Call to Order and Roll Call
The 6th meeting of the Public Pension Oversight Board was held on Monday, August 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; Senator Gerald A. Neal, Representative Brian Linder, John Chilton, Mitchel Denham, Timothy Fyffe, Mike Harmon, James M. "Mac" Jefferson, Sharon Mattingly, and Alison Stemler.
Guests: Donna Early, Executive Director, Judicial Form Retirement System; Donald L. Asfahl, President, Hilliard Lyons; Andrew W. Means, Director of Investments, Hilliard Lyons; Judge Laurance Vanmeter, Kentucky Court of Appeals; David Peden, Chief Investment Officer, Kentucky Retirement Systems; Tony Johnson, Director of Midwest Consulting and a Senior Consultant, R.V. Kuhns & Associates, Inc.; Beau Barnes, Deputy Executive Director, Kentucky Teachers’ Retirement System; and Max Kotary, Partner & Investment Consultant, AON Hewitt
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.
Representative Yonts introduced Timothy Fyffe as a new member to the Public Pension Oversight Board (PPOB). Mr. Fyffe works for Central Bank and is a Chartered Financial Analyst who is involved in business development and investment management for the banks’ high net worth and institutional clients. Mr. Fyffe manages fixed income and equities for personal trusts, employee benefit accounts, and foundation accounts.
Approval of Minutes
Senator Bowen moved that the minutes of the June 27, 2016, meeting be approved. Mac Jefferson seconded the motion, and the minutes were approved without objection.
Judicial Form Retirement System Investment Update (FY 2016)
Donna Early, Executive Director, Judicial Form Retirement System (JFRS), introduced Donald Asfahl, President and Andrew Means, Director of Investments, Hilliard Lyons. Mr. Asfahl stated that Hilliard Lyons Trust Company has about $8.3 billion in assets for individual clients and endowment foundation retirement plans. Current asset allocation as of June 30, 2016, for the judicial defined benefit plan, as well as the legislators defined benefit plan, is about 74 percent equities and about 26 percent fixed income. The cash assets within the portfolio are in custody at State Street. The investment policy is 60 to 80 percent equities with a target of 70 percent and 20 to 40 percent fixed income with a target of 30 percent. The current yield of the equity portfolio is 2.6 percent and about 3.5 percent on fixed income, for a total of 2.9 percent. Dividends are up about 13 percent over the last twelve months ending in June.
Mr. Means explained the investment philosophy and approach. The core equity portfolio focuses on the long-term ownership of great companies purchased at compelling valuations. Underlying the equity approach is a realization that large concentrations of wealth generally result from long-term ownership of successful businesses. The second aspect is identifying management that has shown an ability to maintain that business advantage, looking to buy businesses for clients at discounted prices, and investing from the perspective of a long-term business owner. The average holding period of each investment in the portfolio is around thirteen to fifteen years. The goal is to find great companies, be long-term owners, and let the businesses generate attractive rates of return over long periods of time.
Mr. Means discussed the portfolio’s processes for reducing the risk of owning equities. The portfolio attempts to mitigate business risk by looking for companies with long-term competitive and sustainable advantages. Hilliard Lyons reduces company risk by identifying management teams that allocate the capital intelligently and for the benefit of shareholders. Price risk is minimized by establishing an intrinsic value for each business that is evaluated and by making the investment at a discount to what that intrinsic value is.
Mr. Asfahl discussed the fixed income side of the portfolios, which represents roughly 26 percent of the overall portfolios. Every holding in the portfolio is investment grade. The lowest rated credit holding rating is at least BBB+ and represents only five percent of the portfolio, while everything else is an AA credit rating or above. The portfolio is underweighted treasuries around eight percent relative to the intermediate index, which is approximately 56 percent treasuries. The portfolio’s total yield is about 3.5 percent versus the index at 2.4 percent, which is primarily due to the index’s larger allocation to treasuries and government bonds which have a lower yield than corporate credit. The portfolio’s duration, which is present value of future cash flows, is shorter than the index at about 3.4 years versus four years for the index.
