TLFFRA Educational Conference Actuarial Matters Effect of Actuarial Assumptions on the Soundness of Your Plan TLFFRA Educational Conference October 2, 2017

Questions to Consider What are some reasons for a range of investment return assumptions? Why are many public pension funds using a lower investment return assumption than 10 years ago? What are the effects of a lower investment return assumption? How do DROPs affect our funds? 1

Range of Investment Return Assumptions TLFFRA All Texas NASRA Assumption Funds Funds Survey 8.5% 0 1 1 > 8.0 < 8.5 2 2 2 8.0 12 20 19 > 7.5 < 8.0 17 27 33 > 7.0 – 7.5 7 27 53 7.0 3 7 1 < 7.0 1 9 10 42 93 127 2

Reasons for Different Investment Return Assumptions from Fund to Fund Different asset allocations Different assumptions for major asset classes Different assumptions for inflation Different levels of investment-related expenses Different inclinations of boards of trustees Different actuarial conditions of fund TEXPERS

Different Asset Allocations Have Different Expected Returns Major categories (equities and fixed income) 60/40 vs. 65/35 vs 70/30 vs 75/25 Subcategories that can increase expected return international equities vs. domestic equities small and mid cap vs. large cap emerging markets vs. developed international real estate vs. fixed income world bonds vs. domestic bonds TEXPERS

Different Assumptions for Major Asset Classes Assumed Gross Theoretical Real Rate of Return Other Investment Fixed Weighted Assumptions2 Return Set Equities Income Average1 Inflation Expenses Assumption3 1 6.0% 3.00% 5.01% 3.00% 0.75% 7.26% 2 6.5 2.75 5.26 3.00 0.75 7.51 3 7.0 2.50 5.52 3.00 0.75 7.77 4 7.5 2.25 5.77 3.00 0.75 8.02 1 Assuming asset allocation of 67% equities and 33% fixed income. 2 These assumptions vary from fund to fund but were held constant for illustrating the effect of different gross real rate of return assumptions. 3 Weighted average gross real rate of return plus inflation minus expenses. 5

Different Assumptions for Inflation Most actuaries do not use the same assumption for every client but have a range of assumptions Different actuaries have different ranges As there has been a gradual reduction in investment return assumptions, often the inflation assumption has also been reduced Surveys have been difficult to obtain February 2016 TLFFRA Pension Report by the PRB showed a range of from 2.5% to 4.0% A more reasonable current range might be 2.5% to 3.5% 6

Price Inflation in the USA Years (Dec. to Dec.)   Number of Years Average Annual Increase 1951 – 2016 1956 – 2016 1961 – 2016 1966 – 2016 1971 – 2016 1976 – 2016 1981 – 2016 1986 – 2016 1991 – 2016 1996 – 2016 2001 – 2016 2006 – 2016 65 60 55 50 45 40 35 30 25 20 15 10 3.46% 3.68 3.86 4.07 4.01 3.62 2.73 2.64 2.26 2.12 2.10 1.81 7

Different Levels of Investment-Related Expenses Our preferred practice is to recognize both direct and indirect expenses Direct: paid directly by fund Indirect: paid by reduction in net asset value Expenses of investment managers or mutual funds are wider ranging than you might think Selection of investment managers or mutual funds often focuses mainly on historical performance and less on expense Generally, but not always, total investment-related expenses as a percent of assets are lower for larger funds Range for most of the TLFFRA funds might be from as much as 1.2% down to 0.5% (no survey available) 8

Different Inclinations of Boards of Trustees Board’s investment policy statement requires some consideration of risk and often includes a target asset allocation Some boards rely on their investment consultant for recommending target asset allocation, while other boards have more influence on that policy decision Asset allocation decision is the major determinant of expected return Board usually gives deference to the investment return assumption recommended by the fund’s actuarial firm Collective inclination may influence board to ask for an assumption lower than what actuary recommends TEXPERS

Different Actuarial Conditions of Fund The lower the pay off period for the unfunded liability, the less sensitive it is to a reduction in the investment return assumption The higher the pay off period, the more sensitive it is The better a fund’s actuarial condition, the easier it is to reduce the investment return assumption Other considerations that can enhance an opportunity to reduce the investment return assumption an increase in the total contribution rate favorable investment experience other favorable experience reducing future benefit accruals TEXPERS

