Call to Order and Roll Call
The 10th meeting of the Public Pension Oversight Board was held on Monday, December 18, 2017, at 1:00 PM, in Room 154 of the Capitol Annex. Representative Jerry T. Miller, Chair, called the meeting to order, and the secretary called the roll.
Present were:
Members: Senator Joe Bowen, Co-Chair; Representative Jerry T. Miller, Co-Chair; Senators Jimmy Higdon, Christian McDaniel, Gerald A. Neal, Dennis Parrett, and Wil Schroder; Representatives Ken Fleming, James Kay, Brian Linder, Arnold Simpson, and Russell Webber; J. Michael Brown, John Chilton, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.
Guests: Brad Gross and Bo Cracraft, Legislative Research Commission
LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.
Approval of Minutes
Senator Parrett moved that the minutes of the November 2, 2017, meeting be approved. Senator Bowen seconded the motion, and the minutes were approved without objection.
Recommendations
Senator Bowen opened with a discussion of 2017 Public Pension Oversight Board (PPOB) recommendations. He highlighted that that a great majority of the recommendations made by the PPOB in 2016 were enacted into law during the 2017 Regular session. Senate Bill 2 was a comprehensive transparency accountability proposal signed into law by the Governor on March 10, 2017. Senate Bill 3 required the disclosure of retirement benefit information for current and former members of the General Assembly. Senate Bill 104 addressed many issues related to pension spiking, while House Bill 173, which was a Kentucky Retirement System (KRS) housekeeping bill, was also passed. Senator Bowen noted five recommendations from the 2016 report had not been enacted in law, which he recommended the PPOB re-adopt as recommendations for 2017. The recommendations included:
· Adoption of the Teachers’ Retirement System (TRS) housekeeping bill, similar to provisions included in House Bill 446 during the 2017 Regular Session;
· Legislation to eliminate the option for Legislators’ Retirement Plan (LRP) participants to “spike” their legislative pension from salary earned through other public employment should be enacted;
· General Assembly should evaluate the findings and recommendations of the performance audit conducted by the PFM group and adopt a financially sound approach to address the funding issues facing the state-administered retirement systems. It should also evaluate how to best allocate the funds in the Kentucky Permanent Pension Fund among the state-administered retirement systems;
· PPOB supports measures that would provide additional funding to improve the financial health and cash flow issues facing the Kentucky Employees Retirement System (KERS) nonhazardous pension fund and the State Police Retirement System (SPRS) pension fund;
· PPOB supports measures that would provide additional funding to improve the financial health of the TRS pension fund and that would include a long-term statutory funding plan to pay the actuarially required contribution.
Senator Bowen noted that much of the interim period had been consumed by efforts to craft legislative plans, which would fully fund the pension systems over the long term and implement a sustainable retirement benefit for future teachers, public employees, and retirees. Senator Bowen recognized the obvious philosophical differences regarding how this should be accomplished and noted that some of those differences were represented among the PPOB. Senator Bowen stated a belief that the 2017 PPOB meetings, which included a review of specific pension reform proposals, laid important ground work for the difficult task facing the General Assembly during the 2018 Regular Session.
Senator Higdon recommended two additional administrative recommendations for the board to adopt:
· PPOB should reexamine the fiduciary responsibilities and liabilities of pension board members and actuaries; and
· PPOB should examine the effectiveness of the 2017 pension transparency reforms and determine if additional transparency and accountability measures should be recommended.
Senator Bowen moved that the 2017 Recommendations be approved. Sharon Mattingly seconded the motion, and the recommendations were approved without objection.
Senator Parrett moved that the draft PPOB 2017 Annual Report be approved subject to the addition of the recommendations just approved and any technical edits needed. Representative Fleming seconded the motion, and the draft PPOB 2017 Annual Report was approved without objection.
