Call to Order and Roll Call
The 1st meeting of the Public Pension Oversight Board was held on Monday, January 25, 2016, at 12:00 p.m., in Room 169 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; Senators Jimmy Higdon and Gerald A. Neal; Representatives Brian Linder and Tommy Thompson; Mike Harmon, Tim Longmeyer, John Chilton, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Representatives Brad Montell, Derrick Graham, and Jerry Miller; David Peden, Chief Investment Officer, Kentucky Retirement Systems; Tony Johnson, R.V. Kuhns; Beau Barnes, Deputy Executive Secretary, Kentucky Teachers’ Retirement System; Donna Early, Executive Director, Judicial Form Retirement System; Judge Larry VanMeter, Board of Trustees member, Judicial Form Retirement System; and Bill Thielen, Executive Director, Kentucky Retirement Systems.
LRC Staff: Brad Gross, Bo Cracraft, Terrance Sullivan, Jennifer Hans, and Maurya Allen.
Chairman Bowen directed members’ attention to a report by LRC staff that compares the different retirement systems each quarter. It serves as an informational tool for the members when discussing the plans in relation to one another. He thanked LRC staffer Bo Cracraft for his efforts in gathering and formatting the data.
Approval of Minutes
Representative Thompson moved that the minutes of the December 17, 2015, meeting be approved. Mr. Jefferson seconded the motion, and the minutes were approved without objection.
Kentucky Retirement Systems Investment/Asset Allocation Update
Mr. David Peden, Chief Investment Officer, Kentucky Retirement Systems (KRS), and Mr. Tony Johnson, Investment Consultant, R.V. Kuhns, provided an update regarding KRS investments and asset allocation for the quarter ended December 31, 2015. Mr. Peden reminded members that KRS approved new asset allocation programs in November 2015 following the results of the asset liability study performed in May 2015. The study was completed late in the summer of 2015 and the results were presented to the KRS Investment Committee in August. Mr. Johnson testified that the KRS insurance plans were healthy with an asset level growing at a greater rate than liabilities so the funded ratio was high enough to support a robust, diversified, and growth-oriented asset allocation going forward. With no anticipated changes to the insurance plans that would negatively affect the projections, it was believed that the plans should meet the actuarial target of 7.5 percent. For the pension plans, there were two different conclusions. First, the County Employees Retirement System (CERS) Non-Hazardous, CERS Hazardous, and the Kentucky Employees Retirement System (KERS) Hazardous plans were found to be relatively healthy and could continue to pursue a diversified and growth-oriented asset allocation program, still targeting a 7.5 percent rate of return. Mr. Johnson emphasized the necessity that the forecasted contributions would be made and pension payments would be within the forecasted range.
The second conclusion, for the KERS Non-Hazardous and the State Police Retirement System (SPRS) plans, was that liabilities were projected to grow at rates in excess of the rate of growth for assets. Even at a 7.5 percent rate of return, assets would not keep pace with rate of growth of liabilities. R.V. Kuhns concluded that a different asset allocation program needed to be in place for these plans. Also, even at 7.5 percent rate of return, it would take at least double the return, or 50 percent, to keep up with the rate of growth of liabilities. It is the opinion of R.V. Kuhns and many other investment professionals that, over the next 5-10 years, it would be very difficult for any plan, be it a pension plan or an endowment plan (which can take on higher level of risk), to meet or exceed a 15 percent rate of return. The expectations going forward are much lower than historical rates of return, so even 7.5 percent would be a difficult target to reach.
Mr. Johnson stated that to determine what the asset allocation should be two pieces of information are utilized, liquidity and downside tolerance of the portfolios. The downside tolerance means that, during a market downturn, how much capital depreciation can the system withstand, including how long would it take to recover, for the plans to still be considered solvent. The CERS Hazardous, CERS Non-Hazardous, and KERS Hazardous are healthy enough to withstand market volatility and do not require as much liquidity to meet obligations. This was determined looking at the funded ratio, the projected funded ratio over the next 20 years, and the 20-year peak payout ratio. Typically, a funded ratio of 50 percent or better indicates the plan is healthy, especially if it is improving over time. This is the case for the three referenced plans. It is also good to see a payout ratio of 15 percent or lower, meaning that the amount paid out of the plan each year to meet obligations. For the three plans, over a 20-year period, the peak is 10-11 percent which is comfortable. Mr. Johnson said that there is a glide path to that peak and a glide path down, and that these are not one time payouts.
