Call to Order and Roll Call
The 9th meeting of the Public Pension Oversight Board was held on Monday, November 28, 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, Timothy Fyffe, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: Beau Barnes, Deputy Executive Director, and Mark Whelan, Chief Financial Officer, Teachers’ Retirement System; Donna Early, Executive Director, Judicial Form Retirement System, and Judge Laurance Vanmeter, Kentucky Court of Appeals; David Eager, Interim Executive Director, Kentucky Retirement Systems.
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.
Approval of Minutes
Senator Higdon moved that the minutes of the October 24, 2016, meeting be approved. Mac Jefferson seconded the motion, and the minutes were approved without objection.
Senator Bowen brought attention to items within the file, including: a notice that the December meeting will be held on Monday, December 19, 2016, at noon; a summary of recommendations from the October meeting prepared by the Public Pension Oversight Board (PPOB) staff; the Quarterly Performance Update which now includes total fund benchmark data for the Teachers’ Retirement System (TRS); and an update on HB 271 data information has been received and is available.
Senator Bowen stated that, approaching the 2017 Regular Session, the Governor will be releasing details from the performance audit of the state-administered retirement systems, which was funded in the biennial budget. The Board needs to be prepared to evaluate the findings and recommendations and work with the Governor’s office to put the systems on better financial footing. The Board looks forward to working with the systems on legislative proposals and that its input and expertise is a necessary component. He expects the systems to provide assistance in a timely and accurate manner, and in particular, completing actuarial analyses on retirement bills as required by KRS 6.350. HB 238 requires the systems to submit actuarial valuations to the Legislative Research Commission (LRC) by November 15 and specifies valuation and reporting requirements including sensitivity analysis on key assumptions and a 20-year projection on employer rates.
Actuarial/Financial Update
Beau Barnes, Deputy Executive Secretary and General Counsel, and Mark Whelan, Chief Financial Officer, Teachers’ Retirement System (TRS) stated the fiscal year ending June 30 was a tough year for investment performance with the fund returning a -1.0 percent gross return and -1.29 percent net return. Moving a quarter later, to September 30, the one year return moves to 9.22 percent and illustrates how quickly things can change in the market. The fund tries to focus on the longer term and over the past 30 years, compounded returns for the system have been 8.15 percent gross of fees. Net of fees, the system would probably be in the neighborhood of 8.09 percent for that period of time. TRS is able to achieve these investment returns because it has had the discipline to adhere to investment fundamentals. Mr. Barnes referred to information provided by their consultant, AON Hewitt, which was presented to the TRS Board regarding the importance of risk-reducing assets versus return-seeking assets. Exposure to both is important for plans such as TRS, as it demonstrates the need to have a diversified portfolio. TRS is well-diversified and invested in international and domestic stocks, bonds, and real estate. For example, TRS owns several Wal-Mart and Super Lowes’ buildings within their real estate portfolio that are leased back to those companies at a rental or lease rate.
Mr. Barnes discussed the pension valuation findings for year ending June 30, 2016, performed by Cavanaugh MacDonald Consulting, LLC. The valuation noted a market return of -1.0 percent gross of fees and -1.29 percent net of fees. The market value of the fund decreased $1.2 billion, which was due to investment losses and negative cash flow experienced during the year. TRS had to sell $650 million in assets during the year to cover a shortfall in contributions and investment income. Mr. Barnes noted that everything in the valuation predates the additional funding that was provided by the General Assembly and Governor, thus future testimony will look very different.
In response to a question from Senator Bowen, Mr. Barnes said even if requested funds had been received, there would still have been manageable negative cash flow and TRS could have avoided selling assets.
Mr. Barnes said the return on actuarial value for the one year was 7.6 percent (compared to 7.5 percent assumption). TRS noted the actuarial market values are not calculated year by year, week by week, or day by day, but by a five-year actuarial smoothing process.
In response to a question from Senator Bowen, Mr. Barnes said that he did not believe the investment staff had computed the requested amount of appropriations, but would have them go back to the 2015 year and report back to the PPOB.
In a response to a question from Senator Higdon, Mr. Barnes discussed the investment return assumption utilized in the actuarial analysis and the difference between gross and net returns.
Mr. Barnes reported the funding ratio decreased slightly, from 55.3 percent in the previous year to 54.6 percent in the fiscal year ending June 30, 2016. During the year, TRS received about 57 percent of the recommended employer contributions for the year. The projected contribution for FY 2019 is an additional $554 million. The great news is that the 2016-2018 budget contributes an additional appropriation of $973 million.
