Call to Order and Roll Call
The fifth meeting of the Interim Joint Committee on State Government was held on Wednesday, November 20, 2013, at 1:00 PM, in Room 154 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 Walter Blevins Jr., Ernie Harris, Christian McDaniel, Morgan McGarvey, Gerald Neal, R. J. Palmer II, Albert Robinson, and Damon Thayer; Representatives Johnny Bell, Kevin Bratcher, Dwight Butler, John Carney, Will Coursey, Joseph Fischer, Derrick Graham, Mike Harmon, Kenny Imes, James Kay, Martha Jane King, Jimmie Lee, David Meade, Brad Montell, Tanya Pullin, Jody Richards, Tom Riner, Bart Rowland, Sal Santoro, Kevin Sinnette, Diane St. Onge, John Will Stacy, Tommy Thompson, Tommy Turner, and Ken Upchurch.
Guests: Bill Thielen, Brian Thomas, and Joe Bowman – Kentucky Retirement Systems (KRS); Gary Harbin, Eric Wampler, and Robert “Beau” Barnes – Kentucky Teachers’ Retirement System (KTRS).
LRC Staff: Alisha Miller, Kevin Devlin, Brad Gross, Karen Powell, Greg Woosley, and Peggy Sciantarelli.
Approval of Minutes
The minutes of the September 25 and October 23 meetings were approved without objection, upon motion by Representative Yonts.
Kentucky Retirement Systems – Status Report; Litigation Update
Guest speaker from Kentucky Retirement Systems was Bill Thielen, Executive Director. He was accompanied by Joe Bowman, staff attorney, and Brian Thomas, General Counsel.
Mr. Thielen said KRS is in the final stages of producing the FY 2013 annual valuation, for submission to the Board of Trustees on December 5. Based on the valuation the Board will set the FY 2015 and FY 2016 employer contribution rates for the Kentucky Employees Retirement System (KERS) and the State Police Retirement System (SPRS), and the FY 2015 rate for the County Employees Retirement System (CERS). The consolidated annual financial report should be published in early January 2014. The KRS actuary will conduct an experience study between January and April 2014. Though required only once every 10 years by statute, KRS does the study at least every five years, with the last one completed in 2008. The actuary will subsequently advise the Board of any recommended changes in actuarial assumptions.
Chief Investment Officer T. J. Carlson resigned effective December 31, 2013, to take a position in the Austin, Texas Municipal Retirement System. After his departure David Peden will serve as interim chief investment officer.
KRS is in the process of implementing the requirements of Senate Bill 2, enacted in the 2013 regular session. The new hybrid cash balance plan will become effective January 1, 2014, for new hires. Implementation of the pension “spiking” prohibition has been somewhat problematic for the technology system but will be completed to the extent necessary by January 1.
In January elections will commence to fill two KERS board members’ terms that will expire March 31. Senate Bill 2 increased board membership from nine to 13. Twelve members are now in place; one CERS position is vacant due to resignation. Recently elected members are David Rich (CERS) and Richard Tanner (Kentucky Association of Counties). Mr. Thielen said that KRS looks forward to working with the Public Pension Oversight Board created by Senate Bill 2.
KRS is involved in four lawsuits of significant impact to the systems. Each is in the discovery stage. The most prominent is with Seven Counties Services, Inc., a mental health services agency in the Louisville KY region. Seven Counties filed a Chapter 11 bankruptcy petition in April 2013, seeking to end the necessity for contributions for its employees in the KERS-nonhazardous plan and ultimately seeking to discharge its debt to the plan. Seven Counties argues that it has the right to withdraw from the plan because it is not a governmental entity. The lawsuit also claims that KRS no longer meets the qualifications of a governmental pension plan and is therefore subject to ERISA (Employee Retirement Income Security Act). KRS argues that Seven Counties is governmental and as such cannot file a Chapter 11 bankruptcy petition. KRS’ motion for a preliminary injunction was denied, and in April 2013 Seven Counties ceased making contributions for approximately 1,000 employees (about $1.1 million monthly) but is continuing contributions for about 400 employees ($300,000 monthly). Motions for dismissal by Seven Counties and KRS were denied. The case will go to trial in March 2014.
The Bluegrass Mental Health/Mental Retardation agency filed suit in Franklin Circuit Court seeking a ruling that it is not eligible to participate in the systems and to clarify its employees’ relationship with KERS. The agency began participating in KERS-nonhazardous by executive order in 1978. It has been ruled that employees of Oakwood Services—a sub-entity created in 2010 for new hires—are not required to participate. KRS has appealed two rulings in the case to the state Court of Appeals.