Conversely, looking at KERS Non-Hazardous and SPRS, the current funded ratios are poor, 22 percent for KERS Non-Hazardous and 38 percent for SPRS. Over a projected 20-year period, the funded ratios do not exceed 50 percent, although SPRS comes close. The payout ratio for KERS Non-Hazardous is just over half, meaning over half of the assets are paid out at the peak. And a little over 25 percent assets will be paid out of SPRS at the peak. These show that the demand on assets will be fairly great to meet the pension obligation. In order to do that, it is necessary to reduce the amount of illiquid assets in the portfolio. Pension plans rely on high risk assets, such as stocks, in order to see the greatest return but also generate greater volatility. Private equity also provides volatility. For plans such as KERS Non-Hazardous and SPRS, having a low funded ratio and a high payout ratio indicates that the demand on capital is high and it is necessary to access as much of the assets as possible. It is therefore not possible to have more volatile and illiquid assets in the portfolio because it is necessary to preserve capital and illiquid assets will need to be liquidated sooner rather than later.
Chairman Bowen asked if these projections assumed that the full actuarial required contribution (ARC) was paid each year. Mr. Johnson stated that those were assumed in the models. He said that stress tests performed on the plans showed that there were even worse outcomes. For KERS Non-Hazardous, a worse-case scenario could result in a payout ratio of 80-90 percent in one year. The asset allocation proposed for CERS Non-Hazardous, CERS Hazardous, and KERS Hazardous, was to continue using a robust, diversified portfolio featuring equities, global fixed income, real estate, inflation sensitive assets, hedge funds, private equity, and cash. To achieve a 7.5 percent return, it is necessary to increase the volatility, in this instance, with global equity. R.V. Kuhns also recommended a 10 percent allocation to private equity and a 10 percent allocation to hedge funds.
In 2014-15, there was increased interest in alternative investments in pension plans, particularly in private equity and hedge funds. Private equity received a lot of attention for having higher fees and suffering after the 2008 financial crisis. Mr. Johnson stated that in 2014-15 private equity has driven returns in pension plans across the country. Because these plans can withstand a level of illiquidity and volatility, R.V. Kuhns does recommend a 10 percent allocation to private equity. Similarly, hedge funds received negative attention and there were reports that other pension plans were leaving the hedge fund marketplace. This report has since been reversed, because there is still value in participating in hedge funds. Mr. Johnson said that hedge funds are expensive but that they reduce overall volatility to the portfolio. Although hedge funds appear to be a liability on the portfolio, the benefits will be more apparent during downturns in the market such as are currently occurring. Real estate serves a similar purpose in the portfolio. Combined, the expected return for the portfolio is 7.23 percent, slightly below the desired return but this does not include the assumptions that staff can exceed the median estimations used for projections.
Ms. Stemler asked how much of the global equity represented U.S. investment versus international investment. Mr. Johnson said that the standard ratio was 50 percent in U.S. and 50 percent international and that was the projection. However, this is based on the marketplace and is subject to change. Ms. Stemler stated that that seemed very high for international investment. Mr. Johnson stated that that was on par with the standards worldwide. Representative Miller asked if the KERS and SPRS projections took into account a 4 percent payroll growth. Mr. Johnson said that it did. Representative Miller followed up by asking if a sensitivity analysis had been performed if the payroll growth was flat. Mr. Johnson replied that they had not performed one, but that could be provided for presentation later. Mr. Chilton asked what type of securities the hedge fund investments represented. Mr. Peden answered that they were diversified and included one external relationship fund-to-fund with discretion to invest in a wide range of hedge fund strategies and half in internally managed fund-to-funds which include event driven strategies like merger arbitrage, long short equity, and equity market neutral, or relative value strategies like convertible bond arbitrage and fixed income arbitrage, and finally volatility strategies where if volatility increases the fund makes money and likewise in the opposite direction. The goal being a volatility of between 4.5 and 6 percent. Another goal was to not have correlation to the S&P 500, the credit markets, or interest rates. Underlying securities in a hedge fund are the same as those in the rest of the portfolio, for example, stocks, bonds, loans, cash, and derivatives. Mr. Chilton asked if hedge funds were more actively traded than other portfolios. Mr. Peden stated that it depends on the particular strategy, but they can be.
