Basic Funding Concepts Understanding the Actuarial Valuation 2 Art Tepfer, A.S.A., M.A.A.A., E.A. Tepfer Consulting Group, Ltd. 145 Revere Drive Northbrook, IL 60062 847-509-7740 (847-922-8708 cell) email@example.com
WHAT DOES FUNDING MEAN? The accumulation of “Reserves” to provide pension benefits. Reserves are required for all public pension funds in the State of Illinois. 3
Purposes Of Funding Benefit Security For Participants Budgetary Control For Plan Sponsors Intergenerational Equity IT’S THE LAW!!! 4
Purposes Of Funding 5 In the public sector, the primary purpose is the funding of the pension plan and equity across all generations of taxpayers 1.Taxpayers hold the risk 2.Actuarial funding method determines annual contributions which are aimed to create a stable, sustainable benefit program 3.Balance sheet liability usually not an issue because actuarial liability is not shown on the balance sheet (new GASB rules may change this)
What Is An Actuarial Valuation? 6 Statement Of The Status Of A Pension Fund At A Specific Point In Time
What Does It Tell You? Measure Of The Assets And Liabilities Of The Fund At A Static Point. Contribution Requirements Under Statutory Requirements Recommended Contributions For Current And Future Solvency Useful Statistics For Planning Purposes 7
What Doesn’t It Tell You? Where You Are Headed! 8
The Fundamental Equation Of Pension Funding C + I = B 18
Types of Pension Plans Defined Benefit Pension Plans – The benefit is known and defined in the Plan Defined Contribution Pension Plans – The contribution is known and defined in the Plan 19
The Fundamental Equation Of Pension Funding C + I = B 20
Types of Pension Plans Defined Contribution C + I = B Benefits are unknown Interest income is known Contribution is defined Defined Benefit C + I = B Benefits are defined Interest income is assumed Contribution is unknown 21
The Fundamental Equation Of Pension Funding 22 FUTURE C+I=B PAST
WHERE DO WE PUT THE BOARD ? AND HOW MUCH DIRT GOES IN THE SHOVEL? 23
TYPES OF FUNDING METHODS Cost Allocation Cost Method Prospective benefit at retirement is estimated, the actuarial value at the entry age or attained age is estimated and the cost allocated to a particular year. Example: Entry Age Normal Cost or Aggregate Cost Benefit Allocation Cost Method Benefits are allocated to a particular year and the actuarial value of the allocated portion is assigned to each year. Example: Unit Credit or Projected Unit Credit 24
Determination of Normal Cost Cost Allocation Cost Method 1.Estimate prospective benefit 2.Determine actuarial value of prospective benefit. 3.Divide this value by the value of $1 per year from point A to point B 4.Normal Cost is the resulting quotient Benefit Allocation Cost Method 1.Must ascertain the “accumulated benefit” (amount allocated to a particular year) 2.Determine the actuarial value of the accumulated benefit 3.Normal Cost is the increase in accumulated benefit each year 25
Actuarial Impact of the New Pension Law 26 For the first time the new pension law mandates actuarial methodology for Public Safety funds. – Actuarial calculations must use the Projected Unit Credit Method. – Assets must be valued using a specific actuarial smoothing method.
