UPTE position Updated by Paul Brooks 26 Oct. 2008 The UC Retirement Plan (UCRP): The Need for Actuarial Best Practices & Shared Governance UPTE position Updated by Paul Brooks 26 Oct. 2008

Acknowledgement further information UC employees acknowledge Dr. Charles Schwartz, emeritus professor UCB, for his dedicated research on the UC pension system. His work can be found at: http://socrates.berkeley.edu/~schwrtz/ Attacking the character of the reference writer rather than the facts cited is an Ad Hominem fallacy (described at http://www.nizkor.org/features/fallacies/ad-hominem.html).

The Regents have stated that contributions to UCRP are needed. This presentation will conclude that: The pension plan has been badly managed in the last 8 years. That the pension plans must be managed to best actuarial practices, including: a) Annual stochastic studies; b) Readily available comparison data of fund performance with similar funds, including risk assessment; c) Readily available management cost data. Employees should not have to contribute until UC has contributed enough to make up for the shortfall due to CAP funds. Joint governance with certified trustees is necessary to ensure the pension fund is run competently.

Definition of terms A DBP is a defined benefit plan. At retirement, employees are guaranteed a certain retirement pay for the rest of their lives. It is the responsibility of the retirement fund, usually managed by the employer, to guarantee this. A DCP is a defined contribution plan. At retirement, an employee has only the funds he has saved in instruments savings plans such as a 403B or 401K. There is no guarantee of a specific retirement benefit.

USA Pension History Most pensions were only for executives before 1945. Due to union action, most workers were covered by DBP pensions by the 1950’s. Employers contributed to and controlled the pension fund. Their contributions were tax free, and the fund was listed as an asset. However, they were also liable for paying retirees’ benefits. There was little oversight. Due to various improprieties such as using the funds assets for business takeover, or underfunding the plans, Congress passed Employment Retirement and Income Security Act (ERISA) of 1974.

Pension history continued: During the 1980’s various other acts were passed that made DBP much less attractive to employers. Most dismantled their plans. In 1979 80% of all workers with a pension were covered by a DBP. By 2004 only 20% of employees in private firms were in DBPs. Source: Rasmus, J. 2005. The war at home. Kyklos productions, LLC.

New state employees could have lost their DBP pensions. In 2005 the Governor proposed that on July 1, 2007, all new hires would be on a 401K (DCP) plan. It is only union pressure that is preventing this.

DCPs a poor substitute for DBPs 401Ks (a DCP) have underperformed DBPs. To retire at 65, a person should have 8-9 times their annual salary in a 401K. Most employees with 401Ks are not contributing enough. Part of the problem is that employers only match the employees contribution, say 3%/3%, or 6%/6% at best. DBPs historically have had a split more like 3% employee/ 8-15% employer. Hacker, J. S. 2006. The great risk shift. Oxford Univ. Press. Rasmus, J. 2005. The war at home. Kyklos productions, LLC.

Pension we have at UC. We are very fortunate to have a well funded DBP and a DCP at UC. The DBP is a great benefit that helps to make up for lower wages. It is great for the taxpayer, as no public money has been put in to the DBP in 17 years. 2% of our pay also goes into a DCP which is separate from the DBP.

DCP fund management problems. Most employees have no idea what they are doing in terms of investments. They are easily taken advantage of by DCP fund managers.

DCP management problems, cont. “Imagine a business in which other people hand you their money to look after and pay you handsomely for doing so. Even better, your fees go up ever year, even if you are hopeless at the job.” “That business exists, it is called fund management”. “A special report on asset management” p.3, in: The Economist, vol. 386 No. 8569. March 1st-7th, 2008.

Social Security Note It is therefore understandable that the financial services industry would push hard for private Social Security accounts. The financial services industry expects to make a huge profit charging high fees on private social security accounts.

Individual investors do badly Over the 25 years from 1980 to 2005, the S&P 500 index returned an average of 12.3% a year. Over the same period the average equity mutual fund returned 10%. The average mutual fund investor earned just 7.3%. “A special report on asset management” p.3, in: The Economist, vol. 386 No. 8569. March 1st-7th, 2008.

