Kentucky Public Pensions Authority’s New CIO Receives Sizable Challenge and Opportunity

By David G. Barry

Steve Willer is coming to understand what the phrase “baptism by fire” means.

Recently elevated to chief investment officer of the Kentucky Public Pensions Authority (KPPA), Willer is now tasked with bringing the 10 funds that KPPA oversees into compliance with their asset allocation targets. It is a process, Willer tells Markets Group, that provides both a challenge and an opportunity not usually afforded to new CIOs – or, for that matter, CIOs in general.

“There’s a lot of work to be done in terms of structuring the portfolio,” says Willer, who initially joined KPPA in April 2020 as fixed income division director and served as deputy CIO and interim CIO prior to his new role. KPPA’s prior CIO, Steven Herbert, left in May after less than 18 months on the job.

Willer, who has not been a CIO previously, said changing direction for a public pension fund can at times be akin to switching direction of an “ocean liner” and that dealing with the different asset allocation targets of the plans adds “complexity.”  It does, however, come as valuations have declined in 2022 from where they were in 2021.

KPPA manages five pension funds: The County Employees Retirement System (CERS) Hazardous Fund; The CERS Nonhazardous Fund; the Kentucky Employees Retirement System (KERS) Hazardous Fund; the KERS Nonhazardous funds; and the State Police Retirement System (SPRS). KPPA also manages the health insurance plans that are tied to each of those five pension plans. Together, the 10 funds had $21.6 billion of assets at the end of its fiscal year, June 30.

To varying degrees, the 10 funds are currently overweight in cash and under allocated to such areas as real estate, private equity and real return – which Willer describes as “broadly traditional inflation sensitive” segments such as commodities, infrastructure and Treasury Inflation Protected Securities, or TIPS.

The funds need rebalancing because of a series of moves over the past year, said Willer. These include a special allocation by the state, payments received due to employer cessation, changes to the allocation targets and what Willer says was a “conservative” investing approach.

The fact that these plans were not at their asset allocation targets was a “detractor from performance,”
for the 2022 fiscal year, he said. Being heavy in cash rather than in some of the sectors that performed well – or at least better than equities – such as private equity and real estate – “was not net beneficial” to results.

Collectively, the five pension funds returned -5.7% net of fees and expenses for the 2022 fiscal year, which beat their benchmark of -5.8%. The five insurance funds returned -5.3% net of fees and expenses. In contrast, in fiscal 2021, the funds collectively generated 25% as assets rose from $18.4 billion to $22.9 billion.

According to data presented at the August investment committee meeting of the Kentucky Retirement Systems – the investment committee for the KERS and SPRS funds – asset allocation was responsible for reducing returns across the KERS and SPRS funds by 0.6% and 3.3% for the fiscal year ending June 30. 
Given the funding status of the Kentucky pension funds, anything that can move the needle is crucial.

Pension funds are generally considered in “critical status,” if they fall below the 65% funded level. According to data released earlier this year by KPPA, the pension funds were all in the “critical” category. KERS Hazardous was the best with a funded ratio of 60.4%, while KERS Nonhazardous was the worst at 16.8% as of the end of the 2021 fiscal year.

SPRS Pension had the largest percentage of cash among the funds. As of June 30, 24% of its assets – $131.8 million – was waiting to be deployed. This was in large part due to the Kentucky legislature earlier this year approving an allocation to the fund equal to 60% of the fund’s assets – a total of $215 million. SPRS, as of earlier this year, had a 30.7% funded ratio.

Willer said KPPA has to date reallocated 50% of the capital.

According to the asset allocation targets for the plan, KPPA will look to bring SPRS’ cash percentage down to 5% and reallocate $105 million, largely to the real return and real estate sectors. Both roughly account for 3% of the plan’s assets and are targeted for 10%. To bring those sectors up, $41.8 million would go to real return strategies and $34.4 million to real estate.

SPRS is the most extreme example, but the other pension funds that KPPA oversees also must be rebalanced.

The KERS Nonhazardous Pension Fund, for instance, has $402 million, or 13.4% of its asset allocation in cash and a target of 5%. Meanwhile, its real return allocation is currently at 3%, well below its 10% target and real estate is at 5% – half of its 10% target.

Willer said a key reason for the high cash levels is that KPPA was “concerned with the valuations across a number of markets and what the risk and reward opportunity would be going forward.”

Things are definitely different and Willer said KPPA will seek to take advantage of its dry powder.

“It’s an opportune time,” he said. “We see a lot of values in asset classes.”

Specialty credit, for example, is an area that KPPA is taking a hard look at, Willer said.

He said that staff is now getting “pretty methodical” about sizing up investment opportunities and that his goal is to reduce the cash figure to 3%, if not less.

“It’s an ongoing process to get the right mandates and right structures in place and the allocations to where we are shy of targets,” he said.