Call to Order and Roll Call
The second meeting of the Interim Joint Committee on State Government was held on Wednesday, August 24, 2016, at 12:00 noon, at the Muhammad Ali Center in Louisville, Kentucky. 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 Julie Raque Adams, Ralph Alvarado, Stan Humphries, Christian McDaniel, Morgan McGarvey, Dorsey Ridley, Albert Robinson, and Damon Thayer; Representatives Kevin Bratcher, John Carney, Jim Gooch Jr., Derrick Graham, Kenny Imes, James Kay, Martha Jane King, Mary Lou Marzian, Suzanne Miles, Phil Moffett, Brad Montell, Tom Riner, Steven Rudy, Sal Santoro, and Rita Smart.
LRC Staff: Judy Fritz, Jennifer Black Hans, Bo Cracraft, Karen Powell, Kevin Devlin, and Peggy Sciantarelli.
Approval of Minutes
The minutes of the June 22 meeting were approved without objection, upon motion by Representative Yonts.
Senate Bill 2 (2016 RS) – Analysis and Discussion of National Trends
Jennifer Hans and Bo Cracraft, LRC staff, presented an overview of SB 2 and the various proposals that arose from that legislation during the 2016 regular session of the General Assembly. In conjunction with a slide presentation, staff reviewed the proposals in SB 2 and analyzed certain key aspects and national trends relating to the proposals. (Ms. Hans and Mr. Cracraft gave a similar presentation to the Public Pension Oversight Board on June 27, 2016.)
Ms. Hans reviewed the significant components of SB 2 and the Senate committee substitute to HB 449—both passed by the Senate—and a proposed House committee substitute to SB 2. She said that both the Senate and House versions would require the Judicial Form Retirement System (JFRS) to create a Web site for purposes of transparency. JFRS subsequently decided to do so, and a functioning Web site is now in place. Although Kentucky Retirement Systems (KRS), Kentucky Teachers Retirement System (KTRS), and JFRS have chosen to ban the use of placement agents, the legislation would require this by statute. Both the Senate and House versions addressed investment experience required of KRS board members; reporting of investment expense; public disclosure of contracts and exemptions to disclosure; reporting of investment return; addition of legislative members to the Public Pension Oversight Board; and adherence to Chartered Financial Analyst (CFA) Institute standards. SB 2 would place KRS, KTRS, and JFRS under the Model Procurement Code, but they would remain exempt under the House version. SB 2/GA would require Senate confirmation of appointed KRS/KTRS trustees and the executive director and also would place KRS under the state personnel system; HB 449 SCS and the House proposed substitute would not. The Senate version also proposed adding members to the KTRS board.
Ms. Hans reviewed the governor’s Executive Order 2016-340, which was issued June 17, 2016, and contained provisions similar to SB 2. The order abolished the KRS Board of Trustees, replacing it and transferring its powers to a KRS Board of Directors. It expanded the board from 13 to 17 members; reappointed 13 existing trustee positions; added four new appointed trustee positions, for a total of 10 appointees; required six appointed trustees to have investment experience as defined by KRS 61.645; and provided that the governor shall name the chairperson and vice chairperson. Effective 90 days from issuance, the order would place KRS staff—except the executive director—under the state personnel system and apply CFA Institute standards to the KRS staff, board, and outside managers. Effective July 1, 2016, it required posting to the KRS Web site of all investment holdings, fees and commissions—including underlying managers in Fund of Funds—profit sharing, carried interest, and partnership incentives; and all contracts or offering documents for services, goods, or property purchased by KRS. Ms. Hans said that litigation challenging the executive order was filed by the Attorney General and two existing members of the board of trustees. Franklin Circuit Judge Phillip Shepherd issued a temporary order for injunctive relief on August 22 that addressed several of the governor’s executive orders. His ruling enjoined the removal of a KRS board member but upheld Executive Order 2016-340, which is now in full effect.
Ms. Hans and Mr. Cracraft discussed their analysis of the Model Procurement Code (MPC), investment expense reporting, contract disclosure, and board composition, including the approach taken by other states.
