Public Pension Oversight Board




<MeetMDY1> February 27, 2017


Call to Order and Roll Call

The<MeetNo2> 2nd meeting of the Public Pension Oversight Board was held on<Day> Monday,<MeetMDY2> February 27, 2017, at<MeetTime> 1:00 PM, in<Room> Room 169 of the Capitol Annex. Representative Brian Linder, Chair, called the meeting to order, and the secretary called the roll.


Present were:


Members:<Members> Senator Joe Bowen, Co-Chair; Representative Brian Linder, Co-Chair; Senator Gerald A. Neal; Representatives James Kay and Jerry T. Miller; J. Michael Brown, John Chilton, Timothy Fyffe, Mike Harmon, James M. "Mac" Jefferson, and Sharon Mattingly.


Guests: Brad Gross and Bo Cracraft, LRC; David Rich, Kentucky Retirement Systems (KRS), County Employees Retirement System (CERS) elected trustee; Dolly Guenthner, Retiree.


LRC Staff: Brad Gross, Jennifer Black Hans, Bo Cracraft, and Angela Rhodes.


Approval of Minutes

With a correction noted by Sharon Mattingly, Representative Kay moved that the minutes of the February 6, 2017, meeting be approved. Senator Bowen seconded the motion, and the minutes were approved without objection.


Review of System Administrative Expenses

Bo Cracraft, LRC staff, reviewed administrative expenses with the purpose of providing background information, outlining reporting differences, and discussing the key drivers of administrative costs. Administrative expenses are the day-to-day expenses required to service active and retired members of each system. They include personnel expenses, contractual services, information technology, and operating expenses. Administrative expenses are disclosed as a line item on the Statement of Changes in Net Plan Position which is required by GASB. Most retirement plans are producing standalone annual financial reports which include a more detailed supporting schedule of expenses. Kentucky is a bit unique in that retiree health benefits are largely administered by the retirement systems.


Mr. Cracraft described the process by which administrative expenses are requested and paid by each system. The statute requires the Kentucky Retirement Systems (KRS) to request authorization for administrative expenses within their biennial budget request. Expenses are paid out of the Pension and Retiree Health Trust funds, and prorated among the KRS plans based upon membership. KRS includes an expense load within the annual actuarial valuation and the employer contribution rate calculation. The Teachers’ Retirement System (TRS) effectively follows the same process as KRS. While there is no specific statutory language, staff has followed the biennial budget request process and asks for authorization to use existing TRS trust dollars. TRS has some statutory language, which limits administrative expenses to an amount not to exceed 4 percent of dividend or interest earned from investments during the prior year. TRS administrative expenses are paid out of the pension, retiree health, and life insurance trust funds based on benefits paid, but an expense load is not included within the actuarial valuation. Judicial Form Retirement System (JFRS) is a little difficult to compare from an administrative expense standpoint given its size (two employees) and limited membership. From a budget standpoint, JFRS follows a slightly different process. JFRS requests and receives a direct appropriation from the Judicial and Legislative budgets to covers administrative and investment expenses. No expense load is included in the valuation process.


Mr. Cracraft reported administrative expenses for each system as provided in the financial statements from the Comprehensive Annual Financial Report (CAFR) for the trailing five fiscal years. A perceived decline in KRS expense is largely due to the system self-funding healthcare benefits for Medicare eligible retirees up through 2012. When adjusting KRS expenses, all three plans experienced about 2 percent to 3 percent annual growth in administrative expenses over the past five years.


Mr. Cracraft discussed key drivers to administrative expense, with salaries as the most significant expense, driving 40 percent of total expenses for all systems. The membership, or the size of a plan, often drives the number of employees required to service the plan. Fringe benefits are the second most significant expense driver. They include items such as pension contributions, Social Security, health and life insurance premiums, and other employee benefits. Retirement contributions are dependent on the plan in which the employees participate. KRS is subject to the Kentucky Employees Retirement System (KERS) nonhazardous employer rate, which was 38.77 percent during FY 2016, while the TRS employer rate was 16.105 percent. Not all TRS employees participate in TRS, but a significant portion do, with the remainder participating in KERS. A final driver, which is more difficult to quantify, is the complexity of a plan. A recent CEM study noted that the complexity of KRS and the number of reporting agencies, tiers, or plans administered can impact system expenses.


