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California Pension Systems: Ranking their Funding Assumptions

Roeder Financial       May 2015

This is the sixth periodic survey (click here to see survey results in a new window) which ranks the funding assumptions used by California’s public pension systems from “most conservative” to “most optimistic.” In the related spreadsheet, the “most conservative” system is ranked as #1 and “most optimistic” system is ranked as #37.

Often, there is no absolute “right” or “wrong” in setting assumptions. There can be a number of valid reasons that an assumption package for Entity A differs from Entity B. Entity A might have a larger equity allocation than Entity B. Entity C might wish to have more conservative assumptions to be able to fund an ad hoc COLA in most years. The nation’s largest state plan, CalPERS, may be able to have certain size–related investment efficiencies unavailable to smaller sponsors.

Due to the ongoing financial strain facing many entities, due, in so small part, to skyrocketing pension contributions during the last decade, there continues to be a great temptation for both plan sponsors and labor to minimize pension contribution increases – which have tended to rise by 10–25% of payroll over the last decade. If there is a request by the plan sponsor to change certain actuarial assumptions, this survey may have value in terms of clarifying what “the herd” is doing. Also, employee groups are struggling with the specter of hiring freezes, pay freezes and furloughs. Unions certainly want well funded plans but if it comes at the expense of current employment, unions usually opt for the approach causing the least short–term pain.

Even though active employees benefit in their retirement years by having well funded systems, making assumptions more conservative can have a “cost” for actives. Lower assumed investment assumptions often directly or indirectly translate into higher employee contributions. In recessions, it is not unusual for plan sponsors to tell Retirement Boards that a lack of pension contribution relief will result in additional layoffs.

Defining some of the characteristics of “most conservative” versus “most optimistic” is useful.

Most Conservative	Most Optimistic
Lower Assumed Investment Return	Higher Assumed Investment Return
Higher Assumed Pay Increases	Lower Assumed Pay Increases
Shorter Amortization periods	Longer Amortization Periods
Explicit Expense Load	No Explicit Expense Load
Entry Age Normal Funding	Projected Unit Credit Funding
Level Dollar Amortization	Level Percent of Pay Amortization

Using comparative funded ratios, to determine how well funded a plan is, can be misleading:

• Actuarial assumptions will often not be comparable.

• A relatively high funded ratio could be largely attributable to Pension Obligation Bonds (POB). In looking at the financial viability of a plan, it is essential to look at more than just than the computed actuarial rates if there is also POB debt service.

The most significant development in the 2015 survey, for the third straight year, continues to be the lowering of both assumed investment returns and inflation assumptions. In the 2015 survey, 12 entities reduced their assumed investment return. In the 2014 survey, 16 entities did so. In the 2013 survey, 21 of the 37 entities lowered assumed investment returns.

The ongoing lowering of discount rates is ironic because of a strong bull market in 2009–2014. As a result, most systems are now sitting on unrecognized investment gains for funding purposes. What a refreshing change compared to the aftermath of the 2007–08 financial meltdown! Half now use an assumed investment return of 7.5%. In six years the “standard” has decreased by 0.50% from 8%. In our initial 2009 survey, 60% of the entities used an investment assumption of at least 8%.

Several points should be noted on the amortization of unfunded liabilities. “Open” or “rolling” methods will use the same number of years in a future valuation as is been used in the current valuation. “Layered” means that there is a new amortization base established each year which is funded on a “closed” or “declining” basis. If one believes that a best practice is for an individual’s benefit to be fully funded at their anticipated retirement date, sound practice is to have the amortization period be closely correlated with the average future working lifetime of the active member group (typically between 11 and 15 years). 30–year amortization passes a significant part of the cost, attributed to current participants, to a future generation of taxpayers. Almost half the surveyed entities, have amortization periods of 20+ years for all or significant elements of their unfunded liability – not a best practice. All amortization approaches noted in this survey should be assumed to be level percent of payroll unless otherwise indicated. Level–percent–of–payroll amortization will produce a lower current year contribution than level dollar amortization over the same period.

In 2012, GASB issued Statements #67 and #68 relating to financial disclosure and reporting for governmental pension plans. Their implantation dates are now with us. The biggest change will result in making unfunded liabilities a balance sheet item. Since governmental entities have well over a trillion dollars in unfunded liabilities, some balance sheets are going to look grimmer – especially in situations of dire underfunding such as the State of Illinois system. Still, most institutional investors have long been aware of escalating unfunded liabilities which have been disclosed in footnotes to financial statements. We believe the presence of greater accounting emphasis on the “Net Pension Liability” will not spook the investment community due to general awareness of the many underfunded plans. However, we believe one impact of these new Standards will be to result in slightly more conservative discount rates. The recent bull market will slightly mute the impact of balance sheet recognition of the Net Pension Liability. Net Pension Liabilities are measured using market values. Prior to these Statements, the use of smoothed actuarial values were more integral to the resulting accounting statements.

Most entities in the survey have a June 30 fiscal year end. Thus, this is the first year of implementation of GASB Statement #68, the successor to Statement #27. Prior to this year’s survey, the assumed discount rate was generally determined to be net of all expenses incurred. In the most recent cycle, many more valuations now reflect explicit recognition of administrative expenses –– generally assumed to be a percent of payroll. While this has always been a “best practice” to be as explicit as possible in assumption setting, as we have stated in some of the previous surveys, we do not believe this desired shift will have a significant impact on the overall actuarial picture. Administrative expenses are relatively small compared to the impact of a 25 basis point change on computed actuarial costs.

One unsettling issue continues to be the high contribution rates determined by system actuaries. Almost one third of surveyed entities have contribution rates approaching or exceeding 35% of payroll. In view of the strong equity market, over the past six years, contribution rates of this magnitude may surprise some. Recent health in the equity market has been blunted by unrecognized actuarial losses prior to 2009 and reluctance, in several situations, to fully phase in assumption changes recommended by system actuaries. While 2012 PEPRA legislations significantly reduces benefits for County systems and PERS, only post 2012–hires are impacted. Thus, PEPRA had negligible impact on implementation and will only have significant impact years down the road.

Cynics of the political process will note that the most conservatively funded plan is again the state Legislative system – with the Tier 2 Judges system not far behind.

In one welcome development, there will be a ramped contribution increase of almost 17% over the next five years for the State Teachers Retirement System(“STRS”). Previously, STRS had previously been underfunded by 13% of payroll – even after one had assumed a lengthy 30–year amortization period. STRS had over $70 billion dollars of unfunded liability in their June 30, 2013 valuation. The University of California (“UC”) system is another system in which the combined employer and employee rate lags behind the current actuarial funding rate. To address this shortfall in the future, UC is hopeful to receive increased support from the state, combined with periodic internal borrowing or external financing. The funding status of these systems should be more fully taken into account before California politicians’ claims of a balanced budget can be taken more seriously.

To the extent actuarial losses occur in the future, such losses will become more problematic. This is due to the changing demographics of maturing systems. For many systems, the number of inactive members has approached or exceeded the number of active membership in recent years. Spreading losses on a relatively small payroll base means more volatility in contribution rates, other factors equal.

The source for survey data has largely been from the most recent actuarial valuation report on system web sites. Plan administrators and selected actuaries were sent a draft report to give them the opportunity to make any corrections and updates. The final version will be on the Ramble at roederfinancial.com. Thanks to the many who helped update the survey. If you have any questions, Rick Roeder can be reached at (619) 300 – 8500 or via roederfinancial.com.

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