Public Pension Oversight Board


Minutes of the<MeetNo1> 4th Meeting

of the 2017 Interim


<MeetMDY1> April 24, 2017


Call to Order and Roll Call

The<MeetNo2> 4th meeting of the Public Pension Oversight Board was held on<Day> Monday,<MeetMDY2> April 24, 2017, at<MeetTime> 1:00 PM, in<Room> Room 131 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; Senators Jimmy Higdon, Gerald A. Neal, Dennis Parrett, and Wil Schroder; Representatives Ken Fleming, James Kay, Jerry T. Miller, Arnold Simpson, and Russell Webber; J. Michael Brown, Timothy Fyffe, Mike Harmon, and Sharon Mattingly.


Guests: Beau Barnes, Deputy Executive Director; Donna Early, Executive Director, Judicial Form Retirement System; David Eager, Interim Executive Director, Kentucky Retirement Systems; Bo Cracraft, LRC; Bryanna Carroll, Kentucky League of Cities, Chris Bartley, Kentucky Professional Firefighters, Eric Kennedy, Kentucky School Boards Association, and J.C. Young, Executive Director, Kentucky Magistrates and Commissions Association, J.D. Chaney, Deputy Executive Director, Kentucky League of Cities; Brad Gross and Jennifer Black Hans, LRC.


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


Quarterly Investment/Cash Flow Update

Beau Barnes, Deputy Executive Director, Teachers’ Retirement System (TRS) discussed investment performance as of March 31, 2017, noting the quarterly pension fund return was 5.02 percent while the fiscal year to date return was 11.02 percent. Mr. Barnes stated if these type of returns continue for the last quarter of the fiscal year, TRS would meet or exceed the 7.5 percent assumed rate of return. Over the last 30 years, the compounded gross return of the TRS pension fund was 8.01 percent. For the quarter ending March 31, 2017, the market value of the pension fund was $18.1 billion, which was up from the $16.8 billion reported at the end of the 2016 fiscal year. The medical insurance fund was valued at $743 million, which was also up from $607 million reported at the end of the 2016 fiscal year. In total, the market value of the TRS funds have increased from roughly $17.4 billion to $18.8 billion since the end of the 2016 fiscal year.


Mr. Barnes discussed cash flow and how TRS has been in a negative cash flow situation for the past number of years, which has forced TRS to sell assets when markets were down and assets were undervalued. He stated that TRS received an additional $973 million in the current budget from the Governor and General Assembly which has reduced the negative cash flow from $611.7 million in 2016 to a projected $300.2 million in 2017.


            In response to a question from Senator Higdon, Mr. Barnes stated in the late 1990s, TRS lowered their assumed rate of return from 8 percent to 7.5 percent and TRS feels the 7.5 percent rate is in the right range at this time. In response to an additional question from Senator Higdon, Mr. Barnes stated there are two types of payouts at retirement that can increase a members’ retirement allowance. First, retiring administrators may be compensated by their employer for up to 60 days of annual leave that can be used in their last years’ salary that is then used to calculate their retirement allowance. For those who became members on or after July 1, 2008, this payout is not included in the retirement calculation. Secondly, members can be compensated by their employer for any unused sick leave at 30 percent of their daily rate of pay. The lump sum sick leave payment is then incorporated in the members last year of salary and will increase their retirement allowance.


            In response to a question from Representative Fleming, Mr. Barnes stated that the $125 million coming in every quarter helps make investments manageable and TRS would sell any assets that decreased the least in value to meet cash flow needs.


            Quarterly Investment/Cash Flow Update

            Donna Early, Executive Director, Judicial Form Retirement System noted that performance for the third quarter, in both the Judicial and Legislative funds, slightly exceeded their benchmarks, while both funds have exceeded the benchmark by an average of 250 basis points for the fiscal year to date. Ms. Early pointed out that the Judicial Defined Benefit plan was valued at $370 million as of March 31, 2017, and included 229 members and a total of 346 retirees and beneficiaries. The Judicial Hybrid plan had a market value of $490,729 and included 22 members. The Legislators Defined plan had a market value of $109 million and included 79 members and a total of 216 retirees and beneficiaries. The smallest plan, Legislators Hybrid Cash Balance plan had a market value of $129,106.


            Ms. Early provided a summary of the Judicial plan cash flows fiscal year to date with total income earned, including investment earnings and contributions, of $17.9 million and total payouts of $18.7 million. The Legislators fund had income of $4.2 million and payouts of $3.6 million.


            Quarterly Investment/Cash Flow Update

            David Eager, Interim Executive Director, Kentucky Retirement Systems (KRS) began with a few key points, most notably that markets had been positive, cash flow had improved, and that the Kentucky Employees Retirement System (KERS) non-hazardous fund continues to be the main focus. He noted that as of March 31, 2017, investment markets had been positive, equity markets were up about 15 percent, and alternatives ranged from 3 to 6 percent. KRS added 13 basis points to an unmanaged benchmark, which equated to around $20 million in added gains.


