Call to Order and Roll Call
A meeting of the Public Pension Oversight Board was held on Monday, September 28, 2015, at 12:00 PM, in Room 169 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; Representatives Brian Linder and Tommy Thompson; Robyn Bender, Tom Bennett, Robert Damron, Jane Driskell, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Representative Derrick Graham; Bill Thielen, Executive Director, Kentucky Retirement Systems; Rich Robbins, Deputy Chief Investment Officer, Kentucky Retirement Systems; Joe Gilbert, Director of Public Equity, Kentucky Retirement Systems; Gary Harbin, Executive Secretary, Kentucky Teachers’ Retirement System; Eric Wampler, Deputy Executive Secretary, Kentucky Teachers’ Retirement System; Donna Early, Executive Director, Judicial Form Retirement System; L. B. VanMeter, Chair of the Board of Trustees, Judicial Form Retirement System; J.W. Bryan, State Social Security Administrator; Kim Nicholl, Senior Vice President and Actuary, Segal Consulting; Matthew A. Strom, Vice President and Actuary, Segal Consulting; Todd B. Green, Principal and Consulting Actuary, Cavanaugh MacDonald Consulting; and Alisa Bennett, Principal and Consulting Actuary, Cavanaugh MacDonald Consulting.
LRC Staff: Brad Gross, Committee Staff Administrator; Bo Cracraft; Terrance Sullivan; and Maurya Allen.
Approval of Minutes
Senator Bowen moved that the minutes of the August 24, 2015, meeting be approved. Representative Linder seconded the motion, and the minutes were approved without objection.
Kentucky Retirement Systems Update
Mr. Bill Thielen, Executive Director, Mr. Rich Robbins, Deputy Chief Investment Officer and Director of Fixed Income, and Mr. Joe Gilbert, Director of Public Equity, Kentucky Retirement Systems, presented on the investment performance of the Kentucky Retirement Systems.
Mr. Thielen stated that the total fund return for the past fiscal year was 2.02 percent, compared to the benchmark of 3.31 percent, and that returns were far less than the desired 7.50 percent. For the fiscal year to date, the total pension fund is down 3.30 percent and the total insurance fund is down 3.49 percent, both trailing the total fund benchmarks. The private equity fund is the only asset class currently showing a positive trend, up 0.15 percent for pensions and 0.10 percent for insurance funds.
Mr. Thielen also addressed investment fees and he noted that reported fees have increased 75 percent since 2014, from $62 million to $108 million. However, he assured the board members that the fees paid did not increase from 2014 to 2015, but that changes to the investment reporting methodology are the reason for reports of differing amounts over the last year. The new reporting methods are an effort to provide greater transparency and more information to the public and to the board. For 2014, and before, investment fees for private equity were reported using the Equity Method of reporting, which is endorsed by generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). That method is used across the country for public pension plans and investors, but it does not report private investment fees as a separate line item. For 2015, it was decided to report fees using the Investments Share Method, which reports investment fees as a separate line item instead of netting them against the investment activity. The fees year to year would have been the same if they had been reported in the same, rather than a different, method. He also clarified that the different method does not affect net returns, it was merely a different view of the system’s investments and expenses. Chairman Yonts asked if it was more accurate to look at basis points rather than dollar values when evaluating fees. Mr. Robbins answered that it would provide a more equivalent comparison; however, these fees are not unique to KRS. Any private equity investor is incurring the same fee, KRS has just adopted a new methodology that goes outside of the norms that GAAP endorses, and other groups may soon be following suit.
Chairman Yonts asked for clarification that the fees reflect a netting out of expenses compared to earnings because individual fees may not be reflected in a bill. Mr. Robbins explained that it could be viewed like profit-sharing where anything above a set rate is shared with the investors, thus becoming an incentive to forming a partnership. Prior reporting does not show that activity, but net activity has not changed significantly. Senator Higdon commented that the board may recommend a performance audit to better understand the current situation. Mr. Thielen stated that he would be covering Senator Higdon’s concerns in the rest of his remarks detailing the most recent audit report. Senator Bowen asked if actual costs expended were 75 percent more than the previous year. Mr. Thielen stated that fees have been virtually the same from year to year, and that only the reporting format has changed. Mr. Gilbert added that the easiest way to explain it was that all of KRS’s investments are partnerships. If everyone in a partnership purchased something like a racehorse and that horse won a race and everyone got their proportional share, a member’s share is not an expense to any other member. In private equity, it is also referred to as carried interest and can be considered expenses of the partnership, but they are not additional fees to being in the partnership. Mr. Thielen stated that it was not their desire to justify past actions, they were merely explaining why they had chosen to report in a different manner than GAAP recommends and that this may better contribute to the transparency desired by the committee.
