Call to Order and Roll Call
The seventh meeting of the Public Pension Oversight Board was held on Monday, September 26, 2016, at 12:00 PM, 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; John Chilton, Mitchel Denham, Timothy Fyffe, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: Thomas B. Stephens, Secretary, Kentucky Personnel Cabinet; Jenny Goins, SPHR, Commissioner, Department of Employee Insurance, Kentucky Personnel Cabinet; Beau Barnes, Deputy Executive Director, Kentucky Teachers’ Retirement System, Donna Early, Executive Director, Judicial Form Retirement System; and David Eager, Interim Executive Director, Kentucky Retirement Systems.
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.
Approval of Minutes
Representative Yonts moved that the minutes of the August 22, 2016, meeting be approved. Mac Jefferson seconded the motion, and the minutes were approved without objection.
Semi-Annual Investment Review
Bo Cracraft stated that the investment review is required by statute to be reviewed twice a year. Mr. Cracraft discussed asset allocation and the seven major asset classes that the retirement plans utilize. Historically, about 90 percent of a plan’s performance or portfolio performance is based on how the systems allocate assets. There are traditional assets, which include U.S. equity, non-U.S. equity and fixed income, and there are alternative assets, which include absolute return (hedge funds), real return, real estate and private equity.
Mr. Cracraft went on to explain that a hedge fund is a fund that tries to hedge some level of risk and is a strategy that is largely trying to provide a positive absolute return regardless of the overall market. When looking at hedge funds as an asset class or as a whole, managers are more focused on capital preservation and uncorrelated return stream mostly to equity markets. One of the key differences between a hedge fund is how it is structured and if it is regulated. Hedge funds are largely not regulated by the Securities Exchange Commission (SEC) and it gives flexibility that other managers do not have, such as, investing in a wide range of securities. Hedge funds will invest in traditional stocks and bonds and use more specific techniques.
In response to a question from Senator Bowen, Mr. Cracraft said that there are similarities between a hedge fund and a mutual fund, such as in deferred comp. If investing with a life cycle fund where it is contracted with Vanguard, Vanguard then would reallocate the assets across multiple asset classes. Deferred Comp is not choosing how much is in equity or fixed income; the life cycle manager is entrusted with that duty.
Mr. Cracraft continued with two ways public pension plans are utilizing hedge funds. First, some plans have created an allocation to what Mr. Cracraft calls absolute return. Around 7 to 10 percent of the portfolio is a targeted allocation to that asset class. Even though there is a dedicated allocation, fund of funds or a direct relationship may be utilized. Looking at the LRC peer group, 14 out of the reporting 34 states have a dedicated allocation to absolute return. Secondly, instead of having a dedicated allocation, a plan could utilize hedge funds by allocating to a hedge fund within one of their existing asset classes. For instance, a public equity portfolio may hire an equity long short manager that is within that asset class, and it serves to preserve some diversification or some level of reduction of volatility. Out of the 34 states in the LRC peer group, there are an additional five states that have some level of hedge funds. Also, out of the 34 peers, roughly 19 are utilizing hedge funds in some form or fashion either through a dedicated allocation or through a component of their existing asset allocation. The long-term expectations range from 3.5 to 6 percent, risk ranges from mid-4 to 9 percent with the equity hedge, which is clearly the more volatile strategies. Proponents of utilizing hedge funds say it provides attractive risk-adjusted returns, or it can be utilized as a fixed income replacement. Opponents will argue it does not diversify or provide adequate protection.
Hedge funds performance market review in the one year did not provide the protection anticipated, and looking at the total market it was a difficult year to meet actuarial targets. In fiscal year 2016 returns, there were only a couple of line items that exceeded 6 percent. Real Estate is not a very significant allocation to any of these specific portfolios. When looking at long bonds (bonds that have a maturity greater than 10-plus years), almost no one is really looking at long term allocations given what is expected with interest rates. It was a difficult period for any plan to get close to the 6.5 to 7 percent return hurdle. When investing, where and when the investment was made mattered a lot in this fiscal year. For instance, when looking at equity, large cap stocks were up 4 percent, but small cap stocks were down 6.7 percent, which is a difference of 1,000 basis points. Also, there was a lot of difference between the first and second half of the year for certain asset classes. The first half of the year U.S. high yield was down 7 percent, and the second half it was up 9 percent.
