Call to Order and Roll Call
The 2nd meeting of the Public Pension Oversight Board was held on Monday, February 22, 2016, 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; Representative Brian Linder; John Chilton, Robert Damron, Mike Harmon, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Representative Arnold Simpson.
LRC Staff: Brad Gross, Bo Cracraft, Jennifer Black Hans, and Maurya Allen.
Chairman Yonts directed members’ attention to the scheduled meeting on Monday, March 28, 2016, explaining that it may have to be adjusted due to session.
Approval of Minutes
Senator Bowen moved that the minutes of the January 25, 2016, meeting be approved. Ms. Stemler seconded the motion, and the minutes were approved without objection.
Governor’s Budget for KRS/KTRS & Proposed Audit Update (handout)
Mr. John Chilton, State Budget Director, discussed the Governor’s view of the pension problems and plans to address them. When the Governor took office, there were several problems: a $500,000,000 budget shortfall; underfunded and underperforming pension systems; and the end of the federal government’s 100 percent financing of Medicaid expansion. The state’s financial situation was analyzed, and the possible alternatives that were considered were increasing taxes, decreasing spending, waiting, or borrowing. The course of action taken was to decrease spending, and the objective is to have long term fiscal stability.
Mr. Chilton said two of the Governor’s priorities are strengthening Kentucky’s financial foundation and keeping the commitment to all public servants. Pension costs have increased from 5.4 percent to 12.4 percent of the budget. Medicaid has increased from 12.7 percent to 18.2 percent of the budget, and the remaining general fund expenditures have decreased 12.4 percent over the last 10 years.
For fiscal year 2017, the Governor is proposing an additional $827,000,000 in spending, 81 percent of which will fund pensions and Medicaid. For fiscal year 2018, the proposal is $1,000,000,000 of additional spending compared to fiscal year 2016, of which 83 percent will fund pensions and Medicaid. To accomplish the objectives, the Governor has imposed a 4.5 percent spending reduction for fiscal year 2016 and a nine percent reduction to baseline spending in fiscal year 2017 and fiscal year 2018. The Commonwealth would save about $650,000,000 over a 30 month period due to these reductions.
Mr. Chilton said that the Governor’s plan is not budgeting to zero. Budgeting to zero would mean the budget would anticipate spending every dollar that would be received as projected by the Consensus Forecasting Group. The Governor implemented a buffer, so that if the receipts turn out to be less than the amount projected by the Consensus Forecasting Group, the budgeted amounts would not exceed revenues. If revenues exceed the Governor’s lowered threshold, half would go to pensions and half to the rainy day fund. Of the pension amount, half would go to the Kentucky Teachers’ Retirement System (KTRS) and half to Kentucky Employees Retirement System (KERS). In dollars, this means appropriations of an extra $32,000,000 to KTRS and KERS in fiscal year 2017 and $35,800,000 in fiscal year 2018.
The Governor is saving for a down payment on Kentucky’s future. The unfunded liability in aggregate on all the pension funds is over $30,000,000,000. The rainy day fund under the Governor’s proposal would grow to a balance of $523,000,000, and additionally there is $500,000,000 reserved in the permanent fund, which is over a billion dollars that is available to address the pension problem.
Another way to look at the amount of unfunded liability of $30,000,000,000 is the value is three times the entire $10,000,000,000 general fund budget. The unfunded pension liabilities adversely affect state government and hundreds of other organizations throughout the state. The current budgeted contributions to KERS provides $628,000,000. The Governor is budgeting an additional $132,000,000 and $154,000,000 for FY 2017 and 2018 to cover the increased actuarial required contribution (ARC) and is also providing a general fund appropriation, sometimes called ARC+, of $44,668,000 in each of the fiscal years. Including the contingent appropriation of $32,000,000 and $35,000,000 for each fiscal year results in $1,700,000,000 going into the KERS over the next two years. This is $208,718,000 more in fiscal year 2017 and $234,480,500 more in fiscal year 2018, as compared to fiscal year 2016.
For KTRS, the amount that was contributed for 2016 is $665,500,000. The appropriation for the unfunded ARC is $300,054,900 and $291,465,200 for fiscal years 2017 and 2018 respectively. In addition, the SEEK formula results in $8,400,000 and $17,000,000 additional money for KTRS for fiscal year 2017 and 2018. Combined with the contingent appropriation, possible funding for KTRS over the biennium could reach $2,000,000,000. This is an increase in funding in fiscal year 2017 and 2018 of $340,504,900 and $344,277,700, respectively when compared to fiscal year 2016.