Actuarial Funding Methods 27 There are several funding methods which all have the same ultimate goal: “guarantee” that there will be enough money available to pay the benefits when they come due However, each funding method has characteristics which will make one more appropriate than others in certain situations – Front load – Back load – Level payroll – Level contributions
Entry Age Normal Cost (Cost Allocation) Entry age normal attempts to create level contributions throughout the working career of the employee – Can be level dollar or a level percent of payroll – By far the most utilized funding method in the public sector – More costly early in the career of an employee 28
Projected Unit Credit (PUC) (Benefit Allocation) Projected Unit Credit attempts to fund the “true” present value of the benefits as they accrue, no spreading of costs – Creates lower costs early in an employee’s career – Costs increase dramatically as retirement nears – Most common method in private sector valuations 29
Actuarial Accrued Liability (AAL) 31 The actuarial accrued liability is the accumulation of all normal costs that have occurred in the past – Current retirees have accrued all of their normal costs AAL = PVB – Active members have only accrued some of their normal costs AAL = PVB less PVFNC (present value of future normal costs)
Actuarial Accrued Liability (AAL) The AAL is the sum of all of the AAL’s of the individual members This represents the amount of assets needed in the trust to exactly match the past accruals per the funding method 32
Illustration of AAL Method One Yr Contribution AAL 1 $30,000$30,000 2 $30,000$60,000 3 $30,000$90,000 4 $30,000$120,000 5 $30,000 $150,000 AAL is the sum of all contributions made to date Method Two Yr Contribution AAL 1 $10,000$10,000 2 $20,000$30,000 3 $30,000$60,000 4 $40,000 $100,000 5 $50,000 $150,000 AAL is the Total Goal less the sum of future contribs 33
Unfunded Actuarial Accrued Liability (UAAL) What if you don’t exactly match? What if the trust does not have to have that much money today The UAAL is defined as the difference between the AAL and the amount of assets in the trust (AVA) 34
Actuarial Value of Assets (AVA) 35 New Tax Law 1)On March 30, 2011, the actuarial value of the fund’s assets shall be equal to the market value of the assets as of that date. 2)In determining the actuarial value of the fund’s assets for fiscal years after March 30, 2011, any actuarial gains or losses from investment returns incurred in a fiscal year shall be recognized in equal annual amounts over the 5-year period following that fiscal year.
Illustration of UAAL Method One Yr Contribution AAL 1 $30,000 $30,000 2 $30,000 $60,000 3 $30,000 $90,000 4 $30,000 $120,000 5 $30,000 $150,000 AAL is the sum of all contributions made to date Method Two Yr Contribution AAL 1 $10,000 $10,000 2 $20,000 $30,000 3 $30,000 $60,000 4 $40,000 $100,000 5 $50,000 $150,000 AAL is the Total Goal less the sum of future contribs 36
The “Funding Myth” 37 Funded Percentage – A Quick Ratio Of Assets To Liabilities Easy To Measure Assets---Difficult To Measure Liabilities
Funded Percentage 1.Let’s skip the third payment and assume no interest earnings and no payouts!!! 2.The assets therefore are missing one $30,000 contribution. 3.Watch what happens 38
The Contribution Requirement The contribution is set to be the sum of: – The normal cost for the year and – The amortization of the UAAL [90% under law] Another way to look at it: – The contribution for the current year plus – The contribution to make up any shortfall that may have occurred due to past experience or plan changes 40
WHY DO WE HAVE AN UAAL? 41 If contributions have been made equal to the actuarially determined contribution for the life of the fund, why does the UAAL exist? – New base at law change – Benefit increases which change the accrual for past service – Experience differing from actuarial expectations (assumptions)
BUT NO MATTER HOW YOU LOOK AT IT IT ALWAYS COMES BACK TO 42
The Fundamental Equation Of Pension Funding C + I = B 43
Present Value Concepts Time Value of Money- present value is inversely proportional to interest rate Probability of Payment- depends upon a contingent condition Life Annuity- series of payments made for lifetime Life Insurance- payment made at death 45
Assumption Setting 46 Economic Assumptions Investment Return Salary Increases Inflation Asset Valuation Methodology Demographic Assumptions Mortality And Disability Rates Termination Of Service ( Retirement And Severance ) Definition of Actuarial Assumptions The value of a parameter, or other choice, having an impact on an estimate of a future cost or other actuarial item under evaluation. - Glossary of actuarial terms The economic and demographic estimates used to calculate the present value of the plan’s future obligations.
Key Issues 47 Selection of Assumptions should be a team approach (Board and City). Assumptions should be evaluated at regular intervals by performing a “gain and loss” analysis. The larger the fund, the more frequent and detailed the analysis.
Reasonableness Of Assumptions Is The Most Important Aspect! 49
SELECTION OF DEMOGRAPHIC ASSUMPTIONS Types of Demographic Assumptions— The types of demographic assumptions used to measure pension obligations may include, but are not necessarily limited to, the following: a. retirement b. mortality c. termination of employment 50
SELECTION OF DEMOGRAPHIC ASSUMPTIONS 51 Evaluate Reasonableness of the Selected Assumptions Unless facts and circumstances clearly warrant otherwise, the actuary should base this evaluation on the following criteria: a. The assumption is expected to appropriately model the contingency being measured. b. The assumption is not anticipated to produce significant cumulative actuarial gains or losses over the measurement period.
