Financial Economics

1. Financial Economics A presentation to the 2009 Public Pension Financial Forum by Paul Zorn October 19, 2009 – Sacramento, California

2. Overview • Financial Economics and the MVL • Background • Overview of FE and MVL • Concerns with the FE Approach • GRS Paper for the Society of Actuaries • Background & Methodology • Results • Public Plan Funding Objectives • What’s Next?

3. Financial Economics and the MVL

4. FE Overview - Background • Financial economics (FE) is a branch of economics that studies capital markets – how investments should be valued and how risks should be managed. • FE largely originated in the 1950s, emerging as a result of efforts to value publicly-traded corporations. • Influential in guiding private-sector funding and accounting under the 2006 Pension Protection Act and FASB Statement No. 158.

5. FE Overview – Key Concepts • Pension assets and liabilities should be presented at market value on balance sheet. If not, the corporation’s value is distorted. • For items that do not trade in open markets (e.g., pension liabilities), the best estimate of market value is the price of similar, openly-traded items of the same amount, timing, probability of payment, etc. • According to FE proponents, cash flows from pensions are similar to cash flows from bonds and therefore should be priced like bonds – by discounting the cash flows using bond yields.

6. FE Overview – MVL • The FE “market value liability” (MVL) for the pension promise is measured using: • Unit credit actuarial method (excluding projected future salary and service), and • A “risk free” discount rate (e.g., the Treasury bond yield curve or similar derivative). • Basically MVL reflects a “settlement” measure -- the liability for accrued benefits as if the plan terminated on the valuation date.

7. FE Overview – Advantages of MVL • Proponents of MVL argue it would: • Provide a standard “market” measure of public pension liabilities; • Provide a consistent and comparable measure of funded status across plans; • Reduce temptation to increase benefits; • Reduce temptation to invest in risky assets; • Reduce the extent employer contributions are deferred (and fall on future taxpayers); and • Help stabilize long-term funding.

8. Concerns with MVL Approach • Conventional methods better reflect the underlying nature and dynamics of public plans. • Public pension benefits are based on future salary and service, which are not included in the MVL. • Pension cash flows typically depend on factors that are not included in bond cash flows, such as future salary increases. • Discounting by bond yields ties plan liabilities to external changes in the supply and demand for bonds that may have no relation to changes in the benefits promised by the plan.

9. Concerns with MVL Approach • Conventional approaches provide better information about the contributions needed to fund the plan. • Because the FE approach does not reflect the fundamental dynamics of the plan, it would not be appropriate for determining plan contributions. • It could also create a false impression that the plan was underfunded (or overfunded), even though conventional actuarial methods show contributions are sufficient to fund the plan over time.

10. Concerns with MVL Approach • Conventional approaches are more likely to equitably allocate pension costs between current and future taxpayers. • If the MVL were used to fund the plan, plan contributions would likely be erratic, thereby subjecting taxpayers to volatile funding requirements. • Under the MVL approach, normal costs and contribution rates could not be allocated as a level percent of covered payroll over time.

11. Concerns with MVL Approach • Conventional approaches are more likely to support better funding decisions. • Legislators, taxpayers, and the media may have difficulty distinguishing between a “market value liability” and a “funding liability” – leading to confusion about plan costs and sustainability. • This confusion could lead to poor policy decisions and potentially lead to the needless abandonment of public plans.

12. GRS Paper on Actuarial Methods and Public Pension Funding Objectives

13. Background • Most arguments for and against the MVL are based on theoretical constructs. To provide more empirical information, our paper compares the MVL approach to a conventional approach used by the majority of public plans. • The paper is titled: “Actuarial Methods and Public Pension Funding Objectives: An Empirical Approach” and was written by Norm Jones, Brian Murphy, and myself. It was written for the Society of Actuaries’ Public Pension Finance Symposium and is available at: http://www.soa.org/files/pdf/2009-chicago-ppf-paper-jones-zorn-murphy.pdf • We consider our results illustrative rather than definitive. Nevertheless, we believe they offer useful insights.

