Pension Funding Policy Public Pension Oversight Board May 23 rd,

FUNDING POLICY  Background Governmental Accounting Standards Board (GASB) changes:  GASB 25/27, public pension accounting standards, were historically often used as a funding standard.  GASB 67/68 effectively divorced funding standards from reporting standards.  GASB Comment: “In the past, the accounting and financial reporting standards were closely associated with the approach that many governments take to funding their benefits—that is, toward contributing sufficient resources to a defined benefit pension plan to finance benefit payments when they come due. Consequently, many governments have established funding policies based on the GASB’s standards. However, after reexamining the prior standards for pensions, the GASB concluded that approaches to funding are not necessarily the best approach to accounting for and reporting pension benefits. Therefore, the new Statements mark a definitive separation of accounting and financial reporting from funding.”  However, changes created discussion among public pension funds on the need for reviewing/developing a separate funding policy.  In Kentucky:  Both KRS & KTRS reviewed/developed written funding policies in 2013 and 2014, respectively.  KRS, KTRS, and JFRS have differing funding policies with varying levels of their policies included in state statute.  Recent Legislative Funding Proposals: HB 1 (2016-KTRS—requiring payment of the full ARC); HB 443 (2016- JFRS—changing statutory UL amortization policy); Budget Discussions: KERS NH cash flow issues & KTRS funding.  This presentation will focus on pension funding policies and will not include a discussion on retiree health funding policies. 2 *GASB’s New Pension Standards: Setting the Record Straight, Governmental Accounting Standards Board

Pension Fund Management Funding Policy Investment Policy Funding Policy Benefits Policy Governance Policy Pension Policies C + I = B + E Systematic approach (plan) for determining the amount and timing of contributions. Common Goals:  Benefit Security  Contribution Stability  Intergenerational Equity  Other FUNDING POLICY  Background 3

Actuarial Valuation Demographic Data & Experience (i.e. actual retirement rates) Financial Experience (i.e. actual investment returns) Benefits & Funding Provisions (Statute, Regulation, Board Policy) Actuarial Assumptions & Methods (Statute/Board Policy) 4 Information on Plan Health Funding Level Unfunded Liabilities Employer Contribution Rate PensionRetiree Health Experience Study: An actuarial review of assumptions against experience with recommendations for adjustments (conducted by the system’s actuary). HB 238 passed in the 2016 RS requires the systems to perform an experience study at least once every 5 years and specifies reporting requirements. Actuarial Audit: A secondary review by another actuary to review the current actuary’s work. HB 238 passed in 2016 RS requires the PPOB to retain an actuary and perform an audit at least once every 5 years. Asset/Liability Modeling Study: Typically performed following the experience study and evaluates various asset allocations against projected system liabilities with the ultimate goal of selecting a target asset allocation for the investment portfolio. GASB Information (NPL/PE)

Funding Policy Components Example Funding Policy Components  Actuarial Cost Method  Assumptions  Investment return, Payroll growth  Asset Valuation method  UL Amortization Method/Policy Funding Policy Results  ARC calculation: Normal Cost + Amortized UL payment  Example: KERS NH (as a % of pay) FUNDING POLICY  Background 5 ItemPensionHealthTotal Normal Cost* 3.60%2.35%5.95% UL Pmt %6.00%41.33% Total 38.93%8.35%47.28% *Includes administrative costs

FUNDING POLICY  Importance Possible Funding Issues, noted by the Segal Co./Cheiron (actuarial consultants) in a presentation to the 2015 Public Pension Funding Forum* (abbreviated):  Underfunding  Contribution volatility due to investment returns fluctuations  UL growing despite paying ARC  Contributions growing as a percentage of payroll due to a lack of active payroll growth  Overly optimistic assumptions resulting in greater funding needs  Cost shifting between generations  Revenue growth not able to keep up with growing pension costs 6 *”A Fresh Look At Actuarial Tools to Address Pension Funding Issues”, Paul Angelo, Segal Consulting, Elizabeth Wiley, Cheiron

