Call to Order and Roll Call
A meeting of the Public Pension Oversight Board was held on Monday, June 22, 2015, at 12:00 Noon, 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: 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: Representatives Arnold Simpson and Derrick Graham, Clyde Caudill, Kentucky Retired Teachers Association, among others.
LRC Staff: Brad Gross, Bo Cracraft, Greg Woosley, Terrance Sullivan, and Marlene Rutherford.
Co-Chair Yonts announced that Co-Chair Bowen would not be in attendance due to an unexpected issue. He also indicated that the meeting of the Interim Joint Committee on State Government scheduled for Wednesday, which both he and Senator Bowen co-chair, would be cancelled, and that the Interim Joint Committee on State Government would not meet during the month of July.
Approval of Minutes
Representative Thompson moved that the minutes of the June 1, 2015, meeting be approved. Ms. Bender seconded the motion, and the minutes were approved without objection.
Co-Chair Yonts said that the Governor had appointed a task force to review the Kentucky Teachers Retirement System, and that recent legislation brought both the Kentucky Teacher’s’ Retirement System (KTRS) and Judicial Form Retirement System under the oversight of the PPOB.
Kentucky Retirement Systems Investment Update
David Peden, Chief Investment Officer of the Kentucky Retirement Systems, provided an investment performance summary update for the month of May. He said May was not a good month on an absolute basis, but was compared to the benchmark. The portfolio was up six basis points and the benchmark was down twenty basis points. The positive asset classes were US Public Equity, Absolute Return or hedge funds, and Real Estate. The negative returns came from Emerging Market Equity, Non-US Equity, Real Return or inflation sensitive assets, and Fixed Income. All asset classes outperformed the benchmark with the exception of Real Return. May did not have much effect on the fiscal year to date performance, and for the fiscal year, the portfolio is up 2.66 percent versus the benchmark return of 3.77 percent. Positive performers for the year are US Public Equity, Real Estate, Absolute Return, and Fixed Income. Peer groups have a large investment in US Public Equity, particularly large cap public equity, which explains some divergence of the returns by KRS and those peer groups. The negative performers are Emerging Markets, Real Return and Non-US Equity. KRS asset allocation was invested exactly as was recommended by the investment consultants five years ago, and based on the recent analysis, KRS may or may not make adjustments in the near future. Passive US Equity was the best performing asset class for the first half of the fiscal year, but he expects the investing environment to change and as volatility increases it will create an opportunity for active management to outperform passive funds. In future meetings, KRS will be able to analyze performance for the entire fiscal year and be able to report what asset classes performed well and those that did not and why. It may be important for PPOB to be shown a “heat map” or a visualization of data that reflects what is moving in the marketplace from the best asset class to the worst asset class by year and to show why diversification is important.
Overview of KTRS Funding
Gary L. Harbin, CPA and Executive Secretary of the Kentucky Teachers Retirement System, and Beau Barnes, Deputy Executive General Counsel and Secretary of Operations, provided an overview of KTRS funding.
Mr. Harbin said that teachers do not contribute to Social Security, so the benefits to teachers from KTRS are in many cases their only source of retirement income. Mr. Barnes said that one issue when Social Security was established was that teachers and the employer were already contributing to the pension plan, and including Social Security would have been cost prohibitive.
Mr. Harbin provided a history of KTRS, which was established in 1938 to provide retirement security for the state’s educators. He discussed the administrative and investment costs, the investment performance, and the impact on the state’s economy of the retirement benefits. The average monthly retirement benefit paid to all teachers is $3,042. The total normal cost of pension benefits is 16.75 percent of payroll, with teachers contributing 9.11 percent toward the normal cost of benefits and the state contributing 7.64 percent. Teachers also have withheld from their paychecks an additional 3.75 percent to pay for retiree medical benefits. Teachers contribute 2.91 percent more of the normal cost when compared to a contribution for social security, and the state’s contribution of the normal cost of benefits is 7.64 percent or 1.44 percent over the comparative cost of Social Security to provide pension benefits. It would be extremely expensive if teachers were subject to social security, and it would cost the state, based on the same level of pay received today, about $690 million more each year.
Mr. Harbin stated that, over the last 30 years, the compounded return on investments of KTRS has been 9.5 percent. Returns over the last ten years have ranged from 8.6 percent for the year ending March 31, 2015, placing KTRS in the top ten percent in national rankings, to 11.3 percent over a three year period, 10.4 percent over a five year period, and 7.2 percent over the ten year period.
