Interim Joint Committee on State Government


Minutes of the<MeetNo1> 1st Meeting

of the 2015 Interim


<MeetMDY1> August 26, 2015


Call to Order and Roll Call

The<MeetNo2> first meeting of the Interim Joint Committee on State Government was held on<Day> Wednesday,<MeetMDY2> August 26, 2015, at<MeetTime> 1:00 PM, in<Room> Room 154 of the Capitol Annex. Representative Brent Yonts, Presiding Chair, called the meeting to order. He recognized new members of the interim committee, and the secretary called the roll.


Present were:


Members:<Members> Senator Joe Bowen, Co-Chair; Representative Brent Yonts, Co-Chair; Senators Julie Raque Adams, Denise Harper Angel, Stan Humphries, Christian McDaniel, Morgan McGarvey, Dorsey Ridley, and Albert Robinson; Representatives Kevin Bratcher, John Carney, Leslie Combs, Will Coursey, Joseph Fischer, Jim Gooch Jr., Derrick Graham, David Hale, Mike Harmon, Kenny Imes, James Kay, Martha Jane King, Mary Lou Marzian, David Meade, Suzanne Miles, Phil Moffett, Brad Montell, Sannie Overly, Darryl Owens, Tom Riner, Steven Rudy, Sal Santoro, Kevin Sinnette, Tommy Thompson, Tommy Turner, and Ken Upchurch.


Guests: Representative Arnold Simpson; Representative Ruth Ann Palumbo; Beau Barnes, Kentucky Teachers’ Retirement System; and Gabrielle Summe, Kenton County Clerk.


LRC Staff: Judy Fritz, Alisha Miller, Karen Powell, Brad Gross, Greg Woosley, Kevin Devlin, Terrance Sullivan, and Peggy Sciantarelli.


16 RS BR 58, An Act relating to county clerks

Representative Arnold Simpson, sponsor of BR 58, and Senator Chris McDaniel testified in support of the prefiled bill. It was presented for discussion only. Gabrielle Summe, Kenton County Clerk, accompanied them and spoke in support of the legislation. It would repeal 1860 Kentucky Acts Chapter 351, approved February 18, 1860, entitled “An Act to establish an office for the recording of deeds and mortgages at Covington.” Acts Chapter 351 required individuals recording deeds and mortgages relating to properties in certain areas of Kenton County to file those in Covington rather than Independence.


Ms. Summe explained why Chapter 351 was created in 1860 and how its repeal will benefit Kenton County through cost savings and increased efficiencies, both administratively and for the general public. There is no longer a need to divide the county for the purpose of recording deeds and mortgages. Repeal of the 1860 Act will simplify the recording process and make it less confusing.


There were no questions from the committee, and Representative Yonts thanked the speakers.


Kentucky Teachers’ Retirement System – Funding and Unfunded Liability

The guest speaker was Beau Barnes, Deputy Executive Secretary of Operations and General Counsel, Kentucky Teachers’ Retirement System (KTRS). He provided print copies of his on-screen presentation.


Mr. Barnes stated that KTRS was established by the General Assembly in 1938 and funded in 1940. KTRS administers a defined benefit group retirement plan for local school districts and other public educational agencies in the state. Current employers are comprised of 173 local school districts, the Kentucky Community and Technical College System (KCTCS), 17 educational agencies, and five regional universities (Eastern, Western, Murray, Morehead, and Kentucky State Universities). KTRS hires professional consultants for actuarial, legal, auditing, financial, and other services to assist the Board of Trustees and staff. KTRS is also a member of 14 professional organizations. Payments to consultants, including money managers, are enumerated in the KTRS comprehensive annual financial report.


The KTRS normal cost to pay retirement benefits is modest at 16.75 percent of payroll, with the state’s contribution at 7.64 percent. KTRS does not have funds to meet its other kind of cost—the unfunded liability, represented by benefits compensation already earned by teachers.


KTRS has low administrative and investment costs. Investment performance has been solid and had a positive impact on Kentucky’s economy. A 2012 report by the LRC Program Review and Investigations Committee shows that KTRS investment fees and administrative expenses from FY 2002 to FY 2009 were among the lowest in the nation. KTRS manages about one-third of its assets in house, which helps keep investment costs low. As of June 2014, KTRS administrative expenses, as a percentage of assets, were lower than those of similar size systems in Kansas, New Mexico, Georgia, Louisiana, Ohio, and Indiana. KTRS also bears the cost of administering a retiree medical insurance program, unlike some other similar size plans.