Mr. Barnes discussed an Experience Study, which the actuary conducted by taking a five-year lookback at key assumptions used in the valuation. The study resulted in changes to several assumptions. Assumed price inflation was lowered from 3.5 percent to 3 percent. Assumed wage inflation, which is the total teacher payroll, was lowered from 4.0 percent to 3.5 percent. Assumed merit salary scale was decreased by 0.25 percent for all ages. Assumed rates of withdrawal, disability, retirement, and mortality were all adjusted to better match experience of the system. As a result of these assumption changes, liabilities were decreased by around $297 million.
In response to a question from Mac Jefferson, Mr. Whelan stated that the actual payroll growth from 2015 to 2016 was approximately 1.8 percent.
In response to questions from Senator Higdon, Mr. Barnes stated the lowered wage inflation is an assumption that ultimately does not increase the unfunded liability today. The assumption was changed as a result of payroll not increasing as greatly as projected over the past five-year period. TRS gets a percent of payroll as contributions, so that is not reflected in an increase to the unfunded liability. However, if contributions received are lower than projected, this shortfall will ultimately be made up through an increased ARC in the future.
Mr. Barnes discussed a breakdown of actuarial experience gains and losses during the fiscal year ending June 30, 2016. The actuarial return on assets was 7.6 percent versus the assumption of 7.5 percent, which resulted in a gain of $14.2 million. Salary increases served as a slight actuarial gain of $64.5 million, while turnover and retirements resulted in a loss of $135.2 million. Mortality resulted in a loss of $71.1 million and new entrants were a loss of $37.9 million. Contribution shortfalls accounted for the largest loss of $472.4 million, while assumption changes served as a gain at $297.2 million.
Mr. Barnes reviewed the fund’s total liability of $36.6 billion. Currently assets comprised $17.4 billion, member contributions were $2.9 billion, employer normal cost accounted for $1.6 billion; and unfunded liabilities were $14.5 billion. Looking a recent funded percentages shows that funded status has remained fairly consistent. In 2011, TRS was 57.4 percent funded and in 2016 it is 54.6 percent funded, which is largely due to investment performance during that period of time.
Mr. Barnes discussed the fund’s GASB 67 valuation and the different assumptions used in its calculation. GASB 67 is unusual in that it assumes a worst case scenario and also assumes a depletion date will be reached in the future. It also uses a municipal bond index rate (which is much lower than the 7.5 percent assumed rate) as an assumed rate after the depletion date. Under GASB 67 standards, TRS funded status would move to 35.2 percent versus the 54.6 percent using funding standards. Actuaries for TRS have instructed the TRS Board not to focus or worry on GASB results.
Mr. Barnes discussed the medical insurance fund valuation, which reported the funded status of the medical insurance fund had increased to 21.88 percent as of June 30, 2016, from 18.09 percent on June 30, 2015.
In responding to a question from Senator Bowen, Mr. Barnes and Mr. Whelan explained that for retiree health the state pays an employer contribution, active teachers are paying 3 percent per paycheck and school districts are matching the 3 percent. Retired teachers under age 65 are also paying a Medicaid Part B premium equivalent and the Commonwealth is picking up the cost of new retirees under age 65, who retired on or after July 1, 2010. With all these groups together there is 163.8 percent of ARC.
Similar to pension fund, the same assumptions changes were made for the medical insurance fund. This resulted in an increase to liabilities of $219 million, but this was offset by lower than assumed costs from the two different health care plans. TRS retirees participate in the Medicare Eligible Health Plan (MEHP), which is managed by TRS staff, and all active teachers and retired teachers under the age 65 participate in the Kentucky Employees Health Plan (KEHP), administered by the Personnel Cabinet, Department of Employee Insurance (DEI). DEI and TRS staff have kept costs low and the overall effect decreased liabilities by $278 million.
Mr. Barnes provided and discussed the sensitivity analysis conducted on changes to the discount rate, price inflation, and payroll growth assumptions. Regarding the discount rate, lowering it to 6.5 percent would result in a funded ratio of 48.9 percent (versus 54.6 percent), while increasing it to 8.5 percent would increase the funded ratio to 60.6 percent. Regarding the rate of inflation, the current valuation assumes a 3.0 percent inflation rate and 3.5 percent payroll growth. Under this scenario, as the underlying inflation rate is lowered, the discount rate and payroll growth assumption are also adjusted. Lowering the rate of inflation to 2.75 percent would result in a funded ratio of 53.4 percent (versus 54.6 percent), while lowering the rate to 2.5 percent would reduce the funded ratio to 52.1 percent.