Mr. Thielen next explained changes in the hazardous duty retiree dependent child contribution for health insurance. As a result of the federal Affordable Care Act (ACA) changes in 2010, access to health insurance for dependent children was assured up to age 26. Prior to 2011, KRS contributed to the cost of health insurance for hazardous duty dependent children as defined in KRS 16.505, where a dependent child is defined as “a child in the womb and a natural or legally adopted child of the member who has neither attained age eighteen (18) nor married or who is an unmarried full-time student who has not attained age twenty-two (22).” In 2011, KRS erroneously began paying health insurance contributions on dependent children up to age 26. The error was not discovered until 2014 during an internal audit so, in February 2015, a regulation was promulgated that contributions would only be paid for dependent children as defined in statute. Because of the hardship on retirees with children between the ages of 22 and 26, and because the 2015 plan year had already begun, it was decided that the regulation would be effective for the upcoming 2016 plan year.
As his final update, Mr. Thielen stated that there have been a number of audits of KRS over the last several years as a result of requests from many sectors. Since 2008, the following studies, audits, inquiries and investigations have been performed:
- An annual financial audit by an independent CPA firm;
- A financial audit conducted by the Auditor of Public Accounts every five years, last completed in 2013;
- Two studies of the investment program and investment performance by the General Assembly’s Program Review and Investigations Committee, one in 2008 and another in 2012;
- A comprehensive governance audit conducted by the Auditor of Public Accounts, with a report issued in June 2011;
- A two-and-one-half year inquiry into the use of placement agents by investment firms utilized by KRS by the Securities and Exchange Commission;
- Three asset liability modeling studies from 2000-2013;
- An actuarial audit conducted by the Segal company that would be presented to the oversight board members later in the agenda;
- A private equity return benchmarking report in December 2011;
- An investment cost effectiveness analysis conducted by CEM Benchmarking, Inc. to be presented before the oversight board in the near future; and
- An administrative cost effectiveness analysis to be conducted by CEM Benchmarking, Inc. to be presented to the board in the spring of 2016.
Mr. Thielen noted that all of these studies and investigations have prompted improvements to processes and procedures, but none have shown any problems in terms of fraud or mismanagement. Senator Bowen asked if KRS had requested all of the audits and investigations be performed or if they had been initiated by outside agencies. Mr. Thielen responded that some were outside requests, such as the study of KRS’s investment performance by the General Assembly’s Program Review and Investigations Committee, but some were instituted by KRS. In closing, Mr. Robbins wanted to emphasize that regarding private equity and related fees, the expected returns are outside or in excess of the public markets and that last year was a good example. Private equity returns were 9.6 percent, net of fees, while public equity markets returned 7.3 percent, so even after fees private equity returned 2.3 percent more than public markets.
Chairman Yonts asked how health insurance premiums were expected to change from 2015 to 2016 for retirees. Mr. Thielen stated that he thought the change was going to be flat. Chairman Yonts also asked, in regards to the audits performed by the State Auditor of Public Accounts every five years by statute, how much KRS was charged for the audits. Mr. Thielen answered that the audit performed in 2013, which went beyond a typical financial audit, cost about $120,000. The typical cost of an audit by Dean Dorton would be in the range of $60,000. Chairman Yonts stated that he had heard a quote for hiring an actuary to perform an external audit in excess of $200,000. Mr. Bennett responded that because there is not an actuary on staff, and it is unclear if one is already employed in state government, that would be an accurate estimation of cost for hiring an external actuary to perform an audit.