Summarizing the Governor’s commitment, the possible pension funding is more than $1.8 billion in each of the two fiscal years compared to $1.3 billion in 2016, which is an increase of more than $1.1 billion committed to the pension funds in this budget. The Governor has also called for an audit to determine a recommendation for solving the pension plan crisis by determining the level of unfunded liabilities using consistent assumptions for each of the plans and to identify options for the future. The actuarial reports, audit reports, and financial reports have been done for many years, but the assumptions that are used in connection with the various plans are not the same. Those are determined by the boards of each of the plans.
Another feature of the Governor’s proposal would set aside $500,000,000 in a permanent fund. That money would come from excess funds that exist in the Kentucky Employees Health Insurance fund, which is projected to have a surplus. The use of the permanent fund will be limited to shoring up the ailing pension systems. The rainy day fund would also possibly reach $524,000,000. Mr. Chilton stated the two funds will reserve over $1,000,000,000 to address the various financial issues that the state faces, and Governor Bevin is opposed to using any of the $1,000,000,000 to support general fund operations.
Mr. Chilton discussed items not in the budget, including:
· plans for tax reform. The Governor has proposed no changes for Kentucky’s tax system and wants to give careful consideration to tax reform and plan for some time after the budget is adopted in April;
· plans for pensions;
· plans for Medicaid. The budget contains funds to operate Medicaid as it currently as it stands;
· performance funding details;
· analysis of tax credits and incentives;
· attracting new businesses and business expansion; and
· long-term plans for Kentucky parks.
Senator Bowen asked for an example relative to budgeting to zero. Mr. Chilton stated the economists predict what revenues will be for the next biennium. The Governor’s budget does not include expenditures for 100 percent of that amount. He is budgeting below that amount to provide a buffer if the revenues do not develop as they anticipate.
Senator Higdon commended the Governor’s plan of going forth with an outside audit and that it would be fortunate to meet the commitment of doing the ARC +.
Senator Neal asked if an analysis took place when the Governor put his budget together and if there were any adverse impacts to the programs that were cut. Mr. Chilton answered the 4.5 percent and nine percent are applied to non-exempt agencies and programs. A little more than half were exempt so the nine percent would be applied to non-exempt agencies and programs. The exact areas in which the cuts will be made will be at the discretion of the Cabinet Secretaries to know which areas should be cut and to make a recommendation.
Senator Neal asked if the universities should be alarmed when they begin these cuts that will be devastating to their operations and the impact on the students, impact on maintaining carrying out progression plans on behalf of Kentucky, and economic development ramifications. Mr. Chilton said that with the amount of funding the universities get from the state under the Governor’s proposal, which have been reduced by 4.5 percent to nine percent, they should be alarmed and take action. He does not believe any university gets over 50 percent of their funding from the state and the amount being cut is the nine percent of what the state is providing. The effect on the budget is not nine percent, but rather much lower.
Senator Neal asked if other agencies that are also subject to that cut should be alarmed as well. Mr. Chilton answered that they need to take action to accomplish the decrease in spending. The amount of liability that needs to be paid at some point is huge so all government agencies need to take action to reduce spending in order to deal with the financial problems.
Senator Neal appreciated Mr. Chilton being forthcoming and commented that there should be alarm about the pension liability. Historically, no action has been taken effectively with tax reform which should be the primary concern to project into the future.
Representative Linder commended the Governor on his budget and used the credit card debt analogy, of paying more than the minimum, to come to terms of understanding. Representative Linder asked if in the future, the fund goes to zero, and pension liabilities are coming out of the general fund, what type of cuts overall would that be on state government. Mr. Chilton answered that the SPRS fund is getting close and that there are no projections. If benefits start being paid out of the general fund each year the squeeze will be huge. Using the credit card analogy, the ARC is computed of two components. One is normal cost which is the cost of pensions associated with services provided during the year such as projected earnings, projected payroll, and increases in payroll. If the normal cost is not paid each year, the amount of the normal cost goes up. If normal costs are not paid, that additional amount will not go on a credit card that is paid off every seven to eight years, it goes on a mortgage that is paid over 30 years and continues to grow with very little headway.
