The increased overtime in 2012 was due to the implementation of a new technology system and correcting employer reporting errors. The staffing levels for 2014 increased due to the complexity of the plans administered. In 2014 there were 258 employees. The bulk of administrative expenses are in the area of benefits and operations, which includes accounting, information technology, information security, and procurement, among other things.
Mr. Thielen stated that the KRS personnel system is not under the state merit system. In 2001, a comprehensive review with cost benefit analysis was performed by Ice Miller. The report identified problems with the personnel and pay system. Some of the problems were that the classification system did not allow for accurate placement of KRS employees, and compensation was based on the state’s system and did not take into consideration comparable positions in other retirement systems; as a result, there were excessive overtime hours and staff turnover. The recommendations to address the problems were to move KRS from the merit system and recreate a new classification and compensation system, with some of the same rights and protections and policies relating to state benefits, leave, and payout rules, and with a policy of internal mobility similar to that contained in KRS Chapter 18A.
Responding to a question by Co-Chair Bowen as to benefits that KRS employees receive that other state employees do not, Mr. Thielen said KRS basically mirrors the state’s system yet has a flex schedule program. Co-Chair Bowen asked Mr. Thielen to highlight the differences between the state and KRS systems and report to PPOB staff.
In response to a comment and question by Senator Higdon concerning compensation and simplification of a complex system, Mr. Thielen indicated that legislation has created some of the complexity with the different benefit tiers and the issue of how to administratively handle the issue of pension spiking. KRS had made some recommendations that would simplify the system, but those recommendations have not passed.
Co-Chair Bowen said that it would be helpful if members of the KRS Board would attend PPOB meetings to hear questions and concerns first hand. He said that participation of KRS board members would be beneficial so that both boards could work to address the issues together.
In response to a question by Ms. Driskell concerning the benefit tiers and how service in the different systems are counted, Mr. Thielen said that individuals are counted by the system in which they have the most time, and there is no duplication of numbers in each system.
Mr. Thielen said that KRS 61.645 established the separate personnel system for KRS, passed by legislation 2002. The KRS Board adopted personnel policies and established a classification and pay system to attract, hire, and retain qualified individuals. Copies of those policies and an organization chart were previously provided by LRC staff to PPOB members. KRS has a goal oriented performance management system. The executive staff and division managers establish division goals and meet with employees to establish employee goals. Pay is based on available revenue and on the employee’s rating and uses the state’s budgeted increases as the base for salary increases.
The salary and benefit analysis reflects the six furlough days in FY 2011, the two weeks payroll moved from FY 2012 into FY 2013, and the health administrative fees that were previously paid from the Insurance Trust Fund, but were added to the KRS administrative budget as recommended by the Auditor of Public Accounts, which increased the administrative budget from 2011 to 2014 by about $13 million. The analysis also reflects total actual expenses differing from the Comprehensive Annual Financial Report over FYs 2011 through 2014 because depreciation, standing accruals, and healthcare actual costs are included in the general administrative expenses in the annual report. The number of employees as of calendar year ending December 31, 2003, have increased from 225 to 252 employees as of December 31, 2014, and the salary increases for the same period have decreased from 3.55 percent in 2004 to 2.29 percent in 2014 with employees receiving no increases in some of those years. These percentage increases were those received by all state employees and also included an amount above the state level that was granted by the KRS Board.
In response to a question by Co-Chair Bowen as to the applicant pool, Mr. Thielen said that the applicant pool varies by type of position posted. Several employees left in the investments area for more compensation, which is a challenge for KRS. Over the last few years, counselors have left, and that it takes time to recruit and train individuals. Employees in the IT Department have been stable and have been reclassified in an effort to keep them. As wages have increased in the private sector, KRS sees its employees leave for more compensation.
In response to a question by Mr. Bennett as to the qualifications and requirements for the positions of member service and benefits employees and whether the issue is a retention problem rather than a recruitment problem, Mr. Thielen said it was more a recruitment problem made difficult by the state’s economic condition over the last several years, but that historically, until recently, KRS has had a strong retention rate, except in key areas where competitive rates are being paid. Co-Chair Yonts asked Mr. Thielen to provide the job descriptions, qualifications, and salaries for positions.
