Business Enterprises and Governmental Entities: Fundamental and Actuarial Differences

1. Business Enterprises and Governmental Entities: Fundamental and Actuarial Differences Graham Schmidt, ASA Vice President, EFI Actuaries

2. Overview • 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

3. Fundamental Differences “Why Governmental Accounting and Financial Reporting is – and should be – different” – GASB White Paper

4. Fundamental Differences • 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

5. Fundamental Differences • 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

6. Actuarial Differences Methods, Measurements and Other Issues

7. Private Sector Actuarial Requirements • 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

8. Private Sector Actuarial Requirements • Accounting Continued • Use different rate for “expected return on assets” • used to calculate reported pension expense • average ~ 8.0-8.5% 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

9. Private Sector Actuarial Requirements • 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

10. Private Sector Actuarial Requirements • 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)

11. Private Sector Actuarial Requirements • 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

12. Governmental Approaches • 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)

13. Governmental Approaches • 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

14. Governmental Approaches • 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)

15. Public vs. Private • 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

16. Public vs. Private • 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

17. Public vs. Private • 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

18. Public vs. Private • 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

19. Public vs. Private • 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

20. Public vs. Private • 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?)