Representative Linder commented that he thought it a fair assessment that the nine percent over the next two years may help offset a huge cut in the future years. If it goes back to paying benefits out of the general fund, that would be more than a nine percent cut.
Representative Simpson commented that he applauded the Governor’s ARC + funding relative to pensions. In many instances the uncertainty that lies ahead is that last component, the investment income, and how much will be made or lost. Representative Simpson asked if Governor had thought about the current composition of the pension board and any of the proposed legislative changes that have filed. Mr. Chilton said he had not, and that part of what the audit will encompass is a performance audit on the investments and looking back to determine if the state had received a reasonable return and what could be done in the future.
Representative Simpson stated in looking at other states and their returns Kentucky has not really done as well as some of the sister states. He asked if any of the proposals were being offered by virtue of this committee. Mr. Chilton answered that would be part of what the audit considers.
Representative Simpson asked if any proposals would be looked at before session ended and that it would be appreciated if Mr. Chilton could communicate his support or opposition to the proposals that have resulted from this committee. Mr. Chilton answered that he would, but it would require analysis before he can make a recommendation.
Investment Expense Disclosure & Trends (handout)
Bo Cracraft, Legislative Research Commission staff, provided a review of what is occurring in the industry centering on investment expenses and some of the challenges pension plans are facing. As an introduction, Mr. Cracraft spoke about the focus on investment fees and the task of trying to do that on an annual basis. Within the semi-annual investment reviews, staff has tried to incorporate what funds are reporting as investment expense and also to understand what is leading and causing those fee totals. He stated the discussion began more than a decade ago with several pay to play concerns and lawsuits that were filed outside the state of Kentucky. More recently, the interest has shifted to trying to make relative judgments on what plans are paying specifically within Kentucky, what expenses Kentucky is incurring, and what the costs are to run the investment programs. The demand for transparency has raised attention both within Kentucky and nationally. The last two regular sessions have both included a proposed legislation that would speak directly to disclosure of fees.
During the 2015 Regular Session, House Bill 49 was proposed, but not passed. It would have required additional disclosure then what is currently being done at the state level. It dug down into what is called fund to fund managers. This session we currently have Senate Bill 2, which has been filed and is under consideration. It would do much of the same as House Bill 49 with regards to fees, but it takes another step and starts to incorporate performance-related items, specifically carried interest. Outside of Kentucky, several states, including South Carolina and New Jersey have come under some media attention with regards to fees, specifically with alternative assets. South Carolina, which will be noted later, has been pretty active within this space.
The state of Kentucky is dealing with multi-billion dollar funds. There is no standard on reporting fees at a state level, and it is very difficult to understand what plans are spending and how they are spending.
GASB Statement 67, which was a revision of GASB Statement 25, basically dictates that states should report investment expenses that can be separable from investment income or administrative expenses. It places the onus on the state plans and sponsors to determine what can or cannot be separated from income. Specifically it relates to alternative assets. One issue is the fact that GASB Statement 25 was initially written in 1994, when the average plan had about 95 percent of their assets in U.S. stocks and bonds, which are easily priced securities. With the recent rise of alternative assets and other alternative strategies, more complicated assets and investment structures have also brought more complicated terms and fee agreements. Mr. Cracraft stated that it makes relative comparison difficult and, even within Kentucky, the two larger plans are doing things slightly different.
The Legislative Research Commission (LRC) staff calculated peer group provided expense numbers to the board in January, which included information from 35 funds by just pulling publicly available annual reports. The statements of net plan assets for each state includes a line item for investment expense, which is the number that is used to calculate this peer group. The average fee is 41 basis points, but if you look at the individual states it ranges from a low of 7 basis points to a high of 139 basis points. This is about a 130 plus basis point difference between what one state may report and what another state may report. In Kentucky there is a wide range of results due to the way assets are allocated, but also due to the way expenses are reported. Mr. Cracraft stated the Kentucky Retirement Systems (KRS) staff adjusted how they reported fees in 2015 and their reported fees were 69 basis points, or more than $81,000,000. This was up from 40 basis points in fiscal year 2014 and $46,000,000 of the adjustment was due to a change in reporting some additional private equity and absolute return performance fees.
