Audit Makes 92 Recommendations to Strengthen
See the audit report for Full Details
See The Press Release Actualities
(Frankfort - June 28, 2011)
State Auditor Crit Luallen today released a special audit of the Kentucky Retirement Systems (KRS) which makes 92 recommendations to strengthen Board of Trustees’ oversight and governance of the agency that manages investments of nearly $13 billion and serves almost 330,000 active and retired members.
The audit focused on the specific questions surrounding the use of placement agents at KRS, the internal audit process, and a broad review of Board policies and governance issues.
“Based on the information they reviewed, auditors saw no evidence of a “pay to play” scheme involving placement agents, or of conflicts of interest that benefited KRS officials; nor is there evidence that KRS incurred any additional cost through the use of placement agents,” Luallen said. “However, the audit points to several troubling aspects regarding the use of placement agents and will be referred to the U.S. Securities and Exchange Commission (SEC). The SEC has the authority to determine if further investigation is needed in Kentucky.”
The audit points out that one placement agent had an unusually close working relationship with the former KRS Chief Investment Officer (CIO) and received a high percentage of the investment contracts. He participated in seven of the 13 investment agreements in which placement agents were used, more than all the other agents combined, and made a significant amount of money in fees as a result.
“We followed up every issue that was raised and could not substantiate any specific evidence of wrong doing,” Luallen said. “However, there were instances where the Board could improve accountability, transparency and communication.”
“There is not another public agency in Kentucky that has such a significant fiduciary responsibility affecting as great a number of people as the Kentucky Retirement System’s Board,” Luallen pointed out. “To carry out this responsibility, these Board Trustees need to be highly qualified, adequately informed and fully engaged. Our recommendations offer significant steps KRS can take to strengthen Board governance.”
Although the purpose of this audit was not to examine financial statements or investment performance, the report includes a detailed background section on the financial viability of KRS.
“One overarching concern I want to emphasize is that the long-term viability of the retirement system has been dramatically impacted by the state’s underfunding of its employer contributions since 2003,” said Luallen.
“It is absolutely critical that future governors and legislatures honor the commitment in the 2008 pension reform legislation to continue to increase the employer contribution over the next 15 years to fully fund the retirement system’s obligations,” she said.
Because actuarially recommended contributions were not made in the state budget over the past decade, national studies have identified Kentucky as having one of the most troubled public employee pension funds in the country.
After news reports questioned the use of placement agents by KRS, an internal audit was initiated and was presented to the KRS Board of Trustees in August 2010. Placement agents are intermediaries or third party marketers paid a fee by investment managers to solicit and secure potential investors, such as KRS. Over the past few years, investigations into illegal and unethical activity by placement agents were initiated in other states.
The KRS internal audit found no wrongdoing in the use of placement agents, but some KRS Trustees questioned the internal auditing process, as well as the fees of up to $12 million paid to placement agents since 2004.
Governor Steve Beshear sent a letter in August 2010 to KRS Board Chair Randy Overstreet suggesting that the Board request the Auditor of Public Accounts conduct an independent review of the adequacy of the internal audit process and other matters related to Board oversight.
The KRS Board of Trustees subsequently voted to request a review by the State Auditor.
On September 9, the SEC opened an “informal inquiry” into KRS. The inquiry was described in a letter by an SEC staff attorney as a “non-public, fact-finding inquiry” which “should not be construed as an indication that any violation of law has occurred.”
The state audit found that the use of placement agents was not transparent at KRS. One placement agent worked closely with the former CIO and was involved in numerous KRS investments without the knowledge of other KRS investment staff. This placement agent appears to have acted as a representative of KRS, setting up appointments and making travel arrangements for the former CIO, without the knowledge of other investment staff or Board members.
In August 2009, the former CIO participated in the development of the Placement Agent Disclosure Policy which was adopted by the Board. Even after the policy was adopted, the CIO did not disclose the use of a placement agent, thereby violating the policy.
The former CIO’s working relationship with this placement agent lacked transparency and may not have been in the best interests of KRS. This relationship appears to have been different than that with other placement agents who were in contact with the former CIO. This placement agent was involved in more investments during the former CIO’s tenure than the other placement agents combined, indicating the possibility of preferential treatment. The placement agent could earn a minimum of $1.3 million in fees from KRS investments that he handled. Additionally, firms that this placement agent was affiliated with could earn nearly $3 million from KRS investments in which he participated.
Strengthening KRS investment policies to require additional documentation will result in further transparency and assist in ensuring a consistent process that provides a detailed account of how investment decisions are made. Auditors followed up on media reports that, on two occasions, individuals from the Governor’s Office had contacted the former KRS Executive Director to suggest that KRS meet with individuals working on behalf of two investment firms.
Based on the information reviewed and the statements made by those contacted, examiners concluded that no outside pressure affected KRS investment decisions, and KRS did not place investments with either firm.
The KRS Division of Internal Audit was established to provide an independent appraisal of the various operations and systems of control within KRS. In October 2009, the former KRS Executive Director requested an internal audit related to the involvement of placement agents within the KRS investment process. When a draft report was submitted, KRS Trustees expressed concerns about the internal audit process, including communication, timeliness, and independence.
The state auditors found that procedures for conducting a special internal audit that would document the requirements of the Division of Internal Audit or the Audit Committee did not exist. The inadequate procedures for conducting such an audit caused confusion and suspicion among the Trustees.
In their review, state auditors found no evidence that information from the internal audit was withheld, delayed or covered up to hide fraud or wrongdoing. While the involvement of executive staff in the internal audit process diminished the perception of independence, auditors found there was no evidence the outcome was influenced.
Board Governance and Operational Policies
The audit report contains numerous recommendations to strengthen Board oversight and policies governing budget, travel, conflicts of interest, spending, anonymous reporting of concerns, and consistency in the Board selection process.
While the KRS Trustees receive a great deal of information, the material they receive should be more informative and valuable in providing oversight, including quarterly budget-to-actual expenditures reports, investment expenditure reports, and an annual report of executive staff salaries.
The KRS Board of Trustees is composed of nine members: three are appointed by the governor; two are elected by the County Employees Retirement System (CERS) members; two are elected by the Kentucky Employee Retirement System (KERS) members, one is elected by the State Police Retirement System (SPRS), and the state Personnel Cabinet Secretary is an ex-officio member with voting privileges.
The qualifications for gubernatorial appointees to the Board, as dictated by statute, strive to ensure that the KRS Board possesses the investment background needed to effectively oversee KRS. However, elected Trustees have no qualification requirements. The audit recommends steps to make the election and appointment process more consistent and stronger.
At a minimum, Board applicants should submit a current and detailed resume, a cover letter detailing the applicant’s specific qualifications to be an effective KRS Trustee, authorization for a background check, acknowledgement of any felonies, and a formal application. Such information should be available to the Governor for the appointed positions and to the Trustees before the decision on the final nominees for election of new Trustees.
The review also found that the bylaws do not limit the number of successive terms an individual may serve as board chair or vice chair.
Responding to the audit, the chair of the KRS Board of Trustees, Jennifer Elliott, stated that the Board does not disagree with any of the findings and that they have already begun implementation of many of the recommendations.