Graham Schmidt, ASA Vice President, EFI Actuaries 2/6/20071

 Fundamental Differences ◦ Purposes ◦ Revenue ◦ Budget obligations ◦ Longevity  Actuarial Differences ◦ Private sector requirements (FASB / PBGC / IRS) ◦ Governmental approaches (level cost, transfers, funding rules) ◦ Public vs. private 2/6/20072

“Why Governmental Accounting and Financial Reporting is – and should be – different” – GASB White Paper 2/6/20073

 Purpose ◦ For-Profit Business Enterprise: Generate a financial return on investment ◦ Government: “Focus on providing services and goods to constituents in an efficient, effective, economical and sustainable manner.”  Revenue ◦ For Taxpayer, amount of taxes paid does NOT bear direct relationship to services received  Budget Obligations 2/6/20074

 Longevity ◦ Number of municipal bankruptcy filings 0.02% of business filings ◦ Long-term outlook leads to focus on “trends in operations, rather than on short-term fluctuations, such as in fair values of certain assets and liabilities.”  Short-term fluctuations result in less “decision-useful” measurements  For businesses, short-term more important because of current value of equity 2/6/20075

Methods, Measurements and Other Issues 2/6/20076

 Accounting ◦ Governed by FASB (FAS 87, 106, 132 & 158) ◦ Measure Projected Benefit Obligation (PBO)  Based on Projected Unit Credit actuarial funding method  Prescribed to improve comparability, but mismatch between accounting/funding ◦ Rate used to discount liabilities based on “settlement rates”  based on annuity rates or high-quality fixed income  average ~ 5.5–6.0% in FY 05  can be quite variable from year-to-year 2/6/20077

 Accounting Continued ◦ Use different rate for “expected return on assets”  used to calculate reported pension expense  average ~ % in FY 05  may change due to future FASB projects ◦ Amortization / Smoothing  Most elements amortized over average remaining service of current actives  Only have to amortize portion of g/l  Max smoothing period for assets is 5 years 2/6/20078

 Funding ◦ Basis  Companies offer “qualified” plans to obtain tax advantages  IRS makes rules to ensure funding status (protect PBGC and participants) and ensure “fairness” (non- discrimination, etc)  Rules define minimum / maximum contributions  Pension Protection Act (PPA) changed rules significantly 2/6/20079

 Funding (new rules) ◦ PPA defines “Funding Target” – 100% of PV of accrued benefits (was 90%) [using Unit Credit method] ◦ Unfunded liability must be amortized over 7 years ◦ Discounting based on yield curve (different rates for different payment durations) ◦ Mortality rates dictated by IRS (very large plans can use own experience) 2/6/200710

 Funding ◦ Max asset smoothing is 24 months, with 10% corridor ◦ Plans with low funding levels (“At-Risk Plans”) subject to additional restrictions / requirements:  Contributions  Benefit improvements / changes  Forms of payment (no lump sums) ◦ PPA also increased maximum contribution limits ◦ Changes to multi-employer rules not as significant 2/6/200711

 Not one-size-fits-all ◦ Governmental plans not subject to most of ERISA rules ◦ More difficult for IRS to enforce through tax policy ◦ No Federal restrictions on funding (occurs at State or Local level) ◦ GASB defines accounting standards (GASB 25, 27, 43, 45) - contain more flexibility than FASB (funding methods, amortization, etc) 2/6/200712

 General Actuarial Characteristics ◦ Funding Methods  Most pre-fund  Cost methods split cost into past costs (accrued liability), current year’s cost (normal/service cost), future normal costs  Most common method is Entry Age Normal  Goal is to determine level normal cost needed to fund each individual’s benefit  GASB allows 6 methods  Proposed GASB change: if use Aggregate method, must show funding ratio using EAN 2/6/200713

 General Actuarial Characteristics ◦ Amortization / Smoothing  Most amortize unfunded accrued liability (UAL)  Again, no federal rules, but GASB has some restrictions  Max period 30 years, level $ or % of pay, open or closed period  With long period and level % of pay, current payment may be less than interest on UAL  Assets generally smoothed  Most common to use 3-5 years (CalPERS using 15) ◦ Discount Rate  Generally use expected return on assets  Most common: 8.0% in ‘05 (NASRA survey) 2/6/200714

 Private sector moving towards discounting liabilities at market rates (yield curve) ◦ Influenced by “Financial Economics”  Price of liability is asset consisting of matching cashflows (use yield curve)  “Mark-to-Market” liabilities  $1 of bond = $1 of stock: why would value of liabilities be different?  Discounting of liabilities at 8% anticipates “risk premium” -> transfers risk to future generations  Existence of PBGC has introduced moral hazard – encouraging investment in overly-risky portfolios 2/6/200715

 Why important for Private Sector? ◦ Value of equity/debt important (companies bought & sold) ◦ Earnings and contributions (accounting and funding) directly impacted by fluctuations in interest rates because of FASB / IRS rules  Large penalties for missing earning targets ◦ Liability-Driven Investing (LDI) attempts to reduce volatility due to interest rate risk by taking into account payment structure of liabilities ◦ Generally results in increased allocation to long- duration bonds 2/6/200716

 Why could be different for governments? ◦ GASB: “Information on fair values of capital assets is of limited value” (less likelihood of bankruptcy / termination) ◦ In current practice (accounting & funding), fluctuations in interest rates do NOT impact government plans  Do you measure it?  Does measurement matter? ◦ Assuming plans invest in “risky” assets, current practice does better job determining level contributions 2/6/200717

 Issues with current practice for governments ◦ Discounting at expected rate of return (8%) does not reflect risk of investing ◦ Could measure/contribute using risk-free rate and invest in “matching” portfolio  However, certainty has cost!  Remember purpose: “providing services and goods to constituents in an efficient, effective, economical and sustainable manner” ◦ Alternatively, could project future asset returns / cashflows (including impact of uncertain inflation) using simulation or other methods  Shifts emphasis from liabilities to range of future costs 2/6/200718

 Smoothing / Amortization ◦ Financial Economics approach says smoothing disguises volatility:  “When followed by a corporate bankruptcy, this policy of ignoring economic reality and failing to make needed contributions can lead to devastating losses of retirement income for long-serving employees” – Bradley Belt ◦ With reduced likelihood of bankruptcy / termination in public sector, does argument against still hold?  May cause some shifts in cost between generations, but overall contribution level does not change and is more stable 2/6/200719

 Likelihood of Change? ◦ If government plans forced to measure interest rate volatility (and measurement matters), then changes to investments may result ◦ Important users of financial statements (bond- rating agencies) are not currently demanding changes  Ability to meet cashflow future requirements more important than consideration of “economic” value of plan ◦ Series of high-profile municipal bankruptcies could prompt demand for funding rules (PBGC-type entity?) 2/6/200720