Mr. Cracraft explained what the different asset classes and asset types include when it comes to fees and what is really impacting a plan’s fees. Asset allocations that consist of stocks and bonds is the least expensive plan due to having almost no alternative. These assets tend to have a lower expense ratio and largely do not have performance fees. Basically, it is paying a management fee that is based on a market value and it is directly invoiced based on the current market value at the end of each quarter. Smaller impacts would be internal costs. With internal costs, some plans, even within Kentucky, will report investment salaries, operational expenses, compliance, or operations as an investment fee instead of an administrative cost. With utilization of internal versus external, Georgia is a good example of a plan who does a lot of internal management and not much alternative assets and that helps reduce the amount of fees that are being paid to external vendors. With fund to funds, most plans in this industry are not reporting underlying fund to fund fees within investment expense. What is generally reported is the topline manager who is responsible for the relationship. Anything occurring within the fund itself is paid out of performance or out of the fund. This could potentially have significant impact depending on the size of the mandates. Generally fund to funds are seen within the private equity or absolute return asset classes. If a fund has a large enough allocation to one of the fund to funds and it starts to incorporate the underlying managers, a dramatic or significant impact could be seen in the basis point or total expense at the fund level. If it is a smaller fund or if it does not have a lot of performance fees then it would probably be more of a minimal impact. The alternative asset classes are going to have a larger impact on the total amount of fees that a fund is paying. If you remove the plans that do not have alternative assets and shorten the peer group to those who do have alternative assets, whether it be primarily private equity or hedge funds, it will have an impact. Depending on how the fees are treated, whether it is recorded on financial statements or netted out of income or out of earnings, it is going to be a significant impact. Most alternative assets are not directly invoiced to the underlying plan sponsors. Generally, it is paid out of the fund itself.
Mr. Cracraft explained that what some of the states are doing is so different and makes them difficult to track. As he mentioned earlier, back in 1994 most plans were in public equities and public bonds. Now, with a public equity portfolio, it is very straight forward on how fees are collected. Most generally charge a management fee, and more recently performance fees, but historically an invoice is received at the end of the quarter based off your market value.
Senator Bowen commented on how costs cannot be invoiced, but the majority are netted against income and how that may be complex as far as transparency is concerned. He asked should the people responsible for those funds be able to dig that out. That would be a vital tool if he were to be sitting on an investment board or any type of board. Mr. Cracraft answered that what is occurring is more people are calling for standardization. With no requirement, all the burden is being placed on the state at the plan sponsor level. He agreed with the benefits of standardization, not only knowing the total cost of something and to validate that cost itself, but also to be able to make a relative comparison of other investment strategies. He stated the industry does not incorporate that standardization just yet.
Mr. Cracraft went on to say beyond the management fee for private equity, there are some performance related fees. Mr. Cracraft characterized these fees as carried interest because that is the general term used by the private equity industry. Basically what this represents is that in a general partnership with limited partners, there is an agreement to share profits after a certain return is met, which is called a preferred return. Generally after a preferred return of 6 to 8 percent is met, the general partner retains a portion of the earnings above that or a portion of the profits. One of the difficult things with carried interest within private equity, is that it is dealing with largely illiquid assets and these partnerships generally last from seven to 15 years. A general partner is sourcing companies over the first 3 to 5 years of the relationship, and drawing capital from the limited partners to purchasing underlying companies. The general partners then work those investments over the next 3-5 years to sell in the later stages or potentially take public to begin harvesting the returns. The manner of which these funds calculate carried interest can differ. Some private equity partnerships or really any partnership may accrue carried interest as the valuations of the underlying companies change. Some may actually realize carried interest at the time the asset is disposed. Disposal of all the assets do not occur at the same time and depend on the timing of the underlying investment and how quickly it improves. Others tend to wait until a termination of the fund and a pay out of a portion of carried interest at that point. In the end, something that is moving over a seven to 12 year period can go up or down based on the evaluation of the underlying companies or what it is actually realized at. While that information is generally reported on statements, it is not always known if it is accrued or realized. The other aspect of carried interest is it may be retained at times of disbursement of earnings and is not something that clearly booked at a custodial level or paid via an invoice.
There are several other fees that are related with these partnerships. Most partnerships require an annual audit so the limited partners will share that cost. Portfolio company fees are fees that general partners are paid for monitoring underlying companies. There are also broken deal expenses. While most partnerships do disclose these fees, it can be buried deep in the contract negotiations and within the footnotes of the statements.