DCP’s are not adequately funded “Employers have taken advantage of the switch from DB to DC to cut the level of their payments drastically.” “In America total (employee and employer) DC contributions at the last estimate were … still only 9.8%.” “The trouble with pensions” p.93, in: The Economist, vol. 387 No. 8584. June 14th – 20th , 2008.

The Result: It makes sense for employers to switch from a DBP to a DCP to save money. It is hugely profitable for the investment industry to then manage this money for the average employee. They want this change to occur. The average employee will have a very small pension since they and their employer do not contribute enough to their DCP. They can be charged excessive fees, and their DCP does not earn a high interest rate.

Coincidences? In 2005, the governor proposed that all new state employees be put on a 401K beginning July 1, 2007. The proposed date of the re-start of contributions was July 1, 2007. The first proposed contributions of 8% each were the same split as a 401K. To the claim “UC wants to create a ‘two-tier’ retirement plan or replace the pension with a 401k plan,” the response is “Right now, the Regents are discussing options for keeping the UCRP healthy through contributions. In the future, the Regents may consider making other choices available to employees.”

UCRP historical contributions. Note on the next slide that historically the contributions to the pension plan were 2-3% by employees and variable, but as high as 16% in the 1980’s. In 1990, the fund was so overvalued that contributions were stopped. The 2% employee contribution was put into a DCP account. UC contributions not only stopped but money was taken out for the CAP I and II instead of cost of living increases. UC employees were told they would never have to contribute again.

Regents & UCOP have discussed employee and employer contributions increasing to 5/11% split. CAP 1 CAP 2 References: Historical section based on UC’s response to an information request, 2006 CAP 1 -Back calculated from CAP 1 held by Paul Brooks CAP 2 -http://atyourservice.ucop.edu/employees/retirement/cap/index.html

Regents & UCOP have discussed employee and employer contributions increasing to 8% each. (Schwartz Oct 2008). historical discussed CAP 1 CAP 2 References: Historical section based on UC’s response to an information request, 2006 CAP 1 -Back calculated from CAP 1 held by Paul Brooks CAP 2 -http://atyourservice.ucop.edu/employees/retirement/cap/index.html

UC was top performing fund. In the 1990’s the UC retirement fund was one of the top performing funds in the nation. Therefore contributions did not need to be re-started. It was managed at low (probably 0.1% of assets) in-house. The manager was Patricia Small.

Pension fund management change. Begins in Texas where George W. Bush was governor. A person called Russ worked with the UT pension fund that had been taken over by private interests. http://socrates.berkeley.edu/~schwrtz/ “what's happening with the pension fund part 10”.

Pension fund management change continued. In the late 1990’s, Regent Parsky organized of closed (secret) meetings where Russ and a consultant, Wilshire Associates, critiqued the fund performance. The California Supreme Court ruled these meetings illegal in 2003. S & P performance was fabricated and risk assessment was not evaluated. Many of the calculations that Russ used were incorrect. The supposed loss to the pension fund only amounted to 0.2% per year (less than many management fees) http://socrates.berkeley.edu/~schwrtz/ “what’s happening to the pension fund parts 1-20”.

Patricia Small loses her job. In 2000, the regents retired Patricia Small with a generous severance package that included a clause that she was “not to disparage the regents”. Wilshire Associates donated $80,000 to the Elect George W. Bush campaign that Regent Parsky was managing. http://www.eastbayexpress.com/gyrobase/parsky_s_party/Content?oid=426427&page=3

Regents & Conflict of Interest: The Need for Joint Governance of UCRP In 2000, the first $16 billion of UCRP assets was handed to outside management on the advice of Wilshire Associates, who had been hired to advise the University. Wilshire Associates had donated money to the “Elect George W. Bush” campaign in California, which was managed by Gerald Parsky. Gerald Parsky denied any connection with this donation. http://sfgate.com/cgi-bin/article.cgi?f=/e/a/2000/07/16/NEWS9974.dtl&hw=UC&sn=001&sc=1000