Ms. Hans said that Kentucky Retirement Systems was exempted from state purchasing laws in 1972. In 1978, KRS 61.645 granted contracting authority to the KRS board and exempted it from the MPC, which went into effect that year. Justification for the exemption was that the board had an independent fiduciary responsibility to its members that should be reflected in statute. In 1994, however, the legislature amended the statute to remove the MPC exemption but restored the exemption in 1998. KRS has a written procurement policy, adopted by the board, which requires bidding or a request for proposal (RFP) for any contract over $40,000. The MPC requires contract authorization for any amount over $20,000 or a limit granted by the Finance and Administration Cabinet.
KTRS was exempted from state purchasing laws in 1972. In 1978, when MPC went into effect, KRS 161.340 granted contracting authority to the KTRS board and exempted it from the code. KTRS has a written procurement policy adopted by the board, with a threshold of $30,000, above which it recommends that bidding or an RFP be executed.
JFRS was subject to the MPC prior to 1994 but was exempted in 1994 when HB 183 amended KRS 21.540. Justification for the exemption was to conform JFRS to the other retirement systems and avoid the “tremendous burden” imposed by the MPC contracting process. It was also felt that changing providers could be detrimental to the funds. KRS 21.540 grants contracting authority to the board without MPC limits. JFRS has no written procurement policy but implements an RFP process for its investment brokers.
A survey of 50 states and the District of Columbia indicates that 29 states (57 percent) do not exempt their state retirement system from a model procurement code, and 20 states (39 percent) have an explicit exemption for their state retirement system. The status in two states was indeterminable. Illinois exempts its retirement system from the model procurement code but requires by statute that the system adopt a written procurement policy. Of all states analyzed, Illinois most closely mirrors the provisions of SB 2.
Senator McDaniel asked whether the 29 states with no MPC exemption have better-funded pension plans than the Kentucky Employees Retirement System (KERS) nonhazardous plan. Ms. Hans said that several of the 29 states have better-funded plans. Mr. Cracraft noted that few states, with the exception of Illinois, have worse funded plans than KERS.
The staff slide presentation indicated that a lack of clear reporting standards for investment expense reporting has created ambiguity, specifically as it relates to alternative asset strategies. This has led to a wide variety of reporting within the industry. Governmental Accounting Standards Board (GASB) statements 25 and 67 leave the decision up to individual funds. The desire for transparency and consistency in reporting is reflected in standards of the Institutional Limited Partners Association (ILPA). Ms. Hans noted that the ILPA standard was discussed at the recent annual meeting of the National Conference of State Legislatures.
Mr. Cracraft said there has been much public discussion about transparency relating to management fees paid in Kentucky and surrounding states and whether the use of placement agents is appropriate. Plans the size of KERS and KTRS are generally not using placement agents. When dealing with firms that employ them, placement agents can be written out of transactions. Most plans are reporting some or all of their management fees, which are flat or percentage-based fees paid regardless of performance or markets and which are typical for traditional assets. Management fees are generally calculated from a base percent of assets and invoiced monthly or quarterly. Alternative assets also have management fees, generally a flat one or two percent of assets or of assets that have been committed to the general partner. Incentive or performance fees, which include carried interest and portfolio company fees, are fees tied to performance. They are typical for private equity, hedge funds, or other alternative assets. Plans that have private equity or alternative partnership agreements are paying carried interest. Most plans are not reporting carried interest as an expense but are netting it against the income of the fund. Kentucky Retirement Systems—and plans in South Carolina and Missouri—are reporting private equity carried interest or incentive related fees. Some plans include a note in their financial statements that they are paying it but do not disclose the amount.
Plans the size of KERS or KTRS often incorporate a fund of funds portfolio. (Fund of funds is an investment strategy of holding a portfolio of other investment funds rather than investing directly in stocks, bonds, or other securities.) Typical plans do not report underlying “child” fund expenses. Fees are netted against net asset value of portfolios. Only “parent” manager fees are reported. KRS utilizes its fund of funds for hedge fund investing, whereas KTRS’s fund of funds invests in private equity. Fund of funds managers charge a management fee and an incentive or performance fee. They monitor the portfolios and are responsible for reallocating within them. The underlying funds have fees as well. Historically, those are not being reported at the plan sponsor level—the KRS level—but are netted out of performance. SB 2 GA/HB 449 SCS would require expenses to be disclosed by the manager, including underlying fund of funds; disclosure of all alternative incentive arrangements such as carried interest, profit sharing, and performance fees; and disclosure of “net of fee” return information. The House proposal, to the extent information is available, would require disclosure by individual managers and partnerships, including reporting of fees paid for profit sharing, carried interest, and partnership incentives—all in accordance with ILPA standards. The House proposal calls for a good faith effort by the systems to gain information and did not include reporting on fund of funds.
