Call to Order and Roll Call
The 1st meeting of the Public Pension Oversight Board was held on Monday, February 6, 2017, 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 Brian Linder, Co-Chair; Senator Jimmy Higdon; Representatives James Kay and Jerry T. Miller; J. Michael Brown, John Chilton, Timothy Fyffe, Mike Harmon, and James M. "Mac" Jefferson.
Guests: Beau Barnes, Deputy Executive Director, and Mark Whelan, Chief Financial Officer, Teachers’ Retirement System; Donna Early, Executive Director, Judicial Form Retirement System, Judge Laurance Vanmeter; David Eager, Interim Executive Director, Kentucky Retirement Systems, and Richard Robben, Interim Executive Director, Office of Investments, Fixed Income Assets.
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.
Approval of Minutes
Representative Linder moved that the minutes of the December 19, 2016, meeting be approved. Representative Miller seconded the motion, and the minutes were approved without objection.
Senator Bowen welcomed Representatives James Kay and Jerry T. Miller as new members to the Public Pension Oversight Board (PPOB).
There were no objections to Senator Bowen’s request for a 1:00 p.m. start time for all future meetings.
Quarterly Investment Update – Teacher’s Retirement System
Beau Barnes, Deputy Executive Director, Teacher’s Retirement System (TRS) discussed investment performance for the quarter ending December 31, 2016. The return for that quarter was 1.28 percent. The fiscal year to date return was 5.71 percent. If this pace continues, TRS will be on track to exceed its assumed rate of return for the fiscal year of 7.5 percent.
Mr. Barnes referenced an investment review conducted by Cliffwater, which is an asset manager. Cliffwater did an independent review unbeknownst to TRS that included 64 statewide pension plans from 2006 to 2015. TRS tied for 17th for 10-year returns and tied for 9th on a risk-adjusted basis. Another investment review was conducted by Aon Hewitt, which is TRS’s investment consultant, and TRS ranked in the top 20 percent for the quarter ending December 31, 2016 and top 21 percent for the 10 years ending September 30, 2016.
Mr. Barnes provided an investment outlook and noted several positive factors going forward, such as, attractive valuations and optimism in the market regarding tax reform and deregulation. The next several months will show some volatility, which is not abnormal with a new administration and new policy development. Within the next two to three years from now, equities and real estate that respond well to GDP growth should perform well. TRS’s portfolio has 44 percent in U.S. Equities, 19 percent in Non-U.S. Stocks and 5.6 percent in real estate. The economic indicators are synchronized to global expansion, overseas economies are picking up, oil and gas rig counts improved from 404 to 712 in the last nine months, energy demand is increasing, the Dow hit 20,000, and S&P also hit record levels recently.
Responding to a comment by Senator Bowen, Mr. Barnes stated that TRS uses a combination of in-house indexing and active external management, which is consistent with their strategy for having a diversified portfolio.
Responding to a question by Senator Bowen, Mr. Barnes stated that the asset base increased approximately $17.5 billion as of June 30, 2016. It increased $425 million from the first quarter and had a 1.28 percent increase the second quarter.
Responding to a question by Senator Bowen, Mr. Barnes stated that TRS had an initial meeting with PFM regarding investment and benefits and a follow-up teleconference regarding medical insurance benefits.
Quarterly Investment Update – Judicial Form Retirement System
Donna Early, Executive Director, Judicial Form Retirement System (JFRS) and Judge Laurance Vanmeter, discussed the Judicial and Legislator Defined Benefit and Hybrid Cash Balance Retirement Plans. Mr. Vanmeter stated that JFRS has been in existence since 1960 and the State Auditor recently finished the first state financial statement audit since around 1986, which indicated no findings. TRS has an assumed rate of return of 7 percent. With the Judicial Defined Benefit Retirement Plan, the total portfolio returned almost 9.4 percent over the past one year. The equity portion of the portfolios returned almost 12 percent, which exceeded the S&P 500. The fund equity portfolio has outperformed the S&P 500 index for every period except the trailing 9 month period. JFRS manages approximately $467 million in total assets with 75 percent allocated to equities. The equity portfolio is all S&P 500 companies and totals about 30 individual stocks. The fixed income assets are individual high quality bonds that include corporate and government bonds.
