FCERA 2010 Retirement Board Retreat

1. FCERA 2010 Retirement Board Retreat October 20, 2010 Paul Angelo, FSA Andy Yeung, ASA The Segal Company, San Francisco 5104107v1

2. Outline of Discussion • High level review of FCERA Funding Policy • Based on established practices and written policy documents • Comments on current amortization policy • GASB “Preliminary Views” on accounting and financial reporting

3. Review of FCERA Funding Policy • Three components of a typical funding policy • Funding method • Asset valuation method • Amortization policy • Unique to 1937 Act county systems • Interest crediting and “undistributed” earnings allocation policy • Unique to FCERA • Settlement Agreement

4. Basic Funding Policy Components Amortization of UAAL Actuarial Value of Assets (AVA) Unfunded Actuarial Accrued Liability (UAAL) Present Value of Future Normal Costs Normal Cost

5. Review of FCERA Funding Policy • Funding method • Entry Age Normal (EAN) for FCERA • Model practice, recently endorsed by GASB • Asset valuation method • 5-year smoothing period • Expanded 70%-130% market value corridor adopted by the Board in 2009 (previous corridor was 80%-120%) • UAAL Amortization policy

6. Amortization policy • Amortization structure - current • UAAL amortized in fixed period layers • Level percentage of open payroll • Amortization periods - current • 30-year for plan amendments • 15-year for gains/loss • 15 years for changes in actuarial assumptions • Emerging practice • Shorter for plan amendments, especially windows • Possibly longer for assumption changes

7. Review of FCERA Funding Policy • Interest Crediting and Undistributed Earnings Allocation Policy • Separate document, substantially reviewed in 2008 • Lists priorities to follow in crediting regular interest to various reserves • Including steps to follow if insufficient earnings • Defines uses of undistributed earnings • Provides parameters for granting discretionary benefits • Ad-hoc Supplemental COLA and additional “health” benefits for retirees

8. Review of FCERA Funding Policy • Settlement Agreement • Unique to FCERA • Priorities stated in Undistributed Earnings Policy • Section 6 – enhanced benefits for employees retiring on and after Jan 1, 2001 • Section 8 – enhanced benefits for pre-Jan 1, 2001 retirees and beneficiaries • Section 9 – “health” benefits for pre and post 2001 retirees

9. Review of FCERA Funding Policy • Settlement Agreement benefits • Funded with employer and employee contributions or undistributed earnings • Amounts funded with undistributed earnings • UAAL for existing Sections 6, 8 and 9 benefits • New Section 9 benefits • Normal cost for Sections 6 and 9 benefits • Open policy/legal issue • Definition of regular vs settlement benefits for active General members • Regular benefit: 31676.12 or 31676.14?

10. Review of FCERA Funding Policy • Project for 1st quarter of 2011 • Prepare written funding policy • Incorporate funding, asset smoothing and UAAL amortization methods into a single document • Consider review of amortization method • Consider clarification of “regular benefit” for General members • Review and adoption by the Board

11. Q U E S T I O N S

12. GASB’s Preliminary Views (PV) Document • The Preliminary Views are organized around six issues • Issue 1 An Employer’s Obligation to Its Employees • Issue 2(a & b) Liability Recognition on Balance Sheet • Issue 3(a - d) Measurement of the Total Pension Liability • Issue 4(a & b) Attribution of Changes in the Net Pension Liability to Financial Reporting Periods • Issue 5(a & b) Recognition by a Cost-Sharing Employer • Issue 6 Frequency and Timing of Valuations • GASB is asking for comments on their view of these issues • “Do you agree with this view?” • “Why or why not?”

13. Funding vs Expense (“Issue Zero”) • Current expense based on the Annual Required Contribution or “ARC” • Normal Cost plus UAAL amortization • The ARC rules form a viable basis for a funding requirement • Even though strictly it is only an expensing requirement • For pensions, the ARC functions as a de facto funding standard • Employer contribution schedule compares actual contributions to expense • Current balance sheet liability (net pension obligation or “NPO”) tracks cumulative actual contributions compared to expense • The Contribution Schedule and NPO tell whether the employer has been funding on an actuarially determined basis • The key measure of accountability

14. Funding vs Expense (“Issue Zero”) • From the Plain Language Supplement: • “The principles and concepts in the Preliminary Views would separate how the accounting and financial reporting is determined from how pension benefits are funded.” • “Should the GASB’s preliminary views become accounting and financial reporting standards in the future, governments would not be required to mirror the accounting and financial reporting changes in their funding approaches.”