Mr. Means noted that the judicial and legislative plans’ performance is almost identical given that the strategies have been managed identically and own about the same securities. Over the last year, the LRP portfolio was up 3.3 percent versus 4.3 percent for the 70 percent equity and 30 percent fixed income benchmark. The performance goal for the equities is to substantially outperform the S & P 500 over a full market cycle. For JRP, during this last one year period the equities were up 3.29 percent vs. 3.99 percent for the S & P 500. The trailing three year period return was slightly over the index, while the five year return was over 300 basis points better. Looking at the ten-, fifteen-, and twenty-year returns, all have substantially beaten the S & P 500. Fees have ranged between six to eight basis points during those time periods. LRP numbers are very similar.
Responding to a question by Senator Bowen, Mr. Means and Mr. Asfahl said that Hilliard Lyons would not object to the transparency requirement of the Model Procurement Code (MPC).
Responding to a question by Director John Chilton, Mr. Means stated, in regards to future investment returns, with interest rates being at such low levels, it is likely that in the short to intermediate term returns from the fixed income are going to be below historical normals. For equities, he stated a similar story in the short to intermediate term is likely given the prospect of a rising interest rate market in the near future.
In response to a question from Representative Yonts, Ms. Early and Mr. Vanmeter stated that the investment committees are involved in discussions with Hilliard Lyons at each meeting regarding changes in asset investments.
In response to questions from Representative Jerry Miller, Mr. Asfahl said Hilliard Lyons has been managing JFRS assets since 1993 and that the total portfolio for JFRS and others was currently valued at approximately $8.3 billion. Mr. Asfahl also stated that Hilliard Lyons business is very scalable given the large cap nature and liquidity of the underlying portfolio.
Kentucky Retirement System Investment Update (FY2016)
David Peden, Chief Investment Officer, Kentucky Retirement Systems, and Tony Johnson, Director of Midwest Consulting and a Senior Consultant, R.V. Kuhns & Associates, Inc., presented.
Mr. Peden discussed investment performance and how 90 percent is a function of asset allocation, while the remaining 10 percent is the result of manager selection and rebalancing. The goal of an asset allocation is to strike the right balance between risk and return, which is what the asset liability modeling process seeks to do. Drawing the members’ attention to recent asset class performance, Mr. Peden noted that the S & P 500 index had returned 12.1 percent for the last five years, which is above its longer term historical return of just below 10 percent. Additionally, the NCREIF had a return of 12.2 percent for the past five years with a very low risk versus its longer term historical returns. When looking at risk across each of the time periods, Mr. Peden said the volatility of fund of funds or hedge funds was not much greater than fixed income and that risk was the main driver for why KRS utilized this asset class.
Mr. Peden discussed the target asset allocation for each plan, and noted that KRS includes the information as an appendix of the investment policy statement which is available on the company website. The table shows which asset classes in which KRS invested, the benchmarks for each asset class, and the allowable rate for rebalancing. Mr. Peden noted that the Kentucky Employees Retirement System (KERS) and State Police Retirement System (SPRS) portfolios are beginning to deviate from the three relatively healthy plans and five insurance portfolios.
Responding to a question from Representative Yonts, Mr. Peden explained that SPRS and KERS are largely deviating due to a liquidity crunch and the fact that both are shrinking in value. Given liquidity needs, KRS is moving away from illiquid asset classes for KERS, such as private equity where KRS has not made a private equity investment for this fund since 2009. With regards to SPRS, this was the first year that no private equity investments have been made. Mr. Peden did note that the additional $25 million budgeted above the ARC for SPRS made a huge difference in its unfunded liability and if it was feasible to follow that up in the next budget cycle as well, staff could possibly put them back into a more than normal 7.5 percent return target.
Mr. Johnson discussed the long term benefits of being diversified across all markets. As a firm, R.V. Kuhns believes equities will do well in the long run and bonds will be challenged in coming events as yields start to go up and bond returns challenged.
Mr. Johnson referenced a R.V. Kuhns & Associates, Inc. study that compared how large pension funds, like KRS, allocated across multiple asset classes. The study began with 1995 and moved forward every month calculating a trailing 10-year returns through December 31, 2015. The study calculated a 10 year return for a 60 percent U.S. equity and 40 percent U.S. fixed income portfolio and compared it to the return of diversified portfolio. Over the period studied, 88 percent of the time the diversified portfolio outperformed the 60/40 portfolio. It was not until the last 10 year period that a 60/40 portfolio has outperformed a more diversified portfolio. Several factors have driven this change, most notably the recession experienced in 2008. Looking forward, research shows that equity valuations in the U.S. market are overvalued and stock values are high relative to other markets. If one believes in reversion of the mean, than one would expect the U.S. market to come down and the lower valuations that are seen in international markets and emerging markets will become more attractive. Also, as interest rates start to move up and fixed income is challenged from a returns standpoint, the more basic 60/40 portfolio return will begin to decline.