Overview Example Actuarial Cost Method  Allocates costs to times periods  Defines normal cost  Two most common methods:  Entry Age Normal Cost (EANC), Projected Unit Credit (PUC)  KRS: Uses EANC as required by KRS  KTRS: uses EANC as provided by board policy (used PUC prior to FY 11).  JFRS: uses EANC. KRS allows EANC or PUC. Survey data:  45 of 50 state employee plans use EANC. EANC required for GASB 67 calculations. FUNDING POLICY  Actuarial Cost Method 7

Overview Example Asset Valuation Method  Most pension funds smooth investment gains/losses to reduce contribution volatility.  Typically 5 year smoothing (meaning 20% of a particular year’s gain/loss recognized). Some have shorter/longer smoothing periods.  Some plans use “corridors” where smoothing does not occur or is limited (i.e. Actuarial Value of Assets is 120% of Market value).  KRS/KTRS/JFRS use a 5-year smoothing method via policy FUNDING POLICY  Asset Valuation Method 8

KRS/KTRS/JFRS Public Fund Changes Over Time KRS: 7.5%  Upcoming Change: KERS NH and SPRS pension moving to 6.75% in 2016 valuation.  Recent Changes: 8.25% to 7.75% in 2006 valuation and 7.75% to 7.5% in 2015 valuation. KTRS: 7.5%. JFRS: 7%  Recent Change: 7.5% to 7.0% in 2009 valuation. KERS NH Sensitivity Example:  KERS NH assumption moving from 7.50% to 6.75% estimated to increase:  UL by $900+ M (from $10.0 B to 10.9 B)  ARC requirements by 1.31% of pay (from 47.28% to 48.59%). Public Pension Funds:  ↓ Trend: NASRA Public Fund Survey, more than 50% have lowered investment return assumption since Currently, average of 7.62%. FUNDING POLICIES  Investment Return Assumption 9 NASRA Issue Brief: Public Pension Plan Investment Return Assumptions Updated February 2016

FUNDING POLICY  Amortization Method/Policy Amortization Method/Policy  Amortization Period (varies)  Closed or Open (most closed)  Method  Typically level % but some use level $  Layering/Separate bases KRS: 30 year closed period (2013), level % of pay w/4% payroll growth.  Required by statute except for whether the period is closed/open and payroll growth assumption.  Period reset by KRS board in 2007 and by GA in 2013 via SB 2.  KRS board moved from open to closed period in  Payroll growth reduced by KRS from 5% to 4.5% (2006) to 4% (2015).  Separate 30 year period required for benefit improvements. KTRS: 30 year closed period on legacy liability and 20 year closed period on new sources of UL (2014), level % of pay, w/4% payroll growth.  All provisions by board policy.  2014: KTRS reset period and moved from an open to closed period. JFRS: Interest + 1% of UL (statute) Survey data:  Variable but many funds have a 30 year closed period, level % of pay most common (40 out of 50 states)  Several states recently moved from an open to closed period. Negative amortization: Occurs when the amortized UL payment is less than the interest on the liabilities. 10

FUNDING POLICY  Amortization Method/Policy FY Projected Payroll Level % MethodLevel $ Method ARC (%)ARC ($) Pension Funding LevelARC (%)ARC ($) Pension Funding Level 2016$1,565 M38.77%$607 M38.77%$607 M 20171,610 M48.59%$782 M18%48.59%$782 M18% 20181,663 M49.47%$823 M16%72.61%$1,208 M16% 20201,778 M49.30%$876 M15%69.04%$1,227 M18% 20252,121 M48.54%$1,029 M15%54.88%$1,164 M32% 20302,551 M47.25%$1,206 M19%42.56%$1,086 M46% 20353,076 M46.18%$1,420 M30%32.72%$1,006 M61% 11 Sensitivity to payroll growth assumption (KERS NH) in KRS actuarial valuation:  Decrease from 4% to 2%: Pension ARC increases by 9.07% of pay Difference Between Level % and Level $ Method (KERS NH Example includes both pension and retiree health contributions)*: KRS 20 Year Projections under current assumptions/methods and projections under Level $ method.