In 2011, KRS sued Kentucky River Community Care, Inc. (KRCC)—headquartered in Jackson, KY and serving eight eastern Kentucky counties—after learning that KRCC terminated most of its employees and rehired them in Go-Hire Employment and Development, an entity created by KRCC.
In September 2013 Frontier Housing, Inc. (headquartered in Morehead KY) and Housing Oriented Ministries, Inc., (headquartered in Whitesburg KY), two entities participating in CERS since 2002, filed suit in Franklin Circuit Court asking to be declared ineligible to participate because they are not governmental entities.
Responding to questions from Senator Bowen, Mr. Thielen said he could not at this time estimate the potential fiscal impact of the lawsuits. If the entities were able to withdraw from the systems and not pay their share of the unfunded liability, contribution rates would increase, and KERS and CERS participating employers would incur additional cost. He is not aware of other similar cases that have been decided by the courts. Some states, however, have enacted legislation to permit withdrawal from a pension plan if the requesting entity pays its share of the unfunded liability and costs associated with withdrawal.
In response to Representative Yonts, Mr. Thielen said he would provide the committee with copies of the briefs filed in Seven Counties’ bankruptcy petition. KRS does not yet have approval from the Internal Revenue Service (IRS) for the hybrid cash balance plan but, regardless, is obligated by statute to implement the plan. KRS will seek a ruling as soon as possible. Seven Counties evidently was the source when $227 million was reported as its share of the unfunded liability. A good approximation would be $225 million-$240 million, but the KRS actuary will have to determine the proportional share of pension liability for each employer. Those numbers should be available later.
When Senator Thayer asked about implementation of the “spiking” provision in Senate Bill 2, Mr. Thielen said that KRS may propose legislation to clear up uncertainties about some of the language in the legislation but has no plans to make changes to that provision.
Representative Carney expressed concern about the possibility of additional lawsuits and a reported lucrative real estate purchase by one of the current litigants. Mr. Thielen said the Board of Trustees is concerned about the potential fiscal impact if employer groups are permitted to withdraw from the systems.
Representative Montell asked whether the loss of key investment personnel will be detrimental to KRS. Mr. Thielen said that as of December 31 two investment personnel will be leaving—T. J. Carlson and Carlos “Bo” Craycraft. Mr. Craycraft is pursuing a different career path, and Mr. Carlson accepted a higher-paying position with a Texas pension plan that is 90 percent funded. The investment division has highly skilled and certified personnel. KRS would not want to lose them, but this presents a challenge, considering limitations on compensation and increased job opportunities in the financial, legal, and technology sectors. KRS has just presented to the investment committee a reorganization plan that will hopefully provide better career paths and address issues that may exist in the investment division.
Representative Fischer asked about the unfunded liability in KERS. Mr. Thielen said as of June 30, 2012, KERS-nonhazardous was 27.3 percent funded. Numbers for FY 2013 will be available soon. A minor drop in the funding status is expected, mainly because investment return is smoothed over a five-year period. There has been double-digit return in three of the last four years, and funding status should begin to improve for all the plans. Unfunded liability is amortized over 30 years. If 100 percent of the ARC (actuarially recommended contribution) is paid and 7.75 percent investment return is achieved, the unfunded liability should be paid off during that period. Mr. Thielen said he believes the assumed 7.75 percent rate of return is realistic over the long term.
Responding to questions from Senator McDaniel, Mr. Thielen explained how KRS determines whether increases in creditable compensation would be considered spiking, as outlined in Senate Bill 2.
Senator Blevins inquired about the amount of KRS investments within the state and said he would hope at least five percent of invested funds would go toward spurring the economy in Kentucky. Mr. Thielen said he can provide that information to committee staff but that he believes Kentucky investments range from 3.5-4 percent. Investment staff continually look at opportunities to invest in Kentucky.
Senator Bowen asked whether there are any factors contributing to the current funding problem other than those that have been in the forefront of discussions. Mr. Thielen said he is not aware of any and that KRS has been open in its dealings with the General Assembly. The principal factors are investment loss during the past recession, unfunded COLAs (cost-of-living increases), GASB (Governmental Accounting Standards Board) rules that increased liability in the insurance fund, and an unanticipated increase in early retirements. Senator Bowen thanked Mr. Thielen and staff for their attendance and presentation.