Regarding payroll growth, the current valuation assumes a growth of 3.5 percent and a funded status of 54.6 percent. Under this scenario, all other assumptions, including the individual member salary scale, are held constant so that the only impact is in the amortization of the unfunded liability, leading to higher employer contribution rates. Lowering the rate to 2.0 percent would result in an ARC of 35.245 percent (versus 30.755 percent), while reducing the rate to 0 percent would increase the ARC to 41.985 percent.
In response to a question from Mr. Fyffe, Mr. Barnes stated the inflation rate assumption is connected to several other assumptions. The inflation assumption is linked to the payroll growth rate, so the greater inflation the greater the anticipated payroll. Same with the discount rate. Mr. Barnes also stated that the actuaries make recommendations to the Board of Trustees and the Board evaluates those recommendations, accepting them if warranted.
Senator Higdon commented that the systems needed uniform reporting on net of fees.
Mr. Barnes discussed the financial statements for the fiscal year ending June 30, 2016. He stated total contributions received were $1.2 billion as additions. Investments income was affected by a bad market for the year and the value of the portfolio declined $198 million. Investment expenses offset with total additions resulted in just over $1 billion. Even in a difficult year with a negative cash flow of $650 million and a market that was tough for all investors, there was still a total of additions at a little over $1 billion. Total deductions were $2.1 billion, with the largest factor being benefits paid. The net decrease for the year was $1.1 billion. The net position at the beginning of the year was $18.7 billion and the end of year it declined to $17.6 billion.
Actuarial/Financial Update
Donna Early, Executive Director, Judicial Form Retirement System, and Judge Laurance Vanmeter, Kentucky Court of Appeals presented. Ms. Early stated following the legislative action in 2013, a hybrid plan was created within the judicial and legislators’ plans. Each plan is maintained separately for investment, funding, and reporting purposes.
A full actuarial valuation of each plan, which includes a collection of updated census data and trust information, is conducted every other year. The last such valuation was prepared as of July 1, 2015. Actuarial assumptions and methods used in the valuation are established by statute or the System’s Board of Trustees.
The 2016 valuation is for GASB purposes, and it is primarily a roll-forward valuation of each plan. There were no changes to actuarial assumptions or methods from the July 1, 2015 full valuation.
The primary driver of the change in funded position from July 1, 2015 to July 1, 2016 was a lower than expected investment return. For the defined benefit plans, the long-term rate of return assumption is 7.0 percent. The blended discount rate for GASB purposes was 6.41 percent for the Judicial Defined Benefit Plan and 6.85 percent for the Legislators’ Defined Benefit Plan.
Mr. Early discussed the importance of the salary increase for both plans and the membership is confined to certain people who qualify. For example, there are 138 members in the legislators’ plan, and there can never be any more than 138 members of the General Assembly. The salary assumption is 1 percent for three years and then 3.5 percent after that.
Judge Vanmeter stated that, in the prior FY ending June 30, 2016, Judicial increased 1.3 percent and the Legislators’ increased 2.5 percent, but since June 30 both plans had increased 4.5 percent.
Responding to a question from Senator Bowen, Judge Vanmeter stated from the prior biennium the appropriation was $16 million and the last and most recent appropriation went down to $13 million. Judge Vanmeter stated it would be hard to say if any additional funds will be requested.
Actuarial/Financial Update
David Eager, Interim Executive Director, Kentucky Retirement Systems (KRS) started by highlighting three messages at a high level. First, looking back the FY ending June 30, 2016, was not a good year for investment returns as the KRS total fund dropped 0.5 percent. However, the valuation process takes a smoothed approach, so the return utilized in the valuation was a little over 4 percent. Secondly, there was a growth in the unfunded liability of about $1.5 billion and approximately $1 billion was attributable to a change in the discount rate for the Kentucky Employees Retirement System (KERS) non-hazardous. Third, Mr. Eager discussed the funding status of KRS and noted the five individual plans and their specific dynamics. For example, when the media announces that KRS is the worst funded system in the country at 17 percent, it really references just one plan out of five even though the media and public associates the 17 percent funded status with all five plans. Each system has differences. The funded status is different and the active versus retirees is different. While our current social security system is set up with approximately three active employees to every retiree, KRS has two plans that are less than one to one. The KERS non-hazardous has 38,000 active employees and 40,000 retirees. The State Police Retirement System (SPRS) is worse, although there are far fewer people within the system, there are more retirees.