Mr. Vanmeter discussed the Hybrid Cash Balance Retirement Plan, which is managed separately from the Defined Benefit Plan only because in 15 to 20 years it may be impossible to segregate the two plans. The Judicial and Legislators Hybrid Cash Balance Plans are invested in index funds and the equity in the Defined Benefit Plan that is managed actively has outperformed the index funds.
Mr. Vanmeter stated that the Legislators Defined Benefit Plan is almost identical to the Judicial’s Defined Benefit Plan and the Legislators Hybrid Cash Balance plan is also virtually identical to the Judicial’s Hybrid Cash Balance plan.
Ms. Early stated that there are no future policy changes and no recent changes have been made to the investment policy statement, nor are any anticipated.
In response to Senator Bowen asking for clarification on outsourcing, Mr. Vanmeter answered that Hilliard Lyons Trust Company has been involved with JFRS since 1993, but did not have sole discretionary investment authority until around 2008 or 2009. Ms. Early added that funds are under separate control in a custodian account and that by policy, Hilliard Lyons does not do trading.
Quarterly Investment Update – Kentucky Retirement System
David Eager, Interim Executive Director, Kentucky Retirement System (KRS) discussed performance over the first six months of the fiscal year 2017. Essentially all markets across the board were favorable, with real return, which was the worst performing asset class producing a return of about 0.9 percent and KRS was about 1.9 percent. The U.S. Equity market, where S&P was up about 8.7 percent, was the best performing asset class and KRS’ portfolio was up about 9.5 percent. Asset levels grew in all plans and all 10 plans had more assets at the end then at the beginning.
Mr. Eager discussed the Kentucky Employees Retirement System (KERS) nonhazardous pension plan cash flow and noted the minimal positive asset growth in a market that saw returns of just over 5.0 percent. The County Employees Retirement System (CERS) nonhazardous plan is in much better shape and the insurance plans were even better.
Mr. Eager stated the benchmark, which is a blend of each asset class policy target weight and respective benchmark, was up during the first six months of the fiscal year 5.08 percent compared to 5.19 percent from the portfolio.
In responding to a question from Senator Bowen, Mr. Eager stated the benchmark will vary, such as, the U.S. Equities’ portfolio may likely utilize the S&P 500 or some other index. The benchmark selection is based on specific needs and any one particular category or strategy will have a specific index benchmark.
Mr. Eager said that when looking at each plan there are not a lot of differences. However, asset allocation is moving to a more customized approach for each plan. The KERS nonhazardous plan currently has about 39 percent equities but the CERS funds have 55 percent equities. This trend will continue to move in that direction.
KERS nonhazardous experienced an increase of 30.2 percent in inflows, while outflows slightly increased by 2.6 percent during the first half of FY17 when compared to the same periods in FY16. The increase in inflows are primary due to increased employer contributions (rate increase), in addition to General Fund Appropriations, and recent investment performance. The outflows are due to benefit payments and expenses with a decrease of roughly $350 million last year. Mr. Eager noted the positive investment returns relative to the assumption had only resulted in a flat asset base for KERS. In FY17 there has been an $8 million improvement.
CERS nonhazardous also saw inflows increase 30.2 percent, while outflows grew 2.6 percent as compared to the same periods in FY16. The increase in inflows are due to increased employer contributions (rate increase) and increase in investment performance. CERS saw assets increase by roughly $211 million.
State Police Retirement System (SPRS) experienced an increase of 145.4 percent in inflows, with an increase of 2.1 percent in outflows for FY17 as compared to the same periods in FY16. The increase in inflows are due to increased employer contributions (rate increase), the addition of General Fund Appropriations, and increase in investment performance. SPRS assets increased by roughly $17 million.
