Program Review and Investigations Committee





<MeetMDY1> September 8, 2011


Call to Order and Roll Call

The<MeetNo2> Program Review and Investigations Committee met on<Day> Thursday,<MeetMDY2> September 8, 2011, at<MeetTime> 10:00 AM, in<Room> Room 131 of the Capitol Annex. Representative Fitz Steele, Chair, called the meeting to order, and the secretary called the roll.


Present were:


Members:<Members> Senator Jimmy Higdon, Co-Chair; Representative Fitz Steele, Co-Chair; Senators Perry B. Clark, Vernie McGaha, John Schickel, Brandon Smith, and Katie Kratz Stine; Representatives Dwight D. Butler, Leslie Combs, Terry Mills, David Osborne, Rick Rand, and Arnold Simpson.


Guests: Crit Luallen, State Auditor; Brian Lykins, Executive Director of the Office of Technology and Special Audits; Auditor of Public Accounts. William Thielen, Interim Executive Director, Kentucky Retirement Systems.


LRC Staff: Greg Hager, Committee Staff Administrator; Rick Graycarek; Christopher Hall; Sarah Harp; Colleen Kennedy; Lora Littleton; Jean Ann Myatt; Cindy Upton; Kris Harmon, Graduate Fellow; Stella Mountain, Committee Assistant; Program Review and Investigations Committee Staff. Mike Clark, Emily Spurlock, LRC Staff Economists Office.


Approve Minutes for August 16, 2011

Upon motion by Senator McGaha and second by Representative Mills, the minutes of the August 16, 2011 meeting were approved by voice vote, without objection.


Staff Report: How School Construction Could Affect Employment in Kentucky.

Emily Spurlock presented the first part of the report. Staff were directed to study how renovating or replacing schools deemed “most in need” would impact the number of jobs in Kentucky. The current number of schools that are most in need cannot be determined. In 2010, the Kentucky Department of Education was authorized to hire an independent firm to do a statewide review of the three worst categories of schools. That facility assessment is underway, and the results are scheduled to be released by November 30.


To evaluate activities in terms of job creation, three different types of jobs are considered. Direct jobs are the jobs directly attributable to the activity, such as jobs in the construction industry. Indirect jobs are from the inputs into the construction process, such as through purchasing building materials. Induced jobs result from the workers who are employed spending their wages on items such as food and health care.


Staff used the regional economic impact model REMI to estimate the effect of school construction on jobs in Kentucky. Staff collected detailed information on school construction projects from each of three districts. It appears that initial payments are primarily made to businesses inside Kentucky; details on spending beyond initial payments are unavailable. For the three projects, spending inside the county ranged from about 9 to 41 percent, and the amount spent outside the state ranged from 7 to about 15 percent.


The net impact of school construction on jobs is the difference between jobs created by allocating funds to school construction and jobs that would have been created if funds were allocated elsewhere. This takes into account that jobs and earnings will increase in the first year as construction occurs, but will decrease in future years as resources are allocated to repayment of the bond financing the project.


The analysis in the report is based on a representative school project of $20 million with an assumed construction period of one year. The project is paid for by issuing a 20-year bond at 4.25 percent interest. The annual bond payment is $1.546 million.


Staff considered three alternative sources of funds to repay the bond. The first alternative is higher taxes, which results in lower consumer spending by taxpayers. The annual decrease in consumer spending is equal to the $1.546 million annual bond payment. In the first year of the 20-year period, the year the project is constructed, the net increase is 322 jobs. In the next 19 years, there is a decrease of about 12 jobs per year on average, which adds up to 228 jobs over the entire period. Over the 20-year period, there is a net gain of 94 jobs in Kentucky (322 minus 228). In the first year, the increase in jobs is primarily in the construction industry, followed by retail trade and professional and technical services. In the remaining years, job losses occur primarily in retail trade, and in health care and social assistance. Net earnings increase more than $12 million in the first year. The cumulative decrease in the future years is about $8 million, so there is a $4 million net gain in Kentucky earnings over the 20-year period ($12 million minus $8 million).


The second alternative is for the bond to be repaid by reallocating existing government funds. The job losses in the out years are greater than for the first alternative because state government spending is more likely to have a greater impact in Kentucky than consumer spending. Government spending is more likely to go directly to wages for state government employees. Consumers are more likely purchase goods produced out of state. The net increase in jobs in Kentucky in the first year is 299 jobs. In the following 19 years, there is a decrease of, on average, about 27 jobs per year for a total loss of 519 jobs. The net job loss is 220 jobs in Kentucky over the 20-year period (299 minus 519). As with the first alternative, the increase in jobs in the first year is primarily in the construction industry, retail trade, and professional and technical services. In the following years, jobs losses are concentrated in government. There is a net loss in Kentucky earnings over the 20-year period of $11.3 million.


