SACRS Symposium The 2008 Market Collapse

1. SACRS SymposiumThe 2008 Market Collapse What do we do now? Bob mccroryEFI Actuaries March 20, 2009

2. Today’s Discussion Shifting Costs Hidden Costs Hidden Risk Things That Don’t Work Flying Pigs

3. ShiftingCosts Asset Smoothing Policy Amortization Policy Direct Cost Smoothing

4. Shifting Costs • Tools • Asset Smoothing • Amortization Policy • Direct Cost Smoothing • Ask yourself: • What are our choices? • What are the rules? • What is current practice? • What are your limits?

5. Asset Smoothing Policy • Choices • Market value or actuarial (smoothed) value? • How much smoothing: Three, five, seven, 15 years? • Layered smoothing (one layer for each year) or combined (rolling)? • Corridor around market value? No corridor?

6. Asset Smoothing Policy • Rules • “Reasonable range” around market – ASOP 44, and • “Reasonable period of time” to converge to market – ASOP 44; or • “Sufficiently narrow range” or converges in a “sufficiently short period” • Current Practice • Five-year smoothing with 20% corridor is de facto standard (ERISA) • Combined, not layered smoothing, with factor of 15 and 20% corridor (CalPERS) • What is “reasonable”? What is “sufficient”

7. Amortization Policy • Choices • Actuarial Funding Method: Each produces different balance between normal cost and accrued liability • Layered amortization or combined? • How long? Generally 10 to 30 years • Level $ or level % of payroll (increasing $)? • Different bases and periods for different sources? Gains/losses vs. amendments

8. Amortization Policy • Rules • No more than 30 years (GASB) • Level % of pay is “negative amortization” after about 17 years • Current Practice • Practice varies widely • Gains and losses over a rolling 30-year, level % payroll (CalPERS) • Is level % of payroll reasonable if employment is likely to drop?

9. Direct Cost Smoothing • Choices • Actuarial cost • Phase into actuarial cost over a number of years • Actuarial cost with limits on level (e.g., cost must be less than 23.7%) • Actuarial cost with limits on growth (e.g., cost cannot increase more than 0.6% of pay per year) • Single stipulated cost

10. Direct Cost Smoothing • Rules • CERL requires minimum of normal cost plus 30 year amortization of unfunded • Any contribution less than the Annual Required Contribution will create a Net Pension Obligation under GASB standards • Any limit on contributions could cause insolvency • Underpayments are paid back with interest • Current Practice • Practice varies widely • Limits always legislated • Usually overrides and violates actuarial practice • Is this a loan?

11. HiddenCosts Compensation Policy Disabilities Furloughs Early Retirement

12. Compensation Policy • Review pensionable earnings • Earnings structure – therefore pensionable earnings – may be bargained, subject to immediate change • Review last 50 or so retirements and disabilities. • Jumps in pay at retirement (spiking)? • Categories of pay not available to all members? • Special pay for some members? • Benefit disparities among similarly situated members? • Terminal payments (unused sick leave or vacation) increasing final average pay? • Incentive bonuses?

13. Compensation Policy • Review seniority systems • Can drive access to overtime, thus final compensation and payroll • What impact does this have? Do you want to limit this? • Goals • Not trying to reduce benefits • Improve benefit predictability • Improve adherence to pension policy goals • A pension plan, not a lottery • Rough Rule of Thumb: Save $15 in liabilities for every $1 reduction in benefits

14. Disabilities • Budgetary restrictions often cause increases in disability rates • Encourage less productive employees to take disability • Reduce/privatize limited duty positions • Balance department budget on back of the pension plan • Track changes in disabilities • Not just rates: Employee class and department as well • Ongoing monitoring, not just actuarial study • Maintain consistency in disability policy • Be sure policies for confirming disability, income offsets are followed

15. Hidden Costs • Furloughs • Decrease payroll; leave benefit unchanged • Increase cost as a percent of payroll • Decrease payroll over which unfunded liabilities and gains/losses are amortized • Early Retirement • In general, earlier retirement increases plan costs • Subsidized early retirement adds additional cost • Also reduces payroll base

16. HiddenRisks Plan Maturity Layers Layoffs

17. Plan Maturity • ’37 Act Plans are maturing • Baby Boom is retiring • Replacement employees older • Plan improvements increasing retirement benefits • Government employment static, maybe declining (?) • Result is increase in ratio of assets to payroll

18. Plan MaturityAssets as a Percentage of Payroll

19. Plan Maturity • Increase in ratio of assets to payroll • Typical ‘37 Act plan is increasing from about 5X payroll to around 9X payroll • Represents a sensitivity ratio • As the ratio increases, investment gains and losses are larger relative to payroll • Produces more cost volatility • Increasing risk is structural, permanent, unavoidable • In addition, OPEB benefits are starting to be pre-funded

20. Layers • Layers (tranches?) in asset smoothing and unfunded liability add to cost volatility • Cost steps – up or down – as layers are established and retired • Sometimes these cancel, sometimes they reinforce each other • Layers bring advantages as well • Each layer is eventually retired • Layers are reasonably predictable

21. Layers

22. Layers

23. Layers

24. Layoffs • Our projections routinely assume constant active workforce • Implies an increasing active payroll • Layoffs, hiring freezes, pay freezes all violate these assumptions • Payroll decreases; benefits in pay status unchanged • Members near retirement not affected much • Layoffs usually among younger members who don’t cost much • Increases cost as a percent of payroll • Decreases payroll over which unfunded liabilities and gains/losses are amortized

25. Things That Don’t Work Contribution Limits Downsizing Defecting to CalPERS Quid Pro Quo

26. Contribution Limits • Limit on level or growth of employer contributions • Increase by no more than 0.6% of pay per year • Total contribution less than 23.7% of pay • CalSTRS bases maximum contribution on 1990 formula, benefits, adjusted assets • Generally legislated • Can lead to insolvency • Must be monitored closely and managed

27. Contribution Limits: Funding Ratio

28. Contribution Limits: Chaos

29. Downsizing • Spinning off operations or subdivisions • Lose active members and payroll • Employer contribution decreases • Often lose a revenue stream • Retirees and disabled remain • Fewer active members and payroll to support the Plan • Volatility and risk of remaining Plan increases • Example: General Motors

30. Defecting to CalPERS • Some participating employers are withdrawing to join CalPERS. Impact on Legacy Plan: • Lose active members and payroll • Retirees and disabled remain • Fewer active members and payroll to support the Plan • Lose a revenue stream • CalPERS amortizes initial unfunded and gains and losses over 30 years – often longer than Legacy Plan amortization period • Therefore, employer contribution decreases • Volatility and risk of Legacy Plan increases

31. Quid Pro Quo • “If the Retirement Board reduces our contribution we will…”

32. FlyingPigs The Actuarial World is not the Real World

33. Flying PigsProjected Actuarial Cost

34. Flying PigsSimulated Actuarial Cost

35. Best Friends Work Together!

36. Work Together! • Pension stakeholders must work together • Retirement Board • Board of Supervisors and other employers • Employee organizations • Retirees • Work together to develop: • Shared vision • Shared understanding of the problems • Common strategy and tactics • Shared sacrifice

37. Work Together! • Share information • Retirement Board presentations to employers about current and expected costs • Employer presentations to Retirement Board on employer financial situation • Presentations to employee organizations and retirees on funding basics, current financial environment • Joint planning • Working groups with retirement board, employer, and employee participation • Joint press policy

38. Contact Information Bob McCrory(206) 328-8628bobmccrory@efi-actuaries.com Graham Schmidt(415) 439-5313gschmidt@efi-actuaries.com