Mr. Cracraft continued with hedge funds, which utilize a similar structure in the sense that there is a base management fee and an incentive fee. Some people might say 2 and 20 terms, with 2 representing the management fee, which has recently been more like 1.5 percent in several cases. The incentive fee is very much like carried interest, the difference is asset class includes liquid assets that are generally not held for more than a year and are very easy to price. Most absolute return structures will basically accrue the fee over a calendar year period and a performance fee is paid at the end of the calendar year or cycle. Also included are provisions such as a high-water mark, which state that a hedge fund can only charge a performance fee if it has exceeded their previous high. So the argument is it cannot earn a performance fee on the same dollar twice. Another provision is a claw back provision, which allows investors to potentially recapture fees if performance were to reverse in a subsequent period of time after performance fees have been incurred. Sometimes, claw back and high-water marks are seen with private equity as well, but are more generally associated with hedge funds.
Real estate and real assets can basically have one of the two structures that were previously explained. Some real estate investments are more long term and illiquid and may have more of what would be called a private equity type structure. There are also investment that have things that are fairly liquid, such as a commodity portfolio or even a real estate asset class that is traded publicly as Real Estate Investment Trust (REITs). Those might have a more traditional invoice type set up or an absolute return structure of paying carried interest or incentive fee on an annual basis.
Mr. Cracraft explained how plans are reporting expenses (total dollar reported on the statement of net plan assets). There are three general categories. The funds at the higher end of reported fees are those who tend to be providing more disclosure. These are funds that are trying to identify those carried interest type items such as fund to funds or other fees that are generally linked to alternatives and basically reporting them as an investment expense. The second category, or partial disclosure, are plans that are reporting some expenses within alternative assets but typically do not incorporate the performance related fees. Management fees are being recorded and then a note is included to the financials that state additional fees or additional costs were incurred but were either netted from income or deducted from earnings or another type of setup. Some states will even provide dollar amounts of these additional fees, and other states will add a footnote. The third category includes a hand full of states that are providing no or limited disclosure. Financial statements tend to just report fees that have been directly invoiced, largely the U.S. equity and bonds. Even if a plan has reported alternative assets, it reports a fee of zero and then generally will add a note, but some states do not even add a note, it just shows zero fees. New Hampshire and Tennessee are examples of two states that are in that limited or no disclosure category. Kentucky’s two larger plans are in the more and partial disclosure spaces. KTRS is recording management fees for the private equity partnerships and the private credit type deals, but are not incorporating carried interests. KTRS currently treat that as a sharing of profit and so it is deducted from the net income line. KRS is trying to incorporate carried interest and some other alternative private performance fees.
Mr. Cracraft addressed an earlier question from Senator Bowen, he stated there is a lot of reasoning for standardization and if looking at what states like Missouri and South Carolina are doing, it does lend a credence to the argument that gaining this information is important.
One of the biggest issues is that there is really no requirement or standard currently set. When this Board heard a presentation from CEM Benchmarking in late 2015, one of the things mentioned was a new standard that was being produced by a group called Institutional Limited Partners Association (ILPA). This group’s primary focus is on private equity and limited partner relationships. In January, ILPA, released a template that is believed to be the first attempt at unifying and consolidating all the fee information. It is actually an Excel spreadsheet that the limited partners can send to their general partners to gain the information and it includes things such as carried interest and those other types of portfolio company fees. CEM Benchmarking is also calling for more disclosure. CEM Benchmarking wrote a whitepaper in 2015 that stated the need to create some level of standard, which highlighted the confusion that GASB standards have created. The paper also discussed the difficultly plan sponsors face with getting information from the general partners and the need for more clarity.
South Carolina hired CEM Benchmarking, much like KRS did, and South Carolina thought their fees were going to match what the CEM Benchmarking would report. CEM Benchmarking provided a number that was quite a bit higher then what was reported and so South Carolina found, like Kentucky, they were not incurring any additional fees, but the way they were recorded was not the same. South Carolina has undergone a process over the last couple of years to try to gather information and book it as an investment expense, which is why it is on the higher end. One of the things noted in the CEM Benchmarking white paper is that recording these fees was a very manual process. In November, an article in the Wall Street Journal explained how South Carolina dedicated five full time staff members to source through financial statements of the general partners to pull quarterly fee amounts, whether it be carried interest or portfolio company fees. Not only is it necessary to have human resources, but also a clear understanding of the terms, because every general partner is calculating carried interest slightly different. Currently, the burden is being placed at the planned sponsor level.