Wilshire associates given job Wilshire associates was given the job of making the changes it had recommended (a clear conflict of interest). http://www.eastbayexpress.com/gyrobase/parsky_s_party/Content?oid=426427&page=3 In Nov. 2000, UC traders sold nearly $11.6 billion in stock. (Who got the commission on that?) http://www.eastbayexpress.com/gyrobase/parsky_s_party/Content?oid=426427&page=4

Regents & Conflict of Interest: The Need for Joint Governance of UCRP In 2003, Wilshire Associates was found to be illegally “fast trading” by the SEC. There were many other business practices that are not in the best interest of the client. Did the fund perform better after 2000 when the UCRP management changed? We will need another 5 years of data to make a better determination, but when compared to CalPERS, the University pension fund is not performing as well as in the 1990s (see next slide).

UC privatization management begun Bond fund privatized Reference: compiled from the table on page 7 of http://socrates.berkeley.edu/~schwrtz/UCRP_Data&Questions.pdf

We need Benchmarks! This information is not readily available. The data for 2007-2008 is now being withheld until the closed session of the Regents scheduled Sep. 17. These benchmarks should be put on the UC web page as soon as they are available. We need this data regularly and publically available.

Main faculty and staff concerns. Has the management of the pension fund used actuarial best practices? Have there been conflicts of interest managing the pension fund? Does the fund actually require the start of contributions? How much money has been removed from the pension fund for management fees?

Models & Manipulation: The need for actuarial best practices. The claim that the pension fund needs to re-start contributions is based on actuarial models that try to predict what the liabilities of the fund are. They require projections of input variables including: Life expectancy Inflation Pay increases Number of new employees and their starting salary And about 20 other input variables.

Models & Manipulation Actuarial models are subject to considerable manipulation in their input data to generate a desired outcome. This presentation will show an example of how Social Security data was misquoted during the President’s campaign to “save” Social Security. This will show how the effect of data ‘propagation of error’ carries forward and can be abused. This presentation will show how different assumptions made by actuarial firms make a huge difference in the projections for the retirement fund. 4. This presentation will conclude that the reporting standards in UC’s recent actuarial reports should be upgraded to actuarial best practices. This should include the ‘propagation of error’ and the sensitivity of the actuarial model to different inputs.

Propagation of Error in Models Models are usually computer programs that try to predict something based on past experience. Models input a large number of variables, and then attempt to predict the outcome. Models can be manipulated by not showing data from different projections. All projections must have a “propagation of error” to be valid. This is just as true for pension projections.

Models & Manipulation: Social Security Privatization ` ``` In 2005, President George W. Bush campaigned to create private accounts in Social Security, claiming with absolute certainty that Social Security would be “flat broke in 2041”. The following graph is the actual data as predicted by Social Security in 2004. This is a thorough analysis called a “stochastic study”.

Models & Manipulation: Social Security Privatization assets / annual costs Source: Hiltzik, Michael. 2005. The plot against social security. Harper Collins. ISBN 0-06-083465-X. p. 60.

Models & Manipulation: Social Security Privatization The real figures are that Social Security will go bankrupt between 2030 and infinite, that is, never! Note that in this 2005 projection, the Social Security fund will stop accumulating assets and have to pay out more than it takes in around 2018. Has this always been the case? How well have past projections predicted this point?

Models & Manipulation: Social Security Privatization Year Projection Made Year Social Security projected to begin deficit spending Difference from year projected to projection 1991 2010 19 Hardy, Dorcas R., and C. Colburn Hardy. 1991 Social Insecurity. Villard books, New York 2001 2014 13 http://www.csss.gov/meetings/june-11-minuts.htm 2004 2018 14 Hiltzik, Michael. 2005. The plot against social security. Harper Collins. Every year the projections are updated and the model checked. Note how past projections have been pessimistic and the predicted date that Social Security will go into deficit spending keeps advancing into the future.