Mr. Harbin discussed KTRS investment philosophy and investment structure. KTRS investment committee structure exceeds the current industry standard. The best practices structure has been recommended for use in other states and the investment costs for KTRS are some of the lowest in the nation. There are two outside investment committee experts on the investment committee: Bevis Longstreth and George M. Philip. Teacher retirement benefits have a positive impact on the state’s economy. In 2015, KTRS will pay about $2.1 billion in benefits, with 92 percent of retirees receiving those benefits living in Kentucky and contributing those funds back into the economy.
Mr. Harbin stated that, in July 1985, the system was 54 percent funded with $1.8 billion in assets. Since that time, members have contributed $6 billion and the state has contributed $10.2 billion. Investment income for this period has totaled $21.5 billion, payouts have been $21.2 billion, and the administrative costs have been $200 million. The plan balance as of June 30, 2014, was $18.1 billion, reflecting a 53 percent funded status at that time.
The retiree medical benefits for teachers have been in effect since 1964. This was established when Medicare was passed and was a pay-as-you-go benefit until 2010. Since 1985, members have contributed $1.3 billion and the state has contributed $2.1 billion. The investment income has been $300 million and the medical benefits paid out have totaled $3.2 billion, leaving a balance as of June 30, 2014, of $500 million. The medical benefits fund became a pre-funded fund as of July 1, 2011. In the mid 1990s, the fund was significantly underfunded, and because of this, in the early 2000s, $800 million in contributions were redirected from the pension fund to the medical benefits fund. Since that time, the unfunded liability of benefits has been reduced $2.7 billion.
KTRS has over 141,000 members with over 49,500 receiving benefits monthly. KTRS pays out over $144 million in benefits monthly and has over $18.5 billion in assets for pension and medical plans. The issue now facing KTRS is that one in four teachers are eligible to retire, or approximately 15,000 of the almost 59,000 active members.
Since 2008, the system has experienced negative cash flow and will have sold $1.3 billion in assets to meet benefits over and above the income coming into the plan through 2015, which will lower future investment returns. Additional funding is necessary to stabilize the situation.
Funding is important because 52 percent of retirees less than 80 years old are single and 85 percent 80 and above are single. A large majority of these individuals are females. In most cases, federal law does not allow teachers to receive a social security survivor benefit from their spouse’s account. In 2014, there were 54 retirees age 100 or older and 4,684 age 80 to 89 nine years old, with total retirees age 80 and over at 5,692, which continues to grow.
KTRS reports two sets of numbers on asset and liability valuations in its financial statements, one based on the market value of assets and the assumed rate of return of 7.5 percent, and one based on a reduced assumed rate of return due to the Governmental Accounting Standards Board (GASB) statement 67. The market value of the assets is just over $18 billion as of June 30 2014. Under GASB 67, the actuary uses about a 5.3 percent rate of return under the assumption that because KTRS does not have the full actuarially required contributions being paid into the plan they will have to liquidate a greater amount of assets to fund benefits and will not be able to achieve the full 7.5 percent assumed rate of return. So, using the 7.5 percent rate of return, the pension fund is 53.6 percent funded, but under the GASB 67 valuation it is 45.6 percent funded. Because the medical plan is now on a path of full funding, the 7.5 percent rate of return is used and the medical plan is 15.9 percent funded.
Mr. Harbin noted that liabilities have continued to grow. Although the fixed employer contribution rate of 13.105 percent was sufficient for a number of years, the flat market from 2000 to 2013, which included the great recession, has required additional funding since the 2006-2008 biennium to meet the actuarially required contribution (ARC) level. Assets cannot grow fast enough to catch up to the $30 billion liability, which is why the ARC and contributions need to be increased in the future. Before the downturn in the market, KTRS was conservatively positioned in its portfolio, there was no issue with cash flow, and no money was invested in hedge funds. It is KTRS board policy to not invest with managers who use placement agents. Prior to the 2008 downturn in the market, the plan was in the top four in the nation and since the market is rebounding it is in the top ten. However, if there is another downturn, KTRS will need to sell assets to pay benefits at a time when those assets are depressed in value.