With asset classes’ performance versus expectations and looking at the one, five and 10 year returns for the indexes, there really is no good real return index. In market assumptions for calendar year 2016, some areas have performed both above peers and above expectation. When looking at real estate, it is up over 12 percent over the last five years relative to the expectation of four percent. The Large Cap U.S. equity was up 12 percent the last five years. When looking at the 10 year number, it is above what is expected and is in line with market assumptions.
Responding to a question from Senator Bowen, Mr. Cracraft said that the good fixed income returns were based on Brexit pushing assets up, and the market assumption was lower due to U.S. government bonds and corporate bonds.
Mr. Cracraft discussed fiscal year investment returns by system and looking at periods of time where things were either underperforming expectations or underperforming other asset classes. He calculated a trailing five year number as of a specific date period. He discussed December 2002, which was right after the dot.com bubble and stated there was a flight to safety and that core fixed income had benefited from what was going on in the U.S. market. The U.S. market was largely the only underperformer, and that was due to the underlying tech companies that were located in the United States. Non-U.S. equity was not as affected, and the return for this asset class was still in the 7.5 percent target for actuarial returns. Looking five years forward, the U.S. equity was up just under 13 percent. The fixed income returns were reduced and in the 4.5 to 5 percent range. Non-U.S. equity performed better for that period; thus, the plans that had more non-U.S. equity would probably be expected to perform better than plans that have more U.S. equity because the returns were about double. Looking at 2011, there was a strong negative return within the equity markets and then a strong bounce out of most of those markets. Looking at the end of calendar year 2015, U.S. equities large cap have been on a good run. Real estate has continued to provide outsized returns and asset classes moved up and down.
Mr. Cracraft continued with the asset allocation update and historical review. Over the last decade to 15 years, alternatives have grown but have plateaued around 24 percent. The most recent Cliffwater study reported a median of 22 percent and an average of 24 percent, which is what was reported last year.
Responding to a question from Senator Bowen, Mr. Cracraft said that with the total pension plan universe, about 5 percent out of 20 percent of alternatives would be hedge funds. Looking at the Kentucky Employees Retirement System (KERS) plan, there is about 10.2 percent invested in hedge funds.
Mr. Cracraft discussed current asset allocations and that when looking at the underlying KRS plans, hedge funds ranged from just under 10 to 10.4 percent. KERS looked to be higher due to the assets in that portfolio declined faster than the private equity. For KRS, real return was about 8.5 percent and real estate about five percent of the portfolio. When looking at industry versus KRS, there are more alternatives, which are predominately coming out of the real return bucket and the absolute return bucket. Looking at the KRS plans, two plans are more financially constrained. The KERS and State Police Retirement System (SPRS) are starting to look different than the other plans due to KRS having recently implemented its asset allocation. KERS and SPRS have held a heavier weight in fixed income. Kentucky Teachers’ Retirement System (KTRS) and the two Judicial Form Retirement System (JFRS) plans are effectively unchanged from last year.
Mr. Cracraft discussed asset allocation when looking at the four plans versus the LRC peer group. KRS has increased its equity exposure and has a higher allocation to alternatives. KTRS and JFRS are similar in that they have a little more equity than the larger peer group and not as much alternatives, which is where the overweight in equity is coming from.
With investment performance and looking at the actuarial study and valuations over a five year period, three out of the five plans reached a 7.5 percent return target. When looking 10 and 20 year time frames, that number drops to two out of the four plans. The average median return for one year is in the .6 to 1 percent return, and a lot of plans are looking at 10 and 20 year numbers that are near or below actuarial assumed targets.
