Suit Claims Kentucky Pension System Invested Improperly

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BRADENTON, Fla. – The Kentucky Retirement Systems can add a legal challenge to the challenge of being one of the worst funded public pensions in the country.

The small city of Fort Wright won a recent court victory in its effort to bring a class-action lawsuit against Kentucky's second-largest pension fund.

The Kentucky Court of Appeals ruled Sept. 23 that the KRS Board of Trustees cannot use sovereign immunity to shield itself against the city's allegations that the board made millions in improper investments in alternative asset classes.

The ruling by the three-judge panel, if unchallenged, means that Fort Wright, a city of about 5,700, can proceed with the suit it filed in Franklin Circuit Court in 2014, potentially adding 500 entities to the case demanding return of fees.

The lawsuit contends that KRS broke state law and improperly invested in risky alternative assets such as private equity, hedge funds and unregistered funds, which are "notorious for charging excessive and, indeed, outrageous management fees."

KRS could ask the appellate court to rehear the case or appeal to the Kentucky Supreme Court.

"We are currently evaluating our alternative courses of action," KRS Interim Executive Director David Eager said, adding that a decision will be made within the next two weeks.

If the suit goes forward, discovery and depositions will be taken in the case, said Fort Wright's attorney, Ron Parry of Cincinnati-based Strauss Troy Co. LPA.

Fort Wright sued after getting annual bills for the city's actuarial required contribution that contained "huge sums" going out as fees for alternative investments, which the city deemed inappropriate, Parry said.

The city is a member of the County Employees Retirement System, whose contributions are managed along with those of the Kentucky Employees Retirement System, providing benefits to 355,000 retired and active employees of local and state governments.

The funds of the plans are co-mingled for investment purposes by the KRS board.

Kentucky law prohibits funds of the County Employees Retirement System to be invested in alternative assets, and KRS ignored its fiduciary duty when it did so, the suit contends.

According to the complaint, there are approximately 500 entities that contribute funds to the CERS – including municipalities, counties, and quasi-governmental agencies - that should be included in the suit.

Because of a five-year statute of limitations on claims, the city said that since 2009 it believes that the KRS board has paid more than $50 million in management fees in order to invest CERS assets in alternative asset investments.

The plaintiffs are seeking restitution.

"Our argument is we're not trying to take money out [of the system], but swap investments around so that at the end of day each fund ends up same amount of money but in the form of different investments," Parry said.

Under that scenario, KRS would also return to CERS fees collected by hedge funds and private equity funds, he said.

CERS would remain "salvageable" financially with its investments in less-risky stocks and bonds, Parry said, while leaving KERS with investments in hedge and private equity funds could risk its solvency "without a massive infusion of funds from the Legislature."

The appellate ruling comes as KRS and the Kentucky Teachers Retirement Fund, the state's two largest pension funds, continue to weigh down the state's finances.

Combined, the two plans had the worst-funded ratio in the country at 37.4%, with an unfunded liability of $31.2 billion, S&P Global Ratings said in a Sept. 12 report.

New Jersey had the second-worst funded ratio, 37.8%, followed by Illinois at 40.2%.

S&P cut the Bluegrass State's issuer credit rating to A-plus from AA-minus last year citing "the state's demonstrated lack of commitment when it comes to funding its annual contributions."

Last week, Moody's Investors Service said that Kentucky's combined unfunded liability was $35.8 billion in fiscal 2015 under its adjusted net pension formula.

The pension liability demonstrates the impact of "persistent underfunding of pension liabilities and resulting negative amortization," according to Moody's.

The low funded ratios of Kentucky's plans have evoked warnings from wealth managers and financial advisors against investing in state-issued bonds.

Last month, Cumberland Advisors Chief Investment Officer David Kotok said his firm has four states on its "DO NOT OWN" list: Illinois, New Jersey, Connecticut and Kentucky.

"It is important to recognize that we mean direct obligations of those states," he said. "That is because of concerns over pension funding, deficits, legislative inertia and other issues."

Kotok said investors should select credits with "great care."

"Sell and run from any trouble quickly and early," he said. "Maintain iron discipline on principles that are used to preserve principal."

In January, Gurtin Fixed Income said it anticipated that "dire predictions and pension paranoia" would continue for the foreseeable future but most high-quality obligors have adequately funded pension plans with affordable annual contribution levels.

However, there are outliers where deteriorating pension funding levels are generating budgetary stress that may escalate in coming years, the firm said.

"In some cases, such as the states of Connecticut and Kentucky, we are taking what we believe to be a prudent and cautious approach of not adding further exposure to their debt for our core strategy while waiting to see how they approach their pension contributions in coming budget cycles," Gurtin said.

Should Kentucky and Connecticut continue to underfund pensions or fail to make adjustments, Gurtin said, "We may consider further downgrades and ultimately may fully exit positions in their debt."

Earlier this year, Gov. Matt Bevin and the Legislature ordered cuts to various state agencies to generate $4 billion to contribute its pension plans over the fiscal 2017-18 biennial budget.

The funding was a significant increase in contributions that would reduce the risk of depleting pension system assets, according to Moody's.

While it is not clear if it will move the needle on the funded ratios of the plans, Bevin has taken steps to restructure the pension system and examine spending.

Last month, he hired PFM Group to perform what he said would be a comprehensive review of the state's pension systems, including a solvency and liquidity analysis and a "critical review" of past revenue and expenditures.

"Reforming the state's ailing pension systems is one of this administration's top priorities," said Bevin, a Republican who took office in December.

Bevin in June unilaterally ordered that the Kentucky Retirement System be abolished as an independent board.

Bevin then restructured the KRS' Board of Directors as a state agency, and appointed four new members with investment experience to join the 13 board members who had been appointed under the previous structure.

In creating the new agency, Bevin said his strategy would bring an "unprecedented level of transparency of the Kentucky Retirement Systems," which does not currently provide detailed information about management fees that are paid for various classes of investments.

In an August briefing, state lawmakers were told that KRS has more than 10% of its assets invested in hedge funds, which produced a negative 5.5% return last year.

Some legislators questioned the wisdom of investing in hedge funds.

Bevin has not said if he will recommend new investment strategies under his reorganization plan, nor did he provide a timeframe for PFM to report on its work.

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