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A look into the secretive Kentucky Retirement Systems and the $15.7 billion under its control. For the roughly 340,000 state, city and county workers and retirees, there are more questions about their investments than answers.

When it Comes to Investments, Kentucky Keeps Pension Holders in the Dark

Tommy Elliot, chairman of the Board of Trustees, and Executive Director Bill Thielen listen to a presentation during the meeting of Kentucky Retirement Systems on May 15, 2014.
Alix Mattingly
Tommy Elliot, chairman of the Board of Trustees, and Executive Director Bill Thielen listen to a presentation during the meeting of Kentucky Retirement Systems on May 15, 2014.


At a time when Americans can readily verify what’s in their individual retirement accounts and employer savings plans, the Kentucky Retirement Systems is putting billions of dollars of its pension-holders’ money into investments that are concealed from public view.

As a result, a quarter of the $15.7 billion under KRS’ control might as well be in a black hole for the roughly 340,000 state, city and county workers and retirees in Kentucky. By loading up on so-called “alternative investments” -- basically bets on anything -- KRS now has billions of dollars in murky entities like the “Daniel Boone Fund,” the “Henry Clay Fund” and “Newport Colonels LLC.”

The alternative investments gambit is playing out in public pension plans nationwide. No longer content with ordinary stocks and bonds, pension funds are turning to riskier, fee-happy “hedge funds” and private equity funds to dodge stock market gyrations and solidify investment returns.

KRS, one of the most financially distressed public pension funds in the nation, ranks fifth in exposure to alternatives, according to a survey by the National Association of State Retirement Administrators.

The foray into alternative investments coincides with critical problems bedeviling the Kentucky pension system. KRS only has enough assets to cover about 45 percent of its obligations to its current and future retirees. As of mid-2013, the shortfall stood at $17.6 billion. And a recent court ruling allowing a bankrupt non-profit group to cease paying into KRS has heightened fears of its insolvency.

Transparency is not a hallmark of the hedge funds and private equity firms with whom KRS is doing business. They require KRS to cloak the specific investments in their portfolios. KRS complies.

Kentucky laws enacted in 1992 and 2008exempt the investments from the state Open Records Act. It allows KRS to accept the firms’ claims that transparency would make the makeup of their funds easy prey for copycats. Since everything is under wraps, the public can’t know if the recipes are worth copying.

The Kentucky Center for Investigative Reporting learned that first-hand. Under the state’s open records law, we obtained the latest Daniel Boone, Henry Clay and Newport Colonels annual reports -- for 2012 -- from KRS and turned to the pages containing specific investments. The lists were whited out.KRS refused to supply the names of holdings.

“We view that as essentially forcing the equivalent of Coca-Cola to release their secret formula in exchange for allowing us to invest in Coke,” said KRS Interim Chief Investment Officer David Peden.

The secrecy strikes retiree Kendrick Mills as a suspicious practice. A former city of Louisville firefighter who relies on a 26-year pension for two-thirds of his household income, he prefers full disclosure.

“I want to know what’s in the funds. I want to know the cooking,” said Mills, who is also a retired investment adviser. “It amazes me that the secrecy doesn’t cause an uproar.”

People didn’t know the cooking when they gave tens of billions of dollars to Bernie Madoff, the New York fund manager who seemed to have a Midas touch in good markets and bad. They suffered terrible losses when he was exposed as a con man in 2008.

The Madoff fiasco was still rippling when KRS bought into its first hedge fund in 2009, Connecticut-based Arrowhawk Capital Partners. Arrowhawk was a startup with no track investment record. Unfazed, KRS entrusted it with $100 million.

Arrowhawk was a flop. Under a cloud of controversy over its fees and lack of experience, it folded at the end of 2011. At least KRS got its money back. Not the case with its $24 million investment in The Camelot Group, a New York private equity firm, in 2009. Its owner, Lawrence Penn III, was indicted in February on charges he siphoned $9.3 million from his investors’ accounts to pay for personal extravagances.

KRS lowered the valuation of its Camelot holding by half. Depending on the outcome of the case, KRS could lose part, none or all of its money.