Kentucky Teacher Retirement Systems Update
The next agenda item was a report on the Kentucky Teachers’ Retirement System (KTRS) from Mr. Gary Harbin, Executive Secretary, and Mr. Eric Wampler, Deputy Executive Secretary, Kentucky Teachers’ Retirement System. Mr. Harbin began with an investment update, stating that the investment performance was 5.1 percent for the last quarter of the year ending June 30, 2015. This outpaced the benchmark by approximately 1 percent, but does not meet the needs of the system. Returns of 15 percent are necessary to break even on a system which is 50 percent funded, resulting in a projection of an unfunded liability increase of $1 billion over a year’s time. Mr. Harbin went on to discuss the funding workgroup which is looking into a solution to the unfunded liability and the reality of selling $670 million in investments to meet the $1.8 billion annual payroll. This meant that roughly 37 cents for every dollar spent came from selling investments, which places a burden on the investment staff having to manage the cash flow needs of the system by selling investments. This has already impacted long-term goals by preventing investment in higher return opportunities, such as private equity. Mr. Harbin stated that KTRS is one of only six pension plans in the nation without a funding plan in place for members, which results in having to use a lower discount rate for assumed liabilities.
Mr. Harbin reported that the KTRS funding workgroup is comprised of 23 members representing educators, state officials, members of the Public Pension Oversight Board, members of the Kentucky Chamber of Commerce and professional consultants. The group is roughly halfway through the process, and it recently heard testimony from current, future, and retired teachers concerned about their retirement security. Surprises included the volume of loan debt current and future teachers face when trying to pay bills, and the number of retired teachers on Medicaid because of low benefits received from their retirement. Mr. Harbin stated that while it is a very affordable benefit, at 15.68 percent of pay and with net cost to the state of about 6.5 percent compared to the cost of Social Security at 6.2 percent, testimony from interest groups served as a reminder that teachers do not get Social Security benefits. According to Mr. Harbin, the workgroup participants are hoping to reassure the current, future, and retired teachers that their retirements are secure for the long term and they are beginning to debate specific possibilities to fulfill their charge of making a recommendation to the Governor by December 1, 2015.
Mr. Harbin also stated that consultants at the last workgroup meeting documented the existing unfunded liability of $14 billion and that the cost represents about 21 percent of pay, which cannot be reduced or eliminated by lowering benefits for current teachers or lowering benefits for new teachers according to Mr. Harbin. He stated the cost of the existing benefit is only marginally greater than the costs of Social Security, and when consultants looked at the possibility of moving new teachers to Social Security, rather than continuing them in KTRS, they found that it would not be a reasonable option. He stated the system needs approximately $490 million more per year and how that will be achieved is the task of the workgroup to determine. Senator Bowen asked what the current asset balance was for KTRS. Mr. Harbin said that currently KTRS has $18 billion in assets. Senator Bowen followed that by asking what the balance was in 2013. Mr. Harbin answered that he did not know precise figures, but that it was less. He noted there had been good investment performance since then, although over the last year the balance has decreased from roughly $18.3 billion to $18 billion due to benefit payments. Senator Bowen then asked if assets had been sold to realize gains or to cover expenses. Mr. Harbin stated that assets had been sold to cover expenses, but additionally, assets are valued using market values and as a result of down markets, the assets lost approximately $1.3 billion of value since July 1, 2015.
Senator Higdon asked for clarification of the 15.68 required contribution compared to the true cost of the retirement system. Mr. Harbin stated that because the system has an unfunded liability of 47 percent, the debt must be paid in addition to the normal cost of benefits. The 15.68 percent would be the cost of the benefit if the system was 100 percent funded. However, because the system is only 53 percent funded, and because the markets have dropped so dramatically, earnings of 7.5 percent were not realized, resulting in the $14 billion unfunded liability, which compounds at 7.5 percent. Mr. Harbin also acknowledged that the General Assembly has consistently met their statutorily required contribution and provided additional contributions when it was requested in 2006-2008 to keep the system actuarially sound. Senator Higdon asked what the cumulative costs have been since 2008. Mr. Harbin replied that since 2008, KTRS has sold $2.1 billion in assets to meet the retiree payroll. There have been $1.9 billion in requests to the General Assembly during this same time. Senator Higdon added that there had been a lot of good information brought at the last meeting of the workgroup, in particular that lowering the benefits for new hires would not solve the problem alone and that additional, and increasing, contributions will be necessary.