14. Methodology – Plan Characteristics • The modeled plan is based on a medium-sized statewide plan for general employees using valuation data over the period from June 1978 to June 2008.

15. Methodology – Conventional Approach • Results under the conventional approach were largely derived from actual valuation results over 1984 – 2008, using: • Entry age normal cost method • Expected long-term return • 30-year open amortization of UAL • Investment return based on diversified portfolio • Assets smoothed over 5 years. • For years prior to 1984, results were extrapolated based on trends in the valuation reports, annual financial reports, and other sources.

16. Methodology – MVL Approach • Results under MVL approach derived from valuation results, adjusted to reflect: • Unit credit actuarial cost method • Discount rate: 30-year Treasury yield as of June each year • 30-year open amortization of UAL • Investment return based on diversified portfolio • Market value of assets (no smoothing). • We recognize the process will not exactly replicate an MVL valuation, but we believe it is sufficient to show relevant patterns.

17. Discount Rates • Since discount rates have a strong influence on the results, it is useful to review them first. • Conventional discount rates increased twice during the study period and ranged from 7.0% to 8.5%. • MVL discount rates changed every year during the study period and ranged from 4.3% to 13.9%

18. 1982: MVL rate = 13.9% Conventional rate = 7.0% 2005: MVL rate = 4.3% Conventional rate = 8.5%

19. Results – Normal Costs • Normal costs measure the present value of benefits attributable to service in a given year. • Under the conventional approach, increases in normal costs were generally coincident with benefit increases. • Under the MVL approach, changes in normal costs were erratic and driven largely by changes in the MVL discount rate.

20. 2008: MVL NC = 35.8% Conventional NC = 8.7% 1985: MVL NC = 6.2% Conventional NC = 7.0%

21. Results – Accrued Liabilities • Accrued liabilities measure the present value of accrued benefits under the actuarial cost method. • Conventional accrued liabilities grew steadily from $441 million in 1978 to $9.1 billion in 2008. • MVL liabilities grew erratically from $248 million in 1978 to $12.7 billion in 2008. In the mid 1980s, MVL liabilities were approximately half of conventional liabilities. • In 2003, 2005, and 2008, MVL accrued liabilities increased by more than $1.6 billion each year, due to sharp declines in the MVL discount rate.

22. MVL liabilities grew by more than $1.6 billion each year. MVL liabilities approximately half of conventional liabilities.

23. Results – Funded Levels • Funded levels are determined by dividing the value of plan assets by accrued liabilities. • Under the conventional approach, investment gains and losses are smoothed into the value of assets over 5 years. Under the MVL approach, the market value of assets is used (no smoothing). • To facilitate comparison, assets under both approaches are assumed to be invested in accordance with the plan’s investment policy which shifted over time: • Late 1970s: 35% equities; 65% bonds • Late 2000s: 70% equities; 30% bonds. • Later in the presentation we explore investing 100% of MVL assets in Treasury bonds.

24. MVL funded level is over 100% at times when conventional funded level is below 80%. This is due primarily to discount rates. MVL funded level is more volatile than under the conventional approach due to both the discount rates and use of the market value of assets.

25. Results – Contribution Rates • Contribution rates are determined by adding normal costs and the amortized value of unfunded accrued liability. • To simplify the analysis, a 30-year open amortization period was applied under both approaches. • MVL proponents would likely advocate a much shorter amortization period, which is explored later in the presentation.

26. MVL contributions largely driven by discount rates. Note that even with a 30-year open amortization of UAL, MVL contribution rates are highly volatile.

27. Additional Analysis - 1 MVL Assets Invested in Long-Term Government Bonds • Volatility in the MVL funded ratio might be minimized by investing MVL assets in a portfolio of matching securities with durations aligned with the plan’s liabilities. • Following chart shows MVL funded level based on assets invested in long-term government bonds earning total returns (income plus price appreciation). Two caveats: • The durations of the long-term govt. bonds and the liabilities are not perfectly aligned due to limits on available data; and, • In determining plan contributions, the MVL UAL is amortized over a 30-year open period. • This may be why the MVL funded ratio under the government portfolio projection does not converge to 100%. • Even if the MVL funded ratio converged to 100%, MVL normal costs would still be highly volatile.

