COLA UAAL and the Correction Process Presentation to the FCERA Board of Retirement August 15, 2007 Harvey L. Leiderman Jeffrey R. Rieger Reed Smith, LLP

2 Agenda for Discussion 1.Event #1 – COLA UAAL Error from FY through FY Event # 2 -- “Phase In” of Member Contributions from FY through FY Event # 3 -- General Member “Basic” Rate Error in FY Correction Process 5.Board’s Remaining Decisions 6.Our Recommendations 7.Perspective

3 Event # 1 – COLA UAAL  PPP’s June 30, 2002 valuation recommended employee rates for FY that included half of the UAAL attributable to COLA benefits  Board adopted PPP’s recommended employee rates, including a COLA UAAL component, for FYs 03-04, 04-05, and most of  Board acted in December, 2006 to stop the practice based on Segal Company’s audit of PPP’s valuations and Reed Smith’s legal analysis, which is now a public document

4 Event # 2 – “Phase In” of Employee Contribution Increases  Employee contribution rates were set to dramatically increase from FY to FY in large part due to:  Ventura Settlement increased benefits  No excess earnings to pay for settlement benefit contributions  Assumption changes  Half of COLA UAAL being charged to employees  Board looked for a way to lessen impact; PPP presented various alternatives in Spring, 2004  Board chose to “phase-in” increases, deferring a portion of contributions and spreading them out over time  Contribution relief so long as no employee liabilities would be shifted to employers

5 Event # 2 –“Phase In” of Employee Contributions, cont’d. In hindsight, we now know:  In FY 04-05, the “phase in” resulted in General Tier 1 members paying less than the “normal cost” they would have otherwise paid  In FY and (until March 2007), the “phase in” resulted in General Tier 1 members paying their full “normal cost” and part, but not all, of the COLA UAAL amortization  In all three fiscal years, Safety and General Tier 2 Members paid their full normal cost and part, but not all, of the COLA UAAL amortization

6 Event # 3 – General Member “Basic” Rate Error in FY  Segal has now determined that PPP made another error in calculating General Tier 1 employee rates in FY  Understatement of “basic” contribution rate  Effect was that General Tier 1 members underpaid their “basic” contributions by app. $2.6 million (after interest is applied)  This underpayment was not related to the “phase in”  Board has not yet decided what to do about this newly discovered error

7 Event # 3 – General Member “Basic” Rate Error in FY 03-04, cont’d. Complicating factors:  At the same time General Tier 1 employees were underpaying “basic” contributions by app. $2.6 million (after interest is applied), they were overpaying COLA UAAL by app. $1.2 million (after interest is applied)  Excess earnings were available to potentially reduce employee contributions in FY The Board used some, but not all, excess earnings to reduce employee contributions. If one or both of the errors in FY had not occurred, Board may have exercised its discretion with excess earnings differently

8 Correction Process  On December 6, 2006, Board voted to cease COLA UAAL practice as soon as practicable  On January 10, 2007, Board voted to:  Reverse past employee payments towards COLA UAAL in a lawful, fair and practicable way  Offset amounts underpaid for “deferred normal cost” under the phase-in against amounts overpaid for COLA UAAL, to return members as near as possible to where they would have been had these events not occurred  Implement rate changes to eliminate COLA UAAL in July, 2007  In January, 2007, PPP projected total net overpayments of approximately $3.5 million for General and $4.0 million for Safety

9 Correction Process, cont’d.  On January 24, 2007, Board voted to eliminate COLA UAAL as soon as possible, rather than waiting until July, 2007  On February 7, 2007, Board terminated PPP and hired Segal Company  On February 21, 2007, the Board voted to make refunds for COLA UAAL on an individual basis, if possible  Segal to review PPP’s adjusted rates  Programming assistance from Watson Wyatt

10 Correction Process, cont’d.  On March 7, 2007, Board voted to correct for PPP’s Safety member salary assumption error  In March 2007, all employee rates were reduced to reflect the elimination of the COLA UAAL component; Safety rates also were reduced to correct salary assumption error  From March to July 18, Segal reviewed PPP’s adjusted rates for all affected fiscal years  Found General “basic” error in FY  PPP delayed process by failing to provide necessary information in a timely fashion

11 Correction Process, cont’d.  July 18, 2007 – Segal presented adjusted rates to Board:  Refunds due to Safety and General Tier 2 members  Net “underpayments” from most General Tier 1 members

12 Correction Process, cont’d.  Reasons that everyone’s expectations for General Tier 1 were not met – PPP’s January projections were wrong:  Fewer payments towards COLA UAAL than originally projected because COLA UAAL practice stopped earlier, in March, 2007, instead of July, 2007  Newly discovered “basic” rate error in FY resulted in $2.6 million “underpayment” for that year  PPP had understated the COLA “normal cost” in its January adjusted rates for FY 03-04, creating the appearance that a larger amount had been paid towards COLA UAAL that year than had actually been paid

13 Correction Process, cont’d.  July 18, 2007 continued  Board voted to proceed with refunds for Safety members and General Tier 2 members as originally planned  Board asked Segal and Reed Smith for further input on General Tier 1 members, given newly- discovered errors That takes us up to today

14 Board’s Remaining Decisions 1.Should the Board make adjustments for General Tier 1 “basic” contribution rate error in FY 03-04? 2.Should the Board reconsider its prior decision to offset “deferred normal cost” underpayments that resulted from the “phase in” against COLA UAAL overpayments? 3.For General Tier 1 members, who on balance have underpaid their contributions because of all these events, what should the Board do?

15 Our Recommendations 1.Make no adjustments (either for COLA UAAL or for the “basic” error) for FY General Tier 1 rates  Occurred over three years ago and “basic” error would not have been discovered, but for the COLA UAAL correction process  Board’s discretionary use of some, but not all, excess earnings to reduce employee contributions cannot be reversed; therefore, the Board cannot put members back where they would have been had the errors not occurred  It is reasonable not to refund COLA UAAL “overpayments” in FY when we know that, in total, less than full normal cost contributions were paid in that year  Will result in net “overpayment” by General Tier 1 members of app. $630,000, with most members receiving a refund

16 Our Recommendations 2.Do not reconsider prior decision to offset “deferred normal cost” underpayments resulting from the phase in against COLA UAAL overpayments  Failing to offset would transfer employee liabilities to employers, unless “deferred normal cost” is charged back to employees through adjustments to rates in future years  If employee rates are adjusted in future years (a) member-to-member equity issues arise, and (b) Board cannot put this process behind it for at least another two years  Prudent to deal with as many issues as possible all at once and move forward without further distractions, costs and further impact to future years

17 Our Recommendations 3.Do not collect any net underpayments on a member-by- member basis, but consider recouping total underpayments through FY General Tier 1 employee rates  Individual collection would be inconsistent with phase in policy, burdensome and inefficient  Recouping through rate adjustments would be consistent with phase in policy and ensure that no additional liability is charged to the employer as a result of the phase in  Given unique and complicated circumstances, and relatively small amount involved, Board may consider moving forward without making adjustments for “underpayments”  Uncertainty regarding FY rates  Discretion under CA law not to collect “arrears contributions”  Board may wish to defer decision until receiving final numbers

18 Perspective  Unique circumstances with no single “right” answer  Board has options in addition to our recommendations  Goal should be fairness, equity and sound funding  Correction process is important, but only one small part of the recent COLA UAAL reversal