Regents & Conflict of Interest: The Need for Joint Governance of UCRP Gerald Parsky is a UC Regent & UCRP trustee. Parsky was a member of the President’s Commission to strengthen Social Security in 2001. Members of the commission were chosen on the basis that they favored the creation of private accounts, and the commission was charged with recommending private accounts. This raises serious questions as to the Regents’ objectivity on pension matters. http://www.csss.gov/meetings/june-11-minutes.htm

UCRP: Different Assumptions Result in Different Projections Note: Towers and Perrin’s study projects assets/liabilities of 204% in 2019: Wilshire’s study projects assets/liabilities of 118% in 2020. Dr. Schwartz asked why was there a discrepancy between the 2 studies. Source: http://socrates.berkeley.edu/~schwrtz/WHPF6.html

Dr Schwartz eventually received the following reply to the discrepancy:   University of California April 16, 2001 Office of the President                                                                                             Dear Professor Schwartz: I am following up on your concern about the differences between Wilshire Associates and Towers Perrin in comparing respective asset and liability projections for the University Retirement System. The differences in funded level projections relate to differences in assumptions and not to discrepancies in the models. Given the same inputs both the Wilshire and Towers Perrin models produce nearly identical results. The important differences are: Lump Sum Distributions: Wilshire assumed no lump sum distributions while Towers Perrin assumed a 20% lump sum election. The effect of lump sums is to reduce assets and liabilities in equal dollar amounts and, as a result, Towers Perrin's liability projections will be lower than Wilshire's and its ratio of assets-to-liabilities will be higher. This difference in assumption explains about half of the difference in projected liabilities in year 2015 and almost all of the difference in projected assets. continue on next slide http://socrates.berkeley.edu/~schwrtz part 9

2. New Entrant Age and [Salary]: The remaining difference in liability projections is explained by assumptions made for the average age and salary in new entrants. This became a particularly important input given the assumed 2.5% growth in the active workforce. Wilshire assumed new entrants would come in at a significantly higher age and salary than did Towers Perrin, a difference that caused a more rapid growth in Wilshire's liability projections. This age and salary assumption difference fully explains the remainder of the difference in 2015 liability projections. One purpose for the Towers Perrin liability study was to bring greater accuracy to the liability projections and to use their findings to further examine asset allocation for the retirement plan. Wilshire reports that although the Towers Perrin study shows a stronger projected funded position for the retirement plan compared to their study, their asset allocation recommendation at the time would not have changed. Thank you for your interest in this topic. I hope this addresses your concerns.         Sincerely,        Joseph P. Mullinix        Senior Vice President -- Business and Finance http://socrates.berkeley.edu/~schwrtz part 9

UCRP: Different Assumptions Result in Different Projections This shows the sensitivity of the actuarial model. Adjusting the lump sum distribution from 0 to 20%, and changing the age and salary of new hires, changes the projected funding status of the pension fund from 118% to 208%! Sensitivity analysis is required to meet actuarial best practices. This also shows how easy it is for an actuarial firm to change the results of their projections. This can easily be subject to pressure on the actuarial firm to come up with the results that the group funding the actuarial firm wants to believe.

UCRP: Different Assumptions Result in Different Projections What are the assumptions used in the following graph? What is the model’s sensitivity to inputs? Where are the error bars? Source: http://www.universityofcalifornia.edu/news/ ucrpfuture/welcome.html

UCRP: Different Assumptions Result in Different Projections A Stochastic study is normally done every 3 years and was due in 2006. Why is there no updated Stochastic Study on UCRP? “While we appreciate your advice on ‘best practices,’ our actuary, the Segal Company, feels that a stochastic study in this case would introduce many variables into the analysis that would unnecessarily complicate the picture.” One of the questions our consultant asked UC was why they hadn’t done a stochastic study before making their decision to restart contributions. Here is UC’s response. (BUTTON) In our discussions with Venuti, he found this response from UC to be particularly stunning. Actuaries tend to prefer more information, not less. –UC response to Venuti Report, May 26, 2006

Actuarial Best Practices & UCRP: The Need for Joint Governance of UCRP Segal and Company claim that the data is proprietary. Venuti & Associates have offered to take this issue before the actuarial board of counseling and discipline, where they are confident that they will rule that although the programs that Segal use are proprietary, the data is not. When this data is released, Venuti & Associates can do a thorough analysis. However, this would have to be paid for. The Regents do not appear to realize that sensitivity to input data and propagation of error need to be recognized in actuarial models. This means that : Joint labor management governance of the UCRP is needed to protect the interests of Plan participants.