In response to a question from Mr. Fyffe, Mr. Richard Robben, Interim Executive Director, Office of Investments, Fixed Income Assets stated that at the end of 2015, KRS decided to make a change to the fixed income portfolio benchmark. The change was made to make the benchmark more reflective of the actual risk in the portfolio, such as removing currency from the benchmark given KRS is a U.S. based plan and liabilities are 100 percent USD. The benchmark is a 50/50 blend of investment grade bonds as measured by the Bloomberg Barclays U.S. Universal index and non-investment grade bonds, which is measured by the Bloomberg Barclays High Yield Index.
Mr. Eager discussed the KRS insurance investments and the total fund return of 5.30 percent compared to the benchmark of 5.09 percent. KRS is about 60 percent funded. Allocations are similar to the pension side.
The contributors to performance for pension funds were primarily driven by U.S. Equities, which exceeded their benchmark with reported returns of 9.5 percent FYTD and 14.1 percent for the one year compared to their respective benchmarks of 8.8 percent FYTD and 12.7 percent for the one year. On the insurance side, U.S. Equities exceeded their benchmark with reported returns of 9.5 percent FYTD and 14.7 percent for the one year compared to their respective benchmarks of 8.8 percent FYTD and 12.7 percent for the one year. Financial stocks in the first six months of 2016 were down 6 percent and the last six months it was up 30 percent. Utilities in the first six months were up 24 percent and the last six months it was down 5 percent. There were no significant detractors from performance.
Mr. Eager discussed major changes within KRS. Investments is transitioning out of $700 million in hedge funds due to high fees versus current return potential, liquidity issues, and discussed some strategies that may survive as separate accounts. Going forward KRS will be completing hedge fund transition by December 31, 2017. With organizational changes, KRS had two senior staff departures and the Investment Committee is more engaged. Going forward KRS will have staff additions to the investment operations and determining staffing implications tied to PFM recommendations.
In response to a question from Senator Bowen, Mr. Eager discussed the assumed rate and a suggested change related to proposed legislation included in House Bill 351, which had been filed. This is related to organizations planning to withdraw from the system and how their liability is calculated during their exit. The suggested change would incorporate the 30-year treasury rate in this process.
In response to a question from Senator Higdon, Mr. Eager stated that the objective of smoothing is so that the contribution is more predictable from year to year and there is no smoothing in KRS’s presentation or returns. Smoothing is only incorporated during the actuarial valuation process.
In response to questions from Representative Kay, Mr. Eager stated a cash infusion would have to be a significant amount for a duration of time to make substantial difference for the KERS non-hazardous plan. Also, Mr. Eager stated in regards to disclosure of fund of fund contracts that there are certain fee arrangements that KRS has signed a confidentially agreement and limits their public disclosure.
In response to questions from Representative Miller, Mr. Eager stated differences in benchmarks could be the result of strategy. For example, three different investment portfolio managers who invest in stocks may have very different strategies or market caps. Also, Mr. Eager stated that JFRS utilizes a single manager and that their equities are run by one firm in a 30 stock portfolio which KRS could not possibly do that given their size and needs for more diversification.
Discussion on Unfunded Liability Estimates
John E. Chilton, Budget Director, Office of the State Budget Director discussed the performance audit the PFM Consulting Group is currently in process of completing. Mr. Chilton noted the discussion by each system with regards to investment return, asset class targets, and the various risk profiles of fixed income, equity, hedge fund, or absolute return. Each has different expectations and different return profiles.
Mr. Chilton also discussed the various assumptions that are built into the actuarial formulas, which includes the investment return assumption used in actuarial calculations. How much money that is in the fund is relevant, along with mortality rates, payroll growth, and retirement patterns, which are then are incorporated into the work actuaries do to determine the amount of underfunding that might be in existence at any particular time. The actuaries work with all of these assumptions to predict what might happen in the future.