Mr. Harbin stated that pension budget requests have not been appropriated since 2006, with the exception of an additional $3 million appropriation in fiscal 2007 and an approximately $39 million appropriation in fiscal 2008 above the ARC. The total amount that has been unappropriated since fiscal 2009 is $1.9 billion. KTRS has had to sell $2.1 billion in assets over that same period of time in order to pay benefits to retirees. There was $336 million redirected from the retirement contributions to fund the medical benefits from fiscal 1999 through fiscal 2004. Because the pension fund needed the contributions and in order to continue the medical benefit, the state borrowed funds from fiscal 2005 through fiscal 2010, which was to be repaid over ten years with interest. In 2010, the “shared responsibility” legislation was passed, and a $465 million pension obligation bond was issued to repay the balance due from the transfer of funds from the pension plan to the medical plan of approximately $557 million. From August 2010 through February 2013 there was over $890 million in bonds issued. As the bonds were paid off, the funds were the source of funding for the proposed $3.3 billion bond recommended in the 2015 regular session.
Budgeted contribution rates for the state have been consistent since fiscal year 1999 through fiscal 2016 at 13.105 percent with the exception of fiscal 2007, which increased to 13.215 percent, and in fiscal 2008, which increased to 14.425 percent. The employers contribute 3.25 percent more than the employees since 1975. There is also an employer contribution rate paid directly from the general fund to fund cost of living adjustments (COLAs), minimum benefits, and sick leave payouts. Payments are amortized over twenty years and are a percentage of salary. There have been no additional COLAs awarded since 2011 above the statutory one and one half percent amount.
Fiscal year 2007 was the last year to see a positive cash flow with total contributions of about $704 million, investment income of $1.14 billion, and benefits, refunds and administrative expense of $1.124 billion, resulting in the positive cash flow of $20 million. Since fiscal 2008 through 2014, there has been a $10 million to $439 million, respectively, negative cash flow resulting in a selloff of assets to meet benefit obligations. As baby boomers retire, and with benefits increasing at the rate of over $100 million per year, without additional contributions to the plan KTRS is expecting to have to sell assets of about $3.4 billion over the next four years, from fiscal year 2016 through 2019. This on top of the $2.1 billion in assets sold to meet benefits from fiscal years 2007 through 2015. KTRS was fortunate to be able to sell assets into a rising market, but if markets do not hold up and assets need to be sold it will be at the wrong time.
Mr. Harbin said that House Bill 4 in the 2015 session would have provided a long-term funding solution for teachers’ pensions. The proposed bond of $3.3 billion would have been issued at low interest rates and this amount would not have increased the state’s debt because the debt owed teachers is already on the state’s balance sheet. The bond would not increase payments from the budget because the debt service on the bond would have come from funds already dedicated to fund the pensions. The bond would have increased the funding ratio of the pension plan from 53 percent to 66 percent, and it would have provided a safety net so that investments or assets would not have to be sold at the wrong time. He reiterated that in his opinion one of the fallacies that was discussed during the session was that the bond would increase the state’s debt, but it would not because the state is already reporting $39 billion in liabilities.
Responding to a questions by Co-Chair Yonts concerning this proposed bond being based on low bond rates and how long those rates are expected, Mr. Harbin indicated that the federal reserve is looking to possibly increase rates and that outside experts have indicated that rates could be increased sometime over the next 18 months by one or one and one-half percent, but that it would still be feasible to look into issuing bonds because of the historically low rates and a debt growing at 7.5 percent. The expense to the taxpayers and state would go up about $116 million for every 25 basis points that the rates go up. Mr. Harbin stated that the 13.105 and 2.9 percent employer contribution rates would still need to be made, and that the $3.3 billion bond would keep the investments earning returns without the necessity of depleting assets to pay benefits. He also noted that with the bond the state would be able to step into the additional needed ARC at approximately $44 million per year over the next eight years. Without the bond, the new contribution into the ARC would be about $400 million per year in general fund dollars. The bond would have provided the needed cash flow to pay pensions and allow the state to phase in over eight years to meet the full ARC and then be on track to fully fund the pension plan over the next 20 years. Without the bonding, KTRS will be requesting approximately $1 billion per year in the next budget cycle. The general fund payments over that twenty year period with the eight year phase in without the bond would be $1.2 billion and just over $800 million with the $3.3 billion bond, the bond payment, and the ARC, a savings of about $400 million in 2035-2036.