The third alternative assumes that the bond payments are made through a combination of higher taxes and reduced government spending in other areas. If 70 percent of the payment is met through higher taxes, and 30 percent is met through reducing other government spending, this produces a break-even point for jobs over the 20-year period. The jobs created in the first year are offset by the jobs lost during the payback period. Job gains and losses are distributed by industry similarly as with the previous alternatives. Although the net change in jobs in Kentucky over the 20-year period is zero, the net change in earnings is a loss of $400,000.


It should be kept in mind that the job counts are not necessarily that many unique jobs. Jobs may be full or part time and do not necessarily last a full year. Jobs that occur in more than one year are counted in each year they occur. The job counts reported are for Kentucky only. A shift in spending from one sector to another may create or cost jobs in the state depending on how much of the input is produced in Kentucky. The impact may be different if the amount of construction were to be different. A large amount of school construction may impact prices of inputs and wages, which would increase the cost of the project. Kentucky firms may not be able to meet the needs of too many school construction projects at once, which could mean that more would need to be purchased from out of state, or more employees hired from out of state. Construction activity would produce a positive effect in Kentucky regardless of what is built. Building something that is not valued by Kentucky residents could affect residents negatively if they must give up consumer spending or government services to pay for it.


Ms. Spurlock concluded by saying that while the report focused on jobs and earnings, other researchers have studied different potential benefits of a new school building. Results of studies on the relationship between school facilities and student outcomes vary, and it is unclear how strong that relationship is.


Mike Clark presented the second part of the report. As part of the school construction study, staff were directed to look at apprenticeship programs. For workers, apprenticeship programs provide classroom instruction, on-the-job training, income while training, and associate’s degrees in some cases. For employers, such programs provide a way to develop a trained workforce and to lower wage costs while workers learn.


Programs registered with the Kentucky Labor Cabinet must meet requirements related to classroom time, work experience, and the ratio of apprentices to journeymen. Pay must be at least 40 percent of the journeyman wage, and wages are to increase based on progress. There are nonregistered programs but they are not required to provide information to the Labor Cabinet, so there is no information on them.


            There are 149 registered programs in Kentucky. Of the more than 2,200 active apprentices in these programs, 83 percent are in construction. The number of new construction apprentices entering registered programs each year has declined, peaking at 886 in 2007 and decreasing to 396 in 2010. This coincides with the decline of construction jobs in Kentucky during the economic recession, a decrease of 20,900 jobs (24 percent) since December 2007.


            In a typical year, more than one half of apprentices entering registered apprenticeship programs that year will leave the program.


            Pre-apprenticeship training is not a formal apprenticeship. The focus is on recruiting potential construction workers and apprentices. Basic training is provided on job searching, the construction industry, and safety. The Kentuckiana Works Construction Pipeline program was created in part to help meet minority and gender hiring goals for construction of KFC Yum! Center. Several organizations participated in the program, which consisted of 120 hours of instruction over 5 weeks. Two other pre-apprenticeship programs were created by local workforce investment boards (Green River, Northern Kentucky) in 2010 with funding from the American Recovery and Reinvestment Act. Both programs ended in 2011 when the federal funding ran out.


Certain school projects require contractors to pay prevailing wages. Prevailing wage is a minimum wage for public construction projects. The minimum base wage and fringe benefit vary by trade and location. Contractors may pay apprentices in registered programs a percentage of the prevailing wage based on the apprentice’s wage schedule. This might be an incentive to hire apprentices, but this could be limited due to the lower skill level of apprentices. No data are available on the number of apprentices working on school construction projects.


Senator Higdon commented that it was enlightening to see consideration of the net effect, taking the job losses into account from when the cost of construction is paid back.


Senator Stine asked whether the effect of reduced government spending versus the effect of raising taxes on the private sector indicated that state government is the largest employer in Kentucky, and consequently whether increasing taxes would not harm an already weakened private sector. Mr. Clark said that the different effects from raising taxes or reducing other government spending are affected by what state government and consumers purchase. The reduction in government spending affects employment in Kentucky more negatively because state government spending is predominantly for employees. Consumer spending is more likely to be for goods made out of state.


Senator Stine asked if there is any indication that employers are using apprentices to avoid paying the full prevailing wage. Mr. Clark said that he could check to see if audits done by the Labor Cabinet would provide any information on this.


Senator Stine asked what is known about the number of unregistered and undocumented workers on prevailing wage projects. Mr. Clark said that he could check to see what information is available. In response to a question from Representative Mills, Mr. Clark said that information on prevailing wages for his area is publicly available and staff would get him this information. In response to a question from Representative Combs, Mr. Clark said that fringe benefits required under the prevailing wage law vary among classifications as wage rates do.


Representative Steele said that he wants members of the committee to get copies of the Parsons report to be released on November 30.


Upon motion by Representative Simpson and second by Representative Mills, the report How School Construction Could Affect Employment in Kentucky was adopted by roll call vote.