2017 Actuarial/Financial Update
Brad Gross and Bo Cracraft, Legislative Research Commission staff, provided a year end actuarial and financial update. Mr. Gross began with a summary of the various state retirement systems, which included both pension and retiree health plans administered by KRS, TRS, and the Judicial Form Retirement System (JFRS). Mr. Gross provided a comparison of the total unfunded liability for all plans in 2007 and 2017. In 2007, the total combined unfunded liability for all plans was $26.5 billion, with just over 54 percent of the amount being attributed to the retiree health plans. Moving to 2017, the total unfunded liability has grown to $43.8 billion, with 86 percent accounted for by the pension plans. Mr. Gross noted that over the course of those ten years the pension liability have essentially tripled, while the retiree health liabilities have fallen.
Mr. Cracraft discussed the 2017 actuarial valuation results for each of the state-administered systems and provided a summary of the funding level percentages and unfunded liabilities for each system/plan across both pension and retiree health funds. At a high level, the result reflected a deterioration within the KRS plans, which was largely due to assumption changes, while the TRS and JFRS plans experienced some actuarial improvement.
Mr. Cracraft provided a more detailed review of key changes in the financial health of the three largest plans, which accounted for 90 percent of the total unfunded liabilities. With regards to the KERS and CERS plans, the deterioration in funding levels and additional unfunded liability was primarily due to the assumption change with regards to the assumed rate of return. On the pension side, the change accounted for roughly 90 percent of the unfunded liability growth, while on the insurance side, the assumption changes more than offset positive retiree health premium experience, which caused liabilities to increase from the prior year. With regards to the TRS plans, the unfunded liability was reduced from $14.5 billion to $14.3 billion, which was driven by positive investment experience and lower than expected salary increases. Mr. Cracraft noted that the TRS pension plan did have some negative amortization, or actuarial backloading, which served to partially offset those positive factors. The TRS insurance funds, much like the KRS plans, did see positive retiree health premium experience, which drove the improved funding and reduced liability.
Senator Bowen made a statement to emphasize to members of the Public Pension Oversight Board (PPOB) that the referenced assumption changes were a board decision and not a legislative decision.
In response to a question from Senator Bowen, Mr. Gross noted that with the additional funding in the current budget for TRS, a contribution shortfall was not listed as an unfunded liability growth factor as it had been in the 2016 actuarial valuation review.
In response to a question from Representative Miller, Mr. Cracraft confirmed that, while the KRS boards did decide to reduce their return assumptions, the TRS board choose to keep their assumptions the same.
Mr. Gross discussed the historical trend of the KERS nonhazardous pension and health plans from 2000 through 2017. Looking back at the 2000 fiscal year, the pension fund was nearly 140 percent funded and had a surplus to the unfunded liability of nearly $2 billion. In 2017, the pension fund is 13.6 percent funded and has an unfunded liability of nearly $13.5 billion. On the retiree health side, the plan was 27.4 percent funded and had an unfunded liability of $1.1 billion in 2000 and is now 30.7 percent funded with an unfunded liability of $1.9 billion.
Mr. Gross reviewed employer contribution rates for KERS nonhazardous. Looking back in 2001/2002, the Actuarial Required Contribution (ARC) was just 5.89 percent of pay and given the pension funding levels, all contributions went to fund the retiree health plan. Starting in FY 2003, the budgeted amount was less than the ARC until FY 2015. For the current FY 2018 budget, the ARC is 49.47 percent of pay. There is an additional general fund appropriation above the ARC of $67.6 million. Looking forward, based upon changes to the return and payroll growth assumptions made by the KRS board, the ARC requested for FY 2019 is going to be 83.43 percent of pay. In terms of dollars, KRS has projected an ARC of roughly $844 million for FY 2018 and $1,292 million for FY 2019 for KERS nonhazardous. That represents roughly a $440 million difference, of which half typically comes from general fund dollars.
In response to a question from Senator Bowen, Mr. Gross stated that for FY 2018 and 2019 combined, total employer contributions to KERS would equal roughly $2 billion dollars, with an estimated $1 billion coming from the general fund over those two fiscal years.