The medical benefit fund is now 15.9 percent funded. Prior to the “shared responsibility” legislation, the amount of money to fund teachers’ healthcare was projected to increase and in the last budget would have been over $200 million per year. However, because the cost of those benefits are now shared with the school districts, active teachers, and retired teachers, the amounts in the 2014-15 and 2015-16 budgets were $50 million and $61 million respectively, a savings of about one fourth of the total cost of healthcare. From fiscal 1999 through 2005 there was $335 million allowed by the actuaries to be used out of the pension fund to fund the medical insurance fund and those amounts have never been repaid. In fiscal 2005, the redirected contributions began to be repaid, with $289 million repaid from fiscal 2005 through 2008 and $273 million repaid in fiscal 2009 and 2010.
The unfunded liability the state had prior to the “shared responsibility” legislation in 2010 was $5.9 billion as of June 30, 2007, $6.4 billion in fiscal 2008, and $8.3 billion in fiscal 2009. There was a drop to a total of $3.2 billion as of June 30, 2010, and as of June 30, 2014, it was $2.7 billion, as the positive cash flow begins and the asset base begins to grow.
The “shared responsibility” solution enacted in 2010 House Bill 540 was historic legislation in that it provided a long term, sustainable method to fund medical insurance for retired teachers, and it was a plan that was developed and had input from all of the state’s education community within the KTRS field of membership. Many of the groups in the membership field are included in the makeup of the task force recently appointed by Governor Beshear to study the teachers’ retirement system funding.
Responding to a question by Mr. Jefferson as to whether KTRS has conducted an attribution analysis specifically as it relates to the unfunded liability and what percentage of the unfunded liability is due to the different components, like demographics, or ARC payments not being made, or other factors that contribute to the unfunded liability, Mr. Harbin stated that the driving factor is that the state has been behind in the funding status with the plan’s assets being less than liabilities. KTRS has not done an attribution chart, but the greatest component of the unfunded liability is there have not been enough assets to invest long term to meet the liabilities. The attribution chart tries to encapsulate a complex pension plan in one document, which is difficult and uses information from an actuary that is five years behind current assets and liabilities. The chart does not include the contribution made this biennium of $800 million. He urged the board to use the attribution chart as one piece of information. However, he said an attribution chart was given to the Committee on State Government and would be provided to Mr. Jefferson.
In response to questions by Senator Higdon concerning the monthly benefit of teachers, Mr. Harbin indicated that the membership is not broken down by classification of employee. The benefit calculation uses the same formula for both classroom and administration personnel and are calculated on years of service and salary levels. From 1999 there were $615 million in benefits paid out and in 2014 $1.9 billion, with approximately $2.1 billion to be paid out in 2015. Senator Higdon inquired as to what had fueled this increase in benefits paid out, and Mr. Harbin said that the pension plan was in existence since 1938 and that it takes thirty years after a pension plan is formed for a person to begin drawing a benefit, which would have been around 1968 or 1970. Salaries have increased for teachers and there are significantly more retirees. There are about 1,000 net retirees added each year and there are more teachers retiring than passing away each year. The demographics will stabilize eventually and the asset base will grow because of salary. Mr. Harbin reiterated that the primary reason for the underfunding is not having the assets to invest, with investments accounting for approximately 70 percent of pension plan funding. The underfunding has been occurring for a number of years since 1975, and without the assets to invest KTRS cannot get to the 70 percent funded level. When the pension system was 25 percent funded it was the plan to contribute an additional three and one quarter percent each year over 30 years, but that 13 of those 30 years the markets did not cooperate and were flat and the return could not be attained that was needed. It is a long term issue. It was also during this time that the medical benefit was established, which added additional costs.
Responding to a question from Representative Thompson related to the cash flow and the fact that investment expenses appeared to have doubled from approximately $18 million in fiscal 2010 to $37 billion in fiscal 2014, Mr. Harbin stated that although KTRS was selling assets they went from $15 billion to $18 billion in asset value so there was $3 billion more in assets being invested and KTRS is investing in other asset classes and moving out of bonds, which is an extremely risky asset class. KTRS has reduced its allocation for bonds from 38 percent of the portfolio to 17 percent, so the fees for investing in alternatives is greater, which earn a higher return than the returns of those assets when in bonds. The cash flow data also reflects a percentage increase in benefits each fiscal year.