Kentucky Teachers’ Retirement System – Funding Status Report
Guest speaker was Gary Harbin, Executive Secretary. With him were Eric Wampler, Deputy Executive Secretary for Finance and Administration, and Beau Barnes, Deputy Executive Secretary of Operations and General Counsel. Mr. Harbin provided copies of his PowerPoint presentation.
Mr. Harbin said the KTRS pension liability is growing at 7.5 percent compounded. To remain actuarially sound, KTRS needs $386 million in the first year of the coming biennium and over $400 million in the second year.
Mr. Harbin reviewed charts illustrating annual employer and employee contribution rates since FY 1999 for KTRS and KRS. He said in FYs 2007 and 2008 retired teachers gave up .8 percent and .7 percent ad hoc COLAs, and the legislature appropriated additional funds to keep KTRS actuarially sound. The legislature appropriated additional funds in the form of $865 million in bonds since 2010—primarily to repay KTRS for $465 million borrowed to fund retiree medical benefits, plus $400 million for transition funding when the Shared Responsibility legislation was enacted to provide long-term funding of retired teacher health care. The total contribution rate is now 29.46 percent, reflecting an additional three percent that active teachers began contributing after passage of the legislation. KTRS was 97 percent funded in 1998-99 but now is only 54 percent funded.
KTRS’ pension structure is a defined benefit (DB) plan, which is the most cost effective method of providing for retirement benefits. Defined benefit plans feature professionally managed investments, lower administrative costs, and insurance against longevity and market timing risks. DB plans provide a bridge through market downturns and can deliver the same benefit at about half the cost of a DC (defined contribution) plan. Mr. Harbin pointed out that in June 2013, prior to the market upswing in July, his personal 401k (DC) plan from his previous 30 years employed in the private sector had the same balance as in March 2000.
Mr. Harbin said KTRS has a strong investment committee structure and a strong nine-member board of trustees. Over the last five years, investment performance has ranked in the top seven percent of public pension plans nationally. The assumed rate of return is 7.5 percent. One-year return was 14.1 percent; three-year return was 12.4 percent, and 30-year return was 8.3 percent.
Kentucky teachers do not receive Social Security benefits, and the average annual pension benefit after 30 years service is about $36,000. Pension reform in 2008 lowered costs by significantly reducing the multiplier for new hires. Sick leave credit, formerly unlimited, was limited to 300 days. Vesting for retiree health care was extended from five to 15 years, and age/years-of-service eligibility requirements were increased. Pension reform also provided more actuarially sound benefits for teachers entering the system from out-of-state late in their careers.
The education community, General Assembly, and Governor came together in 2010 to solve the funding needs for retired teachers’ health care. Enactment of the Shared Responsibility legislation reduced the unfunded liability from over $8 billion to $3 billion.
KTRS administrative costs are among the lowest in the nation for statewide pension plans. In 1998, when “ air time” became law, the Board of Trustees assured that those purchasing it would bear the full actuarial cost. Since the implementation of 2002 legislation, retired teachers returning to the classroom can earn only 65 percent of final salary if retired with less than 30 years of service, or 75 percent if retired with 30 or more years. KTRS has 15,000 members—one out of four classroom teachers—now eligible to retire. If they retired and returned to teaching with less than 30 years service, their starting salary would approximate the pay of a new teacher, thus preserving the retirement dividend for school districts.
Retired teachers’ COLAs have always been prefunded. In January 2006, the Governor’s budget recommended an ad hoc COLA of .8 percent and .7 percent over the next two years but excluded funding necessary to sustain teachers’ pensions. Retired teachers gave up this ad hoc COLA to provide half the funding needed to keep the system actuarially sound, with the General Assembly providing the balance needed during that biennium. Before passage of the Shared Responsibility legislation, teachers were contributing 9.855 percent of pay toward retirement and medical benefits. By the end of the current biennium, the six-year phase-in of that legislation will be complete, and teachers will be contributing 12.855 percent of pay.
Mr. Harbin maintained that KTRS’ funding problem is not due to the structure of teachers’ pensions, investment performance, benefits that are too rich, the need for pension reform, cost of retiree health care, administrative costs of the plan, cost of “air time,” retired teachers returning to work, enhanced benefits, unfunded COLAs, board structure, or teachers not contributing their share. Rather, it is due to the state not being able to contribute its share. Since 2008, the state has not made the required annual contributions for teachers’ pensions. The change in GASB accounting rules in 2015 will require the state to report almost double the unfunded liability—from $12 billion as of June 30, 2012, to $23 billion. The problem grows at compounded rates, and the state’s options to solve the problem will decrease with upward movement in interest rates.