In response to questions by Senator Bowen, Mr. Johnson said once interest rates begin to climb, a reversal of what is going on globally will occur and a rebalancing of people investing more globally will be seen. In a 60/40 portfolio, bonds have historically been used as the ultimate protector that would earn about seven to 10 percent, but bonds today are not projected to earn more than three to four percent in the future. The only way to reach the goal is to diversify to markets beyond the U.S. Looking forward, the KRS portfolio is positioned well for the future, and it just has not been positioned well for all the bank intervention and concentration of investments within the U.S.
Responding to questions from Auditor Mike Harmon, Mr. Peden said there is a secondary market for private equity but the plan would have to take a discount when selling. The maturity level of each investment is generally between seven and ten years, with a few investments possibly lasting up to fourteen years. In terms of having meaningful dollars in one particular private equity manager, around the eight to nine year mark is when it will peak and roll over.
Mr. Peden continued with a review of composite performance, which he noted was becoming less important given each individual system is its own entity and allocations are differing. In terms of performance drivers for the year, the more real estate, private equity, core fixed income, and U.S. large cap equity exposure a portfolio had the better it did. The more non-U.S. equity, U.S. small mid cap equity, and hedge funds exposure, the worse the plan performed.
Mr. Peden discussed underlying plan performance beginning with the insurance plans, which all had negative absolute performance, but each plan was pretty close to or outperformed the benchmark.
On the pension side, it was a bit different as a few plans beat their benchmark for the fiscal year, while a couple were a bit more challenging. The KERS non-hazardous and SPRS have different allocations and those were the two plans that trailed the other three. This was mostly due to the change in asset allocation that occurred on January 1. The three healthier plans, KERS hazardous, County Employees Retirement System (CERS) non-hazardous, and CERS hazardous, all rebalanced or purchased additional equity exposure at a low point in the equity market, which SPRS and KERS non-hazardous did not get to participate in. Additionally, KERS’ exposure to private equity is rather dated and mature at this point, which is limiting the upside or appreciation remaining and is serving to drag performance. At this point, KERS non-hazardous still has a lot of capitol tied up in private equity, and its private equity is not being as additive to the portfolios as KRS would like. There is not a lot that can be done except be patient, let it mature, or look at doing a secondary sale. KRS has already done one secondary sale, and it is a reason why the pension private equity portfolio as a whole only did 5.5 percent, while the insurance private equity returned over 10 percent last year. The private equity assets in the insurance plan is more representative of what could be done in private equity.
Mr. Peden explained how the first half of the fiscal year was very difficult and the portfolio ended December down 2.95 percent. January continued to be a difficult market and the portfolio hit a low point at the end of January when it was down 5.56 percent. The second half of the fiscal year was positive and the portfolio got back to only 50 basis points down for the year. The year ending with a great quarter, being up 1.3 percent and the portfolio allocation actually started working well during the last four months. Value stocks are doing better than growth, active management is doing better than passive, and positive contributions from both real return and absolute return will be seen. Mr. Peden stated that KRS is in the bottom third of risk in the peer group from a standard deviation standpoint. Based on funding, the ratio should be in the bottom third in terms of the amount of risk taken. KRS is trying to improve the portfolio from a performance standpoint, but from a risk perspective KRS is exactly where it wants to be.
Responding to questions from Senator Bowen, Mr. Peden stated that CEM Benchmarking Inc. (CEM) study that was presented during the June meeting is the best option available for considering the industry standard on what fees should be. Considering a funds philosophy and asset allocation targets and trying to compare similar plans is the best way to do a comparison at this point.
Responding to a question from Representative Yonts, Mr. Peden said KRS has created a four person investment accounting team that is dedicated to investment operations and are tasked with capturing data for useable information and these responsibilities have become full time positions.
Responding to questions from Timothy Fyffe, Mr. Johnson stated that R.V. Kuhns and KRS staff do have access to allocation information with other plans in the industry, however it is at a broad level. Mr. Johnson said that adjustments made to the portfolio are based on the systems specific needs from a return standpoint and risk standpoint.
