Contribution Volatility and Asset Smoothing

1. Contribution Volatility and Asset Smoothing FCERA Board of Retirement and Fresno County Board of Supervisors Joint Meeting - April 30, 2009 Paul Angelo, FSA & Andy Yeung, ASA The Segal Company San Francisco 5032871

2. Current Contribution Amortization of UAAL Actuarial Value of Assets (AVA) Unfunded Actuarial Accrued Liability (UAAL) Present Value of Future Normal Costs Normal Cost

3. Managing Contribution Volatility • Asset allocation – volatility at the source • Asset smoothing • Specific to investment return volatility • UAAL amortization – assets and liabilities • More than just asset volatility control • Direct contribution rate smoothing • Contribution collar – limits increases • Contribution rate phase-in – delays full impact

4. Actuarial Value of Assets • To reduce the impact of short term asset volatility, plans use an Actuarial Value of Assets (AVA) which “smoothes” returns • Each year, take the difference between: • Actual return on Market Value of Assets (MVA) • Assumed return on MVA (currently 8.00%) • Difference is spread over (typically) five years • Reduces volatility without reducing long term expected return

5. Example: one good year

6. Example: one good, then one bad year

7. The one thing to remember: • Actuarial valuation determines the current or “measured” cost, not the ultimate cost • Assumptions and funding methods affect only the timing of costs C + I = B + E Contributions + Investment Income equals Benefit Payments + Expenses

8. Asset Smoothing Mechanics • When MVA return is greater than assumed • Smoothing “defers gains” • Smoothed value (AVA) is less than MVA • UAAL and contributions are larger • When MVA return is less than assumed • Smoothing “defers losses” • Smoothed value (AVA) is greater than MVA • UAAL and contributions are smaller

9. FCERA Actuarial Value of Assets as of June 30, 2007(Market G/L measured in six month increments)

10. FCERA Actuarial Value of Assets as of June 30, 2008(Market G/L measured in six month increments)

11. FCERA Actuarial Value of Assets as of June 30, 2009ESTIMATED 2008/2009 Market Value return = -28%

12. Asset Smoothing and “MVA Corridor” • Many plans (incl. FCERA) limit how far the AVA can get from the MVA by limiting the AVA ratio • Typical 20% “MVA corridor” means the AVA must be between 120% and 80% of MVA • Maximum deferred gain or loss is 20% of MVA • Hitting the MVA corridor effectively stops smoothing • MVA corridor will have major impact starting in 2009 • For FCERA, 6/30/2009 AVA is 150% of MVA • Immediate cost increase with MVA corridor: 15.0% • Immediate cost increase w/o MVA corridor: 3.3%

13. FCERA Historical MVA and AVA Ratio of AVA to MVA (before 20% MVA Corridor) 86% 86% 95% 95% 116% 116% 106% 100% 97% 92% 108% 150%

14. Actuarial Standards of Practice #44 • ASOP 44 focuses on two key features • How close does AVA stay to MVA • Ratio of AVA to MVA (“AVA Ratio”) • How long before AVA returns to MVA • Smoothing period • ASOP 44 also provides some structure • If “likely” to be “reasonable”, both are required • If “sufficiently close” or “sufficiently short” then only one or the other is required

15. Longer Asset Smoothing Period? • Possible Systemic Reasons • Longer business/economic cycles • Greater actual market volatility (assets) • Greater sensitivity to contribution rate volatility • Greater asset volatility relative to payroll • Higher funded percentages • More mature plan, larger benefit levels • Practical Reasons • Reduce immediate impact of market losses • Delay full impact of market losses

16. 5 year Smoothing and MVA Corridor • Under ASOP 44, is 5 years “sufficiently short”? • Widespread use, industry opinions • Also consider cash flow, employer ability to pay • If any action taken, consider wider MVA corridor • Considerations beyond just complying with ASOP • Maintains policy of some control on AVA vs MVA • Important if also considering longer smoothing • Use actual 5 yr smoothing AVA ratio as a guide • For FCERA, consider 130% or 140% • Fully aware of current and future implications

17. Longer Smoothing and MVA Corridor • Longer smoothing means larger AVA ratios • Longer period increases need for MVA corridor • Possible framework for policy alternatives • 5 year smoothing: corridor based on actual AVA ratio • Longer periods: use this corridor or narrower • Allows more time to get to ultimate contribution rate • Does not lower immediate rate impact • For longest periods (10 - 15 years) use 120%-130%

18. Q U E S T I O N S

19. 5 Year Smoothing Period (Exhibit 3-1) Ratio of AVA to MVA (No Corridor) Shown Above -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

20. 7 Year Smoothing Period (Exhibit 3-2) Ratio of AVA to MVA (No Corridor) Shown Above -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

21. 10 Year Smoothing Period (Exhibit 3-3) Ratio of AVA to MVA (No Corridor) Shown Above -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

22. 12 Year Smoothing Period (Exhibit 3-4) Ratio of AVA to MVA (No Corridor) Shown Above -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

23. Various Smoothing Periods – No Corridor (Exhibit 6) -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

24. Various Smoothing Periods – 120% Corridor (Exhibit 7) -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

25. Various Smoothing Periods – 130% Corridor (Exhibit 8) -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

26. Various Smoothing Periods – 140% Corridor (Exhibit 9) -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

27. Various Smoothing Periods – No Corridor (Exhibit 6) -28% return for 2008/2009, 0% for 2009/2010 and then 8% per year Employer Contribution Rates

28. Q U E S T I O N S