Mr. Cracraft summarized administrative fees as reported in the financial statements or CAFRs of each plan for the fiscal year ending June 30, 2016. The total administrative fees reported were $34,338,000 for KRS, $10,350,263 for TRS, and $473,053 for JFRS.


Mr. Cracraft discussed a slight differences in reporting, which included healthcare administrative fees and investment personnel related expenses. With regards to healthcare administrative fees, all three plans pay the Department of Employee Insurance (DEI) a monthly fee for non-Medicare eligible retirees who are covered under the Kentucky Employees Health Plan. Historically, this expense was treated as a benefit expense and recorded as a deduction rather than an administrative expense. In 2011, as a result of a performance audit, a recommendation was made that KRS begin to incorporate DEI fees into their budget request approved by the General Assembly. TRS and JFRS have continued to report DEI fees as a benefit expense. With regards to investment personnel and related expenses, there is another slight difference between the plans with regards to how internal expenses are recorded. TRS began reporting internal investment staff and related personnel expenses as an investment expense in 2014 as a result of the introduction of GASB 67. JFRS does not have dedicated internal staff, but reports custody and consulting fees as an administrative expense. KRS continues to report all internal staff and related expenses as administrative expenses, which also dates to a recommendation from the 2011 APA performance audit.


Mr. Cracraft compared each plans administrative fees after adjusting for the differences previously noted. Adjusted administrative fees were $30,782,264 for KRS, $10,350,263 for TRS, and $453,127 for JFRS. One of the primary methods used to compare plans is to calculate a cost per active and retired member, which resulted in a cost of $129.21 per member for KRS, $83.87 per member for TRS, and $501.25 per member for JFRS. It is difficult to compare JFRS to the two larger plans. Mr. Cracraft noted that salaries and fringe benefits are driving the difference, and operating expenses--all other expenses besides salaries and fringe benefits--are fairly comparable between the two plans. When looking at salaries and fringe benefits, the KRS cost per member was $93.16 versus the TRS cost of $52.96 per member. Looking at all other expenses (operating expenses), KRS totaled $36.05 per member while TRS totaled $30.91 per member.


Mr. Cracraft summarized personnel expenses and discussed the key drivers of the differences. While the average salary per employee is slightly less, KRS has more employees, which results in a higher total salary base. More employees also results in more health insurance premiums. There are several structural differences or expenses that are employer specific and cannot be controlled or changed by management. Retirement contributions, where KRS is subject to the KERS nonhazardous employer rate of 38.77 percent of pay for all employees, is one notable expense. Only 30 of 100 TRS employees participate in the KERS nonhazardous plan, while the remaining 70 employees participate in TRS and are therefore subject to the lower TRS employer rate. When combined, the effective employer rate TRS paid for all employees was just over 23 percent of payroll. Social Security is another difference, with KRS paying Social Security at 6.2 percent of pay on all employees versus TRS, which pays an effective rate of a little over 2.5 percent given that only 30 of its employees are subject to Social Security. The higher retirement and Social Security costs resulted in an additional cost of $12 and $45 per member respectively for KRS and JFRS.


A CEM Benchmarking (CEM) study from was presented to the Public Pension Oversight Board (PPOB) in June of 2016. CEM is a research firm that collects investment and administrative expense data from plans across the world. The administrative study seeks to measure cost and the level of service provided. KRS was compared to a custom peer group of 13 peers and the larger set of all data collected by CEM. The study only considered administrative expenses of the pension fund, so CEM excluded costs associated with healthcare and investment administration. The study found that total cost per member was $77 for KRS (pension only) versus $112 for the custom peer group and $84 for the universe of funds. KRS fell short of the median score in service with a total score of 62 versus 80 for peers, primarily due to call wait times, percent of undesired outcomes, and the time required to receive written estimates. CEM noted the complexity of KRS, which scored 83 versus 68 for peers, and identified payment options, customization, multiple plans, and tiers as major contributors.