Mr. Gross discussed the historical trend of the CERS nonhazardous pension and health plans from 2000 through 2017. Noting the similarity to the KERS nonhazardous plans, the CERS pension plan had moved from a 156.9 percent funded status in 2000, to its current funding levels, and the unfunded liability had grown over the time period by about $8 billion. The retiree health is better funded than the KERS nonhazardous funds, but a similar trend of growth and improvement can be seen.
Mr. Gross discussed the CERS nonhazardous employer contribution rates. Mr. Gross noted that, with the exception of a small component within the judicial branch, the CERS employer rates are not specified or directly impact the state budget. Looking at employer rates over time, a similar trend of rates increasing is seen, but not as high as the KERS nonhazardous fund. Looking forward, based upon changes to the return and payroll growth assumptions made by the KRS board, the ARC for FY 2019 will increase from 19.18 percent to 28.05 percent for local governments. Lastly, Mr. Gross reviewed a summary of the projected employer contributions across all five KRS plans for FY 2018 and FY 2019. The projections, which were calculated by KRS’ actuary, showed the total difference in dollar terms based on the new valuation and assumptions.
Mr. Gross discussed the historical trend of the TRS pension and health plans from 2000 through 2017. Much like the KRS plans, over the time period the funding level and health of the plan has deteriorated. In 2000, the pension was roughly 95.7 percent funded and while there has been some recent improvement, the fund currently is 56.4 percent funded with a $14.31 billion unfunded liability. The retiree health fund is similar to the KRS retiree health funds relative to the trend. Mr. Gross also discussed recent GASB requirements, which results in TRS having to report two significantly different funding levels and liabilities for accounting and traditional funding purposes.
Senator Bowen and Senator Higdon made statements emphasizing how GASB has highlighted how a plans funding levels and the unfunded liability can change as a result of the assumed investment return. Mr. Gross agreed and referenced previous testimony from the state budget director before the board that calculated the plans unfunded liabilities across multiple return assumptions.
In response to a question from Senator McDaniel, Mr. Gross and Mr. Cracraft confirmed the lower assumed rate used for GASB purposes was driven by the plan having a projected date of insolvency, which forced actuaries to use a blended assumed return. As a plan develops a funding policy and the date of insolvency is pushed further into the future or eliminated, the plan can use their higher assumed rate of return. In the case of TRS, the date of insolvency was 2038 in 2017, which was one year further than the prior year’s valuation.
Mr. Gross discussed the funding mechanism for TRS, which differs from the KRS plans. Instead of a single value for the ARC, TRS operates under a fixed employer contribution plus additional direct state appropriations and employer funding. First, there is a fixed employer contribution rate, set by statute, of 13.105 percent of pay for pension and health costs, which has generally been 85 to 90 percent paid by the general fund. In addition to the fixed rate, over time TRS has been receiving additional direct state appropriations, which are funded fully by the general fund. The direct state appropriations include amortized payments for sick leave, ad hoc colas, as well as the state’s portion of the “shared solution” for health care passed in 2010. More recently, beginning in 2007, TRS has also requested additional funds above the fixed statutory rate to fund the pension ARC due to growth in the unfunded liability. During the most recent biennium, an additional $973 million was appropriated in response to the additional request from TRS. Lastly, as part of the “shared solution” passed in 2010, local school districts are contributing an additional 3 percent of pay for retiree health benefits. When combined, in FY 2017, TRS received total employer contributions of roughly $1.24 billion, with $1.06 billion coming from the general fund. Looking at the upcoming biennium budget, Mr. Gross noted total projected employer contributions requested by TRS would increase by $104 million and $71 million for FY 2019 and FY 2020, respectively, above the current fiscal year.
Mr. Cracraft began a discussion on cash flow, beginning with a review of the various components that serve as inflows to a fund, such as contributions and investment income, and outflows to the fund which consist of benefits and expenses. When considering the cash flow of a plan, several factors are either fixed or driven by markets, which serves to put pressure on employer contributions, typically known as the ARC. For example, if assumptions are changed or actual experience is negative or positive, the ARC will adjust accordingly.