Mr. Johnson discussed KERS Non-Hazardous and SPRS where the payout ratios are high and funded ratios are low. To accomplish the goals for these plans, R.V. Kuhns recommends a target of 6.67 percent return on investment as opposed to the 7.5 percent return for several reasons. First, the necessity to preserve the assets while still targeting a growth orientation. Second, ensuring that assets are liquid enough to cover increased payments in the near future. To do this, it was necessary to lower the allocation to private equity to 2 percent from the previous allocation of 10 percent. This brings down the potential return, and normally allocation would be shifted to compensate. But in the interest of prudence, it is not advised to invest any more in global equity because of volatility, so that class was capped at 50 percent. To reach the lowered allocation however, R.V. Kuhns recommends a natural wind-down of private equity, meaning returns from that asset class will be reinvested in other classes rather than back into private equity.
Senator Higdon stated that he understood other states invest more in real estate leases and that he would like to see Kentucky participate in a similar program. He asked what the likelihood of that happening for KRS might be. Mr. Peden answered that it would be easier for CERS and the hazardous plans to participate in a program like that because they have the available assets and do not have the same needs for liquidity. The 5 percent real estate target outlined in the current asset allocation would however allow for some strategies such as real estate leases and Mr. Peden said that would be something to consider in the future. Mr. Johnson finished his presentation regarding KERS Non-Hazardous by looking at the allocation if they continued to target 7.5 percent returns while maintaining the necessary liquidity. As a result, private equity investment would be 72 percent, and while the expected return would be 7.48 percent, the expected risk would be much higher at 15.58 percent. That also represents a significant downside during an economic downturn, such as the markets are currently experiencing, and would result in a more far-reaching impact. Mr. Peden emphasized that the goal was not to sell private equity in a secondary sale, but the intention is to let it mature and roll off over time. It is anticipated to reach near the 2 percent goal in the next 5 years. Senator Bowen asked for confirmation that there had been no new investment in private equity since 2009. Mr. Peden answered that, for KERS Non-Hazardous, that was correct.
In regards to SPRS, there was a recommendation of higher allocation to global equity and a slightly lower allocation to global fixed income resulting in a slightly higher return. Mr. Johnson explained that that was the result of having better payout ratio but results in a target of 6.77 percent rate of return. To better illustrate the comparison of KRS plans to a hypothetical most efficient portfolio, Mr. Johnson presented an efficient frontier graph mapping the position of each plan relative to the hypothetical plan in terms of annualized return and annualized standard deviation of risk. This showed how the plans could invest more as they got stronger over time, especially those which were already shown to be relatively healthy. He emphasized that it would be much harder for the two struggling plans and that is why it was suggested to be more conservative in investment strategy at this time. Mr. Peden stated that he wanted to share this data with the board to illustrate the mean variance optimization, the return which can be maximized per unit of risk, and that the importance of balancing the investment classes to best meet that optimized situation.
Mr. Chilton asked if the projected funded ratio presented was at the end of 20 years or at some point during the 20 years. Mr. Johnson answered that it was at the end, that the progression was not that great over the 20-year period given the current contribution and liability schedules. Mr. Chilton then asked if the payout ratio was the high point during that time frame and Mr. Johnson answered that it was. Mr. Peden added that after the passage of Senate Bill 2 of the 2013 Regular Session, the improvement was largely in the last 10 years of the modeling study which led to the legislation, so it is correct to assume that most improvement will not be seen in the beginning of the 20-year period.
Representative Thompson stated that it seemed the largest constraint on the return for KERS Non-Hazardous was the illiquidity needed to meet the larger payout ratio. And given the tepid nature of the market currently, which is forecast to remain so for several years, he asked how realistic the 6.67 percent return might be. Mr. Johnson answered that it was difficult to predict the returns at any point of time, but it is believed that with the current payout ratio it is possible to reach 6.67 percent. There will always be downturns, but the recovery is still capable of keeping the pension system solvent over time, especially after a 5-10 year time period.
Before concluding, Mr. Peden briefly testified regarding KRS’s quarterly returns. He stated that during the second fiscal quarter, or the fourth quarter of the calendar year 2015, KRS had a quarterly return of 1.9 percent, just shy of the benchmark return of 2.0 percent. He said that December presented a real challenge, and things had not greatly improved in January to date. Overall, the system is down 2.95 percent and the markets for January had the worst start for equity investments on record. Representative Montell asked if the 2.95 percent referred to the quarter or the full year. Mr. Peden reported that it was for the fiscal year to date, representing the last two quarters of calendar year 2015. Representative Montell asked about the return for the whole calendar year 2015. Mr. Peden answered that the return was essentially flat, down two basis points. And the benchmark was up 64 basis points for the calendar year 2015.