Investment Return Assumptions, FY01 to FY18 TEXPERS

Investment Return Assumption Than 10 Years Ago? Why Are Many Public Pension Funds Using a Lower Investment Return Assumption Than 10 Years Ago? The Great Recession of 2008 (October 2007 – March 2009) Below average growth of the economy since 2009 Sustained period of low interest rates since 2009 Sustained period of low inflation rates since 1991 Increasing scrutiny of public employee DB plans unfunded liability pay off period for unfunded liability investment return assumption plan design governance 12

What Are the Effects of a Lower Investment Return Assumption on a TLFFRA Fund? It will vary from fund to fund Bigger increase in unfunded liability pay off period the higher the current pay off period the higher the current funded ratio the higher the current ratio of the normal contribution rate to the total contribution rate the inflation assumption is not lowered 13

Example 1 – Dramatic Increase in Pay Off Period Investment Return Assumption Base 0.25% 0.50% Valuation Lower Lower Pay Off Period 19.2 yrs. 31.6 yrs. 70.9 yrs. Funded Ratio 83.2% 80.8% 78.5% NCR / TOTCR 73.9% 78.0% 82.2% Inflation base no change no change 14

Example 2 – Modest Increase in Pay Off Period Investment Return Assumption Base 0.25% 0.50% Valuation Lower Lower Pay Off Period 24.6 yrs. 29.1 yrs. 35.1 yrs. Funded Ratio 53.5% 52.0% 50.5% NCR / TOTCR 55.6% 58.4% 61.4% Inflation base no change no change 15

Example 3 – Modest Increase in Pay Off Period with Change in Inflation Investment Return Assumption Base 0.25% 0.50% Valuation Lower Lower Pay Off Period 24.6 yrs. 28.6 yrs. 34.2 yrs. Funded Ratio 53.5% 52.1% 50.7% NCR / TOTCR 55.6% 57.0% 58.6% Inflation base 0.25% lower 0.50% lower 16

How Do DROPs Affect our Funds? Isn’t DROP cost neutral? Why does our actuary say it would increase our pay off period to increase the DROP period? to lower the age at which we can get the maximum DROP lump sum? to credit interest on our monthly benefit during the DROP period? to add the city’s contributions to the DROP lump sum? 17

Is DROP Actuarially Equivalent to the Regular Benefit? Electing DROP provides a lump sum and a lower monthly benefit compared to regular benefit Electing regular benefit provides no lump sum and a higher monthly benefit compared to DROP benefit Actuarial equivalence is based on present values (PV) at retirement date PV of lump sum and DROP monthly annuity compared to PV of higher regular monthly annuity Time value of money makes lump sum up front more valuable than PV of excess of higher regular monthly benefit over lower DROP monthly benefit Generally the PV of DROP is greater than the PV of regular benefit Why does our actuary say it would increase our pay off period to increase the DROP period? To lower the age at which we can get the maximum DROP lump sum? To credit interest on our monthly benefit during the DROP period To add the city’s contributions to the DROP lump sum? 18

Benefit Example DROP not Elected DROP is Elected Monthly Benefit $ 4,600 Monthly Benefit $ 4,000 Value of Future Value of Future Monthly Benefits $ 644,000 Monthly Benefits $ 560,000 Lump Sum $ 130,000 Total Value of Benefits $ 690,000 19

But Somebody Said DROP is Cost Neutral Your fund’s original DROP design may have included minimum age and service for earliest DROP benefit calculation date beyond the average retirement age maximum period for accumulating DROP lump sum Such design was to encourage some firefighters to work to somewhat higher age than they otherwise might A somewhat longer career ending at a higher age slightly reduces the net cost from the interaction of these components increased benefit longer work career for paying for the benefit shorter expected pay out period So DROP could have been approximately cost neutral in the aggregate when it was added 20

So If DROP Was Approximately Cost Neutral When Added, Why Does It Cost to Improve It? Increased DROP period usually increases the disparity in the PV of a DROP benefit and the PV of a regular benefit without enough of an offsetting increase in retirement age Reducing the age at which you can get the maximum DROP lump sum reduces the work career for paying for the benefit and lengthens the expected pay out period Crediting interest or adding the city’s contributions to the DROP lump sum increases the PV of benefits 21