FUNDING POLICIES  Summary ItemKRSKTRSJFRS Statutory ReferencesKRS ; KRS ; ; ; KRS ; Contribution LevelVariableFixed/VariableVariable Funding PolicyStatutory/board policyPrimarily board policyStatutory/board policy Actuarial Cost MethodEntry Age Normal Cost (required by statute) Entry Age Normal Cost (board policy) Entry Age Normal Cost (statute allows board to choose EANC or PUC) Asset Valuation Method5 year smoothed market (board policy) 5 year smoothed market (board policy) 5 year smoothed market (board policy) Amortization Method 30 year (statute) Closed (policy) Level % of payroll method (statute) 4% payroll growth assumption (policy) Reset in 2007/2013 Any benefit increases to be amortized over separate periods (statute). 30 year closed period on “legacy” liabilities and 20 year closed period on any new liabilities (policy). Goal: 100% funded in 30 years. Level % of payroll method (policy) 4% payroll growth assumption (policy) Reset in Assumed rate of return + 1% of unfunded liabilities (statute). 12

KRS/KTRS JFRS KERS NH  Low funding level/significant cash flow issues  Low investment returns in FY 15 and likely for FY 16  Declining actual payroll but 4% projected growth  FY 2015: $1.667 B  FY 2014: $1.708 B  FY 2013: $1.768 B  FY 2012: $1.817 B  Growing ARC and funding levels/UL anticipated to get worse before it gets better.  Significant discussion of ARC+ KTRS  Statute prescribes a fixed employer rate plus additional contributions (but not typical ARC calculation similar to KRS/JFRS).  GASB 67 liabilities vs. funding liabilities:  GASB 67 Liabilities  NPL: $24.4 B; funding level 42.5%  Funding Liabilities  UL: $13.9 B; Funding level 55.3%  HB 1 (2016 RS) specified paying full ARC for KTRS pension fund in future years; other HFA to budget mentioned 4 year phase-in.  Budget ultimately paid 96%/93% of additional funding needed to meet full KTRS pension ARC but did not address GASB 67 issue. JFRS (HB 443—Amortization Method/Policy)  Current (statutory): 7% plus 1% of unfunded liability  HB 443 (2016 RS):  25 closed period on legacy liabilities.  Future legislative changes: 20 year closed period for each change.  Future assumption/method changes: 15 year closed period for each change.  Future gains/losses: 10 year closed period for each change.  Level dollar amortization method FUNDING POLICY  Issues 13

FUNDING POLICY  Risk Management Valuation Frequency/Content/Timing  Valuations performed annually (KRS/KTRS required annual; JFRS required at least every 2 years)  All employer rates vary every 2 years to coincide with the biennial budget except in the case of CERS (varies annually).  HB 238 (2016 RS) requires a 20 year projection of employer rates, funding levels, UL  HB 238 requires sensitivity analysis on key assumptions (investment return, payroll growth, etc.)  HB 238 requires completion of the valuation by November 15 th following close of fiscal year Experience Studies  HB 238 requires all system to perform study every 5 years and requires 20 year projection of employer rates, funding level, and UL of changes.  Requires similar projections on other assumption changes/other changes made by systems Actuarial Audits  KRS/KTRS had audits performed in 2015 by actuary retained by systems.  HB 238 requires audit every 5 years by actuary retained for PPOB. Employer Rate Projections/Review  Requires systems to submit projections by August 15 th in year prior to a budget session  Requires review of employer rates by actuary retained for PPOB prior to budget session Legislative Proposals  An actuarial analysis is required by KRS on any bills that “…increase or decrease the benefits or increase or decrease participation in the benefits or change the actuarial accrued liability of any state administered retirement system…”.  Requires 20 year projection of employer rates, funding level, and UL. Permanent Fund/Performance Audit (HB 238/budget bill)  Creates the Kentucky Permanent Pension Fund and transfers $125 million in FY 17 to the fund from the Public Employee Health Insurance Trust Fund.  Provides that expenditures up to $3 million shall be paid from the fund for a performance audit of the state- administered retirement systems during the fiscal biennium.  RFP can be found at:

FUNDING POLICY  Questions What is the desired outcome? Should funding policies be amended to address each system’s specific issues? Should portions of funding policies be statutory or left to board policy?  Current approach varies by system Should the systems have some consistency in funding provisions or varied to address each system’s needs? 15