SELECTION OF DEMOGRAPHIC ASSUMPTIONS 52 Mortality rates A modern mortality table (RP-2000 is industry standard) Retirement rates Consider 30 year service pension (average entry for public safety is less than age 30) Severance rates Police Portability and Fire reciprocity imply lower severance rates Disability incidence rates Highly subsidized benefit (fund experience is the best indicator).
Selection of Economic Assumptions 54 Economic data and analyses are available from a variety of sources, including representatives of the plan sponsor and administrator, investment managers, economists, accountants, and other professionals. When the actuary is responsible for selecting or giving advice on selecting economic assumptions within the scope of this standard, external expert advice may be considered, but the selection or advice must reflect the actuary’s professional judgment.
Selection of Economic Assumptions 55 As for current practices, many actuaries change economic assumptions infrequently when measuring obligations of ongoing pension plans. Many actuaries maintain a long-term conservative view, especially when selecting economic assumptions for funding purposes where adverse economic experience could jeopardize the delivery of plan benefits. Conservative assumptions require higher contributions initially, increasing the security of promised benefits and reducing the likelihood that future contributions will increase to unaffordable levels
Selection of Economic Assumptions 57 SALARY INCREASES The actuary should review available compensation data. These data may include the following: i.the plan sponsor’s current compensation practice and any anticipated changes in this practice ii.current compensation distributions by age and/or service iii.historical compensation increases and practices of the plan sponsor and other plan sponsors in the same industry or geographic area iv.historical national wage and productivity increases
Selection of Economic Assumptions 60 INVESTMENT RETURN The actuary should review appropriate investment data. These data may include the following: i.current yields to maturity of fixed income securities such as government securities and corporate bonds ii.forecasts of inflation and of total returns for each asset class iii.historical investment data, including real risk-free returns, the inflation component of the return, and the real return or risk premium for each asset class iv. historical plan performance
The Investment Return Assumption 61 Typically consists of several components – A risk free rate consisting of A portion such as 1.5% - 3% due to pure price inflation A small risk free or low risk real return rate in the range of 0.5% - 1.5% – An equity risk premium such as 3.0% representing an assumed reward for taking equity risk
Comments 62 Current actuarial standards require that the discount rate be the expected rate of return on the assets. 6.5%-7.5% would be consistent with a diversified portfolio of 45% or more in equities. There is a heated debate within the financial and actuarial communities on the selection of the discount rate. Financial economists believe that the discount rate should be a risk free type rate, at least as far as financial reporting is concerned. The present value at 3% (chosen to represent a risk free rate) is 40% higher than the present value at 7.5% when measured at time of retirement.
We Got Trouble Right Here in Illinois With a Capital “T” and that rhymes with “C” and that stands for COGFA 63
FUNDING METHODOLOGY 1980-1988 EANC funding with amortization of any Unfunded Liabilities as a Level Dollar amount over a 40 Year period beginning July 1, 1980. (interest 6.5%, salary 5%)
FUNDING METHODOLOGY 1988-1993 EANC funding with amortization of any Unfunded Liabilities as a Level Dollar amount over a 40 Year period beginning July 1, 1980. (interest 7%, salary 5.5%)
FUNDING METHODOLOGY 1993-2011 EANC funding with amortization of any Unfunded Liabilities as a Level Percentage of Payroll amount over a 40 Year period beginning July 1, 1993. (interest 7%, salary 5.5%)
Comparison of Statutory Language regarding the annual actuarial requirement 67 Prior to January 1, 2011: The Normal Cost … Plus [ANY METHOD (but everyone used EANC)] …the annual amount necessary to amortize the fund’s unfunded accrued liabilities over a period of 40 years from July 1, 1993, as annually updated and determined by an enrolled actuary… 40 ILCS 5/4-118(a)
Comparison of Statutory Language regarding the annual actuarial requirement 68 After January 1, 2011: The Normal Cost… Plus [PUC METHOD ONLY] …an annual amount sufficient to bring the total assets of the pension fund up to 90% of the total actuarial liabilities of the pension fund by the end of municipal fiscal year 2040, as annually updated and determined by an enrolled actuary… 40 ILCS 5/4-118(a)
Comparison of Language Prior the annual amount necessary to amortize the fund’s unfunded accrued liabilities over a period of 40 years from July 1, 1993, as annually updated and determined by an enrolled actuary Current an annual amount sufficient to bring the total assets of the pension fund up to 90% of the total actuarial liabilities of the pension fund by the end of municipal fiscal year 2040, as annually updated and determined by an enrolled actuary 69