Responding to a question from Senator Bowen, Mr. Cracraft said each TRS employee was servicing more members on average, which would lead one to expect a lower cost per member. KRS had transitioned to Chapter 18A from a personnel standpoint, but only the Chief Investment Officer (CIO) position salary was decreased as a result of the transition. Existing salaries were not adjusted, but as open positions are filled, one could expect the transition to reduce costs. Brad Gross, LRC staff, said that, when KRS was removed from the state personnel system in 2002, average salaries increased.


Responding to questions from Senator Bowen and Representative Miller, Mr. Cracraft said a few drivers to the notable differences in computer, furniture, and rental expenses reported. With regards to computer and telecommunications, the primary driver of the difference between KRS and TRS (approximately $1.5 million) was due to an upgrade to add “call-back assist” and also a maintenance update required for the FileNet databases. With regards to furniture and equipment, the reported difference was due to hardware purchases. With regards to rental fees, KRS and TRS own their properties, but KRS owns its property under a wholly-owned subsidiary, Perimeter Park West (PPW), which receives a rental payment. A portion of the rental payments is returned to the KRS trust funds in the form of a dividend, but LRC staff cannot determine the amount, so the entire amount was included as an expense.


Public Pension Investment Return Assumptions/Board Structures

Brad Gross and Bo Cracraft reviewed public pension return assumptions and board structures. Mr. Gross discussed the actuarial valuation process. The investment return assumption is one of the key assumptions in the process. He discussed changes in the assumption result and changes to unfunded liabilities, funding levels, and the employer contribution rates. The investment return assumption typically changes as a result of an Experience Study, which occurs at least once every 5 years. The Experience Study often is conducted in conjunction with the Asset/Liability Modeling Study that evaluates various asset allocations against projected system liabilities.


Mr. Gross discussed the actuarial data for the state administered systems. The total unfunded liability for all pension funds as of fiscal year 2016 was $32.792 billion and $5.860 billion in total for all health care plans. Each pension fund was using a 7.5 percent assumed rate of return, with the exception of KERS nonhazardous and the State Police Retirement System (SPRS) pension funds, which are at 6.75 percent, and both JFRS plans, which use a 7 percent assumption. On the retiree health fund side, most systems are assuming a 7.5 percent rate of return, except for TRS, which uses an 8 percent assumption, and JFRS, which uses a 7 percent assumption. A recent PPOB discussion regarding sensitivity analysis was provided by KRS and TRS, along with the PFM illustrative data which evaluated a 4.5 percent assumption (state’s borrowing rate) and a 2.7 percent assumption (30 year treasury rate), which resulted in the unfunded liability for the state pension funds growing from $32.8 billion to $56.9 billion or $82.3 billion.


Mr. Gross said that most public pension funds, including Kentucky, utilize a “market based approach,” with the assumed rate of return being used to both project future investment returns (asset side) and to discount the future streams of benefit payments (liability side). On the actuarial valuation date, the discount rate is used to determine the present value of benefits, actuarially accrued liability, and unfunded liability. If the assumed rate of return decreases, unfunded liabilities increase and employer contributions increase as a result. The process is determined through the actuarial Experience Study, Actuarial Standards of Practice #27, and recommendations from public pension actuaries. Public pension plan actuaries generally evaluate past investment performance, anticipated future investment performance, and peer data in evaluating an appropriate investment return assumption. Mr. Gross referenced some other views including a “bond based approach” and methods used by single and multiple-employer private pension plans.


Mr. Cracraft provided historical fiscal year investment returns for KRS and TRS over the past 30 years, along with a summary of each plans return assumptions. Both plans were using an assumption of 8 percent in FY 1987. TRS lowered its assumption to the current 7.5 percent in 1998. The KRS plans have fluctuated over the last 30 years. Mr. Cracraft provided a summary of TRS and KRS performance over the past 30- and 10-year periods, noting that both plans had slightly exceed the assumed rates of return over the longer 30-year period. However, when considering the most recent 10-year period, both plans had struggled to keep pace with their assumptions.