Mr. Harbin offered a framework for a plan to solve the funding problem and keep the system actuarially sound: (1) adopt a long-term solution this biennium that would stop compounding the problem; (2) make required annual contributions by replacing the state’s debt, which is compounding at 7.5 percent, with a pension obligations bond (POB) issued at historically low rates—now 4.3 percent; and (3) establish a minimum time frame for making required annual contributions from the general fund over the next six years. Bonding would be a good option. The $865 million in bonds previously appropriated by the legislature is now worth over $1.1 billion in the investment portfolio. KTRS also has a $250 million timber portfolio. It has been suggested that right-of-ways along interstate highways and parkways in many states are under-utilized assets that could be converted to timber land.
When asked by Senator Bowen, Mr. Harbin said 31 is the average age for a starting teacher, and teachers are eligible for retirement benefits after 27 years of service. The average teacher retires at age 58, with 30 years of service.
When Representative Yonts asked about five, 10, 15, and 20-year investment return, Mr. Harbin said he did not have those figures with him but could provide them. He said 10-year return did not achieve the 7.5 percent assumed rate due to market conditions. He agreed to also provide a chart requested by Representative Yonts illustrating the percentage of unfunded liability attributable to investment return and various other economic factors such as employer contribution levels, retirement rates and turnover, actuarial assumptions, benefits, and COLAs. When Representative Yonts expressed concern about the funding of additional bond debt, Mr. Harbin explained how it would improve liability in the pension fund. He also explained in detail how KTRS retiree health care has been funded over the years.
Representative Montell said, in his opinion, poor investment return has been the main driver in the state’s not being able to pay its share. Mr. Harbin concurred and said that retiree medical insurance cost has also been a primary factor. Representative Montell agreed with Mr. Harbin that the system must be shored up but expressed concern that, while the proposed bonding and budget appropriations would address the current funding status, the lack of investment return going forward could put KTRS back in the same situation. He emphasized the necessity for cooperation and openness in considering options for the future. Mr. Harbin said that KTRS investments have done everything they are supposed to do, and 7.5 percent return is believed attainable. To achieve those earnings, however, assets must be available to invest. It is a difficult situation, both for KTRS and the legislature, but a plan needs to be in place that can guarantee retirement benefits and fulfill the inviolable contract for teachers in the long term. Although the market involves risk, there is risk, too, if the market performs as hoped and there are no assets to invest.
When asked by Representative Bratcher, Mr. Harbin explained the authority and duties of the KTRS Board of Trustees.
Answering questions from Senator McDaniel, Mr. Harbin said that teachers have been eligible for Medicare since 1986 and must enroll in Medicare Part B at age 65. Spouses pay full cost of their health insurance. He confirmed that, without a funding plan, GASB 67-68 will not allow KTRS any discount rate. After the year 2036, the discount would be a blended rate well below five percent. Regarding the KTRS budget request to cover the funding shortfall, if the market averages 7.5 percent return, the $400 million request per year would be a 30-year commitment.
Responding to questions from Representative Richards, Mr. Harbin said that 64.8 percent of KTRS investments are in stocks and 17 percent in bonds, including treasury bonds. Approximately five percent of assets are in real estate, an area of potential future growth. KTRS is in the process of expanding its real estate investments and has been rotating out of bonds, which may be the riskiest asset at present.
When Senator Blevins asked about investments in the Commonwealth, Mr. Harbin said KTRS looks at every opportunity for in-state investment and has $21 million invested in private equity in Kentucky—one of KTRS’ first private equity investments. He said he does not have the figures with him but would provide Senator Blevins a copy of the annual financial report that was recently submitted to LRC.
Subcommittee Report
Senator Bowen, co-chair of the Task Force on Elections, Constitutional Amendments and Intergovernmental Affairs, read the report of the October 22 subcommittee meeting. The report was adopted without objection, upon motion by Representative Graham.
Recognitions and Adjournment
Representative Kay recognized in the audience two of his constituents, retired teachers Kay Cruse and Laura Gray. Senator Bowen thanked Mr. Harbin for his attendance and presentation.
With business concluded, the meeting adjourned at 3:00 p.m.