Mr. Eager discussed a need to develop a comprehensive plan to address the funded status and noted the KRS Board of Directors was actively working on one. The plan will include funding, investments, assumptions, and communications that deal with how the plan can get from where it is to where it needs to be. KRS believes input from the upcoming PFM audit, as well as recommendations for the Public Pension Oversight Board can all be contribute to developing the plan. There also is a need to be actively challenging our actuaries on assumptions given the current needs of some of our plans.
Mr. Eager discussed the actuarial valuation process, using the example of an individual employee given that the valuation is an aggregate value of each person in the plan. There are known valuation variables such as age, salary, sex, service to date, and occupation. There are also assumed variables or assumptions such as, future salary increases, retirement date, death rates before and after retirement, disability rates/other termination rates, and investment return. Using the assumptions, KRS can then know how much is needed to fund a person’s retirement and when the last payment will be made. Unfortunately, the assumptions or contribution levels are not always met and thus additional money is needed. Mr. Eager stated that going forward KRS is going to treat each of the five plans independently based on their needs, specifically with the way assets are invested.
Mr. Eager summarized each plan’s total assets as of June 30, 2016, noting there were $11.861 billion of assets for all plans combined. This compared to $12.686 at the close of FY 2015. The investment return was negative 0.5 percent, but the big problem was cash flow where the benefit payments exceed the contributions by about $700 million. There was $1.8 billion going out and $1.1 billion coming in.
Mr. Eager discussed the systems unfunded liability and provided key drivers of the increase from the prior year. In total, KRS has $21.17 billion in unfunded liabilities across the five plans, with the greatest amount represented by KERS non-hazardous pension at $11.1 billion. The total unfunded liability went up by $1.5 billion and $1 billion was due to the change in the actuarial assumption; $300 million due to investment returns being at the actuary rate of 4 percent instead of 6.75 percent or 7.50 percent; and demographic factors were at $200 million.
Mr. Eager discussed the funded ratios and highlighted the KERS non-hazardous plan at 16 percent and SPRS at 30.3 percent. The other plans are all around 60 percent. The contribution rates in general went up with SPRS at 71.57 percent, KERS non-hazardous at 41.98 percent, KERS hazardous at 20.48 percent, County Employees Retirement System (CERS) non-hazardous at 14.48 percent, and CERS hazardous at 22.20 percent.
Mr. Eager discussed the sensitivity analysis and stated KRS is in process of reviewing with the actuaries and has until May to decide what assumptions will be made. He discussed the investment return (discount rate), inflation assumptions, and payroll growth assumptions for the current 2016 valuations. Mr. Eager stated the better funded plans are more affected by changes in the discount rate.
In response to a question from Senator Bowen, Mr. Eager stated participants in the hybrid cash balance plan are included in the projections, but the problem is there are so few people in the cash balance plan and they tend to leave (turnover rate is high) more often. As a result, the positive impact for the overall system from the cash balance plan is going to be 20, 25 to 30 years down the road.
With regards to the payroll growth assumption, focusing on KERS non-hazardous, the valuation is using a 4 percent assumption. Over the last 10 years, there are maybe two years that we had positive growth and it has been negative more recently due to people or employers leaving the plan. So wages might be increases, but the population is not. Mr. Eager stated the payroll growth does not affect the funded status, but you do see contribution rates increase significantly given the growth rate declines.
In response to a question from Mac Jefferson, Mr. Eager stated the additional funding to pay the accumulated liability comes from legislation.
Mr. Eager continued by discussing the total KERS pension liability, which is $15.59 billion. An issue is the retired benefits payable is $10.22 billion of the amount, while active employees only account for 4.93 billion.
In response to a question from Senator Bowen, Mr. Eager stated that the negative cash flow for all plans exceeded the income by $700 million a year. KERS is about $300 million per year. Total assets are about $1.9 billion.
Representative Graham stated that the PPOB should look at the privatization on state hires and find out why employment has reduced from approximately 41,000 to 31,000 employees. It would give an indication as to how much funding is missing.
Representatives Yonts noted a lawsuit filed involving Western Kentucky University (WKU) and the pension system where WKU has outsourced lawn care. He stated the same situation has also occurred with all food services and medical services within Corrections, all medical services with any hospital operated by the state, and most of engineering in the Transportation Cabinet. Representative Yonts stated that there should be a statute that allows privatization, but still requires a payment into the system.
With no further business, the meeting was adjourned. The next regularly scheduled meeting is Monday, December 19, 2016.