Representative Linder asked Mr. Harbin to expound on the earlier discussion with Senator Higdon. Mr. Harbin said the funding level in the late 90s was 97 percent just before the technology bubble busted. In the early 2000s, the funding level was smoothed over five years to arrive at the market value so the funding level does not reflect all the downturn in the market, which lost 50 percent of its value. However, the funding level did not drop by 50 percent because of the smoothing. The market increased up to October 2007 and then dropped 60 percent, which accounts for the 97 percent funded status in the late 90s to 53 percent today. Representative Linder indicated that it appeared to him that the main root of the problem is trying to recover from 2008, which is when the additional ARC increase was requested. Mr. Harbin said in 2008 the recession put pressure on all pension plans, but the decrease in the funding level has occurred over several years, which included the medical plan funding issue that was growing as an obligation of the state. Also, when the technology bubble busted it appeared the pension plan was well funded at 97 percent, but that was based on an exuberant market. In 1985, the pension plan was 53 percent funded and is 53 percent funded today. There were other factors that need to be considered during that time, for example the actuary was using a different rate of return assumption for liabilities. Representative Linder stated that these pensions were created many years ago and were based on different assumptions that have changed over time, such as life span. Mr. Harbin said that the average age of a classroom teacher at the time of retirement is about 58 years old and that they retire with 30 years of service. He also noted that the teachers now live to about the age of 80 years old.
Responding to questions by Representative Simpson concerning the additional funding needed for the retirement plan, Mr. Harbin said the actuary had determined that at the 97 percent funding level that contributions that would have gone to the pension plan could be directed to the medical benefit plan and $336 million was redirected to the medical plan. In retrospect, the contributions should not have come out of the pension plan and gone into the medical plan because the assets were at unsustainable levels. In fiscal 2005, money had to be borrowed to continue to fund the medical plan until 2010 when the shared responsibility legislation was enacted.
Responding to comments by Co-Chair Yonts regarding those nearing eligibility for retirement, Mr. Harbin stated that approximately one in four teachers in Kentucky are eligible for retirement. As to funding, he noted that the pension plan is funded by employee contributions from the teachers, the matching contributions from the state budget through the SEEK formula, and specific appropriations to cover items such as COLAs, sick leave payouts, etc. KTRS is in the position of where KRS was in 2008 when contribution rates began to increase. KTRS was able to avoid having to sell assets to meet benefits in a falling market, but KTRS is at the tipping point. KTRS is four times as big as KRS in the state budget because all teachers are in the KTRS, whereas not all state employees are in the KRS, and that the majority of contributions come out of the general fund budget. If KTRS does not get the funds to invest then the funds to come out of the general fund would be four times greater and the contribution amount increases will be much higher.
In response to Representative Thompson concerning the total outstanding debt, Mr. Harbin said the $886 million has been paid down and that the annual payment is $116 million per year out of the state budget.
Representative Linder asked about the average $3,100 benefit amount and whether KTRS could break down the average pay out of all retirees per month to reflect the percentages and dollar amount each is receiving. Mr. Harbin indicated that there is a schedule at the end of the Comprehensive Annual Financial Report (CAFR) that breaks payments out by years of service and goes back about twenty years.
Co-Chair Yonts asked that Mr. Gross provide the Board with the CAFR schedule and the attribution report presented to the Committee on State Government.
In response to Co-Chair Yonts inquiring whether school systems having financial trouble was a factor on teacher retirement, Mr. Harbin said that this issue had not been reviewed; however when there is instability in a system you would tend to have more individuals retire. Co-Chair Yonts suggested KTRS may want to obtain information or statistics from the Kentucky Department of Education of those districts in a difficult financial situation. Mr. Harbin did say that when KERA was implemented many retired.
Responding to Representative Graham concerning the ARC payment, bonding issue and the plan of action from the teachers’ retirement association, Mr. Harbin stated the ARC payment needed is over $500 million additional dollars from the state budget and the bond would have lowered that to $44 million in the first year and $88 million in the second year, with the total additional ARC payment growing to about $400 million eight years down the road. The bond would have been paid with monies already coming to the pension plan. It is the plan of KTRS to work closely with the task force appointed by the Governor and to reach a reasonable funding solution, and that bonding is still a viable plan and all options will be on the table.
Co-Chair Yonts announced the next meeting would be on August 24 at noon.
The meeting adjourned at about 1:30 p.m.