Comparison of Language Prior “Necessary Condition” Must be there for the effect to be true If absent, cannot occur. Current “Sufficient Condition” Whenever A is present, B will follow 70
So What is Supposed to Happen? 71 Switch from EANC to PUC
Excerpts from the New York Times article September 18, 2010 The Illusion of Pension Savings Earlier this year, Illinois said it had found a way to save billions of dollars. It would slash the pensions of workers it had not yet hired. The real-world savings would not materialize for decades, of course, but thanks to an actuarial trick, the state could start counting the savings this year and use it to help balance its budget. 75
Excerpts from the New York Times article September 18, 2010 The Illusion of Pension Savings “In a plan that is not well funded, I wouldn’t recommend it,” said Norm Jones, chief actuary for Gabriel Roeder Smith & Company, an actuarial firm that helps Illinois and a number of other states that have adopted the method. He said the firm’s actuaries informed officials of the risks and it was the officials’ decision to use the technique. “Responsible funding methods do not work this way,” said Jeremy Gold, an independent actuary in New York who has been outspoken about the distortions built into pension numbers. He said the technique was much like the mortgages with very low teaser rates that proliferated during the housing bubble. 76
Excerpts from the New York Times article September 18, 2010 The Illusion of Pension Savings Dubious pension numbers in Illinois are not easily shrugged off after a warning shot fired by the Securities and Exchange Commission in August. Actuaries must disclose their methods and assumptions, but this one has been hidden in plain view because it often goes by the name of a method that is widely used and is accepted by the Governmental Accounting Standards Board. The technique falls into a family of complex and subtle calculations called “cost methods,” which actuaries use to spread pension costs over many years. Few outside of the profession know how the cost methods work or what their names mean. 77
Excerpts from the New York Times article September 18, 2010 The Illusion of Pension Savings Illinois issued public documents this year naming its cost method as one that did not permit the cost of future employees’ benefits to be factored into the current year’s contributions. The apparent contradiction caught actuaries’ attention. Sandor Goldstein, an actuary who helps the state operate some of the pension funds in its big system, acknowledges that Illinois’s disclosures are “somewhat misleading.” He also said he had warned the state that its funding method “may not be an appropriate one.” Illinois’s pension funds are more fragile than most, but their survival is essential to thousands of people. The state’s teachers and certain other workers do not participate in Social Security, so for them, the pension fund is their only source of retirement income. 78
Excerpts from the New York Times article September 18, 2010 The Illusion of Pension Savings Frank Todisco, senior pension fellow at the American Academy of Actuaries, declined to comment on the situation in Illinois, but said the Actuarial Standards Board was working on revised standards that, if adopted, would clarify actuarial assumptions and lead to more detailed descriptions of risk. It can easily take several years to revise an actuarial standard. That may not be fast enough to help Illinois’s pension system, which continues to sink. “When you’re in a deep hole, it’s a long way out,” said Mr. Jones. 79
“THE ACTUARIAL TRICK” 80 Closed Group Method- Traditional actuarial approach to perform a valuation of the current members of the group. Open Group Method- First developed in the 1970’s to model alternative population and experience scenarios to evaluate their effects on potential asset growth and future funding levels. Not designed to determine statutory contribution amounts.
“THE ACTUARIAL TRICK” 81 Closed Group Method Used for determining annual contributions for funding purposes. Relies on a “Stationary Population” Uses traditional actuarial methodology
“THE ACTUARIAL TRICK” Open Group Method (Projected Actuarial Valuation) Used for analyzing assumptions and cost methods Considers scenarios of population growth and/or decline Uses statistical analysis to develop scenarios of possible outcomes and analyzes probability models for sensitivity. 82
“THE ACTUARIAL TRICK” 83 Open Group Method (Projected Actuarial Valuation) Step 1: Project the financial characteristics for the analysis period assuming the actuarial assumptions used in the regular valuation are exactly fulfilled. Step 2: Project the population characteristics for the analysis period assuming a population growth and/or decline. Step 3: Develop probability models of the potential liabilities and funding levels which can occur. Step 4: Apply statistical techniques to measure the likelihood of each alternative scenario. Monte Carol simulation. Step 5. Modify the financial assumptions selected in Step 1 and repeat the analysis.