Mr. Cracraft provided a historical review of cash flow for the KERS nonhazardous pension fund from FY 2000 to FY 2017. Looking back towards the year 2000, the fund was 140 percent funded, thus little to no employer contributions is seen at this time. In 2001, total outflows grew pretty consistently through 2009, which is largely the result of the plan maturing and a legislative enacted retirement window. Also in 2001 and 2002, investment markets experienced the tech telecom or IPO bubble and the corresponding asset losses. However, while payouts were growing, the strong investment returns of 2004 through 2007 served to partially mask some of the benefit payment growth and the asset base continued to grow. By FY 2009, the plans were experiencing the great recession, payouts more than doubled, and as a result the asset base of the plan cuts almost in half. The result is a much smaller plan, which had less ability to generate investment income and thus more pressure was placed on the employer. From 2010 to 2017, while employer contributions had increased fairly consistently, the total asset value had continued to decline due to level of payouts.
In response to a question from Representative Fleming regarding the asset allocation of KRS during the 2009 time frame, Mr. Cracraft referenced a 2008 Public Pension Working Group that hired a consultant to evaluate the asset allocation for both KRS and TRS. At that time, both plans were invested fairly heavily in public equity, which was one of the worst performers during the market downturn. During the Working Group, there was much discussion regarding the alternative assets classes, which served to be less volatile or risky during the Great Recession. In the end, one of the outcomes from the Public Pension Working Group was a recommendation that KRS and TRS become more diversified, specifically outside public assets. Since that working group, KRS has moved fairly aggressively in that direction, adding real return, private equity, and hedge funds. TRS has also moved in that direction, but a bit more conservatively, stepping into private equity and more private assets over time.
Mr. Cracraft continued with a more detailed review of cash flow for the KERS nonhazardous fund over the two most recent fiscal years, noting two primary takeaways. First, the gap between the total payouts of the fund and total contributions has gotten smaller as a result of the additional employer contributions in FY 2017. Given the size of the fund and its payout ratio, a critical need of the fund would be to reach a point where it could cash flow just on contributions and retain any investment income or asset gains. Secondly, Mr. Cracraft highlighted that if the recommended ARC of 71.03 percent of pay (amount dedicated to pension only) for FY 2019 could be budgeted, the fund would likely reach a point where it would cash flow just on employer contributions. All employee contributions and investment income could be retained to help the fund grow.
Mr. Cracraft moved to a similar discussion on the historical cash flow of the CERS nonhazardous plan from FY 2000 to FY 2017. When compared to the KERS plan, a significant difference between the two is the payout ratio and the asset gain component for CERS. Both plans experienced significant losses in 2001-2002, but CERS was able to capture much of the positive returns over the 2004 to 2007 timeframe as a result of their lower payout ratio. Similarly, after the great recession, while KERS has had to sell almost all their gains to meet payouts, the CERS plan has been able to retain the majority. As a result, over the past several years, the CERS plan has seen total assets grow, while KERS has consistently declined. Mr. Gross added the difference was also a byproduct of the KERS nonhazardous fund rapidly maturing versus CERS, which had a more level growth in benefit payments.
Mr. Cracraft provided a snapshot of cash flow over the past two fiscal years, which highlighted the impact from CERS being able to grow the asset base. Given the larger base of assets, although both plans had similar results, the amount of dollars CERS was able to generate was much larger. From a pure cash flow standpoint, the CERS plan did have some slight negative cash flow over the 2017 fiscal year, as a portion of the asset gains were used to meet total payouts. Much like the KERS plan, if recommended ARC rates for FY 2019 are met, the CERS plan would be projected to cash flow from just contributions.
Mr. Cracraft discussed the historical cash flow for TRS from FY 2000 to FY 2017. Much like the CERS plan, the TRS did not have to sell assets during the market downturns in 2008-2009, and was able to capture most of the upside experienced in 2010 through 2015. More recently, when looking at 2013 and on, total payouts have continued to grow and the fund has had to sell some asset gains to meet payouts.