Mr. Barnes said the KTRS Board has administered the retirement system in a reasonable and cost efficient manner. Changes directed by the Board put reemployment on an actuarially sound basis. The average retirement age increased from 54 to almost 58 and average years of service at retirement increased from 27 to 30. Purchasers of “air time” are required to pay full actuarial cost. The annual guaranteed 1.5 percent cost-of-living-adjustments (COLAs) that teachers receive each July are prefunded within the contribution rate. Funding to increase COLAs above the 1.5 percent level have been included in past KTRS budget requests, but the increases were not granted unless prefunded. Per board direction, medical benefits are now prefunded. Since the passage of shared responsibility legislation in 2010, teachers now pay an additional 3.75 percent of their salary for retiree medical benefits. Other modifications to the health insurance program prevented an additional $5 billion unfunded liability in the medical insurance fund from accruing. KTRS saves $11 million annually on purchase of retiree medical prescriptions through a coalition with the University of Kentucky, the University of Louisville, and other agencies. The Investment Committee is structured to generate top investment performance, and KTRS does not do business with money managers who use placement agents. KTRS investment costs are among the lowest in the nation. The investment committee is advised by two highly reputed New York investment consultants, Bevis Longstreth and George M. Philip.


In FY 2015, KTRS paid approximately $2.1 billion in retirement benefits. This has had a positive impact on Kentucky’s economy, since 92 percent of retirees live in the state. KTRS has 141,520 members and distributes more than $144 million monthly in retirement benefits. Of 58,967 active members, almost 15,000 are eligible to retire. There have been 1,491 retirements in 2015, the most in any one year since 2001. In June/July 2015, there were 2,082 visitors to the KTRS office, compared to 1,812 in June/July 2014.


Before 2002, teachers and administrators from other states would come to Kentucky to teach for five years in order to access the medical insurance benefit, a practice that was actuarially unsound. As a result of board action, the General Assembly enacted legislation to change requirements for medical insurance participation and to lower the benefit factor from 2.5 percent to 2 percent for retirees having less than 10 years of service. Pension reform legislation in 2008 further adjusted the benefit factors for service of less than six, 10, or 20 years.


Since 2008, KTRS has experienced a negative cash flow. Income from contributions and investments was not sufficient, and it was necessary to begin selling assets in order to pay retirement benefits. Approximately $9.5 million in assets were sold in 2008. About $600 million in assets were sold in the last fiscal year. In FYs 2016-2019, KTRS will need to sell approximately $3.4 billion in assets. Investment strategy is becoming increasingly constrained by liquidity requirements. These constraints will lower future investment returns. Additional funding will help stabilize the situation and improve liquidity. A fixed employer contribution of 13.105 percent was sufficient for years. KTRS investments have performed well since 2013, but due to the 13-year flat market between 2000 and 2013 and the 2008 Great Recession, additional funding for pensions has been needed since the 2006-2008 budget biennium.


A request for additional funding of about $42 million was appropriated in the 2006-08 budget, but additional funding has not been made available in subsequent budget cycles. Without additional funds to begin reducing the unfunded liability, the deteriorating pension fund will be in peril. The KTRS draft budget request for FY 2017-18 indicates that $520,372,000 additional funds will be requested in the first year of the biennium and $488,896,600 in the second year in order to put the pension fund on an actuarially sound basis. This is over and above the request for the statutory 13.105 percent employer contribution. The estimated additional funding requests for the upcoming budget have grown from the $386,400,000 and $487,400,000 amounts requested for FYs 2015 and 2016. Prior to enactment of the shared responsibility legislation enacted in 2010, the employee contribution rate was 9.855 percent. The rate will be 12.855 percent in FY 2015-16, completing the gradual phase-in of additional contributions by employees.


In FY 2007, there was $20 million positive cash flow in the pension fund. Negative cash flow is growing each year, from $10 million in FY 2008 to $439 million in FY 2014. In the last fiscal year 26.5 percent of benefits were paid from selling assets. Negative cash flow is projected to be $650 million in FY 2015 and, without additional funding, to reach over $1.8 billion by FY 2026. Data for FY 2015 will be available later in the year.


As of June 30, 2014, the pension fund was 53.6 percent funded and had an unfunded liability of $14 billion. Under new reporting requirements of the Governmental Accounting Standards Board (GASB) the funding level for the pension fund would drop to 45.6 percent for FY 2014. Medical insurance was funded at 15.9 percent as of June 30, 2014, and the percentage funded is growing each year. The GASB mandate to use a lower assumed rate of return does not apply to the medical benefit fund because it is being funded on an actuarially sound basis. The Commonwealth’s General Fund provides about 95 percent of the employer contribution for KTRS. By comparison, about 52 percent of the employer contribution for Kentucky Retirement Systems comes from the General Fund.