Mr. Cracraft provided a national perspective on return assumptions across other state pension plans. From a performance standpoint, the LRC peer group (which consists of 43 state employee plans) had a 10-year media return of 5.9 percent and average return of 5.7 percent. This trend was consistent with Kentucky, where plans have struggled to reach the assumed rate of return. Regarding the return assumption, staff provided a distribution of all 50 state employee plans based on 2015/2016 data, which showed the majority of plans (23 of 50) are utilizing an assumption in the 7.5 to 8 percent range. The median assumption is 7.5 percent, which is utilized by 12 plans and was the most commonly used assumption. The range started at the low end of 6.75 percent, which was the KERS, SPRS, and Indiana plans. No plans are currently above 8 percent, but 10 plans are utilizing an 8 percent return assumption. Sixteen plans reduced their assumptions for the most recently completed valuation, and 6 plans adopted lower assumptions for future use. A recent NASRA study reported almost three fourths of plans measured had lowered assumptions since FY 2010.


Mr. Gross said that the KERS and SPRS pension assumption has changed from 8.25 percent to 7.75 percent in 2006, 7.5 percent in 2015, and 6.75 percent in 2016. The CERS nonhazardous pension assumption changed from 8.25 percent to 7.75 percent in 2006 and 7.5 percent in 2015. The current TRS assumption is 7.5 percent and has not changed recently.


Mr. Gross provided some sensitivity analysis for KERS, CERS, and TRS with regards to the return assumption. Better-funded plans are more sensitive to changes in the investment return assumption. With an assumed rate of return of 6.75, 5.75, and 5 percent, the KERS nonhazardous pension funding levels decreased from 16 percent to 14.4 percent to 13.3 percent, while unfunded liabilities increased from $11.11 billion to $12.52 billion to $13.7 billion under the two assumption changes. Using a 5.75 percent assumed rate of return, the ARC for this fund increased by roughly 2.3 percent of pay while a reduction to a 5.0 percent assumption resulted in an increased ARC of 4.07 percent of pay for this fund. An increase of 1 percent of pay in the KERS nonhazardous ARC costs roughly $16 million in total funds of which half typically comes from General Fund dollars. With an assumed rate of return of 7.5, 6.5, and 5 percent, the CERS nonhazardous funding levels decreased from 59 percent to 52.3 percent to 45 percent, while unfunded liabilities increased from $4.54 billion to $5.96 billion and to $8 billion under the alternative assumptions. Using a 6.5 percent assumed rate of return, the ARC for CERS nonhazardous employers increased roughly 3.7 percent of pay and under a 5 percent assumed rate of return, the same ARC increases 8.57 percent of pay. An increase of 1 percent of pay in the ARC results in roughly $24 million total funds needed from CERS nonhazardous employers. With an assumed rate of return of 7.5, 6.5, and 5 percent, TRS funding levels decreased from 54.6 percent to 48.9 percent to 40.9 percent, while unfunded liabilities increased $14.53 billion to $18.28 billion to $25.29 billion. Using a 6.5 percent assumed rate of return, the ARC for TRS increased roughly 8.41 percent and using a 5 percent assumed rate of return results in a 25 percent of pay increase in the ARC. An increase of 1 percent of pay in the ARC for TRS results in roughly an increase in funding needed of $35 million (total funds).


Responding to questions from Senator McDaniel, Mr. Gross stated that assumptions used by actuaries generally come from the Experience Study, which considers the actual experience versus each assumption over the most recent 5 year period. With regards to the investment return assumption, the board ultimately makes the decision in conjunction with their actuary. The process of setting a payroll growth assumption generally begins with comparing the current assumptions with actual experience, considering recent national trends, and looking at expectations provided by the actuary.


The actuary uses this information to provide a recommended assumption, which the board can approve or not. Most pension funds utilize some form of payroll growth assumption, primarily because this assumption is incorporated on the financing side using a level percentage of payroll method.


Responding to a question from Senator McDaniel, Mr. Gross stated the fiduciary responsibility of trustees is explicit to the members. A statutory provision from 2008 indicates that the trustees have a responsibility to the taxpayers as well.


Senator McDaniel noted the sensitivity of the KERS nonhazardous plan to payroll growth assumptions and expressed disappointment that the previous retirement system board had not challenged the assumptions provided by the actuary, which had produced inaccurate and likely lower ARC estimates.


Responding to a question from Representative Miller, Mr. Cracraft stated that the TRS Board decided to use 8 percent return for its retiree health plan. This assumption is likely based off the fund’s current asset allocation.