Responding to a question by Mr. Jefferson concerning investment in technology to alleviate administrative costs and whether research in technology upgrades for savings is being conducted, Mr. Thielen stated in 2005 a $22 million capital project for technology was approved because KRS was operating on a thirty-year old system. An external firm was hired for the final phase of that technology project in 2011, and a good part of 2012 was spent correcting problems related to transitioning employer reporting to the new system, which resulted in a lot of overtime. There were over 40,000 errors in reporting that resulted in the retirements being inaccurate and each of these errors had to be corrected. Mr. Thielen said that KRS has an IT staff of about 29 qualified employees who are constantly looking for improvement in the system, but they are finding that considerably more money is spent each year on software and updates. Mr. Peden said that KRS spends a lot of money maintaining existing systems and on information security, and therefore there is not a lot of money available for researching technology.
Co-Chair Bowen commented on continuing to identify efficiencies, but he stated that the more important issue is the unfunded mandate and that all areas need to be reviewed and considered for those efficiencies, including looking at how KRS is paying its investment management groups. He asked about opportunities for other groups, including PPOB, to have input and express concerns during the process of the Siegel group performing an actuarial study on the systems. Mr. Thielen noted that Siegel is a national practice full actuarial firm, and that the RFP contained three meetings in which the company would present to the KRS Board, PPOB, and any legislative committee, and that there will be an opportunity to ask questions at those meetings. The review will be very data driven and will look at assumptions and Cavanaugh MacDonald’s methodology, but will not look at any fees paid to investment management groups. KRS is in the process of reviewing and hiring CEM Benchmarking, an independent provider of cost and performance benchmarking analysis for pension funds that provides direct comparative insights on realized net investment returns and management fees for different asset classes. The results will be available at a later time.
Responding to a question by Representative Miller concerning the rate of return over a 20-year period, Mr. Peden stated that as of February the rate of return for 20 years is 8.27 percent.
Representative Miller inquired about the article written by John Cheves concerning the Camelot Group private equity issue. Responding to a question concerning the matter and the decisions that were made before Mr. Peden becoming Chief Investment Officer, Mr. Thielen stated that all investment decisions are made by the investment committee and ratified by the full board. Mr. Peden indicated that Adam Tosh, CIO at the time, and the investment committee went through the investment process and recommended the group after due diligence. The full investment committee heard the presentation by Camelot Group and the committee increased the initial recommendation for investment. This decision was in May 2009. The fraud was committed through the overbilling of the fund, and KRS has written down fifty percent of the investment, although there is still an opportunity for additional returns from where those assets were marked. He said it was unlikely that KRS would get back the whole investment, but there was a good possibility to get more back than was marked down. Mr. Peden indicated that KRS was aware there was an issue with the group when it received notification from the New York Auditor’s Office. He said that not all private equity is bad, but that in this situation, one person controlled all the decisions. KRS will not invest where there is not a good balance of decision-making in the fund, a strong back office operation or comptroller, and strong investment decision-making authority. There is no reason to believe that there is an existing “Camelot” in the current portfolio. Mr. Thielen also stated that placement agents have not been used for over six years, and Mr. Peden explained the “infrastructure” of how payments are made. The management fees paid to a fund supports the infrastructure, which is the marketing and sales process, and is the same whether for a third party marketer or an internal marketing staff member. Mr. Peden also indicated that if there is a placement agent involved that is disclosed to the investment committee prior to the investment being approved
Update on 2015 Legislative Action
Co-Chair Yonts provided an update of the bills that were enacted in the 2015 session that directly impacted the state-administered retirement systems, and he discussed those bills that did not pass. House Bill 47 added other state-administered systems to the PPOB oversight functions; House Bill 62 established a process for voluntary and involuntary cessation of agency participation in the Kentucky Retirement Systems; Senate Bill 62 related to the re-employment of elected officials in the same position; and House Bill 163/House Bill 181 limited employer payments on retirees re-employed on or after September 1, 2008. Mr. Thielen indicated that it will take several months to promulgate regulations implementing House Bill 62.
Co-Chair Yonts also stated that suggested topics for discussion and study for the remainder of the year should be submitted by board members by e-mailing the co-chairs. He said that, due to legislative conferences, PPOB will not meet in July.
Before adjournment, Mr. Thielen announced that he will retire at the end of the calendar year, provided that the KRS Board finds a replacement.
There being no further business, the meeting adjourned at approximately 2:25 p.m.
A copy of the PowerPoint presentation used by Mr. Thielen is on file in the Legislative Research Commission Library.