Responding to a question from Senator Bowen, Mr. Cracraft stated that the percentage of funding is only produced in each plan on an annual basis with the valuations.
Mr. Cracraft discussed the three major areas where fees are accounted—management fees, incentive or performance fees, and other/fund of fund fees. There is clearly a desire for transparency, and new emerging standards have been seen, such as a template that was produced by the Institutional Limited Partner Association (ILPA). The Public Pension Oversight Board has heard multiple presentations from CEM Benchmarking, which within the fee discussion, is really trying to lead into more transparency. Even within Kentucky, both of the large plans have endorsed the ILPA template, although everyone is not reporting the same information, but there is a growing trend for more transparency. Mr. Cracraft explained what the Kentucky plans report in fees versus the emerging standards. He also discussed preliminary actual fees for the plans for fiscal year 2016. The KRS pension is reporting the carried interest and portfolio level fees that are associated with their private equity and hedge funds. KRS is not reporting fund of fund fees. KTRS incorporates management fees only.
Mr. Cracraft discussed key questions regarding fees need to be answered: 1) definition of fee. Management fees, incentive or performance, and other/fund of funds are the three types of fees to consider in developing standard. There has been some recent legislation that has been passed in California, which is identifying carried interest and portfolio level fees as reportable items that need to be reported going forward. Illinois is another state that has introduced proposed legislation that has not been passed but that is very similar to the California language; 2) mandatory or voluntary disclosure. California is making new investments mandatory, and with existing relationships the plan has to make a best effort to report the fees. Kentucky had various proposals that included mandatory or best effort requirements on the plans to go out and get information from partners and report it; and 3) level of transparency desired. This is the detail, such as knowing the total fee dollar amount and the amount of management fee versus performance fee.
Responding to a question from Representative Yonts, Mr. Cracraft stated that ILPA is a third party association made up of limited partners that work with general partners to develop a template for disclosure of fees. If Kentucky adopted the ILPA standard across the board, it would be up to multiple parties involved on the issue of whether the standard would be mandatory.
Responding to a question from Senator Higdon, Mr. Cracraft said most plans’ salaries of individuals are considered an administrative expense and are reported as a separate line item with the financial statements. Other plans separate their investment staff sand report their salaries within their investment expense. Some plans utilize internal management. KRS and KTRS have assets that are managed in house.
Mr. Cracraft said that not much has changed from last year with current portfolio allocations along with targets. KRS had some slight changes with its fixed income and U.S. equity around its asset liability modeling study that was implemented around the first of the year. KTRS is effectively unchanged; its equity dropped one percent and its alternative investments increased one percent.
Senator Bowen introduced David Eager. Mr. Eager stated he was put on the Kentucky Retirement Systems Board at the end of April and is the Interim Executive Director for Kentucky Retirement Systems. His background is primarily based around the institutional investment management business, consulting to retirement and endowment funds. He managed Mercer’s Investment Consulting Group for a period of time and has consulted to investment management companies.
Responding to questions from Senator Higdon, Mr. Eager said at this time there is no plan to help with underfunding but that there will be a plan. He stated that the KRS investment committee has four institutionally qualified people for the first time and is looking at ways to develop a plan.
Responding to questions from Senator Higdon, Beau Barnes, Deputy Executive Director, Kentucky Teachers’ Retirement System, stated that in regard to the component of the medical insurance program called the non-single subsidy, which is within the Kentucky Employees’ Health Plan (KEHP), individuals under age 65 that choose parent-plus, couple, or family coverage and members that retired prior to July 1, 2010 will not receive additional funding to help cover dependent costs. Over 900 individuals across the Commonwealth will pay more for their medical insurance starting January 1, 2017. The amount could vary significantly, depending on which plan has been selected. KTRS sent a letter in July 2016 notifying members and stating that staff are available to members to help find other options in the market.
Responding to a question from Representative Yonts in regard to the returns, the KERS employment factor, and that the system is down several thousand employees paying into the system, Mr. Eager said the actuarial process has a lot of factors with the unrealistic four percent assumed increase of salary and that the interest, salary, and mortality assumptions will be reviewed.