At the July 31 meeting of the KTRS Funding Work Group established by Governor Beshear, Morgan Stanley executives William Mack and Dennis Farrell testified that the three major bond rating agencies—Moody’s, Fitch Group, and Standard & Poor’s (S&P)—are concerned about the unfunded liability and it is becoming a huge issue for states. Moody’s gives equal weight to bond debt and unfunded pension liability. Ryan Barrow, Executive Director of the Office of Financial Management, Finance and Administration Cabinet, said he receives inquiries weekly from the bond rating agencies regarding the unfunded liability of the teachers’ pension fund and activities of the work group. He also receives inquiries from potential buyers of Kentucky bonds, and some are not buying them because of concern about unfunded liability. Mr. Mack and Mr. Farrell testified that a pension obligation bond by itself is not a solution and would have a negative impact on the Commonwealth’s credit rating. A pension obligation bond coupled with a plan can be a neutral event that would not lead to a downgrade in Kentucky’s credit rating. They also said the unfunded liability of pension plans can dry up debt capacity just as bonds do. Fully funding the actuarially required contribution is the key to any solution.


Mr. Barnes said he testified to the work group about the scope of the inviolable contract and the findings of the 2007 Blue Ribbon Commission on Public Retirement Systems, which did a detailed study of the inviolable contract of KTRS and Kentucky Retirement Systems. He said the inviolable contract covers all of the KTRS governing statutes—KRS 161.220-161.710. The inviolable contract is subject to amendment, however, for certain retirement allowance calculations, post-retirement reemployment provisions, benefits for members serving as part-time or substitute teachers, the retirement factor for certain qualified years in excess of 30, retired teachers’ health insurance, and sick leave payments used for retirement calculation purposes. Regarding retiree health insurance, the inviolable contract applies only to access to group coverage. The work group asked about the guaranteed 1.5 percent cost-of-living adjustment for teachers, which is guaranteed by the inviolable contract. It is built into the contribution structure and is included in KTRS budget requests. Because teachers are not eligible for Social Security benefits, the guaranteed COLA is intended to replicate the annual COLAs provided by Social Security. The KTRS Funding Work Group has scheduled six more meetings and will file its final report by December 1, 2015.


The Public Pension Oversight Board received an update on KTRS investment performance at its August meeting. KTRS continues to rank near the top in investment performance when compared to other pension plans. One-year return was 5.1 percent; 3-year, 12.3 percent; 5-year, 12.0 percent; 10-year, 7.0 percent; 20-year, 7.6 percent; and 30-year, 8.7 percent. KTRS investment return compared favorably to CalSTRS, the California State Teachers’ Retirement System, which is one of the largest pension plans in the world. CalSTRS has $191.4 billion in assets and is 68 percent funded.


Mr. Barnes concluded his presentation. During the discussion that followed, several members thanked him for the presentation and commended him for his work.


Responding to questions from Representative Montell, Mr. Barnes said that, based on the current 45.6 percent funding level, GASB projects that the pension fund would probably be depleted in 2036. Approximately 11.5 percent of the current 13.105 percent employer contribution is directed solely toward pensions. Representative Montell said that, for all practical purposes, pensions were fully funded in the year 2000. Today’s presentation indicates the normal cost of teachers’ pension benefits would require a state contribution of only 7.64 percent. He stated that it was not the lack of funding by the legislature that led to the current unfunded liability. The Commonwealth has not missed one year of funding the employer contribution at 13.105 percent or higher. The solution will not be easy, but it is imperative to address the whole picture and not just funding and investment return. The additional funds requested would not be sufficient in the event of another market downturn.


Answering questions from Senator McDaniel, Mr. Barnes said that Social Security coverage for Kentucky teachers is a possibility but would require a referendum in each school district. It would also be expensive, costing the Commonwealth approximately $90 million per year. He explained the statutory process for selecting board members. The State Treasurer and Commissioner of the Department of Education are ex officio members of the Board. Currently there is one vacancy. With regard to retiree health insurance, the dependent subsidy is provided under the shared responsibility plan enacted in 2010, and retired members pay the full cost of their coverage. Mr. Barnes said he is unsure about the cost of the dependent subsidy but will get that information for Senator McDaniel. He believes it is about $2 million.


Senator McDaniel asked whether, in the event of system default and teacher retirement becoming pay-as-you-go system, is it accurate that the general fund would have to make direct payment, through KTRS, for retiree pensions. Mr. Barnes said that is what the inviolable contract language would say, but financial reality would likely make it impossible. Senator McDaniel said, for example, that if bonds were issued at 4.5 percent interest, to be repaid by the general fund, and KTRS achieved the 7.5 percent assumed rate of return on the bonds, the interest cost to fund the retirement system under a bonding scenario would be 12 percent just to break even. It is important to understand that issuance of a bond would dramatically increase the required rate of return on behalf of the Commonwealth. Mr. Barnes said it is ultimately taxpayer dollars that are involved.