Kentucky Teachers’ Retirement System Investment Update
Mr. Beau Barnes, Deputy Executive Secretary, Kentucky Teachers’ Retirement System (KTRS), presented the investment update for KTRS for the quarter ended December 31, 2015. Mr. Barnes apologized that he did not yet have the detailed report they would normally be able to provide. He stated that the numbers he had were preliminary reports and KTRS is working with their custodial bank, Bank of New York, so that for future meetings they will have final audited returns and greater detail. He did inform the board that KTRS’ returns were 3.5 percent, largely as a result of improvements in equity markets. The bond market was relatively flat. And he testified that while November was a good month, December was an off month for the system. He also stated that the national benchmarks for the system were not available at this time. However, he would be willing to come back to testify when all data become available. Chairman Bowen asked for clarification regarding the returns for the fiscal year to date. Mr. Barnes answered that the returns for the quarter were 3.5 percent and for the fiscal year to date they were -2.4 percent because the first quarter was a very bad quarter for the system.
Judicial Form Retirement System Investment Update
Ms. Donna Early, Executive Director, Judicial Form Retirement System (JFRS), and Judge Larry VanMeter, Investment Committee Chairperson, JFRS, were present to speak regarding the investment update for the quarter ended December 31, 2015. Chairman Bowen reminded members of the board that all the information regarding investment updates for the systems was on the handout provided in member packets by LRC staff. Judge VanMeter said that the investment return was 4.7 percent, meeting their benchmark. For the fiscal year to date, returns were up 1.4 percent. The equity portfolio is largely in publicly traded S&P companies and the bond portfolio is largely in corporate bonds with some municipal bonds due to taxation. The ratio is approximately 75 percent equity, 25 percent fixed income. The returns are always above benchmark, which is positive and the system does not see a need to change strategies at this time. The annual income, dividends, and interest combined with the ARC payment roughly equals the annual cash requirements for the pensions so the system does not need to dip into investments to meet those needs. The JFRS investment manager had expressed to the JFRS Investment Committee that risk equals permanent loss of capital so the committee does not concern itself with a short-term market declines because there will always be ups and downs with the market. They do not participate in private equity or hedge funds as the other systems do so they cannot report on those.
Kentucky Retirement Systems Update on Agency Participation Issues/Contract Employees
Mr. Bill Thielen, Executive Director, Kentucky Retirement Systems (KRS), spoke regarding agency participation and contract employee issues facing KRS. He began by introducing three members of the KRS Board of Trustees who were in attendance, Tommy Elliot, Chair; David Rich, CERS representative; and Vince Lang, KERS representative. Mr. Thielen said that during the fall there had been discussion of about the changes in assumptions made by the KRS Board of Trustees, particularly the payroll growth assumption which was reduced from 4.5 to 4.0 percent. One reason proposed for the lack of payroll growth was that some agencies which participate in the systems were able to avoid making contributions for employees, which they might have historically made, through hiring independent contractors or using other methods. The Public Pension Oversight Board made a recommendation in December that KRS was to study issues related to agency participation, including the use of independent contractors, and provide a listing of all agencies attempting to avoid making contributions through various means. Mr. Thielen said that KRS had collected data covering the last four fiscal years and have developed a spreadsheet provided to members showing both member number trends and salary trends. The member trends data shows the number of members being reported, meaning contributions being paid, and the salary trends the total salaries or compensations reported, by the various classes of agencies. He explained that the data was only provided for the last four years because there is difficulty getting accurate data due to the implementation of the new technology system in 2011. The legacy technology system does not allow for the collation of this kind of data. KRS is continuing to work on this project with the goal of extending the data at least as far back as 2009.