Responding to a question from Senator Bowen, Mr. Eager said KRS would be meeting with outside counsel in regard to determining an appeal of the recent decision by the Court of Appeals in the Fort Wright case.
In response to questions from Representative Thompson, Mr. Eager said he was impressed with the audit scope and the consultants performing the comprehensive audit. Mr. Barnes said he was impressed with the professionalism and that KTRS has already submitted documents to Director Chilton’s office.
2017 Kentucky Employees’ Health Plan Update
Thomas Stephens, Secretary, and Jenny Goins, Commissioner, Kentucky Personnel Cabinet, discussed the overview of the health insurance plan. Mr. Stephens said that the plan is the largest self-insured plan in Kentucky and has been self-funded since 2006. There is approximately a $1.7 billion annual spend. There are 178,000 eligible active employees and a total of 290,000 insured, including dependents. The school board members make up the largest part of the plan at 54 percent, and retirees make up about 20 percent of the plan.
Ms. Goins discussed membership and claims. Since 2004, the KRS non-Medicare eligible retiree membership in the plan averaged 27,000 retirees excluding dependents. The lowest population was 25,000 in 2015, so the numbers are dropping. The highest was in 2009, which was almost 30,000 retirees. The retiree population lags behind the active population in trend reduction.
Ms. Goins said that the retirees cost about 20 percent of the overall medical spend and 24 percent overall pharmacy.
Ms. Goins discussed the KEHP vendor partners. She said that, before being self-insured, there was an RFP process, which included primarily two major vendors, a medical TPA and a pharmacy TPA and other vendors subcontracted within those. In 2014. an RFP allowed the Personnel Cabinet to select the actual experts in each of those fields, and now there are five vendors that help manage the self-insured plan. Anthem is the medical TPA, CVS/Caremark is the pharmacy TPA, WageWorks is the flexible spending TPA, HumanaVitality—which will be transitioning to a new name, Go 365—is the wellness vendor, and Vitals SmartShopper is the transparency vendor.
Mr. Stephens discussed the breakdown of the covered lives by agency. KTRS represents about 7 percent, and KRS represents 13 percent. By plan, LivingWell Consumer Driven Health Plan (CDHP) is 42 percent, LivingWell Preferred Provider Organization (PPO) is 35 percent, Standard CDHP is 7 percent, Standard PPO is 5 percent, and waive coverage is 11 percent. With coverage level, which is one of the key elements of cost control, single members in the plan make up the largest component of 31 percent, family at 29 percent, parent plus at 22 percent, couple at 7 percent, and waive coverage at 11 percent. Approximately 7,000 couples take advantage of the cross reference coverage, which is included in the family percentages.
Mr. Stephens discussed the 2017 open enrollment. Everyone who participates in the system will have to actively re-select coverage on October 10 – 24, 2016. He stated there are 13 statewide benefit fairs.
Ms. Goins discussed the 2017 plan highlights that included no premium increase for the LivingWell plans if members completed their 2016 LivingWell promise. If a standard plan is selected, there will be one percent premium increase for 2017. The single plan selection is offered at a low-cost of $13.10 per month, the non-smoker premium with the standard CDHP option. There is a slight change for the deductible and maximum out-of-pocket. The deductible is increased for the LivingWell PPO by $250 for single level and $500 for family level, and the maximum out-of-pocket is increased by $250 for single level and $500 for family. With the pharmacy benefits, Ms. Goins said a continued focus is how to make sure members are adhering to their medications, especially the preventive medications. The more the member adheres to the medications the less expensive it is for the member and the health plan. A new benefit for 2017 is that CVS has developed a prevention therapy drug list for members with LivingWell or Standard CDHP and who are taking a preventive prescription to bypass the deductible and only pay the percentage co-insurance amount. Also, the Diabetes Value Benefit will continue allowing members to pay a reduced co-pay and co-insurance with no deductibles for most of their maintenance diabetes prescriptions and $0 for diabetic supplies. The positive result from this program is nine percent increased utilization of those diabetic drugs. Twenty-two percent of members in a CDHP have started taking the diabetes medicines. Mr. Stephens added that the supplies that are included with the diabetes prescriptions are all covered under the plan without meeting a deductible. Ms. Goins continued with Telehealth, which gives online access to a doctor 24 hours a day/7 days a week with a wait time of a few minutes. The program was started in July 2015 with the LiveHealth Online Medical, and there are more than 10,000 people that have enrolled and about 3,500 that have actually taken advantage of the program. From July 2015 to July 2016, there has already been a savings of $700,000. With the difficulty of finding in-network providers for behavioral health issues, LiveHealth Online Psychology will start January 1, 2017.