Actuarial Best Practices & UCRP: The Need for Joint Governance of UCRP This data and statement by Segal is totally unacceptable for the standards at the University of California. The data must be represented with a detailed report on the sensitivity of the model to various inputs and a report of how realistic these inputs are, meeting actuarial best practices standards, with peer review. Any actuarial work not done to these standards should be dismissed and the actuarial firm’s contract discontinued. Arguments that the cost of running the model with different inputs would be too costly are not credible for a fund the size of UCRP. The Unions bargaining over the pensions have hired their own actuarial firm, Venuti and Associates, who have recommended doing a more thorough analysis. In a response to a critique of their work by Venuti and Associates, Segal and Co. have recommended that the unions should do their own actuarial study. In 2006 UC would not release the data for Venuti and Associates to do this.

UCRP Management & Performance: the need for Joint Governance It is possible that the lower return for UCRP since privatization is a result of increased management fees. Before the fund was privatized, the cost of management was around $20 million per year, or 0.1% of the fund. Management fee of 0.36% is now probable but the information is difficult to get. http://socrates.berkeley.edu/~schwrtz/UCRPFees.html “Most investors are paying much more than they think they are” (Consumer Reports Money Adviser, Feb 2007 p.6). If management fees are 0.36%, this would cost the fund about $100 million annually than if the previous cost was 0.1% under UC management. Joint governance would provide more oversight to determine the extent of these possible fees and cost to UCRP.

CAP funds In the early 1990’s and 2000’s the state was short of money and did not provide much money for a cost of living pay increase. Since the pension fund was so overfunded, the Regents took money out and put it into a “Capital Accumulation Provision” account for each employee, instead of a cost of living increase. CAPs are managed by the pension fund, but separate and not included in pension assets.

Regents & UCOP have discussed employee and employer contributions increasing to 8% each. (Schwartz Oct 2008). historical discussed CAP 1 CAP 2 References: Historical section based on UC’s response to an information request, 2006 CAP 1 -Back calculated from CAP 1 held by Paul Brooks CAP 2 -http://atyourservice.ucop.edu/employees/retirement/cap/index.html

UCRP Management & Performance: the need for Joint Governance Had this money not been removed from the fund, it would have at least $1.2 billion more than it does now. The actual figure is higher as employees who have retired since the CAPs were approved have taken this money out. CAP I earns 8.5% interest, CAP 2, 7.5% interest. This means that if employees have to pay into the Fund before this money is paid back, then the employees are paying for their own CAP 1 and 2 pay raise, with interest.

UCRP Management & Performance: the need for Joint Governance UCOP & The Regents have discussed increasing contributions to a 5/11% split for employee and employer. Equal contributions are not consistent with UCRP contributions history. Before the “holiday,” employees generally paid 2-3%, and UC paid the rest, up to 16%, depending on liabilities and the performance of the Fund.

Qualify the Trustees A complaint often made on the concept of joint governance is that employee trustees are not competent trustees. In Britain it is now the law that pension trustees must be qualified before they can serve. This requires a course of several days time. ttp://www.thepensionsregulator.gov.uk/trustees/trusteeKnowledge/index.aspx UC Should take the lead in establishing a qualification program in the United States.

The Regents have stated that contributions to UCRP are needed. Conclusions The pension plan has been badly managed in the last 8 years. The pension plans must be managed to best actuarial practices, including: a) Annual stochastic studies; b) Readily available comparison data of fund performance with similar funds, including risk assessment; c) Readily available management cost data. Employees should not have to contribute until UC has contributed enough to make up for the shortfall due to CAP funds. Joint governance with certified trustees is necessary to ensure the pension fund is run competently.