Responding to a question from Mr. Fyffe, Mr. Peden noted that 20 percent of the MSCI all country world index is emerging markets. The previous asset allocation targets included a dedicated additional four percent allocation largely to juice up the return. The new allocation does increase total exposure, but the dedicated allocation was removed.
Responding to a question from Mr. Fyffe, Mr. Johnson discussed how R.V. Kuhns evaluates current market valuations. When looking at valuations, the firm looks back historically over the entire timeframe using a representative index. For instance, within the large cap U.S. market, R.V. Kuhns uses the S & P 500 over its history and reviews normal or historical valuations. These historical values can then be compared to more recent periods, such as today where earnings and dividends are historically high. Using this information, one can project the expected return given a normalized range of earnings and dividends. When looking back to R.V. Kuhns most recent forecast which was done in 2015, the U.S. market was viewed as being richly valued relative to its historical average. The current return expectation for U.S. market is going to come down slightly given it is still above the historical normals. Looking at international markets, the valuations are relatively low compared to the U.S. market place. Projecting out over a ten to twenty year period, those averages are going to come up. The forecasted view is that investors should be overweight if not equal weight to the U.S. market. Lastly, the strength of the U.S. dollar has been strong for so long that when converting international investments into U.S. market places it actually drags valuations down. Watching the valuation of the dollar come down, the benefits of the international markets just on the currency basis alone starts to show positive effects in the market place.
Responding to a question by Senator Damon Thayer, Mr. Peden stated that the cash infusion that SB 2 required the legislature to meet is invested into the broad investment portfolio. However, the employer contribution last year was around $500 million and the employee contributions around $100 million. KRS pays out $900 million in benefits and refunds, so it will still take a number of years before the portfolio will not be shrinking and staff can fully invest the additional contributions. The ARC plus that was given in the more recent budget just went into effect in July, but that obviously helps escalate that difference.
Responding to a question by John Chilton, Mr. Peden discussed return expectations. Cash is currently earning between 0 and 50 basis points, while in fixed income, the 10-year yielding is at 1.5 percent which put the total fixed income yielding just shy of two percent at the start of last fiscal year. Within core fixed income the index just returned six percent and KRS had one particular enhanced index manager that returned 6.6 percent. This was not expected given the expectation of rising rates. In fact, due to the Brexit and fear around that decision, core fixed income returned 1.8 percent in June alone. So given these returns, one would expect some reversal within fixed income. So with the core fixed income earning two percent or less and cash being 0 to 50 bases points, equities are going to be required to do a ton of heavy lifting to get any type of positive return. In fact, KRS had to add additional equities to the portfolio in order to try and create a portfolio that would earn 7.5 percent, but adding equities adds risk to the portfolio. That is part of trying to strike the balance between risk and return. Mr. Peden believes that it is going to be difficult to earn 7.5 percent in the next five year period until interest rates normalize.
Responding to a question from Representative Yonts regarding the upcoming financial audit, Mr. Peden stated that KRS had provided a number of documents to the Governor’s Office and was waiting to find out if the final audit for all systems would be a fast audit or if there was going to be a request for an extension.
Kentucky Teachers’ Retirement System Investment Update (FY2016)
Beau Barnes, Deputy Executive Director, Kentucky Teachers’ Retirement System (KTRS, and Max Kotary, Partner & Investment Consultant, AON Hewitt presented.
Mr. Barnes reiterated that it was a lackluster year in the market, noting that some asset classes struggled more than others, although many of the assets that had lackluster results this year have served the portfolio very well in prior years and were the same assets that have helped achieve good returns in past years, such as, 18.1 percent for 2014. Beyond tough markets, a big problem that KTRS had was negative cash flow. KTRS has projected that about $650 million in assets were sold during the fiscal year just to pay monthly retirement benefits. KTRS not only had to sell investments, but also had to forgo several investment opportunities when markets were down and assets were available at an undervalued price. KTRS received a cash infusion of $973 million from the budget. The first installment of about $125 million was received on July 1 and timing was positive. Markets have been up since June 3, and the portfolio has created additional funding of about $325 million in market value, which is about a two percent gain in the portfolio.
Mr. Barnes discussed how performance had historically been presented. The plan has historically reported returns gross of any fees and then reported expenses as a separate line item. The plan has been reporting net of fee returns to the oversight board, but the performance included in the presentation is still gross. Looking back, prior to 2000 the fees range between five and six basis points. KTRS was not invested in non–U.S. stocks due to it being more expensive than U.S. stocks. Also, private equity was not part of the portfolio, and real estate investments were not what they are today. The fees have increased from that historic five to six basis points to 25 basis point by the end of 2015. Compared to other pension plans in the country, the fees are still low.