Ms. Goins discussed there would be no change with the health plans, but there will be a change to the LivingWell promise. The EEOC issued a federal ruling that prohibits use of a gatekeeper concept, meaning if a LivingWell promise was not completed the member would have to opt for a standard plan option. In 2017, there is access to all four plans, but if the LivingWell promise was not completed in 2016, a surcharge of $40 will be added to the monthly premium if a LivingWell plan is selected for 2017.
Responding to a question from Auditor Harmon, Ms. Goins stated that KEHP has not received any comments or concerns regarding the Epi-pen, and that basically the cost is $600, even with a benefit card or a manufactured discount card, and is still a $300 cost to the plan. KEHP Is working closely with CVS/Caremark, the Pharmacy Benefit Manager.
2017 Retiree Health Plan Update – Kentucky Teachers’ Retirement System
Mr. Beau Barnes, Deputy Executive Director, Kentucky Teachers’ Retirement System, discussed the medical insurance program for KTRS that consists of two plans. The first plan is KEHP, which provides coverage for members under age 65 that are otherwise ineligible for Medicare, which consists of about 15,000 enrolled members. The second plan is the Medicare Eligible Health Plan (MEHP) which provides coverage for members age 65 or older and which consists of about 31,000 enrolled members. The MEHP is a self-funded drug plan that is administered by Express Scripts and is a fully insured Medicare Advantage plan through United Health Care.
Health insurance was first offered in 1964, the same year Medicare was first offered. It was established on a pay-as-you-go basis and was not established as a pre-funded plan like the pension fund. The cost of coverage at that time was so inexpensive that spouses could be added on the members’ coverage at no cost. Today, spouses are eligible for coverage under the member for full cost.
Mr. Barnes discussed the significant changes to the plan through the years. The changes were promoted by the KTRS board, and the General Assembly to help control costs. KTRS nationally has been at the forefront in taking advantage of any federal subsidies. In 2001, adverse selection was reduced by making permanent any election by surviving spouses to terminate KTRS coverage. In 2002, an increase from 20 to 27 years of service was required to receive the maximum supplement, and return-to-work retirees were required to obtain insurance with an active employer if that coverage is as good or better as KTRS offered. In 2006, a positioned MEHP drug plan took advantage of Medicare Part D subsidies. In 2007, a positioned MEHP drug plan managed to secure federal Medicare Advantage subsidies. In 2008, the pension reform legislation that impacted all retirement systems required new members to have a minimum 15 years for retiree insurance. In 2010, landmark legislation passed that fully addressed challenges in funding for retired teacher’s medical insurance, requiring active teachers, retired teachers under the age 65, and school districts to contribute more to medical insurance funding. This enactment changed the pay-as-you-go plan as it had been since 1964 and put it on track to becoming a prefunded plan. From 2006 to 2009, there was never more than a 3.5 percent funded status. In 2010, the first year of shared responsibility, the funded status went from 3.5 to 7.5 percent and in 2015 has grown to 18.1 percent. Also in 2010, the MEHP drug plan was moved from Medicare Part D subsidy to an employer group waiver prescription drug plan obtaining greater federal subsidies. In 2012, KTRS was one of the first members of the Know Your Rx Coalition, and that positioned the MEHP drug plan to take advantage of private drug manufacturers’ 50 percent subsidy in Medicare Part D’s coverage gap. In 2013, KTRS further reduced adverse selection with a “Spousal Shared Risk Waiver” that made permanent any election by living members’ spouses to terminate KTRS Medicare coverage. In 2014, KTRS implemented a Medicare High Performance Formulary that has a 50 percent coinsurance level for a brand-name, non-preferred drug tier.