Kentucky House Speaker Greg Stumbo, for one, has had it with such fiascos. In an e-mailed statement, he said the KRS Board of Trustees needs more members with “significant experience” in investments.

“If they are taking part in these risky investments, that’s a breach of their fiduciary duty,” Stumbo wrote in an e-mailed statement. “There is too much money and too many people’s livelihood at stake.”

Mike Cherry served alongside Stumbo in the Kentucky House and became a KRS trustee after his retirement. Approached in June, the Princeton resident wouldn’t touch the subject of secret investments.

“I just don’t want to get into those areas you want to talk about,” said Cherry, a movie theater owner named to the KRS board last year by Gov. Steve Beshear.

Of the 13 people on the Board of Trustees, 10 didn’t reply to e-mailed interview requests. Two -- Mary Helen Peter and Randy Stevens -- steered us to board chairman Tommy Elliott, a senior vice president at Old National Bank in Louisville. Elliott did not respond to e-mailed questions. He would not consent to a personal interview, only one in the presence of KRS officials.

“I’m not interested in getting engaged with you on a one-on-one,” said Elliott, another Beshear appointee, in a phone call.

A Hankering for hedge funds | Create Infographics


Hedge funds are investment pools geared for wealthy people and institutions. Many fund managers pick stocks that they think will grow in value faster than the overall markets. Some offer mosaics of stocks, bonds, currencies, commodities, international ventures and other securities to cushion against market calamities. Because hedge funds are subject to less regulatory oversight, they can’t be sold to the general public.

In August 2011, KRS bellied up to the hedge fund window with a $1 billion bet on three startup funds. The companies behind them -- Blackstone, Prisma Capital Partners and Pacific Alternative Asset Management -- were established and respected on Wall Street. Each of the three funds would be tailored specifically for KRS. They would invest not in stocks or specific securities, as most hedge funds do, but in other hedge funds. Such things are called “funds of funds.”

The KRS board, whose members are chosen by the governor and the specific retiree groups, gave the gambit a thumbs-up. Blackstone called its offering the Henry Clay Fund; Prisma’s, the Daniel Boone Fund; Pacific’s, the Newport Colonels. By the end of 2013, KRS upped its stake in the funds to more than $500 million each. Together they now constitute 10 percent of KRS’ investment portfolio.

Following KRS’ white-out job on those funds’ most recent audited financial reports, it appears the funds can invest in funds containing anything, from topless doughnut shops to Tongan coconut farms. KRS admitted to one holding in its Henry Clay Fund: an unspecified stake in SAC Capital, the Connecticut hedge fund run by the controversial Steven A. Cohen. SAC pleaded guilty in April to securities fraud and agreed to a $1.8 billion settlement. KRS pulled its money from SAC.

“We have no idea what’s in any of these things,” said Chris Tobe, a pension consultant and former KRS trustee who skewered the agency in his 2013 book Kentucky Fried Pensions. “If someone is omitting the most important part of a financial statement, you have to assume they’re hiding something. The money could be sitting in offshore accounts.”

The sellers themselves issue a “buyer beware” caveat. Contained in the Henry Clay Fund report for 2012 is the admission that some of its confidential investments could become unsellable.

“While the managing member (Blackstone) monitors and attempts to manage these risks, the varying degrees of transparency into and potential illiquidity of the financial instruments held by the investee funds may hinder the managing member’s ability to effectively manage and mitigate these risks,” the report states. That's an ominous statement for the 340,000 people who own pieces of this stockpile.

Citing the secrecy agreements with fund managers, KRS interim chief investment officer Peden -- himself a former Prisma employee until 2005 -- refused to discuss the contents of its alternative funds.

By agreeing to terms of confidentiality, Peden said, KRS gets a better deal on fees, saving at least $17 million a year on its entire pension portfolio.

“I’m not sure how the average retiree or taxpayer is going to be better off knowing the individual names of the managers underlying the hedge funds when all they need to be worried about is the performance of that fund of funds manager,” Peden said.

