Call to Order and Roll Call
The 8th meeting of the Public Pension Oversight Board was held on Monday, September 25, 2017, at 1:00 PM, in Room 154 of the Capitol Annex. Representative Brian Linder, 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; Senators Jimmy Higdon, Christian McDaniel, Gerald A. Neal, Dennis Parrett, and Wil Schroder; Representatives Ken Fleming, James Kay, Jerry T. Miller, Arnold Simpson, and Russell Webber; J. Michael Brown, John Chilton, Timothy Fyffe, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: Bo Cracraft, Legislative Research Commission; Donna Early, Executive Director, Judicial Form Retirement System; Beau Barnes, Deputy Executive Director, Teachers’ 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
Senator Bowen moved that minutes of the June 26, 2017 meeting be approved. Representative Webber seconded the motion, and the minutes were approved without objection.
Semi-Annual Investment Review
Bo Cracraft, Legislative Research Commission, discussed the total assets under management for all state administered pension and insurance plans. Total assets were approximately $36.6 billion, with the pension assets totaling $31 billion and the insurance assets totaling $5.6 billion. Mr. Cracraft noted a couple unique differences between the two trusts, highlighting the Teachers’ Retirement System (TRS) accounted for approximately 60 percent of the assets on the pension side, while the underlying five systems of the Kentucky Retirement Systems (KRS) accounted for the majority of insurance assets.
Mr. Cracraft provided a market review and noted that, overall, the 2017 fiscal year was a positive year for investment markets, with several asset classes posting strong positive returns. Most notably, the more traditional asset classes, such as public equity, that almost every pension plan is utilizing, were top performers. Equity markets, including U.S. and Non-U.S., bounced back from tough 2016 performance. Outside of equity markets, non-investment grade, or higher yielding, bonds performed well and provided a little over 12.5 percent return. Private Real Estate provided 7.9 percent return, while U.S. Core Fixed and Treasury Inflation Protected Securities (TIPS) were slightly down.
Mr. Cracraft provided a summary of annual fiscal year returns for plans over the past 20 years. Mr. Cracraft highlighted a slight change made from prior staff reviews to report the Kentucky Employee Retirement System (KERS) and County Employees Retirement System (CERS) independently. Reporting the plans independently makes more sense as the plans begin to perform differently, as evident over the past three plus years.
Moving to trailing performance, Mr. Cracraft highlight one year returns that ranged from 12 to 15 percent, noting that all the plans had performed well relative to assumptions, performance benchmarks, and median returns of public or staff developed peer groups. Taking a longer term view, Mr. Cracraft noted that 10- and 20-year returns had come down from prior years, which was largely due to the fact that strong performance from the late 1990s was now dropping out of the 20-year period. Looking beyond, at 30-years, both KRS and TRS had returns above 8 percent, while since inception the Judiciary Form Retirement System (JFRS) was also above 8 percent.
Mr. Cracraft provided an update to recent changes to return assumptions for several of the plans. He noted recent discussion regarding plan assumptions and changes currently occurring within the industry. A lot of plans across the country are changing assumptions, with 35 out of the 69 plans included in staff’s peer group having adjusted their assumption either for their most recent or upcoming valuations. While more plans are lowering assumptions, the median and average for the industry is still 7.5 percent, which is a reflection of the slow, incremental nature of changes being experienced. Within Kentucky, two of the systems have made changes to assumptions. First, KRS changed assumptions for all ten of their underlying plans on the pension and insurance side, while JFRS also reduced their assumption. TRS has been having active discussions but, as of today, there have not been any changes to their assumption.
