January 28, 2021

The Big Challenges Facing the New Kentucky Pension Plan CIO

Ahead of an April 1 system overhaul, Steven Herbert has a ‘hundred actions’ he needs to perform.

Reported by Sarah Min

When Steven Herbert started at the Kentucky Retirement Systems (KRS) last week, after a monthslong talent search, he became the sixth investment chief in 13 years to take the helm at the struggling pension program.

Kentucky Retirement Systems CIO Steven Herbert

The $18.3 billion state system has had a tough time holding on to its investment staff. Herbert will replace Rich Robben, the former CIO who departed last fall for a consulting position. But other allocators have decamped before him, including David Peden, now a consultant at Mercer subsidiary Pavilion; TJ Carlson, now CIO at Texas Municipal; Adam Tosh, now senior portfolio manager in Alaska’s Bristol Bay Native Corporation; and John Krimmel, now an NEPC consultant.

But, for the moment, the new investment chief is taking it all in stride.

“I feel really good,” said Herbert, just hours into his new role last week. “I’m comfortable with the industry and this type of investment role. While being at the new employer is overwhelming, the position makes sense to me.”

The CIO has spent decades working in different sectors of the financial industry, including spending seven years as a consultant with Mercer, which is where KRS Executive Director David Eager, a former consultant himself, heard of him. Herbert led the development for what would become the firm’s Global Investment Manager Database (GIMD).

“I had not met Steve previously, but I’d heard a lot about him from former colleagues at Mercer,” Eager said when the new investment officer was announced. “I knew a lot of people who knew him and he came highly regarded and recommended.”

The new investment chief has joined the state at a pivotal time. Starting April 1, KRS will be split into three board systems, one to oversee the two plans for state employees and state police, another to oversee the county plans, and a third board to oversee the ongoing administration and investment management of the system. It could also mean the formation of two investment committees “in all likelihood,” instead of one, according to Eager—though that possibility is still up in the air.

The overhaul means Herbert will have to figure out how to divvy up assets that previously belonged to a single trust, including illiquid funds allocated among 70 private equity managers, in addition to getting to know the system’s current crop of money managers. It will mean double the work that prior CIOs have dealt with, as well as at least six months to fully transition. Herbert has just two.

“The devil’s in the details,” Eager told CIO. “We have a list of, well, in excess of a hundred actions that need to take place” before April 1.

A Tough Spot

Just two decades ago, the state pension system was 100% funded. But then came years of underfunding from state legislators, who ignored calls for greater contributions from actuaries and maintained an open amortization period that masked the growing liabilities. The state pension fund found itself falling behind on its obligations.

Today, KRS’s largest plan for state employees, the $3.4 billion Kentucky Employees Retirement System (KERS) Non-Hazardous Plan, is one of the nation’s worst-funded state plans with a roughly 14% funded status. Former employees have said the KERS fund will likely be the first state pension plan to declare bankruptcy, although that outcome may be decades away.

It’s a tough spot for allocators. The liquidity needs are so high at the pension fund that the investment staff will have to maintain an extremely conservative portfolio. And that’s in a low interest rate environment that has other investors casting about elsewhere for higher returns. It also means the investment chief has virtually no room for mistakes. The pension system is so heavily path dependent, sources say, that a single bad year could erase any progress it might have made.

“We’ll try to squeeze every basic point that we can get, but you could have exceptionally good performance, and it doesn’t have much impact, unfortunately,” Eager said. “If anything, we need liquidity and we need downside protection because you can’t have the assets contribute anything that leads to impairment of the funded status. So, ergo, we’ve got to be conservative, we’ve got to be liquid.”

Still, the pension system appears to have turned a corner for the moment. Recently, after reducing the KERS return target to 5.25%, down from 7.5%, the state government has increased contributions into KERS to about $1 billion, approximately a 70% increase from a roughly $600,000 sponsor contribution in prior years, to dig the plan out of insolvency. Those efforts are paying off: The pension fund reported positive cash flow in fiscal year 2020. (The assumed targets in the other pension funds are at 6.25%.)

Red Tape, Bureaucracy

The board is already undergoing massive changes ahead of April 1. This month alone, KRS said the board of trustees chairman David Harris and trustee Matthew Monteiro have resigned, effective April 1. Harris’ term was due to expire next year, but Eager said Harris will be leaving after already having extended his prior four-year term, in order to help KRS transition to the new system.

More board appointments are on the way. Splitting the five pension plans across two board systems will also further complicate an already complex system of plans. But new board members will be elected by the governor and trustees, meaning Herbert will have to contend with a mix of trustees who are unlikely to have investment experience. Herbert hopes his experiences as a consultant will help him communicate with the trustees.

Ongoing lawsuits are also troubling the fund. Last summer, Kentucky Attorney General Daniel Cameron revived a lawsuit accusing both hedge fund managers and KRS of mishandling assets under the pension system. Prior CIO Carlson is also included in the suit. (Eager declined to comment on ongoing litigation).

“These public pension CIOs are operating in a fishbowl,” said Keith Brainard, research director at the National Association of State Retirement Administrators (NASRA). “In addition to the challenging investment market, they have to be mindful of public perceptions.”

Fewer Managers, Bigger Mandates

Herbert will need more resources as he manages the system. The system, which has a three-person investment team, is hiring for a director of fixed income, a position previously held by Steve Willer, who has been promoted to deputy investment chief at the fund.

Still, a five-person investment team including Herbert would fall short of the number of professionals needed to run such a complex system. Smaller-sized university endowments, sized at just $1 billion, employ teams of at least 10 investment staff members.

Going forward, Herbert will continue a trend KRS had been moving toward over the past several years: Fewer managers, with bigger mandates. It’s an approach the executive director is pushing for at the fund.

“I think the biggest challenge is not being lured into hiring the most recent hot manager. The one that’s got the best performance the last three to five years. It’s just a trap that almost everybody seems to fall into. It was that way 40 years ago. It’s that way today,” Eager said.

Instead, Eager is hoping the new CIO will have a “better understanding of the drivers of performance.”

The pension fund has already moved in that direction. As of June 30, the $18 billion KRS fund had increased some of its allocations, including putting $2.5 billion into a fixed income allocation with Lord Abbett, roughly $1 billion into private equity with BlackRock, and $700 million in core fixed income with Loomis, Sayles, and Co.

“It’s a really nice way to cap off my career being both on the consulting side and the investment management side predominately throughout my career,” Herbert said of his new job. “And this gives me the ability to bring those to KRS, and, at the same time, get the asset owner experience.”