Mr. Cracraft discussed what level of disclosure is required after deciding what information is wanted. Most states are reporting fee information or expense information annually and incorporating it in their annual reports. GASB requires that investment expense be incorporated in the financial statements. In most cases, state plans are also including additional schedules that outline fees at a manager level, an asset class level, or total external manager fees. Mr. Cracraft referred to Slide 10 of the handout and stated 41 out of 50 states are providing at least asset class level data, 19 of those 41 are actually providing manager level detail. Kentucky’s two larger funds that have multiple managers are doing both at asset class and KTRS also discloses information at a manager level. The fee information is generally provided at a total dollar amount, but does not include a breakdown of management or performance fees. Having this level of disclosure could help in the case you have two managers that are doing the same thing and one has a higher reported fee. That higher fee may also have been earned because their performance has been better.
A trend in the states, as well as in Kentucky, is to try and pull in more cost information. One of the real handicaps is as asset allocation has grown and become more complex, and as plans have started to invest in more unique asset strategies, the level of reporting that is required is really the same as it was two decades ago. While the asset terms and structures have become more complex, the reporting functions have not kept up. This leads to the inconsistency that the peer group shows and makes relative comparisons pretty hard if not impossible.
Mr. Cracraft spoke to the call for standardization and noted there are a lot of benefits, but finding the information can be a burden on plans. Without a change in requirement, it’s also difficult to know if managers will participate. Lastly, if managers do participate, will they provide the data in the formats that is needed at the plan sponsor level.
When looking at what is considered a fee, all states already consider items directly invoiced. Some states, including Kentucky, are recording private equity or other alternative management fees.
Lastly, Mr. Cracraft discussed what level of disclosure is needed. Once finding out the data needed, it is important to understand if manager level data is enough, or is a fee a management fee versus performance or another fee. It is important to understand and comprehend what is driving the total fee number.
Representative Simpson asked if it is typical to do requests for proposals and if that is the case, could a proposal mandate required information. He also asked what type of investments. Mr. Cracraft answered within public equities or bond portfolios it is possible to see a request for proposal and a request for information. Within the alternative space, that type of network and system is not seen. Generally, (using private equity as an example) most funds that are investing in this space have consultants that help source investment and private equity investments which are arranged across different vintage years. So there might be a buyout fund in 2016 and that fund will not be raising a new fund until that fund is fully invested 5 or 6 years later. Plans try to manage the vintage year exposure, so they would not invest in buyouts for 3 consecutive years. Generally, in this space, consultants and state investment staffs work together to source which funds are fundraising and whether or not those are funds they would be interested participating in. The way it works is if a plan, such as KRS (using Blackstone as example) invests in the Blackstone Fund I, and it does well, when Blackstone begins to fundraise for Fund II, a lot of times plans choose to re-up or invest again. So it may be investors in fund I and then it might participate in fund II, and so on. Partnering with a good firm it is possible to continue to participate in their strategies. It is somewhat the model that KTRS is using to try to identify good partners and as it continues to introduce new funds for their schedule to re-up and keep the number of partnerships lower. Only more recently have the pension plans been able to start to drive some of the terms.
Representative Simpson asked if it was typical to put requirements on agreements or restrict their investment recommendations to funds that clarified the amount of fees. Mr. Cracraft responded that he could not answer that question without doing more research. He believes that the plans could probably dictate to the consultants that they only want to invest in funds that are going to follow ILPA standards, but the argument could be made that the funds that produce the highest returns or that have produced historically the best returns do not follow that standard. It is possible to subject yourself to maybe a less qualified investment just to get the reporting.
Representative Simpson asked has any state that has seen active laws that would cover this topic of transparency. Mr. Cracraft responded he did not know.
Senator Bowen commented that this is a reflection of how the Public Pension Oversight Board (PPOB) has evolved and that the quality of the information is better, and the questions asked are more astute as we grow and mature as a board this whole process is elevated. He stated that going forward he would suggest that the questions should be directed more towards the investment committees. The exercise would help those boards perform in the most efficient and highest level possible because obviously in some measure this is a partnership.
Senator Higdon referred to Mr. Cracraft talking about reporting private equity as muddy. He asked if Mr. Cracraft could elaborate more on the use of that term with those particular funds and the transparency there. Mr. Cracraft noted that a lot had happened in the industry over the past 5-10 years. Five years ago, most of these private equity general partners pretty much did anything with regards to reporting and disclosure until the market correction in 2008-2009. Most of the larger firms, that have experience relationships with public funds, have adapted and do a good job of reporting management fees. Mr. Cracraft even argued that most were providing some level of carried interest, but there were other types of fees that were usually buried. Mr. Cracraft noted a couple recent settlements involving private equity firms KKR and Blackstone, which highlighted other types of fees, included broken deal fees and portfolio monitoring fees. The settlements were significant and highlighted the difficult and sometime unclear nature of these other fees.