“THE ACTUARIAL TRICK” 84 If one were to apply the technique to determine a statutory contribution, here is how it should be done. Perform 30 annual actuarial valuations using the current participants in the fund and the selected actuarial assumptions. For each valuation make an additional assumption of new entrants, examining all possible reasonable characteristics: age at hire, salary at hire. For each valuation make an additional assumption of future growth rate in the population. Graph all of the results to determine the mean and standard deviation of the distribution. THE GRAPH WOULD LOOK LIKE THIS:
“THE ACTUARIAL TRICK” 86 Determine the confidence limit (95% -99%) and test each valuation within the confidence limit for a contribution percentage. Apply a “Monte Carlo Simulation” analysis to determine the appropriate contribution percentage. What Does Monte Carlo Simulation Mean? A problem solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called simulations, using random variables. (Approximately 10,000 simulations)
“THE ACTUARIAL TRICK” 87 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! Step 1: Project the financial characteristics for the analysis period (30 years) assuming the actuarial assumptions used in the regular valuation are exactly fulfilled.
“THE ACTUARIAL TRICK” 88 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! Step 2. Project the population characteristics for the analysis period (30 years) assuming a constant population which replaces the current tier 1 participants with tier 2 participants.
“THE ACTUARIAL TRICK” 89 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! Step 3: Net the results from Steps 1 and 2 and target a 90% funding level in 2040 on the final group.
“THE ACTUARIAL TRICK” 90 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! Step 4. Guess at a contribution amount (% of pay) that will work and test to see if it remains level during the period. Keep guessing until you get close and then STOP!
“THE ACTUARIAL TRICK” 91 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! MAJOR PROBLEM The methodology includes all possible outcomes, using the assumptions stated, and therefore includes analyses of poorly funded groups going bankrupt.
“THE ACTUARIAL TRICK” 92 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! ANOTHER MAJOR PROBLEM There are no assumptions made for population growth or shrinkage, thus the estimates are faulty.
“THE ACTUARIAL TRICK” 95 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! ANOTHER MAJOR PROBLEM Because the group size is so small, the graph really looks like this.
“THE ACTUARIAL TRICK” How Illinois Does it! 96 The statistics fail because there is no usable confidence limit.
“THE ACTUARIAL TRICK” 97 Open Group Method (Projected Actuarial Valuation) – How Illinois Does it! COGFA doesn’t seem to understand or care!
BUT GASB 98 we may have a Partner Right Here in Illinois With a Capital “P” and that rhymes with “G” and that stands for
“THE ACTUARIAL TRICK” 99 GASB Proposed Draft indicates that disclosure of actuarial liabilities for Comprehensive Annual Financial Reporting (CAFR) must be calculated using the Entry Age Normal Cost method as a level percentage of payroll and must use a closed group for these calculations.
Breaking News!!!! 100 Wall Street Journal – January 25, 2011 The Securities and Exchange Commission has launched an inquiry into public statements by Illinois officials about the state's underfunded pension fund, according to a report. The Wall Street Journal claimed the inquiry was focused on public statements concerning a measure passed last year intended to shore up the retirement system. The newspaper said one issue being examined is whether Illinois was taking future savings and treating them as current reductions in the cost of the pension fund. A measure Illinois took to save costs was to raise the retirement age for newly hired Illinois workers. ------------------------------------------------- January 26, 2011- Illinois unveiled overhauled reporting standards in its latest bond offering statement that also announced a rise in unfunded pension liabilities to $75.7 billion and revealed a pending SEC inquiry.
Breaking News!!!! 101 Wall Street Journal – January 25, 2011 In October Moody's Investor Services downgraded Illinois general obligation bonds following concerns over its unfunded pension liabilities. The ratings agency revised its outlook on the state from stable to negative, affecting $25bn of debt in the state. Moody's said Illinois reported a very large negative fund balance for the last fiscal year and faced fragile economic conditions and continuing uncertainty over its ability to meet pension funding obligations. So far, Illinois has incurred over $7bn in long-term debt and $3.8bn of pension funding debt.
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