In general, the data does show that only the KERS Non-Hazardous plan experienced a decrease in the number of members for which contributions were being reported for this time period. Over that time the numbers dropped by 4,462 members, nearly all of which can be attributed to decreases from three agency classes. Those classes were regional mental health units, health departments, universities. Only the state plans showed a decrease in total payrolls. The KERS Non-Hazardous plan decreased by approximately $150 million and a majority of that is attributable to the three classes mentioned. In the KERS Hazardous plan there was a decrease of just over $1 million and in SPRS there was a decrease of approximately $4 million. It is not possible at this time to identify the exact causes for these declines, but KRS staff is attempting to get more information on the number of independent contractors that have replaced employees or those that were hired outright and never represented an employee. That information is not readily available but there are sources which have identified over 600 independent contractors who work in the Commonwealth Office of Technology and with the implementation of the Kentucky Human Resources Information System (KHRIS). Aside from that it is difficult to know the number of contractors working for other state agencies. It may be necessary to perform an open records request to get that information from each state agency.
Representative Yonts asked how many individuals were a part of the mental health unit which is known to have dissolved and then recreated itself using only contract laborers. Mr. Thielen indicated that the representative was likely referring to Seven Counties Services, which had approximately 1,300 employees, and Kentucky River Community Care, which had approximately 600 employees. Representative Yonts asked if the total costs of privatization of food services and medical services in corrections had been considered. Mr. Thielen stated that they had not, and indicated that corrections and transportation were two areas that would need much closer investigation. Representative Yonts expressed that nursing staff in state supported hospitals throughout the state might also present another source. He then stated that the Finance and Administration Cabinet is working on a report, in accordance with a 2010 statute, regarding personnel information be maintained and the last report was issued in 2011. Chairman Bowen asked for clarification regarding the Kentucky River Community Care situation. Mr. Thielen stated that it was also in litigation, as is the Seven Counties Services situation. Chairman Bowen asked for an update on the Seven Counties Services litigation. Mr. Thielen reported that currently the case is under appeal in district court and it is unknown when that appeal will be heard. Additionally, KRS has filed a motion to move a specific issue to the Kentucky Supreme Court and no statement has been made on that yet.
Auditor Harmon asked about the impact on investment strategies due to the loss of money contributed because of privatization. Mr. Thielen said they had not looked at that specifically, but it was evident that less contributions did have a negative impact on investment ability. Long-range investment returns have been positive, with poor returns in the short-term, and it would be preferable to have greater ability to invest in some longer range strategies. Mr. Longmeyer asked if there are new participants in the third tier of benefits, which would automatically result in a net gain, what the impacts were for losses in the first or second tier. Mr. Thielen said that that was true and that most of the contributions currently are going to pay the unfunded liability.
Representative Yonts asked if capturing the percentage of payroll from privatization would contribute significantly to cash flow. Mr. Thielen stated that it would absolutely be a positive, much like retired/re-employed situation. Representative Yonts followed up with a question about the level of state employees currently employed. Mr. Thielen said that the state is at its lowest number of employees for several years. KRS will continue to work on quantifying the impact of this issue.
Mr. Thielen spoke in regards to other recommendations from the Public Pension Oversight Board made in their December meeting. The various retirement systems have discussed presenting their returns as net-of-fees, which KRS already does, so they are already in compliance. Representative Yonts asked if KRS had collaborated with the other two systems on ways to do that. Mr. Thielen said KRS had reached out to KTRS but an agreement had not been reached. And it was his understanding that JFRS would follow the lead of the other two larger systems. Representative Yonts asked that that be clarified by next board meeting so it can be included in legislation if necessary.
Senator Higdon asked what CERS Hazardous Insurance Plan costs were, following the change to covering dependents which went into effect on January 1, 2016. Mr. Thielen said that it would take until the end of January to have the most accurate numbers. Senator Higdon also asked if KRS had any recommended legislation that the board should be aware of. Mr. Thielen answered that the most pressing legislation was the KRS housekeeping legislation which was prefiled. He also briefly mentioned pension spiking reform legislation and an actuarial analysis of flat payroll growth at the recommendation of Representative Miller.
Representative Yonts also asked about the board recommendation that KRS present three options for addressing cash flow issues facing the KERS Non-Hazardous fund. Mr. Thielen said that in a letter sent to the board in December they had outlined four options for improvements of cash flow. Senator Bowen directed members’ attention as well to a handout with legislation related to the board jurisdiction that had been introduced in the General Assembly. He encouraged members to become acquainted with the legislation and support its passage.
With no further business to come before the board, the meeting was adjourned at 1:30 p.m. The next regularly scheduled meeting of the board will be Monday, February 22, 2016 at 12:00 p.m.