Auditor Harmon asked about retaining the 20 percent of the excess funds or preferred return and what analysis determines the preferred return and is it an assumed rate for the overall portfolio or is it a different investment strategy. Mr. Cracraft answered that it is generally dictated at time of investment. When a pension fund presents a private equity investment, it is included in the terms and for most private equity investments it is generally in the 6 percent to 8 percent range. For some of the fund to funds or the hedge funds it could be lower or might be a risk free rate plus some static amount. The preferred return is a fairly standard amount and depends on type of investment, such as venture capital, distressed debt, or a buyout portfolio. These all have different tiers of preferred return.
James Mac Jefferson commented that the report was not easily put together and that he was sure Mr. Cracraft did not just Google investment fees and pull it right off the shelf and that there really is not a comprehensible report like this. He asked what the carried interest would be in the example of the hospital going forward 10 years and to explain in a positive outcome sale and a negative or break even. Also, what the carried interest would have been hypothetically and how that would impact what fund is charged or what the limited partner is charged. Mr. Cracraft stated assuming the fund bought the hospital for $100,000,000 and held it for 3 to 5 years, then ultimately took it public and did an initial public offering and valued the company in the initial IPO price at $200,000,000. Basically, the cost would be $100,000,000. With a guarantee of a 5 percent return over a five year period, that would be a 25 percent return. A guaranteed 5 percent return annualized would now make that investment $125,000,000 and the general partner would keep 20 percent of that additional $75,000,000. The fund may accrue over time as it valued the hospital or it could wait and record the carried interest at time of disposal. Mr. Cracraft stated this would be the way it would work using a very simplistic model and also noted that most private equity partnerships also return your management fees before the 20 percent carry is calculated. The general partner is only retaining 20 percent of the net profit above the preferred return and after the paid management fees.
James Mac Jefferson asked if the outcome was negative and the fund was accruing carried interest along the way, would any carried interest be owed if the outcome was $100,000,000, and would that be an even break. Mr. Cracraft answered yes, even if the final outcome was $120,000,000, in that case it would not have exceeded the preferred return and no carried interest was be due. If the general partner had accrued some value for carried interest based on a previous value of the hospital, once the final proceeds of $120,000,000 were realized, the accrued amount would be reversed.
James Mac Jefferson asked if the complicated thing in reporting these fees is that carried interest is accrued annually and if there is a negative outcome, it is actually never paid. Mr. Cracraft answered some of the examples that are included in the first appendix (handout) do point to this. In some cases there is a reported negative fee at a manager level and some of that is due to the fact that most of the state funds are on a June 30 fiscal year and a lot of these partnerships are on a calendar year.
Sharon Mattingly asked how this is all driven by the terms of private equity contracted sale and who reviews those private equity contracts for Kentucky. Mr. Cracraft answered he could speak with KRS and went on to say the plan does have an internal legal staff and a contract with a third party attorney who takes the lead on these issues. KRS has a template checklist for things to ask for and they utilize a legal firm out of Wisconsin. A lot of these things have side letters that are for each particular limited partner. Mr. Cracraft indicated that his understanding was that KRS internal legal staff helped the investment staff with that process.
Legislative Update (handout)
Brad Gross, Legislative Research Commission, provided a legislative update about bills that are in the General Assembly that relate to pensions, such as funding, transparency reporting requirements, housekeeping bills, and bills about reemployment after retirement. Currently there are 27 bills being followed and the last day to request new bills was February 19. The last day to file new House bills is March 1, the last day to file new Senate bills is March 3 and certainly Sine Die is April 12. The pension bills can be followed under the Legislative Research Commission’s website by going to retirement and pensions. When a pension bill is written, it is categorized under this heading and it is fairly easy to follow on a day to day basis.
When talking about legislative items, and pulling bills up on the Legislative Record there are all kinds of letters next to the bill number. The actuarial Analysis (AA) is an important item relative to pension bills because any bill that has an impact on the unfunded liabilities or participation in benefits of a state administrative retirement system requires an actuarial analysis. Local Mandates (LM) are also often done as well as Fiscal Notes (FN).