Mr. Kotary provided a summary of performance during the fiscal year. When focusing on the one year numbers, the fiscal year return through June 30, 2016, was negative 1 percent. It was a challenging year on an absolute and relative basis as the policy index that measures returns was up 1.5 percent. U.S. equity, which fell 1.8 percent, and non-U.S. equity, which fell 10.8 percent, were clear underperformers. The fixed income side of the portfolio was an area of strength, up nearly seven percent and modestly outperforming the index. The additional categories, which is largely credit and higher yielding credits were also challenged from a return prospective on both an absolute and relative basis. The real estate portfolio was a standout performer on both an absolute and relative basis returning 13 percent and more than doubling the performance of the benchmark index.
Mr. Kotary highlighted the funds asset allocation relative to policy targets. As of June 30, actual asset allocation was more or less in line with all long term policy targets. Over time the plan has sought to diversify exposure to real estate, private equity, and other alternative assets, which is something the system plans to continue going forward.
Mr. Kotary discussed relative performance, noting that U.S. equity was the primary reason total performance lagged the policy benchmark. It was a very challenging market for active managers over the past year, with about 90 percent of active managers failing to add value over the benchmark index. Longer term returns remain strong compared to peers. Looking over three-, five-, or ten-years relative to a peer universe of large public plans, this system ranks in the top of that universe.
Responding to questions from Representative Yonts, Mr. Kotary stated there are two reasons why 90 percent of U.S. equity portfolios failed to outperform the broad U.S. stock market; first, fundamentals are not being rewarded or recognized in the market; and secondly, there has been an extreme focus on dividend income. Mr. Kotary also stated that with anticipated increase of the Federal interest rates the fixed income investments would be challenged. Over the past six or seven months it went from market pricing three or four Federal hikes over the forward twelve month period to it being even money as to whether or not there would even be a Fed rate hike over the twelve month period.
Mr. Kotary continued with focusing on the one year period, the medical insurance trust fund fell -1.7 percent and trailed its policy benchmark by 1.2 percent. The largest driver of relative underperformance was the additional categories asset class, which was down almost three percent relative to a benchmark return of 1.5 percent. Those are mostly credit orientated investments, high yield, bank loan, etc. Mr. Kotary also highlighted current asset allocation for the medical fund, longer term performance and noted that investments within private equity and real estate will continue to be funded over the next several years. In fact, one of the reasons the fund trailed its benchmark index was due to the time it takes to get investments in private equity and real estate working. This portfolio was below its targets during the year as it established investments to be made. When looking at performance relative to the benchmark index, about half of the reason it lagged was the portfolio was underweighted to those sectors of the market relative to its benchmark.
Responding to questions from Mac Jefferson regarding the funds current allocation, Mr. Kotary noted that fixed income was one of the stronger areas of the market over the past year and this performance has resulted in fixed income assets growing as a percentage of total pension assets. Mr. Kotary noted that staff generally will use overweights to take cash for benefits or bills. There are also times when a hard rebound is required due to assets reaching the top end of a target, however this is not preferred as long as the allocations are close given the cost involved.
Responding to a question from Mr. Chilton, Mr. Kotary stated that AON Hewitt’s view over the near term is not much different from others, with the expectation that it is going to be a challenging market. Over a longer term time horizon, looking out 10 to 30 years and looking at assumptions, 7.5 percent looks achievable.
Responding to a question from Senator Bowen, Mr. Kotary stated that AON and staff would look to make changes if there are clear opportunities, however it appears most asset classes are going to be challenging and there are not a lot of very attractive options on a relative value basis available.
Responding to questions from Auditor Harmon, Mr. Barnes said with an adjusted assumed rate the investment strategy would probably stay the same, but the actuarial measures of unfunded liability funded status, and the budget requests would change.
Performance Audit Update
John E. Chilton, Budget Director, Office of the State Budget Director stated in May a request for proposal for the pension audits for the analysis was issued. There have been multiple proposals by consultants and there is an evaluation committee that is working on negotiating a contract. Work should begin in early September.
With no further business to come before the board, the meeting was adjourned. The next regularly scheduled meeting is Monday, September 26, 2016.