            Mr. Eager discussed investment returns for the pension fund as of March 31, 2017. He noted the total returns for the fiscal year to date were 9.91 percent for the pension plan and 10.11 percent insurance. Individual plan returns on the pension side included KERS non-hazardous at 8.75 percent, KERS hazardous at 9.86 percent, County Employees Retirement System (CERS) non-hazardous at 10.23 percent, CERS hazardous at 10.15 percent, and State Police Retirement System (SPRS) at 9.22 percent. On the insurance side, individual plans’ returns for the fiscal year to date included KERS non-hazardous at 10.29 percent, KERS hazardous at 10.17 percent, CERS non-hazardous at 10.06 percent, CERS hazardous at 10.05 percent, and SPRS at 10.04 percent.


            Mr. Eager discussed the pension and insurance fund asset allocations and noted KRS was starting to see some differences on the pension side, most notably within U.S. Equity and Non U.S. Equity, where the KERS non-hazardous fund is down to a 39.6 percent allocation, while CERS and the other funds are closer to 52 percent. In insurance, most of the systems are in the 60 percent or greater range in terms of funding and have similar asset allocations.


            Mr. Eager discussed cash flow for the KRS pension funds through the third quarter. KERS non-hazardous total contribution inflow was $735 million, while the contribution outflow was $734 million. Inflows increased by 37.18 percent and outflows increased by 2.17 percent. The KERS hazardous fund had total contribution inflows of $91 million and outflows of $51 million. Inflows increased by 167.16 percent and outflows increased by 3.65 percent. The CERS non-hazardous fund had total inflows of $825 million and outflows of $575 million. Inflows increased by 137.95 percent and outflows increased by 5.90 percent. The CERS hazardous fund had total inflows of $283 million and outflows of $183 million. Inflows increased by 120.88 percent and outflows increased by 5.94 percent. The SPRS contribution inflow was $66 million and outflows were $44 million. Inflows increased by 165.67 percent and the outflows increased by 1.87 percent.


            In response to questions from Representative Kay, Mr. Eager stated he had not been alerted that outside counsel had been hired to discuss fiduciary issues. He noted that Brian Thomas, General Counsel, had departed KRS in September 2016 and Carmine Lacarrino, who was hired in January 2017, had also recently departed KRS.


            In response to a question from Senator Bowen, Mr. Eager stated that the net asset base as of March 31, 2017, was $11.6 billion for the pension fund and $4.6 billion for insurance, for a total of $16.2 billion. In 2016, the pension fund was $10.9 billion and insurance was $4.6 billion, for a total of $15.1 billion.


            In response to a question from Senator Higdon, Mr. Eager stated that there are a significant number of issues that need to be addressed in regards to system separation.


            Calendar Year Ended Investment Review

            Bo Cracraft, LRC, provided a semi-annual investment return covering the 2016 calendar year. He noted 2016 was more encouraging then the prior year, as evident by several benchmark returns exceeding 7 percent during the year. Mr. Cracraft noted that each of the retirement systems had returned 7 percent or more for the one year ending December 31, 2016. At a plan level, the KERS non-hazardous and SPRS plans have lagged behind the other KRS plans primarily due to a below target allocation to equity in the short term, and when considering longer-term results, some of relative underperformance is due to cash flow constraints.


            Mr. Cracraft discussed changes in asset allocation since June 30, 2016, which were less than a one percent deviation for the two larger plans. With regards to KRS, evidence of their recent decision to reduce and redeem some of their hedge fund assets were beginning to be reflected and absolute return assets were down just over 0.5 percent.


            Mr. Cracraft discussed recent performance and noted that early 2017 returns have been encouraging from both a return and benchmark standpoint. All three plans have posted fiscal year to date returns of 10 percent or more. Mr. Cracraft also noted that the KRS Board was spending time discussing asset allocation, where to reallocate the assets being redeemed from hedge funds, and creating tailored allocations specifically for each of the individual plans. KRS has asked their consultant, R.V. Kuhns, to review capital market expectations and potential allocations. On a similar note, while not directly related to rebalances or redemptions, TRS had also asked their consultant, AON Hewitt, to do a review of their current asset mix, targets, and how it relates to current assumptions.


            CERS Separation

Senator Bowen made a few opening comments and noted the following presentation had also been heard by the State Government Committee during regular session, but the initiative was slowed down at the request of the Executive Branch. Senator Bowen reiterated his belief that separation of CERS from KRS is very important and would be good public policy.


            Bryanna Carroll, Kentucky League of Cities (KLC), stated that CERS pension stability is the top priority for many associations and employee groups within CERS. The proposed CERS separation would remove the entire group of CERS employers. CERS is on an upward trajectory and is funded at 61.5 percent, while KERS and SPRS combined are 23.8 percent funded. Currently, CERS is paying 63 percent of the administrative expenditures for KRS and CERS liabilities are approximately $19.3 billion, which is 53 percent of all KRS liabilities.