Relative to the Governor’s state budget proposal, KRS has proposed two different numbers when talking about the ARC. Technically the ARC, for example, is KERS nonhazardous fund at 47.28 percent of payroll. This value came from the 2015 valuation. However, the KRS board has recommended reducing the assumed rate of return from 7.5 percent down to 6.75 and if that rate was utilized now instead of later, that ARC would be 48.59 percent of pay, which is the number that is included in the budget as well as the projection for that second year. A lot of discussion has occurred in past meeting about the cash flow for the KERS nonhazardous pension fund, and last year, despite paying the full ARC of 38.77 percent of payroll, the pension fund saw a decline of $250,000,000. Some of the discussion at that time was even if the assumed rate of return had been earned that the funds still would have lost ground as far as the asset base. Looking at the ARC payments that are set in the Governor’s budget and if all these contingent monies go specifically to KERS nonhazardous pension fund, the fund could, assuming future payroll stays the same and the systems earn 6.75 percent, could see some minor asset gains in the following fiscal years.
According to KTRS, the amount needed to fund the pension fund on actuarial sound basis is roughly $520,000,000 in FY 2017 and $513,000,000 in FY 2018. Incorporating reduced debt service for bonds that have been previously issued, that number is closer $510,800,000 and $493,600,000 for each year respectively. Looking at the appropriations that are made to KTRS, the Governor’s budget provides about 60 percent of that value. So about 60 percent of the ARC is being paid. With the contingent appropriations it could move up to 65 percent or 66 percent of that amount as well.
Other funding bills include Speaker Stumbo’s bill which would authorize $3,300,000,000 in bonds to address the KTRS pension fund issues, would require payment of the ARC in FY 2015, and would begin a process to phase into the full ARC with general fund contributions over a nine year period and utilizing those bonds to pay the difference over that timeframe. This bill last year was House Bill 4.
Other bills that have been introduced include Senate Bill 2, by Chairman Bowen, which has passed out of the Senate and addresses several issues that were recommendations of the PPOB and some items that were discussed today. As far as fee reporting it will require all of those individual fees that Bo Cracraft discussed today also be reported. It would require that the systems to be subject to the Model Procurement Code. It would modify the definition of an investment expert for the two members appointed by the Governor to the KRS Board. It would add appointed members to the KTRS Board and would require Senate confirmation of those board members and the executive director. It would also put KRS back under the state personnel system and would add six additional legislators to the PPOB. The bill passed the Senate 38 to 0.
Senate Bill 45 requires disclosure of retirement benefits of current and former legislatures and passed the Senate 38 to 0.
House Bill 238 is a bill that was introduced last year. It would require a standardized approach to what is included in the actuarial valuations. It would require experienced studies on all the retirement systems on a five year basis. It would require reporting of the valuation by November 15. Currently the valuations are being done sometime in November, but typically in the December range. Also, an actuarial analysis, the same way bills are done on any changes made the board, is required under the bill. It would also require the PPOB to retain an actuary to do an actuarial audit, which is a second check on the existing actuary, at least once every ten years and to have that actuary review the budget’s needs of the systems prior to each budget biennium. The bill passed the House 95 to 0.
Senate Bill 113, the Judicial Form Retirement System housekeeping bill, passed the Senate 38 to 0.
House Bill 153, an issue discussed during the interim about volunteer issues or paid volunteer issues with the KRS passed the House 95 to 0.
House Bill 263, a measure that limits the two appointed trustees to the KRS Board by the Governor that must have investment experience, passed the House 92 to 0. It actually limits it in a similar fashion than Senate Bill 2, but it also provides that the Governor may appoint them from a list submitted by the CFA Society of Louisville.
Senate Bill 72, allows members of the Legislative Retirement Plan (LRP) to elect to have benefits based solely upon legislative salary and any salary earned in the state retirement system prior to January 1, 2014. The bill passed the Senate 37 to 0.
House Bill 172 relates to death before retirement benefits for KTRS. There are situations where an individual is receiving survivor benefits and if they are remarried they lose those benefits in KTRS. This bill would create a situation where they would not. The bill passed House 93 to 0.
With no further business to come before the board, the meeting was adjourned at 1:54 p.m. The next regularly scheduled meeting of the board will be Monday, March 28, 2016 at 12:00 p.m.