KRS is asking all its private equity and hedge fund managers to provide fee information on a quarterly basis. They are receiving about 98 percent of the information requested; the remaining two percent generally represents managers with whom they are no longer doing business.
When Representative Montell asked about the extent of the fund of funds portfolios, Mr. Cracraft said most plans start with the fund of funds route and, as they become comfortable, reallocate a portion directly with managers. KRS is in the midst of that process and at the recent investment committee meeting indicated it will have about five percent of the total fund allocated to fund of funds. KTRS has less than a one percent fund of funds allocation—for private equity—which accounts for only about 5.9-6.5 percent of its portfolio. Although KTRS may have only one-half percent in fund of funds, it may include 30 private equity underlying partners. KRS may have 60 underlying managers in its one fund of funds. With that size portfolio, aggregating the information becomes an administrative burden.
Senator Bowen reminded the committee that the funding situation in Kentucky is direr than in any other state, except for Illinois. Other states have also achieved better investment returns than Kentucky.
Staff’s slide presentation indicated that the lack of a standard has resulted in a variety of reporting. Only a handful of plans are meeting 2016 legislative mandates. Mr. Cracraft said that Kentucky plans have taken different approaches. KRS has about 98 percent of its private equity and hedge fund fees incorporated into the most recent fiscal year numbers. KRS is only reporting fees at an asset class level, not a manager level. KTRS is treating carried interest as profit sharing. It is netted out as net income of the fund. Both KRS and KTRS are not reporting the fund of funds. That would be an additional level of disclosure required in the Senate proposal. JFRS has a single asset manager who manages public equities and public fixed income and does not have any partnership level agreements. JFRS invoices only management fees. GASB language has left it up to the plans whether or not to break out incentive related fees. Most plans are reporting all management level fees. A small minority of plans, which appears to be growing, is reporting private equity and alternative type related fees as expenses—for example, Missouri and South Carolina, which is on the forefront. Both the Senate and House proposals agreed on the need to start reporting returns net of fees.
Information on net versus gross reporting in 44 states reveals that the majority, or 57 percent, are reporting net of fee returns. States are trending toward a net of fee reporting cycle. The most recent financial statements of the 50 states indicates that 19, or about 38 percent, are reporting manager level fees. Reporting of manager level data may differ from state to state. One may report manager level fees but not include alternative managers or other type fees.
With respect to investment contract disclosure, SB 2 GA/HB 449 SCS would have required public disclosure of all contracts, except those which, if disclosed, would negatively impact ability to competitively invest in real estate or other asset classes. All contracts, regardless of exemption would be subject to review by the trustees, state auditor, and the legislative Government Contract Review Committee. The House proposal did not require public disclosure of contracts. All contracts, regardless of exemption, would be subject to review by the board, state auditor, governor, or members of the General Assembly, provided the individual signs a confidentiality agreement. Investment manager agreements (IMAs) are not generally public. Fee information is negotiated and a “most favored nation” clause may apply. None of Kentucky’s state plans now provide public disclosure of IMAs.
Mr. Cracraft said he has not been able to find state postings of IMAs online. Several states have transparency portals that provide information on service contracts, whether with a consultant or an investment data provider. Information is not generally available with respect to general partners or investment manager contracts. The concern is that if a contract were to be made available and everyone knows what is being paid for a product, it could trigger a “most favored nation” clause. Asset managers are more concerned about this because not only will competitors know what they are offering but, more importantly, consultants will know. In addition, many IMAs reveal portfolio guidelines, and this is a manager concern. Ms. Hans noted that the IMAs being discussed are specifically exempted from KRS’s written procurement policy.