15. Funding vs Expense (“Issue Zero”) • PV defines a Net Pension Liability (NPL) • Essentially, NPL is the UAAL using EAN and market value of assets • NPL (not the NPO) would go on the balance sheet • See more under Issue 2 • Under PV, expense is based on year-to-year change in NPL • Limited and inconsistent ability to amortize, creating expense volatility • Resulting expense measure is no longer a viable basis for funding • GASB PV does not address consequences • Loss of ARC/NPO means loss of information on employer accountability • Volatility in the expense results in Interperiod inequity • Two competing measures of cost: funding and expense

16. Actuaries’ Response - Introduction • Interperiod Equity: Pension expense should reflect balance between two kind of interperiod equity • Intergenerational – through demographic matching • Period-to-period – through volatility management • Pension Accounting and Pension Funding • “Issue Zero” • Level Cost of Services Framework • GASB endorses this approach to service cost (aka Normal Cost) • Treat variations around service cost similar to service cost • Framework components • Cost method • Asset smoothing • NPL (aka UAAL) amortization, where NPL is based on smoothed assets

17. Next Major Steps • Comment period for the PV ended September 17 • AAA, CCA, CAAP and SACRS all submitted comments • October: Three hearings on PV comments • GASB and staff developing positions on remaining topics • Employer Notes and Required Supplementary information (RSI) • Plan basic financial statement, notes and RSI • OPEB (but safe to assume OPEB will follow pension) • Exposure Draft (ED) scheduled for June 2011 • Comment period for ED by September 2011 • Final Pension Standard scheduled for June 2012 • Effective date(s) in 2013(?); transition and phase-in periods(?)

18. Reference Section for GASB’s Preliminary Views (PV) Document

19. Issue 1 – Employer’s Obligation • Employer has obligation for pension benefits due to “employment exchange” • Not satisfied until benefits are paid • Employer remains primarily responsible for pension obligation in excess of plan assets • To the extent funded, plan is primary and employer is secondary • Responses: General agreement

20. Issue 2 – Liability Recognition • NPL is Total Pension Liability minus market value of assets • (At this point, we don’t yet know how TPL will be measured) • Is NPL a liability and if so where should it be reported? • Issue 2a: NPL meets definition of an accounting “liability” • Present obligation to sacrifice resources • Little or no discretion to avoid • Conclusions based on GASB Concept Statement 4 • Issue 2b: NPL is measurable with “sufficient reliability” for recognition in basic financial statements • Instead of just Notes or Required Supplementary Information (RSI) • Based on GASB Concept Statements 1 and 3

21. Issue 2 – Liability Recognition • NPO rejected as insufficient for sole balance sheet liability • GASB PV does not address loss of what NPO measured • “Issue Zero” • Industry response is generally adverse • Too large relative to other statement items • Too volatile relative to other statement items • Some argue insufficient reliability • Asset volatility, liability remeasurements • Actuaries’ response: Base NPL on smoothed assets • Addresses volatility concern • In GASB terms, MVA based NPL is not sufficiently reliable

22. Issue 3 – Measurement of Total Pension Liability (TPL) • Process: project benefits, discount, attribute (allocate) to service • Issue 3a: What to include in projecting benefits • Automatic COLAs • Ad hoc COLAs if “not substantively different” from automatic COLAs • Future salary increases and service • Issue 3b: Criteria for Ad hoc COLAs that are “not substantively different” • Response: General agreement • Criteria for including ad hoc COLAs should reflect basis, process and authority for granting them • Could involve an assumption like “3 of 5 years”

23. Issue 3 – Measurement of Total Pension Liability • Issue 3c: Discount rate • Separate projected benefits for current members into two benefit streams • Projected benefits that covered by projected assets: discount at the long-term expected rate of return • Benefits payable after assets run out: discount at municipal bond index rate • Determine single discount rate that produces same combined present value • Use that “single equivalent” discount rate for entire calculation • Service Cost, TPL, interest on TPL, etc • Response: General agreement • GASB PV agrees that employer's cost is "reduced by the expected return on investments“ • But only if there are still any invested assets • Rejected market pricing discount rates

24. Issue 3c – Discount Rate • Common misunderstandings • A 80% funded plan would use a discount rate of 80% of the expected return plus 20% of the municipal index rate • Wrong: Single rate depends on projected assets and benefits, not current funded status • Benefits after assets run out are discounted at municipal index rate only back to when assets run out; before that use the expected return • Wrong: projected benefits payable after assets run out are discounted at municipal index rate for all years back to valuation date • Responses on municipal bond index • Taxable or nontaxable: prefer taxable • Current rate or average: prefer average

25. Issue 3c – Discount Rate • Projecting Employer Contributions (for depletion date) • GASB PV says use “employer’s stated contribution policy and recent contribution pattern” • Not just the current contribution rate (except for fixed rate plans) • Responses: Include all contributions that fund benefits for current members • GASB PV is inconsistent on this • “include projected future contributions from all sources related to funding the benefits of employees currently in the plan” • “reasonable expectation of future employer contribution levels for current employees” • GASB should clarify to include all UAAL payments even if amortized as percent of open payroll (including future hires) • Excluding member and employer normal cost contributions for future hires

