Actuarial Assumptions and Methods: What is Reasonable? LAPERS Seminar 2015 Actuarial Assumptions and Methods: What is Reasonable? John Garrett, ASA, MAAA, FCA Principal and Consulting Actuary Cavanaugh Macdonald Consulting, LLC

Perception of the Actuarial Valuation Population Data Actuary Contribution Rates Plan Provisions Financial Reporting This is unfortunately the case in many instances. Hopefully by the end of the morning you will have a better idea of what goes on in the black box. Assumptions & Methods

Basic Funding Equation: C + I = B + E INFLOW: Employee Contributions + Employer Contributions Investment Income OUTFLOW: Benefit Payments Expenses

Purpose of Valuations Benefits payments are defined by plan Employee contributions are typically defined by plan Investment Income (net of expenses) is “assumed” Employer contributions usually the dependent variable Requires an actuarial valuation to determine the employer contribution necessary to solve the funding equation over the long term future. Most employer’s desire stability in the rate Based on the actuarial assumptions and methods recommended by the actuary and adopted by the Board.

Actuarial Assumptions Assumptions are utilized to estimate unknown future events in order to calculate the actuarial present value of future plan benefits Demographic Assumptions Retirement Rates Disability Turnover/Withdrawal Mortality Promotional/Step Pay Increases Miscellaneous Economic Assumptions Price Inflation May also be the COLA assumption Wage Inflation Real Rate of Wage Increase Investment Return Real Rate of Investment Return Payroll Growth Rate Here’s how NOT to measure experience...

Things That Happen to People KNOWN at valuation date: Age Salary Gender Service to date Occupation Date of Hire (Age 30) Valuation Date (Age 45) Retirement (Age 60) Death (Age 85) 15 Years 25 Years 30 Years An Individual’s Valuation Timeline

Calculation of Expected Future Benefits

Impact of Assumptions The timing of future benefit payments is impacted by demographic assumptions such as rates of retirement, withdrawal, disability and death. The size of future plan payments to actives is impacted by salary increase assumptions, the size of future payments to both actives and retirees is impacted by mortality, COLA assumptions. The present value of every future payment is impacted by the assumed rate of investment return.

Assumptions are Precisely Wrong Many demographic assumptions use probabilities Rates of deaths, retirements, disabilities…etc. Reality is binary – 0 or 1, yes or no, did or did not This results in assumptions which are not realistic for the individual But…. The goal is that demographic assumptions applied to large populations accurately reflect the experience of that population Law of Large Numbers

What Are The Right Assumptions? Assumptions ideally are the best estimate of future experience Based on sufficient experience or related experience of similar populations Example: Mortality Assumptions of Small Public Plans Not too heavily based on recent experience and reflects future expectations Example: Investment Returns Assumption should be unbiased – not overly pessimistic or optimistic “Reflects Actuary’s professional judgment” “Common Sense” based on statistical analysis

How Do We Know We Have Good Assumptions? Actuarial valuations should report the actuarial gains and losses due to material assumptions Investment return, salary increases, post-retirement mortality, rates of retirement and other material assumptions Well performing assumptions should result in offsetting gains and losses overtime Lower impact to unfunded accrued liabilities Lower resulting contribution volatility Smaller plans have less opportunity for offsetting experience Periodic review of assumptions (Experience Studies) to make adjustments as necessary Never meant to be forever

Example of Actuarial Gains and Losses by Source

Actuarial Methods Actuarial Methods are the various techniques employed by actuaries to allocate program costs to specific periods Three primary types of methods used in public pension valuations Actuarial Cost Method Actuarial Asset Smoothing Method UAAL Amortization Method Usually defined in the plan’s funding policy

Actuarial Cost Methods Allocate cost of pension benefit accruing over a career Accrued liability – value of benefits allocated to past service Normal cost – cost of this year’s benefit accrual (actual or average) Examples Entry Age Normal Normal cost is the average annual rate over career Accrued liability is the accumulation of past normal cost Projected Unit Credit Accrued Liability is the present value of accrued benefit Normal cost is the expected accrual earned in upcoming year

Actuarial Asset Smoothing Why smooth investment experience? Range of Return Expectation 22.00% 1 Std Dev Above Mean 8.00% Long-term Expected Return 1 Std Dev Below Mean (6.00)% 1 5 10 15 20 25 30 Years

Actuarial Asset Smoothing Typically 3 to 5 year smoothing Spreads “unexpected” returns Unexpected market return Unexpected actuarial return Difference between market and actuarial values

UAAL Amortization Methods Amortization Payment Amount Attributes Level as a dollar amount Similar to most loan financing (home mortgage, car loans, etc.) Level as a percentage of payroll Increasing dollar amounts Requires payroll growth assumption Amortization Payment Period Attributes Closed amortization period Similar to most loan financing Open amortization period Annual refinancing of loan

UAAL Amortization Methods

UAAL Amortization Methods

UAAL Amortization Methods

Who’s Methods Are These? Methods utilized in valuations should best fit the funding objectives of the Board Balance of cost stability and desired funding progress Methods utilized should make sense Level percent of pay amortization for a plan closed to new entrants? Does an open amortization period make sense? As with assumptions - actuary recommends but Board selects

What Is Going On With Actuaries? American Academy of Actuaries (actuary.org) Issue Brief on “Objectives and Principles for Funding Public Sector Pension Plans” Society of Actuaries (soa.org) “Report of the Blue Ribbon Panel on Public Pension Plan Funding” Actuarial Standards Board (actuarialstandardsboard.org) Currently considering whether Actuarial Standards of Practice (ASOPs) specific to public pension plan funding are necessary Conference of Consulting Actuaries (ccactuaries.org) White Paper - “Actuarial Funding Policies and Practices for Public Pension Plans” http://www.ccactuaries.org/communities/ppc/library/Public-Plans-Community-347-41187.PDF Provides “Model”, “Recommended”, “Acceptable”, “Acceptable with Conditions”, “Non- recommended” and “Unacceptable” practices for each of the three common methods.