Mr. Cracraft asset allocation and highlighted that a plan’s underlying return is largely driven by the way a plan allocates assets. Staff discussed more traditional asset classes, such as public equities and fixed income, noting most are utilized by every plan in the peer group, liquid in nature, and well-known. Other options, such as Alternative Assets, include real estate, private equity, and absolute return. Mr. Cracraft noted that most plans allocate 75 to 80 percent of their assets in traditional assets and that, historically, 90 percent of plan returns were dictated by how they decided to allocate among these asset classes. Mr. Cracraft discussed the larger universe, noting that, across public pension funds, the average allocations had remained relatively unchanged. In the mid-1980s, it was predominantly fixed income with a healthy allocation of public equity, which rotated over in the mid-1990s. Within the last few decades, alternative assets begun to increase, and the peer group has had a consistent allocation of around 25 percent the past several years.
In response to a question from Senator Bowen, Mr. Cracraft stated that not all of Kentucky’s plans mirror the larger universe. He noted the differences between TRS and KRS, where TRS is following the larger trend of adding alternative assets, but has been slower and less aggressive than KRS. Ultimately, this is driven by Investment Committees, who perform asset liability modeling studies and have consultants help present the data before making a decision on how to allocate assets.
Mr. Cracraft discussed recently approved new targets for KRS’ asset allocation. The KRS Investment Committee has been evaluating their asset allocation over the last several quarters and recently approved new targets for each plan that staff will begin transitioning to over the course of fiscal year 2018. KRS has decided to reclassify assets into three new strategic allocations: Equity, Credit, and Diversifying Assets. The underlying asset classes remain the same, but how staff aggregates will look different as they target 45 percent to Equity, 30 percent to Credit, and 25 percent to Diversifying Assets. The most notable reduction is in Non U.S. Equity and U.S. Equity, which is being reallocated into Global Fixed and Credit or Illiquid Fixed.
In response to a question from Representative Miller, Mr. Cracraft stated the difference between real return and absolute return is real return includes hard assets, commodities, inflation linked assets, or total return products, while absolute returns are fund of fund or direct hedge funds and are treated as a separate allocation.
In response to questions from Representative Kay, Mr. Cracraft indicated he did not believe KRS had taken a fully passive approach on the equity side just yet, and that KRS’ decision likely is dependent on the upcoming budget and cash flow. If the plan continues to sell assets at a regular rate, it is more difficult to invest in active, niche strategies that tend to be more volatile. A portfolio that is consistently having to sell assets would rather passively invest in the larger market.
In response to questions from Representative Kay, Mr. Cracraft noted that if a plan does have a large number of retirements then one would expect total benefit payments to increase, while the level of active employee contributions would decline. In that scenario, there would be a need for additional employer contributions to make up the difference.
In response to a question from Representative Fleming, Mr. Cracraft clarified that Credit Fixed are strategies that a lot of plans call opportunistic or illiquid credit. Some of these are below investment grade strategies, some are bank loan or direct lending approaches, while others might be distressed debt. The strategies are structured more like private partnerships, generally have longer time horizons, and are more speculative.
In response to a question from Representative Fleming, Mr. Cracraft indicated he believed the recent allocation changes were more reflective of KRS’s concern over equity returns in the short term. Public equity markets, especially in the U.S., have had a tremendous period of growth, and valuations across the board are considered a bit over valued. Capital market assumptions and expectations have come down, so there is concern going forward. Within fixed income, Kentucky has entered a period where most feel rates have to go up, so the opportunity in core U.S. fixed income is also not overly attractive. So, a lot of plans are trying to be more credit oriented, more private. Both TRS and KRS, have been diversifying their fixed income portfolios out of traditional public into more opportunistic credit oriented mandates. End to end, Mr. Cracraft noted that much of this had more to do with concern over the next 5 to 10 years of equity markets.
