The New Future of Public Retirement Systems

1. The New Future of Public Retirement Systems CSMFO February 2009 Girard Miller Senior Strategist PFM Group

2. Topics • Impact of Market Meltdown of 2008 • GASB 45 implementation progress • Deferred compensation issues • Retirement benefits: sustainability • Benefits Bonds: POBs and OPEB-OBs

3. Impact of 2008 Market Meltdown • After 5 decades of actuarial funding, public pension plans were reasonably well funded, on average • But some plans are grossly, chronically underfunded • Recent market meltdown changed all that • Unfunded liabilities will skyrocket and ARC will increase • Unfortunately, the 2008 Market Meltdown changed all that • Funding ratios typically declined 20-25 percent • Resulting increase in employer costs: 2 to 4 percent of salaries • The Public-Pension Straddle Option: • Heads employees win (when markets go up) and • Tails taxpayers lose (when markets go down) • Impact on OPEB plans much less significant since most were unfunded or just starting up

4. Legacy of the Public-Pension Straddle Option:Skyrocketing employer pension costs By 2012, employer costs may double from 2002 levels Chart source: NASRA public funds survey 2007 Employer costs have increased 40% and employee costs remained constant Heads employees win, tails taxpayers lose 4

5. What hasn’t worked • Abuses in pension systems draw public ire • Spiking • Retroactive pension increases • Especially behind closed doors • Unrealistic discount rates: investment assumptions • Ad hoc COLAs • Further accounting reforms seem likely • Amortization of unfunded liabilities Often fails the “intergenerational equity” test Need to better align with services provided Otherwise, it’s an ‘un-voted tax’ on future generations

6. GASB accounting issues • Market Value? • Issue now before the actuarial boards • GASB will evaluate • Better and more disclosure of discount rate? • Issue: comparability

7. GASB accounting issues • Market Value? • Issue now before the actuarial boards • GASB will evaluate • Better and more disclosure? • Issue: comparability • Amortization policies • Is 30 years with open amortization a proper limit? • Are retroactive benefits better expensed immediately? • COLAs: substance over form What to do about ad hoc COLAs?

8. Girard’s suggestions to GASB • Prohibit amortization periods longer than remaining average service lives of employees and remaining lives of retirees • Otherwise future taxpayers will be burdened with costs of deceased workers who provided services to their grandparents • Require immediate expensing of retro pension and benefit increases • Calculate and disclose liabilities using national average investment assumption if plan uses a higher number

9. Deferred Compensation Plans • Market meltdown impact on individuals • Horror, terror and fear • Deferred retirement dates for those with major dependence on 457 & 401 plans • Fiduciary challenges for plan sponsors • Review investment menus • Review fee structures • Resist higher-fee products from vendors seeking new revenues to replace asset-based fees • Opportunities to re-bid plans • Hyper-competition has returned

10. Retirement investingThe long-term view • This is clearly not a garden-variety recession • Significant risk of double-dip or longer malaise • Until housing and mortgage markets stabilize, federal stimulus is probably insufficient • Ultimately, long-term equity investments from the lows in this terrible period will appear attractive • But an entire generation will have lost confidence • Good news: historical returns have returned to long-term growth rate of 9.6%, so we have now “reverted to the mean”

11. Long-Wave Economics These graphs depict wholesale price trends, not GDP We are here Long-wave cycles = 55 years on average Chart: http://www.kwaves.com/kond_overview.htm 11

12. Long-term investment outlook • See Girard Miller’s historical research on Governing.com • http://www.governing.com/articles/0807gmmw.htm • Equities outlook over 20 year and longer periods: historically favorable from these levels • Suggests an equity-tilt strategy • Will eventually open a ‘Benefits Bonds window’

13. The Business Cycle and the Benefit Bonds Window Benefits Bond Window 13

14. The New Benefits Bonds Paradigm: POBs and OPEB-OBs • Issue only during recessionary window, not any time • Invest only in equities initially • Why sell bonds to buy bonds? • Eventually migrate to balanced asset allocation • Requires a separate POB trust • OPEB plans can set up new integrated OPEB trust • But not if a pooled investment is used • Enables surplus equity returns to pay off debt • Properly rewards taxpayers for the added risk they absorb • Prevents future earnings from funding another benefits increase that inevitably causes yet another deficit See Girard’s New Benefits Bonds Paradigm at http://www.governing.com/articles/0901gmillerc.htm

15. OPEB: (retiree medical)The “Other” retirement plan • Huge contrast with pension systems • Vast differences in approaches, history, and future outlook • GASB 45 and its aftermath • Where the public sector stands today • Phase I, II and III governments • Actuarial analysis vs. action planning and funding

16. Pensions: 60-65% funded Primary retirement benefit Defined benefit model fits the liabilities well Inflation caps for most plans Mature plans with large assets Governance well established; statutes well codified Homogeneous or comparable benefits structures OPEB: Almost completely unfunded ($1.5 trillion) Secondary retirement benefit An “undefined benefit” Medical cost inflation risks Startup plans w/ zero assets Governance TBD Very diverse plan structures Pools don’t necessarily work: variation in asset-liability profiles Comparisons: Pensions vs OPEB

17. Current Landscape for OPEB • Phase I & II work is done: larger plans know their liabilities • Few are actually funding their ARC • “No Money”: Recession is the perfect storm • When will rating agencies eventually take notice? • Few are doing strategic planning • Few are doing sustainability analysis • OPEB bonds window in 2009, maybe into 2010

18. Needed: OPEB Strategic Maps • Sustainability analysis • Comprehensive OPEB strategic plan • Includes both strategies and implementation path • Funding strategy & plan • Benefits design strategy • This is where the evolution will take place • Thoughtful leaders must also address sufficiency • Governance & trust structure • Investment infrastructure: DB & DC hybrids?

19. Outlook in OPEB benefits plan design • Sustainability is key issue at plan sponsor and taxpayer level • Look for tiered benefits plans to emerge • Employee contributions or increases • Higher retiree/employee cost shares on co-pays, deductibles, % of premium, etc. • Dependent coverage • Eligible retirement age • Vesting schedules and “early retirement” reforms • Eventually will see more defined contribution plan features here • Key issue here is sufficiency

20. Summary • Pension plans will require higher contributions • Expect to pay an additional 2 to 4% of payroll • Pay attention to GASB accounting study • Deferred compensation plans: Revisit and review • ‘Benefits Bonds Window’ expected later this year • Learn the 5 key principles of the New Benefits Bonds Paradigm • To achieve retirement finance sustainability, OPEB will be trimmed before pensions

21. Summary: OPEB • OPEB will likely evolve more dramatically • Key questions will be sustainability and sufficiency • Current benefits may be unsustainable • Sustainability audit is worth considering • Plan re-design and cost mitigation are foreseeable in the OPEB sector • OPEB bonds expected to be feasible in 2H09 • 65% of AAL liability is the ‘new paradigm’ limit See Girard’s New Benefits Bonds Paradigm at http://www.governing.com/articles/0901gmillerc.htm

22. Girard Miller’s contact infoand Governing.com columns link • Phone 310.795.1354 • Email: • girardinmalibu@charter.net • or: millerg@pfm.com • Governing.com: Column index link: • http://www.governing.com/articles/gmiller.htm

23. QUESTIONS? • Markets? • Defined benefit pension plans? • Deferred compensation plans? • OPEB? • GASB and Accounting? • Benefits Bonds: POBs and OPEB-OBs?