Senator Bowen commented that the board has acted irresponsibly with the assumptions that the Cavanaugh group had offered. This is a three stage pyramid, the actuary, the board, and the General Assembly, and each one of these, starting with the General Assembly, takes the information that is given. The actuaries, board, and previous legislators have performed poorly.


Representative Kay agreed with Senator Bowen, and added that the legislators had a bad ARC and did not pay it, and that hedge funds are making a lot of investment earnings and fees.


Responding to a question from Representative Simpson, Mr. Gross stated that the recommendations from the board are typically distributed to the Governor’s Budget Office and the General Assembly, and ultimately the Governor issues the first budget proposal. There has been deviation in the past from what KRS had recommended to the Governor and General Assembly. From FY 2003 to FY 2014, the budgeted rates were lower than what was requested for KERS and SPRS, but there were a few years in which the General Assembly appropriated a higher rate than what was included in the proposed budget from the Governor's Office.


Mr. Gross reviewed each state-administered system’s board structures as written in statute and as amended by SB 2. The KRS Board has increased from 13 to 17 members, with the four added members all appointed and requiring investment experience. The TRS board will increase from 9 to 11 members, with the additional 2 members appointed by the Governor being required to have investment experience. The JFRS Board remains at 8 members, but the 2 gubernatorial appointees going forward will be required to have investment experience. Looking over the last 30 years, Mr. Gross noted the TRS and JFRS have essentially experienced no structural changes to their board composition. Over the same time period, KRS had experienced two changes in structure of the Board in 2010 and 2013. In 2010, HB 146 required 2 of 3 gubernatorial appointees to have investment experience. In 2013, SB 2 expanded the board from 9 to 13 members, adding a CERS elected trustee and three gubernatorial appointees from lists submitted by Kentucky League of Cities, Kentucky Association of Counties, and the Kentucky School Board Association.


Mr. Cracraft discussed a national perspective of pension governance, describing three basic models all retirement plans generally fall within. The least common model (4 of 50 states) is a sole fiduciary model, where responsibility is vested in an elected or appointed state official, generally the Treasurer or Comptroller. The most common (29 states) is an Integrated Investment and Pension Model, where a single fiduciary board is responsible for both investment and benefit administration. Responsibility is generally delegated through an executive director or CEO, while some states delegate benefit and investment administration separately. Seventeen states employ a segregated investment model in which two separate entities have been created to handle investments and benefits, each with its own Fiduciary Board.


Mr. Cracraft discussed statutory requirements on appointed trustees, saying that 28 of 46 states have language regarding qualifications of fiduciary board members. The language varies in detail and breath of expertise, with most states having fairly broad definitions of experience. Several states have created independent investment councils or committees to help acquire the needed investment experience. These were most often found in states that may have had a low representation of appointed trustees or states that did not have statutory language regarding knowledge.


Responding to a question from Representative Miller, Mr. Cracraft stated that Tennessee has one fiduciary board (20 members) that incorporates multiple retirement plans; the board has representation of each plan. Tennessee had delegated authority of benefits and investment separately, while also creating an independent investment council that meets at least twice with investment staff.


Responding to a question from Sharon Mattingly, Mr. Cracraft stated there had not been much movement between integrated and segregated plans recently. While not a change in model, Indiana recently changed to consolidate its state and teacher plans about 7 to 10 years ago.


Representative Linder announced that the gubernatorial appointee Alison Stemler has tendered her resignation.


Public Comments

David Rich, a CERS elected trustee to the KRS Board, testified that he would like to have the KRS and PPOB Boards converse more in regards to issues, problems or the possibility of circumventing costs that could be avoided. He wanted to know whether, in regards to the Affordable Care Act, the PPOB is satisfied with the answers provided in why KRS spent an additional $18 to $27 million in 2015 on insurance that deals with hazardous duty retirees. Mr. Rich stated that he felt the PPOB should do a risk analysis on why and how that money was spent.


Dolly Guenthner, Retiree, testified that there is corruption in Elizabethtown in regards to double dipper fraud and wants the fraudulent acts to be investigated. She stated that there are problems with KRS 61.637 and pension spiking that need to be addressed.


With no further business, the meeting was adjourned. The next regularly scheduled meeting is Monday, March 27, 2017.