Mr. Cracraft provided a summary of reported fees and noted that, while passage of SB2 during the 2017 regular session introduced new reporting requirements, the majority of changes are not required until the upcoming fiscal year. For fiscal year 2017, the average management fees, which are based upon market or committed value, were 41 basis points for KRS, 31 basis points for TRS, and 6 basis points for JFRS. Other Fees and Incentives, which are items that were incorporated into SB2, included carried interest and profit sharing, are expenses that will be begin being reported in the first quarter of the 2018 fiscal year. For fiscal year 2017, KRS included these fees, which added 31 additional basis points to management fees, resulting in a total fee of 72.6 basis points. JFRS does not utilize performance incentives, while TRS will begin reporting in the future. KRS Insurance Fund fees are pretty consistent with the pension fund on a basis point comparison. TRS fees are slightly higher for their insurance fund, which is a product of the fund having a more growth-oriented allocation that includes a higher allocation to additional categories.
In a response to Senator Parrett, Mr. Cracraft stated that when management fees are compared to other pensions in the U.S., TRS is likely slightly below peers, while KRS is average to slightly below average of peers.
Mr. Cracraft provide an update on the how the plans were transitioning in regard to new SB 2 compliance requirements. At a high level, each of the plans are working diligently to meet the requirements if they have not already. As of August 2017, both KRS and TRS met new requirements regarding investment expertise on their boards. JFRS cannot comply until current terms expire, but will do so with future appointments. In regard to the Asset Code of Conduct requirement, KRS staff has incorporated additional language for new contracts or renewals, while existing managers have been notified of the law change regarding Code of Conduct. TRS, which had existing code of conduct language in statute, has already required existing managers to comply and has assured that new contracts will incorporate SB2 requirements where not already in place. Public disclosure of investment contracts is likely the most labor intensive of the new requirements, with several hundred managers across the larger plans. Both TRS and KRS are in the process of reviewing their contracts for redaction purposes, and TRS has recently started to post contracts online. Lastly, all three plans have adopted new Investment Procurement policies and submitted them to the Finance Secretary for certification. The TRS and JFRS policies have been approved by the Finance Secretary.
Biennial Budget Request – Judicial Form Retirement System
Donna Early, Executive Director, Judicial Form Retirement System, noted the agency administers both the Judicial Retirement Plan (JRP) and the Legislators’ Retirement Plan (LRP). Ms. Early reviewed return and asset allocation information for both the defined benefit and hybrid cash balance plans of JRP and LRP. The board is pleased with performance and all portfolios have outperformed their policy benchmarks for all trailing periods except the final quarter of fiscal year 2017. The JRP defined benefit plan total portfolio market value was $371 million and the hybrid cash plan is $542,775, while the Legislators’ defined benefit plan totaled $110 million and the Hybrid cash plan was $145,643. Ms. Early stated that performance trends from fiscal year 2017 are expected to continue through the first quarter of fiscal year 2018.
Ms. Early provided preliminary information on cash flow from fiscal year 2017 and noted that both JRP and LRP saw assets grow 10.1 percent over the fiscal year.
Ms. Early discussed funding data and noted a change in the long-term interest rate for the defined benefit plans to 6.5 percent from 7 percent. In regard to the ARC payment, Ms. Early pointed out that the funding formula for JFRS is a statutory formula, which provides for the same appropriation each year of the biennium. For the JRP defined benefit plan, the 2016-2018 biennium budgeted amount was $13.1 million and the preliminary estimates for 2018-2020 are expected to be $8.6 million, which is a decrease of $4.5 million, or 34.36 percent. Using a percent of payroll formula, the JRP contribution rate is expected to decline from 43.66 percent of pay to 31.31 percent. Estimated contributions for the JRP hybrid cash balance plan is estimated to increase $94,000, or 35 percent, which is an increase in dollars, but not percent of pay. For the LRP defined benefit plan, the 2016-2018 biennium budgeted amount was almost $2.4 million and the preliminary estimates for 2018-2020 are expected to be $1.1 million, which is a decrease of $1.2 million, or 53.87 percent. Using a percent of payroll formula, the JRP contribution rate is expected to decline from 53.38 percent of pay to 29.75 percent. Estimated contributions for the JRP hybrid cash balance plan is estimated to increase $5,000, or 35 percent, which is an increase in dollars, but not percent of pay.