28. MVL funded ratio with government bond portfolio appears to converge to about 90%.

29. Additional Analysis - 2 MVL Contributions Based on Shorter Amortization Periods • MVL proponents would likely argue for an amortization period much shorter than 30 years. • The following chart shows the impact on MVL contribution rates of using 5 and 10-year amortization periods. • Generally, shortening the amortization period increases contribution rate volatility.

30. Generally, shortening the amortization period increases contribution rate volatility.

31. Public Plan Funding Objectives

32. Objective 1: Valuation Reflects Plan Dynamics • The funding measure should reflect the dynamics of the plan. • Under MVL • Liabilities can increase significantly due to changes in the discount rate, even in the absence of changes in plan benefits. • Changes in the discount rate also leads to significant swings in normal costs, funded ratios and contribution rates. • Under conventional approach • Normal costs, liabilities, funded ratios, and contribution rates are much more stable.

33. Objective 2: Stable Contribution Rates • Increasing pension contributions is generally subject to lengthy political process and so governments prefer stable contribution rates. • Under MVL – contributions are, at times, much higher and more volatile than under conventional approach – and are therefore considerably more difficult to fund.

34. Objective 3: Equitable Allocation of Pension Costs • Because taxes are obligatory, fairness plays a role in determining how pension costs should be allocated. • Under the conventional approach, normal costs are allocated as a level % of covered payroll, and therefore remain at roughly the same % of real income over time. • Under MVL, the discount rate changes overwhelm the additional costs associated with accrued benefits.

35. Objective 4: Coordination of Accounting and Funding Measures • Currently, governmental accounting and reporting standards call for coordination of accounting and funding measures. • If MVL were substituted for conventional funding (or accounting), confusion would result – not only in the transition year, but on an ongoing basis, due to the impact of the MVL discount rate.

36. Conclusions • MVL funding would result in frequent, rapid, and erratic changes in plan contributions, accrued liabilities, and funded levels. • By contrast, conventional funding is more stable over time and better reflects the dynamics of the plan. • If the MVL approach were applied to public plan funding, it would lead to erratic demands on government resources which could lead to plan termination or to the ultimate abandonment of the MVL approach.

37. What’s Next?

38. Actuarial Standards Board • In September 2008, the Public Interest Committee of the American Academy of Actuaries requested the Actuarial Standards Board to consider an Actuarial Standard of Practice (ASOP) related to measuring the economic value of pension assets and liabilities. (Note, the ASB is independent from the Academy.) • In December 2008, the Actuarial Standards Board considered the issue and referred it to its Pension Committee for further discussion and recommendations. • As of June 2009, the Pension Committee had begun its review and is considering possible alternatives to ASOP 27 (related to selecting economic assumptions) and ASOP 4 (related to measuring pension obligations).

39. CCA Public Plans Committee • In July 2009, the Conference of Consulting Actuaries (CCA) announced that it had established a Public Plans Committee (PPC). • CCA provided resources to public plan actuaries as they discussed responses to the GASB’s Invitation to Comment on public pension accounting and financial reporting issues. Response was ultimately sent over individual actuaries’ signatures. • Future topics may include: • Managing volatility • Model funding policies • Governance issues

40. Questions?

41. Disclaimers • Circular 230 Notice: Pursuant to regulations issued by the IRS, to the extent this presentation concerns tax matters, it is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) marketing or recommending to another party any tax-related matter addressed within. Each taxpayer should seek advice based on the individual’s circumstances from an independent tax advisor. • This presentation shall not be construed to provide tax advice, legal advice or investment advice. • Readers are cautioned to examine original source materials and to consult with subject matter experts before making decisions related to the subject matter of this presentation. • This presentation expresses the views of the author and does not necessarily express the views of Gabriel, Roeder, Smith & Company.