Mr. Chilton noted that presentations in the future will help explain each assumption and how each effects the underfunding for the various plans, but focused the discussion on the discount rate, or investment return assumption, used by actuaries for calculating the accumulating liabilities. The KERS non-hazardous and SPRS plans currently use 6.75 percent as the assumption for long-term return on investments. The SPRS is relatively small because of the small number of state troopers that are involved in that plan. The KERS nonhazardous is a very large plan with a large number of employees. Both of these plans are severely underfunded. The Judicial and Legislative systems both use a 7 percent expected return, while all of the other plans use a 7.5 percent expected return.
Mr. Chilton discussed the funding levels of each plan using their current assumptions for investment return and noted the benefit from understanding how much these calculations can change when the assumptions are changed. For example, what if the investment return over the long-term is the guaranteed rate available in current markets using the 30-year treasury happened. While not suggesting the state should incur debt to cover any underfunding, PFM also evaluated liabilities using the estimated borrowing rate of Kentucky as an assumption.
Mr. Chilton provided a summary of calculated unfunded liabilities and funding ratios for each plan when considering alternative investment assumptions. With regards to the KERS nonhazardous pension fund, the current valuation indicated an $11 billion unfunded liability when using a 6.75 percent assumption. Changing the assumption to 2.7 percent, which was the average the 30-year treasury rate in 2016 results in a $19.3 billion unfunded liability. Using the state borrowing rate of 4.5 percent indicated a $14.8 billion unfunded liability. The KERS nonhazardous pension funding status, which was 16 percent based on their assumed rate, fell to 13 percent using the state’s borrowing rate and 10 percent when using the treasury rate. The KERS hazardous pension fund unfunded liability grew from $400 million to $1.1 billion using the 30 year treasury rate. TRS, which had a reported unfunded liability of $14.5 billion using its current assumption, would almost double to $29 billion using a 4.5 percent rate and grow to $43 million when using the treasury rate. The funding percentage for TRS goes from 55 percent to 37 percent and then to 29 percent. The relative change in funding for the KERS non-hazardous fund is less dramatic giving its current asset base as compared to the larger plans.
Blending all plans together, using the 2016 actuarial assumptions, on the average, the funds are 47 percent funded. At the state’s borrowing rate of 4.5 percent rate, this funding ratio would drop to 34 percent, while applying the 30-year treasury rate would reflect a funding level of 26 percent. The Governor asked for the 30-year treasury rate because it is theoretically a guaranteed rate over the long-term. However, moving assets into other types of investments where the investment risk is greater gives reason to the expected returns could be greater than it is in U.S. Government Securities.
Mr. Chilton also noted that current assumptions being used were not out of line with what other pension funds across the industry. The 6.75 percent utilized by KERS and SPRS are likely on the lower side, while the 7.5 percent is maybe on the higher side of what other funds are currently using.
Mr. Chilton reiterated that all of these are estimates of what is going to happen in the future and what kind of a return plans expected to earn. The future will be the future, but making the best guess while using a reasonable approach to investing is important for resolving the underfunding and making them sustainable on a long-term basis.
Mr. Chilton stated the calculations did not represent PFM’s opinion of an appropriate investment return assumption and were provided simply to illustrate the financial implications of the assumptions. The alternative rates used are also estimates and even the U.S. Treasury rate changes frequently. PFM is working on a variety of calculations and will provide other illustrations to help better understand the status of all plans and how the underfunding occurred.
Senator Bowen stated HB 238 was passed in the 2016 regular session and requires the PPOB to employ the services of an actuary. Senator Higdon moved that HB 238, a motion to authorize or to request funds for LRC to hire an actuary, be approved. Representative Miller seconded the motion, and HB 238 was approved without objection.
With no further business, the meeting was adjourned. The next regularly scheduled meeting is Monday, February 27, 2017.