NEW MASTERPIECE OR PRIVATE SECTOR KNOCKOFF

1. GASB’s New Pension Standard NEW MASTERPIECE OR PRIVATE SECTOR KNOCKOFF

2. Recent Headlines • Hidden Pension Fiasco may Foment Another $1 Trillion Bailout –Bloomberg.com • Pensions That Are Seeing Red-State Pensions with low funding Illinois, Rhode Island Oklahoma, New Hampshire, New Jersey, WSJ • Houston Lays Off 700 Due to Rising Pension Costs, Associated Press • San Francisco’s Average Public Employee Pension Pays More Than the Average Private Sector Worker Earns, San Francisco Chronicle

3. More Headlines • Rewriting Retirement, Governing Magazine • Small City’s Depleted Pension Rattles Rhode Island/Bondholders Win in Rhode Island, New York Times/WSJ • Gilt Edge Pensions, Forbes • Police & Fire Pensions Threaten Local Government’s Solvency Throughout California, Mission Viejo Patch • Battle Looms Over Huge Cost of Public Pensions, New York Times

4. GASB Proposes New Approach to Pension Accounting • Given the publicity and intense pressure to do “something” about Public Pensions, GASB begins their re-examination of Pension Accounting • They are walking a tightrope of expectations from all sides of the debate. • Plans and their employers want a tightening of GASB 25/27, some economists demand a risk free rate of return which would dramatically raise the PV of liabilities lowering the funded status for every plan. • GASB chose to utilize as its model FASB 87 for private sector entities.

5. GASB’s Timeline • January 2006 – In wake of Statement 45, adds pensions back to research agenda • April 2008 – Added to current agenda and began initial work on Invitation to Comment • March 2009 – Issued broad-based Invitation to Comment • 115 comment letters (including GFOAT) • 2 public hearings with 17 presenters

6. GASB’s Timeline (cont.) • June 2010 – Issued Preliminary Views document • 193 comment letters & 3 public hearings with 29 presenters • GFOAT focused on several key points: • Funding information (ARC) is key for management, governance, and citizens to understand pension performance • Reliability of liability – govt. doesn’t hire actuary or control plan data • “Liability” – TMRS reports reduction of $775 million in liabilities due to plan changes over last 3 years • Projected Unit Credit mirrors employee’s career • Why ignore the pension plan accounting?

7. GASB’s Timeline (cont.) • July 2011 – Issued Exposure Draft • 645 comment letters & 3 public hearings • GFOAT focused on several key points: • Projected Unit Credit still a better method • Disclosures need to be modified to be effective – avoid duplication with pension plan and make sure AAC data is not relegated to RSI only • Consider segregation in Statement of Net Position • Give additional time to implement • Plan Net Position concept leads to confusion • June 2012 (Estimated) – Issue Final Standard

8. Income Statement vs. Balance Sheet • Government financial management has always been operations oriented: • Nature of Governmental Assets • Taxation-the underlying wealth of government • Annual Budget Cycle • Governments were comfortable with GASB 25/27 because it took an income statement approach • Focus was determination of the ARC • ARC drove both APC and liability recognition in SNA

9. Income Statement vs. Balance Sheet • In the new pension standard, the focus is on the balance sheet:

10. Overview of the Proposals • Disconnects state and local governmental pension accounting measures from the funding measures used to determine pension contributions; • Requires employers to recognize an unfunded pension obligation (aka, the “net pension liability”) as a balance sheet liability in their basic financial statements based on the market value of assets;

11. Overview of the Proposals • Requires employers to record a new measure of the pension expense in their basic financial statements that will have little relation to the actuarially determined contribution; and • Replaces most of the current note disclosures and required supplementary information with information based on the new measures and removes actuarial based funding disclosures. The proposal includes over four pages of footnote requirements and two pages of RSI requirements.

12. Net Pension Liability • The total pension liability is calculated by: • Projecting future benefits arising from automatic COLAs (and ad hoc COLAs, to the extent they are substantively automatic ), as well as projected service and projected salaries; • Discounting the present value of future benefits using a single discount rate (discussed further in the next section); and • Allocating the cost of pension benefits over past, present, and future periods using the traditional entry age actuarial cost method with service costs determined as a level percent of projected payroll on an employee-by-employee basis.

13. Net Pension Liability • Single Discount Rate is comprised of two Parts: • Expected Rate of Return for Portion Pre-funded • High Quality AA rate for PAYGO Portion • Requires extensive future cash flow projections • Prohibits inclusion of contributions for future members making the lower rate likely for most plans • The higher the rate, the lower the PV of the Liabilities • NPL=TPL-Net Position of Plan at fair value of assets

14. Pension Expense • Components of the new pension expense include: • +Service cost ( similar to the old entry age normal cost); • +Interest on the total pension liability as of the beginning of the year; • +/-Changes in the total pension liability over the year from assumptions vs. actual (with certain deferrals for actives); • +/-Differences between actual and projected earnings over the year (with certain deferrals); • -Projected investment returns over the year; • -Employee contributions; and • +/-Other changes in plan net position (i.e. amortization of the deferrals).