Representative Marzian said she is alarmed by the size of the unfunded liability and believes bonding is the only option. When she asked about interest rates, Mr. Barnes said nothing is guaranteed, but he is optimistic. Indications are that the Federal Reserve will not raise interest rates in the fall.


Responding to Representative Riner, Mr. Barnes said he has heard that House Speaker Greg Stumbo may prefile legislation to direct money from casino gambling into the KTRS pension fund, but he has not spoken with him and is not familiar with the details.


Representative Moffett asked whether thought has been given to extending the amount of service needed in order to retire. Mr. Barnes said the KTRS board has not been averse to changing the plan and has made numerous changes during his own tenure. The Board also established a funding and benefits committee that examines possible tweaks to the plan. The KTRS funding work group has been looking at the possibility of a different benefit tier for new teachers and changes in areas not covered by the inviolable contract.


Representative Carney said he supports structural change to the system and hopes the work group will offer some viable recommendations. He also asked how Social Security spousal survivor benefits would be affected by a KTRS retirement allowance. Mr. Barnes explained that the government pension offset, which is a federal provision that can be changed only by Congress, would reduce spousal survivor benefits by two-thirds of the KTRS retirement allowance. For example, for a $30,000 retirement allowance, $20,000 would be applied to reduce the spousal social security benefit. In most cases the offset would in effect eliminate the spousal social security benefit.


Responding to questions from Representative Upchurch, Mr. Barnes said cash flow for the past fiscal year was worse than expected. The 2036 target year for possible depletion of the pension fund is subject to revision. It could be earlier than 2036 if nothing is done. He confirmed that contributions previously borrowed from the pension fund had been repaid in full, with interest. The Commonwealth issued a bond in August 2010 for $469 million; $2 million went for bond issue cost, and $467 million went back into the pension fund. Representative Upchurch said some of his constituents did not know the money had been repaid. They believe the fund will soon be bankrupt and that the legislature’s failure to enact legislation in 2015 to address the unfunded liability was in essence a vote against teachers. Hopefully, there will be some resolution when the legislature meets next year. In the meantime it would be helpful if the professional organizations would do a better job by communicating accurate information to teachers and retirees. Mr. Barnes said it is essential for the General Assembly, governor’s budget staff, teachers, and everyone involved to have accurate information in order to solve the problem.


Responding to questions from Representative Harmon, Mr. Barnes said that KTRS foresees future rates of return close to 7.5 percent and feels that is achievable. As of June 30, 2015, 30-year return was 8.7 percent. Some experts view the recent market correction as a good thing. Stocks declined by more than 10 percent, compared to a bear market which is a decline of more than 20 percent. Regardless of what the market does, KTRS has a cash flow problem that requires the selling of assets. In the event of future market downturns, assets might have to be sold at less than actual value in order to pay retirement benefits. The loss in stock value would then further affect the benefit fund. The Morgan Stanley experts spoke about funding as a means to get through a down market, especially when considering the liquidity issues of KTRS. When KTRS was 97 percent funded in 2000, it was based on an illusory market created by the “dot com” bubble. Before that, funding percentage was in the low 70s and returned to that level after the tech market crashed. Negative cash flow is probably going to be over $700 million this year and over $800 million next year.


Responding to a question from Representative Imes, Mr. Barnes reviewed figures in his slide presentation to explain how KTRS arrived at the dollar amount for the $3.3 billion bond proposed in the 2015 regular session. He said that amount was chosen because the revenue streams supported it. The larger the cash infusion to the pension fund, the more time will be available to slowly phase into the full additional funding needed for the pension fund.


Representative Thompson said the KTRS investment return has been exceptional. The assumed rate of return is 7.5 percent, even though the U. S. economy has been growing at only about 2.3 percent. He asked Mr. Barnes whether the unfunded liability would increase if KTRS is able to earn only 2 or 3 percent on investments. Mr. Barnes said that is correct, and stocks would have to be sold below value.


In response to Senator Bowen, Mr. Barnes said KTRS has a number of alternative assets—timberland, for example—and that their value is counted when measuring the unfunded liability. The alternative assets have been strong performers.


Senator Bowen, Co-Chair of the Task Force on Elections, Constitutional Amendments and Intergovernmental Affairs, read the report for the August 25 meeting of the task force.


There being no further business, the meeting was adjourned at 2:49 p.m.