Ms. Hans reviewed board composition of KRS, KTRS and JFRS. Under SB 2 the governor’s appointees would become subject to Senate confirmation, and it would narrow the definition of investment experience. There were no proposed changes to the JFRS board. With respect to the KTRS board, SB 2 would have added additional gubernatorial appointees, and two appointees would be required to meet a revised “investment experience” definition. A previous staff study of 25 similar integrated organizations found that they generally had boards that seated from 7-20 members, with a combination of elected and appointed members; 14 states required some investment experience.
Senator Bowen said it is a nonpartisan goal of the General Assembly to position the retirement systems to meet obligations to state employees and retired teachers. From his perspective, transparency would be the natural first step. KERS and KTRS have had a fair amount of exposure in hedge funds and alternative investments. Those investments have the highest fee structure, and it is difficult to determine the actual cost of the fees. KRS and KTRS have not met their benchmarks in the last several years, in spite of an extended bull market period. Their investments have failed to exceed nationwide standards, whereas JFRS has had a positive return on investment.
Senator Bowen said that at the most recent meeting of the Public Pension Oversight Board, when he asked presenters representing JFRS whether they would object to being subject to the MPC, they said they would not. He said SB 2 is an attempt to salvage the systems and put them on the road to recovery. He is open to any compromise or conversation that will help advance what he believes are important components of SB 2. He added that the original version of SB 2 included a number of compromises.
Senator McDaniel contended that requirements for full disclosure of fees does not negatively affect funding status. He asked about investment fees charged to KERS and KTRS last fiscal year, and Mr. Cracraft said it totaled $118 million for the pension and insurance funds combined. There was negative impact on investment income, but there was some positive income for servicing cash flow. Senator McDaniel said that with a 6.75 percent assumed rate of return, a certain amount of growth on assets would have been expected, but the systems experienced a decline. The point, he said, is that the General Assembly for two years, through its appropriations, did its job exactly as anticipated, but failure continued at the system level.
When Representative Bratcher inquired about Tennessee’s retirement system, Mr. Cracraft said Tennessee has a less complicated portfolio but does have alternative assets. That state would probably be considered “middle of the road” with respect to investing in traditional assets like public equity and fixed income, but it also has a small allocation in private equity. Senator Bowen said that Tennessee’s pension system, which was discussed during the recent Southern Legislative Conference, is flush, with relatively little or no debt, and its rainy day trust fund is in the hundreds of millions.
Senator Bowen said that a quick calculation at the recent Public Pension Oversight Board meeting indicated that if the KTRS system used the same investment model and realized the same investment return as the judicial system, the fund would have realized income between $600 and $700 million last year. He said the General Assembly is responsible for making the proper appropriations and must continue to do so. However, the question needs to be raised whether KRS and KTRS are using suitable investment models.
When Representative Kay asked how the fees compare in size with other public plans, Mr. Cracraft said that KRS would be slightly above the median and that KTRS would probably range in the bottom 25 percent. Representative Kay, noting that JFRS is much better funded than KERS, said he believes it is worthwhile to consider combining the two plans as a show of solidarity—an idea he has proposed in the past. State employees would then know that when legislators are making decisions about their pensions they are not making separate decisions about the pensions of legislators and judges. He told Senator Bowen that he appreciates his efforts for transparency and accountability and that he, too, feels the time has come to take a closer look at the fees being charged by private equity firms and hedge funds.
Representative Montell said that Representative Kay’s idea of combining the systems is worth considering. He asked whether the retirement system boards and those working inside the systems are fully aware of the fee structure, and Mr. Cracraft said they would not necessarily know the exact dollar amounts or be receiving periodic reports on the fees but would have access to the information. They should request the information, and he believes KRS is trying to start down that road. He pointed out that KRS has asked some of its recent general partners to adopt ILPA standards.
Representative Moffett spoke against investment contracts that include a “most favored nation” clause because they keep the truth out of the hands of people who make the decisions. He said Kentucky plans should move away from that type investment.
Senator Bowen thanked Ms. Hans and Mr. Cracraft and the members for attending to discuss these complex issues. With business concluded, the meeting was adjourned at 1:32 p.m.