            Ms. Carroll continued and noted a 2012 task force that was assembled to study pension reform which lead to SB 2 in 2013 and a third tier known as the hybrid cash balance plan. As a result of these changes, CERS is at a higher funded percentage than it was prior to the passage of SB 2, despite more conservative actuarial assumptions. Actuaries have projected CERS will be fully funded by 2043, the end of the current amortization period. CERS assets totaled approximately $12 billion, which is approximately 73 percent of KRS assets. Since 2000, the administrative costs have increased 245 percent, which is significant since CERS pays 63 percent of the administrative costs.


            Ms. Carroll discussed the separation proposal and that KERS continues to be on a downward trajectory. CERS members feel that it is time to separate and ensure local control of local pensions. Separating CERS from KRS will ensure the long term solvency of CERS and also allow the focus to be on fixing the funding shortfalls of the remaining KRS plans. The proposal includes the creation of a nine member CERS Board of Trustees, which would include, three members that are elected officials, three members that must have investment experience, and three members that must have retirement experience. The new CERS Board would still report to the Public Pension Oversight Board (PPOB). The current KRS Board includes six CERS representatives, while the Investment Committee contains no CERS representatives. The three current elected members on the KRS Board would transition to the CERS Board. Lastly, Ms. Carroll noted there were no benefit changes included in the proposal and over 95 percent of the bill is taken directly from the current language and mirrored into a new set of statutes for CERS.


            Mr. Chris Bartley, Kentucky Professional Firefighters, testified that the Kentucky Professional Firefighters fully support the separation of CERS from KRS. CERS separation maintains a status quo for the retirements of their members. It would protect and maintain the current benefit levels, protect the inviolable contract, and protect overall retirements of those retired, active, or recently hired. Mr. Bartley stated that firefighters cannot take anymore retirement reductions and noted that most firefighters in the state do not receive social security and rely on the benefit as their sole retirement. Separation basically allows a secure dignified retirement for the firefighters who protect the Commonwealth.


            Eric Kennedy, Kentucky School Boards Association, testified that local school districts participate in CERS, accounting for over half of all active employees in the plan. Like others in the system, school boards have made tough budget choices through the past few years in order to fund student services, education, and the pension system. Mr. Kennedy stated that any further benefit reductions would be devastating to retain staff that is needed.


            J.C. Young, Kentucky Magistrates and Commissions Association, stated that a purpose for the separation proposal is to separate out funds and ensure there is no comingling, while also providing a microscope on management in the future.


            Senator Bowen made comments that in no way should the separation be perceived as abandoning KRS or in particular KERS. This will be an opportunity to give focus on the most troubled system.


            In response to several questions, Ms. Carroll stated that 95 percent of the bill was mirrored from statute and currently Kentucky Revised Statute 61.565 requires full funding of the ARC, which would also be required of CERS after separation. The inviolable contract currently is established with the state and specifically reads that it is the responsibility of employers to pay the costs and this language would also remain the same. Ms. Carroll stated that the employers are responsible for their own liabilities and agreed there is zero liability for the state with separation and that the CERS liabilities will not show up on the state’s books. As for investments, there may be some that are comingled for larger investments and in terms of a separation, CERS could buyout of those comingled investments and that the bill allows for four years from date of passage to hash out those details. Ms. Carroll stated that at this time there are no legal analysis available that shows how a separation would impact the Commonwealth or the stakeholder in CERS, but that there is an actuary looking at that information.


            In response to several questions, Mr. Kennedy stated that the current statutory provision for the inviolable contract for CERS is between the employee and the Commonwealth and they believe it would be a breach of contract to change the language. Mr. Kennedy discussed what would happen if an individual city or any of the employers in CERS were to file bankruptcy or were dissolved, and referenced recorded law that would require the cities or counties to payout of all existing debts, including pension liabilities.


            In response to questions from Representative Simpson, J.D. Chaney discussed that the inviolable contract is a guarantee by the General Assembly to not alter, impair, or amend the benefits promised to the employees. Mr. Chaney stated that if a city where to go out of existence, the employer contributions would be adjusted across the system and all remaining participating employers would be responsible for payment. The state has no statutory or constitutional obligation to intervene.


Legislative Update

            Brad Gross and Jennifer Black Hans, LRC, discussed the legislation directly impacting the state-administered retirement systems. Bills that passed included SB 2, SB 3, SB 104, SB 126, SB 197, HB 173, HB 351, HB 471, and HB 520.


            Public Comments

            Dolly Guenthner, Retiree, who had requested to make comment, declined stating she had changed her mind.


            With no further business, the meeting was adjourned. The next regularly scheduled meeting is Monday, May 22, 2017.