Chairman Yonts asked if an actuarial audit was currently being performed on KTRS. Mr. Wampler responded that an audit was being performed and that he would report on the progress of that audit. He stated that KTRS contracted with the Segal Company in June 2015 to conduct an audit that will include a full replication of the pension and health insurance actuarial reports for 2014, which is consistent with GFOA best practices. The audit began in July 2015 and must be completed by December 2015 when the results will be presented to the KTRS Board of Trustees. Chairman Yonts stated that the oversight board would also like a copy of the results of the audit as soon as possible after its completion. He also asked if the working group report would be ready by the November 20, 2015 deadline. Mr. Harbin clarified that the report is due to the Governor by December 1, 2015 so that is the actual deadline. Chairman Yonts asked if there was any indication that the recommendation will be anything other than a bond issue. Mr. Harbin stated that he was unsure at this point what the recommendation would be, but that the working group is open to many different options.
Mr. Harbin also wanted to make the board aware of the approximately 40,000 retirees who receive healthcare coverage through the retirement system. Of those, approximately half are covered under Medicare Part B, the premium for which is scheduled to increase by 52 percent on January 1, 2016, roughly increasing from $104 per month to $159 per month. KTRS has been reaching out to contacts in Washington, D.C. to get the most accurate and up to date information regarding this change. As a result of the “hold harmless” provision of Social Security, if there is not a COLA awarded to Social Security recipients, then the Medicare Part B premium cannot increase. Social Security recipients without a COLA make up about 70 percent of the population that receive Medicare Part B, meaning that Medicare will charge the remaining 30 percent of the population what is necessary to cover the difference. This will result in a final cost of $159 per month for all retirees, including teachers who have Medicare Part B. Additionally, with the shared responsibility legislation passed in 2010, all retirees under age 65 are required to pay a Medicare Part B equivalent into a medical trust so their premiums will also increase on January 1, 2016. Senator Higdon commented that he felt the shared sacrifice bill was a good piece of legislation, but he asked if it had indirectly caused this increase to members’ out-of-pocket expenses. Mr. Harbin replied that the under 65 population agreed to pay more, but as a result of things happening on the federal level, the under 65 population will be matching the over 65 population’s premium increase. There is currently a bill on the federal level designed to address this and prevent future inequity.
Representative Linder asked if there was no resolution at the federal level, because this only applies to those with a COLA increase, will the increase be greater than their COLA thus resulting in a negative impact on wages. Mr. Harbin answered that the phrasing of the harmless clause implies that the Medicare Part B increase should be covered by COLA increases. Representative Graham asked for clarification regarding the cost increase to Medicare Part B being covered by the premium increase on those that receive a COLA. Mr. Harbin explained that because there is no COLA for those receiving Social Security, there will be an increase for those that do not receive Social Security but pay into Medicare Part B and that will be passed on to non-recipients. Representative Graham asked what the solution at the federal level will look like, but Mr. Harbin said it was unclear at this time and he would give the board an update at a later meeting.
Judicial Form Retirement Systems Update
The oversight board then heard an update on the Judicial Form Retirement Systems by Ms. Donna Early, Executive Director, and Judge L. B. VanMeter, Chair of the Board of Trustees, Judicial Form Retirement Systems. Ms. Early explained that the Judicial Form Retirement System is charged with the administration of the judicial and legislators retirement plans. The Board of Trustees for the system consists of eight members: three judicial appointees, three legislative appointees, and two gubernatorial appointees. These individuals also serve on the investment committee for the system. They meet quarterly and at the October 9, 2015, meeting they will be discussing several items that are not ready to be reported on at this time. The system is on schedule for the actuarial audit to be completed, and a draft of proposed insurance rates will go before the board at the next meeting and will be shared with the oversight board once those rates are approved. Ms. Early also indicated that the presentation from LRC staff on investments will cover some of the Judicial Form Retirement Systems’ investment performance as well. Judge VanMeter stated that there was additionally some clean-up legislation to propose during the upcoming legislative session, some of which was proposed last session but did not pass. Chairman Yonts asked about the healthcare rates for the system in the upcoming year. Ms. Early said that the costs would remain flat, but the contribution levels would be determined by the Board of Trustees and could potentially increase.