2017 Retiree Health Plan Update – Judicial Form Retirement System
Donna Early, Executive Director, Judicial Form Retirement System, said that health insurance has been provided to members, retirees, and dependents in the Legislative Retirement Plan (LRP) since 1982. In 1988, the same health insurance coverage was provided to members of the Judicial Retirement Plan (JRP) plan. The health insurance subsidy that is provided is based on years of service by the retiree. There are two separate plans by statutory requirement. Coverage is provided to the non-Medicare eligible retirees and the Medicare eligible retirees.
The Medicare eligible retiree’s coverage since 2014 has been through a Medicare advantage PPO plan that has been provided by Humana. There are 158 policyholders in LRP and 253 policyholders in JRP. Ms. Early noted that the increases over the past ten years have fallen with the actuarial assumptions.
Ms. Early said that non-Medicare eligible retirees are covered under KEHP, which includes 97 policyholders in JRP and 21 policyholders in LRP.
The medical actuarial funded status is over 100 percent funded in both LRP and JRP.
The health insurance subsidies anticipated for 2017 for LRP will be approximately $745,000 and for JRP will be approximately $2 million.
Responding to a question from Senator Bowen, Ms. Early said there has been discussion of merging with either KRS or KTRS. She believes the LRP and JRP plans are unique and should be kept separate.
2017 Retiree Health Plan Update – Kentucky Retirement Systems
David Eager, Interim Executive Director, Kentucky Retirement Systems, said about 10 years ago KRS was about 20 percent funded for health care and now is in the 60 percent range. There is one plan that is over funded and only one that is below 60 percent. Costs have decreased in the last five years using Humana, and KRS is in a great position to serve the members. There are 90,000 people who will complete open enrollment, and KRS expects to have about 20,000 people on campus.
KRS retirees began receiving health benefits following passage of legislation in 1978. In 2003, KRS removed health care from the inviolable contract for members that began participating on or after July 1, 2003, and these retirees must have 10 years of service to be eligible to participate in KRS’ health insurance program. In 2008, the required years to be eligible to participate in KRS’ health insurance program increased to 15 years of service. There are currently 25,000 individuals in the Medicare eligible plans and 51,000 in the KEHP plans.
Mr. Eager discussed the Medicare eligible premiums from 2006 and how the cost was in an upward trend until 2013, when KRS took on Humana and the premiums dropped. The KRS Medicare Advantage Plans began in 2013 with a huge savings. For those not eligible for Medicare, the LivingWell PPO Single Premium is paid fully for non-hazardous retirees with 20 years or greater service credit. LivingWell PPO Parent Plus, Couple and Family premium is paid fully for hazardous duty retirees with 20 years or greater hazardous duty service credit.
KERS non-hazardous has experienced positive cash flow since 2012 and improved funding levels from 7.8 percent in 2006 to 28.8 percent in 2015. KERS hazardous has historically experienced positive cash flows, leading to increased funding levels from 34.3 percent in 2006 to 120.4 percent in 2015. SPRS has experienced stable cash flows, and funding levels increased from 18.1 percent in 2006 to 65.8 percent in 2015. County Employees Retirement System (CERS) non-hazardous has historically experienced positive cash flows, and funding levels improved from 16.9 percent in 2006 to 68.7 percent in 2015. CERS hazardous also historically experienced positive cash flows, and funding levels improved from 21.9 percent in 2006 to 72.3 percent in 2015.
With no further business to come before the board, the meeting was adjourned. The next regularly scheduled meeting is Monday, October 24, 2016.