26. Issue 3 – Total Pension Liability Measurement • Issue 3d: Attribution Method – Entry Age Normal • Assigns value consistently to past and future years • Consistent relationship to base salary level • Consistent with ongoing, career-long view of employment exchange • Rejected accrued benefit measures (including PUC) • Discount rate and attribution method are clear endorsement of level cost over market pricing model • “Board emphasizes that fair valuing the total pension liability is not a relevant objective for accounting and financial reporting” • Response: Strong agreement

27. Issue 4 – Attribution of NPL Changes to Periods • Expense amounts are determined by attributing year-to-year changes in the NPL to reporting periods. • GASB treats changes in TPL and plan assets separately • Differs from ARC where amortization is based on changes in UAAL • Expense components (preview!) • Entry age service cost (normal cost) • Plus assumed interest (at single equivalent rate) on TPL • Less expected investment return (at expected return) on MVA, • Plus/minus cumulative differences in actual vs expected investment returns if over 15% of MVA (see issue 4b) • Plus/minus short amortization of “other changes” in active TPL (issue 4a) • Plus/minus entire amount of “other changes” in inactive TPL (issue 4a) • Other changes include plan amendments, liability gains (-) or losses (+), assumption changes

28. Issue 4a – Changes in Total Pension Liability • Same treatment for three types of changes • Plan amendments • Liability gains and losses • Assumption changes • Changes for inactive members (including retirees) are recognized immediately. • Changes for active members are recognized over a weighted average of remaining service lives. • Very short: 10 years or less • PV is silent on amortization method • Separating out interest on assets and total liability could imply straight line principal amortization • Not consistent with level cost methodology for service cost

29. Issue 4a – Changes in Total Pension Liability • Concept is that change in liability determines expense • Deferred recognition justified only by “interperiod equity” matching of cost with services • Liability gain/loss and assumption changes lumped with plan amendments “to avoid unnecessary complexity” (!) • This expense model is clearly not a viable basis for funding • Example: immediate recognition of assumption changes for retirees • Actuaries’ response: Pension expense should reflect balance between two kind of interperiod equity (from Introduction) • Intergenerational – through demographic matching • Period-to-period – through volatility management • Also consistent with level cost methodology for service cost • Treat variations around service cost similar to service cost

30. Issue 4a – TPL Changes - Responses • Distinguish plan amendments from other changes • For plan changes: Accept short amortization • For liability gains/losses and assumption changes: • Attribution period that balances demographic matching with longer periods that manage volatility • Promotes both long and short term interperiod equity • This leads to range of 15 to 20 years • 15 year period also assures a minimum attribution of interest on the beginning-of-year liability amount (no negative amortization)

31. Issue 4a – TPL Changes - Responses • Possible basis for both expense and a New ARC, • New ARC allows for a range of amortization periods • Expense is based on short end of range

32. Issue 4b – Changes in Plan Assets • Investment earnings different from the long-term expected rate are deferred indefinitely • Until cumulative deferral exceeds 15% of fair value, • Amounts beyond 15% recognized immediately in pension expense • This is unlimited asset smoothing within a narrow market value corridor • Based on belief that past gain/loss will be offset by future loss/gain • Leads to either too little or too much expense volatility • This expense model is not a viable basis for funding • No recognition of investment gains/losses inside a narrow corridor • Immediate recognition of investment gains/losses outside a narrow corridor • Also, recognized investment gains/losses are not amortized (more later)

33. Issue 4b – Asset Changes - Responses • Add a “return to market” condition to recognize investment gains and losses over a short period (e.g., five years) • Note that under actuarial standards of practice, a “sufficiently short” return to market condition can eliminate the need for market value corridor • Actuaries’ response: five year smoothing, no corridor • Used for defining NPL (under issue 2b) • Replaces PV method under Issue 4b • Implied result – both smooth and amortize investment volatility • Key feature of level cost of services model • Required by extraordinary asset volatility, compared to other experience

34. Issue 5 – Cost Sharing Employers • Issue 5a: Each employer should recognize a proportionate share of the plan’s collective total NPL and changes in NPL • Issue 5b: GASB suggests prorate on contributions and asks for alternative methods • Industry response is adverse • Violates the pooling concept of a cost sharing plan • Not a reliable estimate of each employer’s own liability and expense • Actuaries’ response references GASB 27 rationale • Also includes example of inequitable results

35. Issue 6 – Frequency and Timing of Measurements • Actuarial valuations must be performed at least every other year • The “comprehensive measurement” date must be • No more than 24 months prior to the employer’s fiscal year end (FYE) • If not at FYE, must use the most recent available • Valuation is “updated” to FYE, reflecting: • (a) significant changes occurring since that valuation • (c) market value of assets as of the employer’s fiscal year end (implied?) • Response using example: 6/30/2010 valuation for 2011/2012 FY • Intervening actuarial valuation at 6/30/2011 • Need to know expense and contributions before FYE – and even FYB • Ability to roll forward assets and liabilities • Different plan and fiscal years, especially for multiple employer plans

36. Q U E S T I O N S