FICA Withholding on Employee Pension Contributions Update
The fifth agenda item was an update on FICA withholding on employee pension contributions presented by Mr. J. W. Bryan, State Social Security Administrator. Mr. Bryan gave a brief overview of the history of Social Security for government employees. He also presented information on the IRS Memorandum of Agreement regarding costs to employees and employers. Mr. Bryan explained that a recent ruling determined that the method used by the Commonwealth to calculate Social Security tax liability was incorrect, and the IRS is requiring Kentucky to prepare a reasonable plan to address the treatment of pension contributions to bring the state into compliance. The agreement was reached via contract negotiations and the new calculation will go into effect on January 1, 2017, giving agencies time to plan, implement payroll systems, and communicate with impacted employers and employees. All governmental employers (including the executive, legislative, and judicial branches of state government), eight universities and the Kentucky Community and Technical College System, and 1,471 county, city, and local school districts are impacted. Mr. Bryan stated that this will cost an estimated $5.7 million in additional payroll taxes but, for employees who participate in Social Security, the additional contributions will result in increased Social Security benefits upon retirement.
Chairman Yonts asked if teachers who participate in Social Security and Medicare would experience an increase and if they were aware of that increase. Mr. Bryan assured him that teachers were aware, as were members of local governments. He has been working with the Kentucky Association of Counties (KACo), the Kentucky League of Cities (KLC), and the Kentucky County Employees Retirement System (CERS). Chairman Yonts also asked about cafeteria plan expenditures, whether they would be paid by employee or employer. Mr. Bryan stated that the employer would still be responsible for those contributions, and he noted this is covered under a federal statute making it separate from other income contributions made by the employer. Senator Bowen asked for reassurance that this would not be retroactively implemented. Mr. Bryan assured him that it would not. Representative Graham asked if the costs for teachers would be in addition to the Medicare costs mentioned earlier. Mr. Harbin answered on behalf of the KTRS that this would impact active teachers, not current retirees.
Kentucky Retirement Systems Actuarial Audit Results
The sixth item discussed was the results of the actuarial audit recently performed on the Kentucky Retirement Systems (KRS) by Segal Consulting. Ms. Kim Nicholl, Senior Vice President and Actuary, and Mr. Matthew A. Strom, Vice President and Actuary, Segal Consulting, presented the audit findings. Ms. Nicholl covered the scope of the audit, the data used, and verification of the test life detail. The audit was limited in scope, and they noted Segal did not perform a full replication audit, but rather used “test life” data. Test lives are actual members and highlight the scope of the system and its benefits, including all the tiers, retirement systems, and benefits covered by KRS. The data was compared and found to be accurate, although several recommendations were provided concerning some assumptions made regarding the data. The data provided to the actuaries for evaluation of liabilities and contributions showed a match within 1 percent, which is better than the 5 percent generally accepted as good. The only difference greater than 5 percent was the data applicable to beneficiary age; however, the difference seems to be a result of the way the data was reported. Ms. Nicholl assured the members that this small discrepancy would have no measurable impact on the results. Concerning the valuation report, it was noted that the recommended employer contribution rate (dollar amount of contribution divided by payroll) appeared to contain a slight miscalculation. Ms. Nicholl also drew members’ attention to the comments section of the valuation report, indicating that there were some noteworthy items for future review.
Ms. Nicholl noted a second recommendation regarding the “experience gain / (loss)” assumptions. She explained there were differing types of gains and losses, demographic and asset. These were currently totaled and expressed as a percentage of the actuarially accrued liability, and it was recommended that these be split. The demographic gains and losses should be expressed as a percentage of liabilities, while the asset gains and losses should be expressed as a percentage of the assets. Finally, she commented that several of the actuarial assumptions were either incorrectly or incompletely disclosed in the valuation reports.
Mr. Strom spoke regarding the test life data and he noted that it reflected individual active members, and regarding retired individuals with known benefit amount and date of birth it would be expected to match very closely with expected liability, which it did. Some areas of improvement regarding programming and reporting were highlighted, but they were found to have no net effect on the valuation report of the whole system. There were no major issues noted with the economic assumption recommendations and only one question regarding the mortality data, where actual deaths were nearly double expected for the 55 to 64 age range. Mr. Strom also highlighted recommendations to the retirement rate analysis and lower term rates regarding turnover and termination. He also gave a brief overview of valuation methods. Overall, Ms. Nicholl said the data appeared complete and the assumptions and methods were reasonable and complied with actuarial standards of practice. Some suggestions were made to improve the usefulness of reports and to fine tune the actuarial liabilities.