Ron Parry, a Cincinnati lawyer who represents the city of Fort Wright in a class-action lawsuit filed against KRS on June 2, begs to differ. He says pension fund holdings should be disclosed to the cities, counties, organizations and pension-holders who paid for them.

“They would like to know where their money is going,” Parry said. “If you had money in, say, the Vanguard Wellington Fund, you could get on the Internet and find where every nickel of that money is invested. Investing in essentially secret investments is very questionable for a public pension plan.”

Parry’s lawsuit contends that state law forbids the agency from sinking city and county pension money into hedge funds and private equity funds. Along with backing out of those investments, the suit asks that all fees paid toward those “illegal and imprudent investments” -- more than $50 million -- to be returned to the KRS fund covering city and county employees. KRS is asking a Kenton County judge to dismiss the suit. It says Fort Wright has no legal standing to complain.

Coincidentally, hedge funds as public pension fodder were recently panned by the man considered the world’s most successful investor -- Berkshire Hathaway CEO Warren Buffett. His opinion came in response to a question from a board member of the San Francisco Employees’ Retirement System in May. Buffett’s answer: “I would not go with hedge funds -- would prefer index funds.”

The Tennessee Consolidated Retirement System seems to have taken that advice to heart. Of its $40.4 billion in assets, not a dime goes into hedge funds, only 1 percent into private equity firms. Its net return on investments for 2013 was slightly better than that of KRS. “We’ve looked at hedge funds, but never found them compelling enough to put ahead of our other options,” said TCRS spokesman Blake Fontenay.

One of the reasons why hedge funds are controversial is their cost. Fund managers typically charge a 2 percent annual management fee and rake in 20 percent of any profit on its investment portfolio. Because working-class investors never go near hedge funds, they have no gripe with those fees. As stakeholders in hedge fund-smitten KRS, however, they might. KRS says it paid $53.6 million in fees in the year ended June 30, 2013, or 0.37 percent of its assets. That would be low, but it appears to be understated.

Take the Henry Clay, Daniel Boone and Newport Colonels funds, for example. For 2012, KRS reports having paid $12.7 million in fees -- a reasonable 1 percent -- to the managers of those funds, Blackstone, Pacific and Kohlberg Kravis Roberts & Co., which bought Prisma. But what it paid to the many funds within those funds is off limits, KRS says, because of the secrecy clauses.

Tobe has confidential KRS papers from 2011 showing the fees at every layer of the three funds. For their part, Blackstone, Pacific and KKR would charge annual “management fees” ranging from 0.5 to 0.75 percent of the value of the funds. They would also take an “incentive fee” of 5 to 10 percent of profits. This is what added up to the $15 million in fees that KRS was willing to disclose for those funds in 2012.

The big money went to the mysterious underlying funds.

According to Tobe’s documents, Blackstone estimated that the managers of its sub-funds charged an average of 1.62 percent of assets under management, along with an average slice of 19.78 percent of any profit. Going by that, Tobe calculates that between Jan. 1, 2012, and March 31, 2014, KRS paid Blackstone’s sub-managers about $40.5 million in fees. Based on similar fee structures, KKR raked in about $38.9 million, Pacific $33 million, Tobe estimates.

The cumulative tally? By Tobe’s math, KRS paid $156 million in fees in connection with the Henry Clay, Daniel Boone and Newport Colonels funds during the 27-month span.

“The fees are excessive,” Tobe said. “These funds can’t get them from anywhere besides public pension plans. Corporate plans are too smart to pay these outrageous fees. The only stupid people are the taxpayers of Kentucky for letting these people get away with this.”

Not even KRS Executive Director William Thielen knows how much money was paid out in fees to the underlying funds. That information, he said, is “proprietary” even to him. Peden said the agency only cares about the net return on investment -- after fees are subtracted. Peden would not comment on Tobe’s fee scenario.

Tobe’s estimate of $156 million in fees paid to the three funds of funds triggered a moment of incredulity for one of Louisville’s most respected investment advisers, Wayne Hancock. His Main Street company, Atlas Brown, manages about $325 million for its clients. When shown Tobe’s fee estimate, Hancock’s eyes widened.