Auditor Luallen summarized the Auditor of Public Accounts (APA) special audit of the Kentucky Retirement Systems (KRS) that was released on June 28. The audit makes 92 recommendations to strengthen Board of Trustees’ oversight and governance of the agency. The audit did not identify any matters that appear to have impacted KRS’s financial condition.       The audit focused on the specific questions surrounding the use of placement agents at KRS, the internal audit process, and a broad review of board policies and governance issues.


            Auditors saw no evidence of a “pay to play” scheme involving placement agents, of conflicts of interest that benefited KRS officials, or that KRS incurred additional costs through the use of placement agents. However, the audit points to several troubling aspects regarding the use of placement agents and the report was referred to the Securities and Exchange Commission, which has the authority to determine if further investigation is needed in Kentucky.


            The audit found that the use of placement agents lacked transparency and may not have always been in the best interest of KRS. One placement agent had an unusually close working relationship with the former KRS chief investment officer and received a high percentage of the investment contracts. The involvement of this placement agent was not transparent to other investment staff, the investment committee, or the board.


            The audit recommends that all information required by the Retirement Systems’ Placement Agent Disclosure Policy be presented to the KRS Board of Trustees in a clear and transparent manner, that the Disclosure Statement for placement agents include political contributions made to Kentucky officials within the past two years, that the General Assembly consider requiring the registration of placement agents as executive agency lobbyists with the Executive Branch Ethics Commission, and importantly, that the investment committee of the board receive more detailed information on recommended investments.


            Regarding the internal audit process at KRS, trustees had expressed concerns about the internal audit of placement agents, including inadequate communication, timeliness, and independence. State auditors found that there were inadequate procedures for conducting such a special internal audit. As a result, the internal audit had insufficient involvement from the board and resulted in confusion and suspicion among the trustees. The APA audit recommends that the KRS Audit Committee develop and approve detailed procedures for special audits requested by management or external sources, and that the KRS Division of Internal Audit conduct all audit fieldwork in an independent manner separate from the influence of KRS management.


            Auditor Luallen reviewed recommendations related to board governance and operational policies. The APA audit contains specific recommendations to strengthen policies governing budgeting, conflicts of interest, travel, spending, anonymous reporting of concerns, and consistency in the board selection process.


            She elaborated on recommendations that would make the election and appointment process for the board more consistent and stronger. The qualifications for gubernatorial appointees to the board, as dictated by statute, help ensure that the board possesses the investment background needed to effectively oversee KRS. However, elected trustees have no qualification requirements. The audit recommends that the same disclosure requirements and application process be followed for both elected and appointed board members. At a minimum, applicants should be required to detail how their specific qualifications prepare them to be an effective trustee, and both types of trustee applicants should authorize a background check. Such information should be available to the governor for the appointed positions, and to the trustees before their decision on the final nominees for election of new trustees.


            Although the purpose of this special audit was not to examine KRS financial statements or investment performance, the report includes a detailed background section on the history and financial viability of the retirement system.


            One overarching concern is that the long-term viability of the retirement system has been dramatically impacted by the state’s consistent underfunding of its employer contributions since 2003. The reforms passed in 2008 legislative session will be helpful to the future viability of the system.


            On August 29, APA received the 60-day letter required from KRS that advises of its response to the audit’s recommendations. Its response agrees to implement 50 or the 54 recommendations (KRS grouped the recommendations differently than in the original report). Three recommendations have been deferred until the November board meeting, and KRS is continuing to study one recommendation.


            Representative Rand asked what share of the KRS board is elected. Auditor Luallen said that the board is made up of three members appointed by the governor, two members elected by KERS [Kentucky Employees Retirement System] members and retirees, two members elected by CERS [County Employees Retirement System] members and retirees, one member elected by state police members and retirees, and the Secretary of the Personnel Cabinet. For elected members, the board makes decisions as to which names go forward to be voted on. There are requirements for the gubernatorial appointees but not the elected members. The report recommended that there be transparency for how the experience of elected board nominees qualifies them for the board. She noted that KRS has the most critical fiduciary responsibility of any board in the state.


            Representative Rand said that the qualification of elected members is critical because they make up a majority of board members. In response to a question from him, Auditor Luallen said that there are no specific standards that elected members must meet.


            Senator Higdon directed staff to distribute to committee members the 24-page background section from the auditor’s report on KRS.


            Senator Higdon asked if travel expenses were recorded as budget items or as part of investment costs. Mr. Lykens said they were recorded as budget items under administrative expenses. Auditor Luallen added that information on travel expenses should be provided to the investment committee so that this could be considered as part of investment decisions.


            Representative Mills asked what the mechanism is for following up on recommendations. Auditor Luallen said that the 60-day response is all that is required by statute. The office will continue to monitor the status of the recommendations for KRS; her sense was that compliance was good. She noted her office has a good relationship with the current leadership at KRS.


            Representative Simpson asked that the supplemental minutes of the November KRS board meeting be provided to the committee. Mr. Thielen said that this would be done.


            Representative Simpson commended Auditor Luallen and her staff for the work on this and other reports. Representative Steele echoed his comments.


The meeting was adjourned at 11:27 AM.