Senator Bowen asked what the differences would be between the limited scope audit of KRS and the full scope audit proposed for KTRS. Ms. Nicholl explained that the limited scope audit does not replicate the total valuation, but the liabilities for test lives. Because the test lives cover all the different tiers, plans, and benefits, it can be said that they are within the reasonable range for a match. A full scope audit will do the same but look at all the members’ liabilities and combine them to establish a total liability and total contribution rate. Mr. Jefferson asked if it was necessary to change actuaries in the same way that businesses are recommended to change auditors periodically. Ms. Nicholl responded that it is not necessary as long as there is a good relationship with the actuary and a belief that accurate figures are being presented. Mr. Jefferson then asked if it was preferable to have a different firm perform the experience study than performs the annual or regular audit. Ms. Nicholl answered that it makes sense for the actuary that performs the valuation study to perform the experience study because they are most familiar with the data and the plan benefits. Mr. Jefferson asked if it is unusual for boards of trustees to include scenario analysis in actuarial reports. Ms. Nicholl said that it is typically provided as a supplement if requested. However, she stated that while it was good to have to account for assumptions and inform decision making, it would increase fees. Mr. Jefferson had a final question regarding payroll growth and if it was similar across the nation. Ms. Nicholl said that it has been similarly flat or negative growth across the country because of the economy, but that it is expected to rebound.
Ms. Stemler asked if there were some systems performing more frequent audits or if the five-year audit was standard. Ms. Nicholl responded that she occasionally sees three-year audits, but a five-year audit is standard and provides the best overall picture of the system. Ms. Stemler then asked if it was accurate that the approach to payroll did not make a significant impact on growth. Ms. Nicholl said that the payroll growth assumption needs to be investigated because the system is not achieving the 4.5 percent payroll growth assumption. Senator Higdon asked if there were any concerns using the test life data. Ms. Nicholl said that yes, some small areas of concern regarding calculation programming were noted in the report, but that overall these impacted such a small number of individuals that there was no real impact on the system as a whole.
Kentucky Retirement Systems Consulting Actuary Response to Actuarial Audit
The seventh item on the agenda was a response to the actuarial audit by the KRS consulting actuary, Cavanaugh MacDonald Consulting. Representing Cavanaugh MacDonald Consulting were Mr. Todd B. Green, Principal and Consulting Actuary, and Ms. Alisa Bennett, Principal and Consulting Actuary. Mr. Thielen also briefly spoke to some questions the members had concerning the audit. First, he stated that a limited scope audit was chosen because it is an accepted actuarial process. The costs of conducting a full scope audit on such a complex system as KRS would have been much higher. Additionally, he noted that the board has decided to put some sensitivity analysis in the valuation reporting this year to address some concerns. Mr. Green stated that the actuarial audit is a value to the system, improving the valuation process. It also helps the board of trustees and members of the Public Pension Oversight Board be more confident that the numbers reported have been calculated correctly. The methodology of using raw test case data for the audit allowed for a more nuanced audit. Ms. Bennett added that this certainly seemed to be the case because the coding errors were very tiny and will allow for fine-tuning of future valuations.
Mr. Green covered some of the recommendations presented in the audit results, such as the employer contribution rates being slightly understated. It was the position of Cavanaugh MacDonald to disagree because the valuation rate was presented as a dollar contribution that is adjusted for the timing of payments. Mr. Green also pointed out that the valuation reports are always accompanied by a 20-year projection. If the contribution rates were significantly understated it would be reflected in the 20-year projection. Ms. Bennett said that one of the benefits of an outside audit is having an objective party interpret reports and highlight where communication would be better. Clearly there are some areas where the reports do not communicate effectively and efforts will be made to correct that. Mr. Green stated that Cavanaugh MacDonald is working with the KRS Board of Trustees to implement most of the corrections recommended by Segal Consulting in their report.
Mr. Green next stated that in the area of projected benefits Cavanaugh MacDonald agreed with the findings concerning differences and have corrected the numbers applicable to liabilities, which now range from 0.06 percent to a negative 0.09 percent. Ms. Bennett stated that this was further evidence that this was a very thorough audit because it was able to increase accuracy to this level. Mr. Green went on to discuss how the fact that members may have service in more than one of KRS’s five systems can affect how the retirement benefits are calculated. The system is currently making the assumption that members with hazardous and non-hazardous service will retire from the non-hazardous system and that will defer payment of benefits until after age 65. However, a member retiring in the hazardous system will receive benefits at age 55. Cavanaugh MacDonald plans to improve the description of this calculation in their valuation report. It was also recommended that other assumptions be lowered following the last experience study performed.