Much like the KERS fund, when looking at a more detailed review of the most recent two fiscal years, Mr. Cracraft noted that additional TRS employer contributions in FY 2017 had closed much of the gap between total payouts and contributions. However, without the asset gains in FY 2017, the fund did have a slight negative cash flow in the sense it did require a portion of the asset gains to meet benefit payments.
Lastly, Mr. Cracraft referenced sensitivity analysis that is provided within the TRS valuation. While TRS did not change the investment return or payroll growth assumptions like KRS, the sensitivity analysis does give an indication of what would happen to the ARC if the assumptions were to change. Mr. Cracraft discussed a summary of the analysis, which indicated a one percentage point decline in the return assumption would require an additional $300 million in contributions, while moving the payroll growth assumption to zero would require $392 million in additional employer contributions. Mr. Cracraft highlighted that if both of these changes were incorporated, the additional contributions of just under $700 million would put the fund in a position where it cash flowed solely from contributions.
In response to a question from Representative Miller regarding GASB 67, Mr. Gross confirmed that if a funding plan was developed and provided in statute, the GASB and funding values would come together regardless of the assumed rate of return. Mr. Cracraft stated that the GASB number is effectively based on a 4.5 percent assumed rate of return and the sensitivity analysis is based on 6.5 percent, however if the reduce assumed rate of return were to continue, the sensitivity analysis would project a similar level of funding to that of GASB.
In response to a question from Senator Bowen, Mr. Gross stated that GASB is a standardized approach to provide consistent accounting values across all governmental entities. Mr. Cracraft stated that GASB also has to do with multi-employer plans where each employer has to report their portion of the net pension liability on their financial statements. It effectively is supposed to give a more conservative value of their risk and liability.
In response to a question from Senator Parrett, Mr. Gross stated that no actuarial analysis considering another market downturn similar to 2008-2009 had been conducted. This is something that ultimately would have to be systems actuaries. Considering the size of the plans, it would have a larger impact on the funds with more assets.
In response to questions from Senator Higdon, Mr. Gross stated that there is a statutory 1.5 percent Cost of Living Adjustment (COLA) for all TRS retirees and beneficiaries. In years past, the TRS Board would recommend that additional funding be appropriated to provide ad hoc COLAs above this 1.5 percent amount. If awarded, there would be an additional general fund appropriation to pay off one particular ad hoc COLA over a 20 year amortization period. In regards to the COLA formula, Mr. Gross stated that actuaries build valuations based upon assumptions. There is a prefunded cost built in to the normal cost calculation for the 1.5 percent COLA.
In response to questions from Senator Schroder, Mr. Gross stated that at no time in the past did the General Assembly borrow from KERS or CERS to put money into the general fund, road fund, or any other fund. In regards to TRS, Mr. Gross stated that there has been no money directly taken and provided to the general fund, road fund, or any other fund, but there was a situation in 1998 which changed slightly in 2004 where the retiree health fund did not have enough money coming in from a small statutory rate to pay the health benefits set by the TRS board. The TRS Board initially redirected funding and then in 2004 there was a provision put into place that redirected funds from the pension fund to help fund retiree health benefits. A provision was put into place to pay that redirected money back at the assumed rate of return of 7.5 percent and the balance was paid off with a bond issue in 2010.
In response to a question from Representative Miller, Mr. Gross stated that 13.105 percent of pay for pension and health costs for TRS has been in statute since before 2000.
In response to a question from Representative Kay, no members of the board were able to provide an update or status on any pending pension legislation.
Public Comment
Gregg Riggs, a retired fire fighter and state employee provided comment. Mr. Riggs stated that pensions cannot be fixed without addressing tax reform and there has to be a revenue stream. He read an editorial that was published in the Frankfort State Journal on October 5, 2017 in regards to a special session that pension reform and tax reform must be considered together. He commented that legislative retirement needed to be merged into KERS and he asked that a recommendation be made that money put into pension funds not able to be touched by legislators.
Senator Bowen stated that function of the PPOB Board is oversight and not in the business of drafting legislation. He states that legislation has been drafted up to this point that legislators’ retirement fund be part of KRS.
With no further business, the meeting was adjourned.