Biennial Budget Request – Kentucky Teachers’ Retirement System
Beau Barnes, Deputy Executive Director, Teachers’ Retirement System, discussed the investment performance and rankings relative to public peers. In the past year, TRS’ investment return was in the top 8 percent of the country. Over a 3-year period, TRS ranks in the top 11 percent, over 5 years in the top 13 percent, and over the 10-year period in the top 9 percent.
Mr. Barnes discussed TRS’ gross and net returns. He stated TRS has been able to negotiate among the lowest investment fees in the country. Over the 1 year, net of fee returns were are 15.02 percent, 3 year are 6.03 percent, 5 year are 9.87 percent, 10 year are 6.09 percent, 20 year are 6.55 percent, and the 30 year period gross return is 8.1 percent.
Mr. Barnes provided the systems budget request and highlighted several key components, such as annual budget expenditures, amortized payments, actuarial determined employer contributions (ADEC), and statutory contributions. First, Mr. Barnes discussed annual budget expenditures, which represent normal, recurring budget expenses. The largest and majority of this component is the Commonwealth’s share of the 2010 shared responsibility legislation regarding retired teachers’ health insurance. Next, Mr. Barnes described total amortized payments, which represent past benefit adjustments that the state is amortizing over time, such as prior ad hoc COLA adjustments. Third, Mr. Barnes outlined ADEC, which includes any prior year shortfalls and the remaining funding needed to pay down the current unfunded liability. Next, Mr. Barnes referenced statutory contributions included in the Department of Education budget, which represented the 13.105 percent statutory rate for all employers. Lastly, Mr. Barnes highlighted one additional state expenditure related to the system, which is an expense required for the state to service bonds issued as part of the shared solution. This expense is included in the TRS budget, although all proceeds are used to pay down the existing bonds. Mr. Barnes noted, when all dollars are incorporated, the TRS total budget request for fiscal year 2019 is estimated to by just under $1.3 billion.
In response to a question from Representative Miller, Mr. Barnes stated that TRS continually monitors its actuarial assumptions and can assure the Public Pension Oversight Board (PPOB) all the assumptions are developed fully in compliance with actuarial standards of practice, which are promulgated by the Actuarial Standards Board. Mr. Barnes stated that TRS’ recent payroll growth was 3.5 percent.
In a response to questions from Senator Schroder, Mr. Barnes confirmed that TRS had received proceeds from bonds, which completely fully repaid all funds perivously borrowed from TRS by the state to help pay for retiree health insurance. TRS received the funding from the bonds issued. Senator Schroder highlighted the fact that a lot of misinformation regarding this topic and the use of the funds borrowed. He just wanted to highlight the fact that all funds were used for the TRS health insurance and not general budget balancing.
Mr. Barnes discussed cash flow from the recent fiscal year and highlighted the $495 million increase in employer contributions. Total assets for TRS were $16.8 billion at the beginning of fiscal year 2017 and $18.7 billion at the end of fiscal year 2017. He stated there were still some negative cash flow but still had investment gains of approximately $2 billion.
Biennial Budget Request – Kentucky Retirement System
David Eager, Interim Executive Director, Kentucky Retirement Systems (KRS), made a few opening comments. KRS is beginning to see projections for the first time in quite a while where the unfunded liability is flattening out. All 10 plans experienced an increase in plan assets over the past year and received $98 million over the ARC. Mr. Eager highlighted how hard KRS is working to drive fees down, saying that retirements are up 13.5 percent as of the end of September. About 6,000 additional active members are eligible to retire with full benefits.
Mr. Eager discussed recent assumption changes and highlighted the inflation assumption, which he believes is the key assumption. This assumption drives the investment assumption and he referenced the Federal Reserve’s target of 2 percent, which is just below KRS’ new assumption of 2.3 percent.