Chairman Yonts asked about the valuation in 2013, once the law changed it was assumed all the unfunded liability would be paid in 30 years but a more recent report has indicated the system will be insolvent in 20 years. Mr. Green answered that they cannot say there is no chance, but at this point the systems seem sound, pending changes made by the Commonwealth. Chairman Yonts emphasized that the state’s commitment to pay the actuarially required contribution and an improving economy are essential to the funded status of the systems. Mr. Green added that hiring more individuals into the system without service in another system would also contribute positively.
Fiscal Year 2015 State Administered Retirement System Investment Review
The eighth and final item on the agenda was an investment review of the state-administered retirement systems for the 2015 fiscal year. The presentation was given by LRC staff member Bo Craycraft. Mr. Craycraft specifically drew members’ attention to the information regarding the legislative and judicial retirement systems, which have posted strong returns of 10.5 and 10.9 percent respectively over the last two years. He also noted that they are small plans and are limited in their investment potential in comparison to larger plans, such as KTRS. Mr. Craycraft illustrated how the plans compare to their peer group systems and emphasized how these plans compare to the KTRS plan. He noted that over the 10- and 20-year periods most of the plans have come close to or exceeded their benchmarks and their investment return assumptions. Mr. Craycraft also highlighted a comparison of asset allocation between systems. Again, he showed how the state administered plans compare to peer groups such as an aggregate LRC peer group and a peer group reported by Cliffwater. Mr. Craycraft briefly discussed the sources of fees and fees reporting, and he highlighted several factors that impact fees, including internal management and asset allocation.
Chairman Yonts asked for clarification on the alternative asset allocation, specifically hedge funds. Mr. Craycraft explained that there are four large classes of alternative assets: private equity; real estate; real assets; and hedge funds. He briefly described the liquidity and expected returns of these classes. Senator Higdon asked about the fee differences between KRS and KTRS versus the Legislative Retirement Plan (LRP) and the Judicial Retirement Plan (JRP). Mr. Craycraft emphasized that the LRP and JRP are able to take risks that would not be prudent for the larger systems and that this strategy results in the higher returns and lower fees seen by the systems. Mr. Jefferson asked about the management fees for KTRS, assuming all fixed income is handled in-house, if it would be safe to assume that the management fees reported are largely staff salaries. Mr. Craycraft answered that no, the fees represent external manager fees for things such as high-yield bonds and European / non-US bank loans. Mr. Jefferson then asked if it would be necessary to have a separate line item for staff salaries, technology expenses, external fees, etc. in order to make a true comparison. Mr. Craycraft stated that yes, it would be necessary to break the category down and that would also affect the basis points figures. He noted that what was given in the presentation was an aggregate figure. Finally, Mr. Jefferson asked, regarding costs reported for KRS and hedge funds, if the data provided was strictly base fees or if incentive fees were included in the figures. Mr. Craycraft stated that it does include performance fees paid to managers.
Chairman Yonts asked about the possibility of utilizing internal management to cut expenses for KRS such as was suggested for KTRS and JFRS. Mr. Thielen said that it is something that could be looked into but would require budget approval from the State Budget Office and the General Assembly in order to hire more staff at a competitive rate. Representative Thompson asked when the Board of Trustees for KRS would be reevaluating asset allocation. Mr. Thielen stated there is a retreat scheduled for the board in October where reports on asset classes will be heard, but it is unclear whether a decision will be made at that time or at a later meeting. He clarified that there is not a significant investment in alternative asset classes at this time, but that is something that will be considered moving forward.
Senator Bowen asked to speak prior to adjournment to recommend a full scope actuarial audit of KRS by an outside firm. He felt that while the information provided by KRS at this meeting was valuable and was all the information available, it does not provide the outside perspective needed for members to perform their oversight function well. An outside source would truly gauge the effectiveness and efficiency of all KRS management practices. In his opinion, a limited scope audit as presented at the meeting was simply inadequate to allow policy makers to make decisions, and he noted that just as private industry regularly hires consultants to evaluate and make best practice recommendations to maximize performance, KRS is a multi-billion dollar government agency and it is in no less need of an independent review.
With no further comments or questions, Chairman Yonts thanked the members and presenters and the meeting was adjourned. He announced that the next regularly scheduled meeting would be on October 26, 2015 at 12:00 noon.