15. Amortization • Amortization when applicable is: • Always straight line • Starts at the beginning of the reporting period • Five years for difference between expected and actual rate of return on investments • The remaining service life of active employees (probably between 10-15 years for most plans) for difference between assumptions and actual • Separate for Gains (proposed deferred inflows) and losses (proposed deferred outflows).

16. Cost Sharing and Special Funding • Cost Sharing Employers to be required to recognize a NPL for their proportionate share of the Plan’s NPL. • Changes in Proportionate Shares deferred and amortized. • Non employer funders recognize a liability based on conditional or unconditional aspect of their funding commitment • Conditional--treated as a grant • Unconditional--non-employer records share of the NPL

17. Footnotes • Footnotes include: • Description of Benefits • Assumptions • Plan Net Position • Changes in the NPL (14 elements) • Components of Pension Expense (12 elements) • Information on deferred Inflows and Outflows • Allocated Insurance Contracts

18. Required Supplementary Information • Ten Year Schedules on: • Changes in the NPL (14 elements) • TPL, PNP and NPL and % of PNP to TPL, covered payroll (CP) and % of NPL to CP • Actuarially Calculated Contributions (if employer does one) and actual contributions made • Notes to the RSI

19. Effective Date • Periods ending June 2013 for employers with PNP over $1 billion • Periods ending June 2014 for all others.

20. Implications to Government • Government Finance Officer’s should consider the following: • Audit and Reporting Implications • Funding Implications • Communicating and reconciling differences between funding and reporting numbers to: • Elected Officials and those charged with governance • Rating Agencies, Investors and media • Employees and employee associations

21. Audit and Reporting Implications • Government Pension Plans are often separately governed, managed, and independent in both form and substance from the employers that sponsor them. • These plans have their own management and outside actuaries that will generate the NPL that employers would be required to report as a liability. • This NPL could easily be the largest liability of the government; and extremely material in many situations.

22. Audit and Reporting Implications • Until recently, actuarial data was completely RSI--but now is included as a footnote and soon to be part of the employer’s financial statements raising the following issues: • Can the employer be confident that a very large number prepared by an outside entity is fairly stated in all material respects? • Will the multi-employer agency pension plan’s auditor be willing to accept any responsibility for the actuarial data if GASB only requires RSI disclosure of actuarial data?

23. Audit and Reporting Implications • Will the employer’s auditor feel the need to perform additional procedures under SAS 73 vs. what they’ve done in the past but how is that done if the procedures need to be performed on a separate and independent entity?

24. Funding Implications • Unlike the private sector that must fund in accordance with ERISA & PBGC requirements, there is no regulatory funding mandate for government. • In the past the parameters set by GASB 25 & 27 were the de facto standard for funding. • GASB has made it clear that determination of adequate funding is not their responsibility and has structured the pension expense number so that it will be almost impossible to use for funding purposes.

25. Funding Implications • Without a nationally recognized standard, it will be impossible to use shorthand (i.e in compliance with GASB 25) to describe the funding approach. • Employers and their plans will have to explain both the requirements for GASB reporting and the policies for funding. • Both financial statement preparers and users will have to better understand and more carefully analyze the adequacy of funding approaches on a government by government basis. • Government reporting in accordance with GAAP would no longer be required to report an actuarially calculated contribution requirement and compare it to what they actually contributed.

26. Funding Implications • If a government and its plan choose to utilize an actuarially calculated contribution (ACC) they will need to decide whether to include separate sets of ACC trend information in addition to the GAAP compliant trend information.

27. Explaining the Numbers • To reduce confusion, employers should keep the ACC as close to the GAAP number as possible: • Use the same actuarial method (entry age) • Use the same basic assumptions • Use the same base year census data • Certain areas will likely be different, however: • Actuary update of latest valuation to the employer’s financial statement date. • Actuarial gains and losses related to retirees and inactives will probably be amortized for funding purposes to reduce funding volatility.

28. Explaining the Numbers • Recognition of investment gains and losses will probably be different--and longer than the GAAP requirement--again to reduce volatility. • Plan changes (especially enhancements) will likely be amortized rather than recognized immediately. • If an employer chooses to include detailed trend information on a funding basis in its CAFR, the preparer will need to label that informationand choose a CAFR location to clearly communicate that this is not the GAAP required disclosures.

29. Conclusion • GASB’s new standards will provide for a completely different perspective and display of pension information. • To achieve maximum benefit, employers will need to work closely with their pension plans to ensure a smooth transition in reporting approaches while maintaining a clear funding strategy and discipline to ensure improving funding status and predictable funding requirements over time.

30. Final Thoughts • The proposed standards undoubtedly do a better job of reporting the employer’s unfunded pension liability as of a point in time. • But it does not address the obvious follow up questions of If this is where we are at: • 1) What should we do about it? and • 2) Are we doing it?