Mr. Eager discussed the estimated annual required contributions for each underlying plan. He highlighted the KERS non-hazardous plan, where contributions for fiscal year 2017 were $772.9 million, or 48.59 percent of pay, but are estimated in fiscal year 2019 to total $1,338.1 million, or 84.06 percent of pay. When incorporating all five pension plans and using the revised assumptions for payroll, inflation, and investment return, the total increase in contributions from fiscal year 2018 is expected to be just under $1.0 billion.
Mr. Eager discussed investment returns and stated that from an actuarial standpoint, using the smoothing 5-year model, the return is going to be about 8 percent, while the actual market return was about 13 percent. The actuarial value of assets has been about $800 million more than real market value, so KRS is going to close that gap by about $300 million.
Mr. Eager provided a summary of unfunded liabilities for each system. He highlighted KERS non-hazardous, which, when the revised assumptions were used, was 14 percent funded in fiscal year 2016. Mr. Eager stated that to his knowledge, KERS was the most underfunded plan in the country, and the collective funds are at a tie with New Jersey. Looking at projections going forward, incorporating the additional funding requested, KERS’ unfunded position should bottom out at about $13.45 billion in fiscal year 2018, before beginning to fall.
Mr. Eager discussed cash flow for the fiscal year. While the asset levels for all five pension plans have gone up, they still are not in great shape and relied on investment income. He highlighted the KERS non-hazardous, noting it had $913 million in total cash inflows, which included member contributions of $105 million, employer contributions of $703 million (from $513 million), and the remaining from employer cessation payments and investment income. The total outflow was $971 million so the net cash flow was still negative. Mr. Eager stated there was a similar pattern for all KRS plans.
Representative Kay asked if Mr. Eager thought it would be an advantage to KERS if the Legislators’ Retirement Plan were to share in the KERS non-hazardous retirement plan. Mr. Eager stated he would defer the question to the General Assembly.
Representative Kay made a comment that he believed it would be a good avenue for the legislators to move their retirement to KERS. He noted several comments had been made today that indicate the Legislature’s underfunding has not been the main source of the problem, but he referenced the PFM Group Consulting, LLC (PFM) report #2 that noted underfunding as a huge portion of the problem and estimated total underfunding of KERS non-hazardous to the tune of $2.6 billion. He noted the plan only held $2.1 billion in assets for the plan and the underfunded amount totaled more than what is currently in the plan. Rep. Kay noted past COLAs, which were passed without funding, and highlighted the Legislature’s passage of the law requiring the calculation for the ARC. Mr. Kay stated the Legislature will stand upon its responsibility to fund these systems and not pass the buck.
Representative Linder noted that HB 238 in 2016 required the PPOB to retain an actuary to be paid for by the systems and to evaluate the funding needs prior to each budget biennium. In June, an RFP was issued and it closed on August 8, 2017. During the August meeting, a three-member review panel consisting of Representative Linder, Senator Schroeder, and Co-Chairman Bowen was assigned to review the proposals. Unfortunately, the panel only received two proposals. Therefore, it is the opinion of the Co-Chairs to not reward a contract based on the following information. First, it would save the systems taxpayer dollars due to the requirement already fulfilled by PFM, which sufficiently answered the question of funding, and would therefore be redundant. Second, there was a lack responses, with only two qualified parties. Representative Linder entertained a motion to recommend to the Legislative Research Commission (LRC) that no contract be awarded under the solicitation and that it be cancelled. Senator Bowen moved that the PPOB recommend to the LRC that RFP be cancelled. Representative Webber seconded the motion, and the cancellation was approved without objection.
Public Comment
Gregg Riggs, retired Chief Officer, Frankfort Fire & EMS, wanted to know why the legislative and judicial retirement was treated differently. He stated the JFRS is better funded and does not take the chances like the other systems. Mr. Riggs wanted to know why the legislators even had a retirement plan due to being considered part-time employees under the Constitution. He pleaded for the legislators to either drop their retirement or pool together in the other systems.
With no further business, the meeting was adjourned.