“If that’s the fee, could there have been a way to keep the business in the state of Kentucky and lower the overall cost?” he asked.

Others are catching on. Massachusetts’ $59 billion state retirement system has begun pressing hedge fund managers to lower their fees. It is also selling its remaining stakes in funds of funds. The Wisconsin public pension plan has cut its fee costs by letting the state investment board manage its money without outside help.

Funds of funds have lagged in each of the past 5 years ... | Create Infographics

(view the interactive graphics here and here)

... and over longer-term periods | Create Infographics


For all the concerns about paying high fees for secret, nontraditional investments, not too many pension-holders are going to care as long as KRS’ investment strategy is blowing away the market.

But it’s not.

The shift in strategy has hurt overall returns. Last year, for example, KRS earned 12.7 percent on its money, well below the national median of 16 percent among U.S. public pension plans.

In 2008, when the U.S. stock market nosedived 37 percent, alternatives would have been a better, if still not profitable, place to be. But stocks do better than most investments over the long run. The Standard & Poor’s 500 Index, a market barometer made up of 500 blue-chip U.S. stocks, grew an average of almost 18 percent a year in the five-year bull market of 2009 through 2013. The KRS pension fund averaged 11.3 percent.

Alternative investments -- at least the ones chosen by KRS -- proved to be an inferior place to park one’s money during those five years. KRS’ private equity investments returned an average of 9.7 percent a year, while real estate made 7.9 percent. Its hedge funds and “real return” investments -- in such things as agricultural lending, power generation and master limited partnerships -- had average annual gains of 5.5 and 4.5 percent, respectively, between their startup dates and last Dec. 31.

As for funds of funds, the realm of the Daniel Boone and Henry Clay funds, they have proven inferior to the stock market over both the short-term and the long-term.

Hedge Fund Research Inc., a Chicago-based firm that tracks the industry, compiles historic net return data for the sector that now represents 1,757 funds of funds. Over the last five calendar years, funds of funds delivered an average annual gain of 7.8 percent after expenses, less than half of the S&P 500’s 18 percent. Over the last 20 full years, the HFRI funds of funds universe averaged 5.4 percent a year, considerably lower than the S&P 500’s 9.2 percent.

John Harris, a retired Kentucky State Police forensic chemist who lives in London, Ky., was disturbed by the secrecy and the questionable value of KRS’ funds of funds.

“They need to get a good return on their money,” said Harris, 65. “But if they’re not getting good returns and they’re paying more in fees than they are on stock, they need to take a good look at what they’re doing.”

Jim Carroll, a retired Kentucky Parks Department spokesman who helps run a Kentucky Government Retirees page on Facebook, had the same line of questioning. “Where is the linkage between the performance and the compensation?” the Frankfort resident asked. “Are the fund managers being paid for doing a lousy job?”

The same question is being asked elsewhere. Last year, a study by the Maryland Public Policy Institute and Maryland Tax Education Foundation concluded that state pension plans that pay the most in money-management fees get some of the worst investment returns.

As with most KRS pension-holders, Carroll frets most about the dangerously low funding levels of the state plan. But as a volunteer liaison to his group’s 3,786 Facebook followers, Carroll would like KRS to be more appreciative of the fact that the money it invests belongs to the pension-holders. Putting billions of dollars into black-box investment funds that charge high fees is not Carroll’s idea of fiduciary responsibility.

“If there are other hedge funds that are disclosing their holdings and fees, there’s no doubt in my mind that KRS should look at those hedge funds,” he said.

At least one state official has formally issued a call for more transparency in KRS. State Rep. Jim Wayne, D-Louisville, introduced a bill in March that would require more disclosure of investment contract details and fees. It would ban the use of high-priced investment middlemen and would require gubernatorial appointees to the KRS board to have “appropriate investment expertise.”

The bill, Wayne said, was panned by KRS. It went nowhere. “The message was: Don’t ruffle any feathers here,” Wayne said.

Reporter James McNair can be reached at jmcnair@kycir.org or (502) 814-6543