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Are the Actuaries Being Unfair to the California Legislature??
Rick Roeder, FSA June 2021
I have a recurring nightmare. I am a newborn, fresh out of my mother’s womb. My mother greets me with a big smile but says to me, “Son, I have some bad news for you. The instant you left my womb, you incurred a lot of debt.” . I start to wail, as only babies can. “NO FAIR!”, I scream. “I did not expect to have significant debt until the end of my Senior year in college.” (In my dreams, Bernie Sanders never seems to get his way. I fully expect to pay tuition in 2040).
My mother sees my non-stop agitation. I am inconsolable. Finally, I plead, “Can I go back in your womb?” Taking pity on me, she agrees. For another week, I have temporary relief.
I wake up and am very relieved that my nightmare has passed. However, the post-PEPRA Tier of active members has no such luxury. For they too are saddled with debt not of their own making.
California entities have been dealing with non-stop increases in Unfunded Accrued Liability (“UAL”) despite PEPRA’s reduced benefits for post-2012 hires. With a decade-long bull market and the lower costs for PEPRA hires, one would have expected contribution rates to be decreasing. That simply has not happened. Instead, many entities have contribution rates escalating to rates that not even Rod Serling and the Twilight Zone could have imagined 20 years ago.
Why have rates kept going up? Simply, because Systems undervalued the cost of benefits. Significantly! Most, but not all of the underpricing, has to do with assumed investment returns being a bit higher than actual returns. Longer life expectancies, lower rates of employee termination and lengthy UAL amortization periods also were significant elements to rate hikes.
How has the actuarial community generally dealt with the rising tide of UAL in conjunction with the relatively new Tier of PEPRA actives? Generally, with total and complete indifference! With a few exceptions, the norm for financing UAL has not changed in our post-PEPRA world. Typically, the UAL liability is amortized through a series of payment schedules which are based on a level-percent of payroll basis. To explain: Suppose a new layer of UAL is financed on a basis where each year’s payment would be $1 million dollars, employing a level-dollar basis. If such UAL layer were instead financed on the typical level-percent-of payroll basis, the UAL amortization payment in year 1 would be less than $1 million. WHY? Level-percent-of-payroll amortization assumes that annual payroll will increase each year during the financing period.
In an inflationary world , level-percent-of-payroll financing of UAL makes perfect sense. However, when dealing with a System with multiple Tiers, allocating the UAL financing to different Tiers can get complicated. All pre-PEPRA tiers are closed to new hires. Thus, one can expect the active member payroll to decline over time for the “Classic” active member group(s). Across-the-board, level-percent-of-payroll financing works poorly in assigning costs to closed Tiers.
A technical issue arises in assigning UAL costs to closed Tiers when level-percent-of-payroll UAL financing is used. This approach assumes that overall payroll increases annually by assumed inflation. While this is a reasonable assumption in aggregate, closed Tiers, not being open to new hires, do not have their payroll increasing by inflation. Over decades, the payroll for a closed Tier trends toward zero. Because of this complication for closed Tiers, actuaries have generally assigned UAL financing on a uniform, across-the-board approach without any regard to Tier. From solely a standpoint of simplicity, the current mainstream approach rocks. But, actuaries are not creatures of simplicity. Have you ever fully read an actuarial report? Be honest. 50+ pages of mind-numbing numbers that would terrify most.
However, the mainstream approach can be quite ineuitable in allocating costs to the post-PEPRA Tier. There are complexities in developing a better mousetrap. I offer two alternative approaches that would better allocate UAL financing costs among different Tiers of active members when a new Tier is introduced (I feel certain that creative minds can derive additional alternatives):
ALTERNATIVE #1: Make no change in calculating the UAL financing as a level-percent-of-payroll for the entire active member payroll. Thus, the total financing of the UAL by the employer would not change a nickel from the current orthodoxy. There would be a tracking of the accrued liability attributed to the different Tiers of active employees. A proportionate amount of UAL financing would be apportioned to each Tier, based on the accrued liabilities of different Tiers at the valuation date.
ALTERNATIVE #2: At the point that a Tier is closed to new members, there is unfunded liability assigned to such Tier. The UAL for the closed Tier is amortized on a level-dollar basis since that Tier’s payroll will not be increasing by inflation each year. To the extent UAL occurs for the PEPRA Tier, that UAL would be financed on a level-percent-of-payroll basis. The City of San Diego has a partially closed System and uses this approach. A methodology would need to be developed to allocate subsequent gains and losses. Again, a pro-rate based on accrued liabilities would be reasonable.
If a System did not a change to its approach when PEPRA was initially put in place, has it missed the boat if they now wish to adopt an alternative approach now? No, but there might need to be a post-PEPRA, year-by-year tracking of each Tier’s accrued liabilities so that each year’s actuarial gains and losses can be properly allocated.
Another issue exists for entities that have multiple closed Tiers as often is the case. If there is a closed Tier that has no actives, any UAL attributed to that Tier needs to be allocated to other Tiers.
I would like to be devil’s advocate and point out potential objections to an alternative approach to UAL amortization:
OBJECTION #1: A large majority of Systems in California spread UAL costs as a uniform percentage for all Tiers.
RESPONSE: Very true. There are some technical challenges in allocating UAL costs when there are closed Tiers. However, it can readily be accomplished as the City of San Diego has shown.
I would also note that the precedent of history may have made all of us a touch lazy. UAL amortization allocation among different Tiers is not a new issue. I remember bringing up the same issue to a client 30 years ago. However, times were different in 1991. We were in the midst of an unprecedented bull market where contribution rates were dropping each year. With dropping rates, this issue did not seem very important. Times were good.
30 years later, times have dramatically changed as current contribution rates attest.
OBJECTION #2: It is easier to use a level-percent-of payroll approach for amortization.
RESPONSE: Definitely true. However, I think the distinction in rates for different Tiers in an increasingly political environment, where contribution rates have escalated as much as they have, is a worthwhile endeavor. The cost distinction may become increasingly important if we soon have to deal with a bear market that triggers additional rate increases.
OBJECTION #3: If benefit levels for a post-PEPRA Tier are not that much different than for the “replaced” Tier, there is not a strong need to differentiate costs.
RESPONSE: My recommendation has nothing to do with benefit levels of classic Tiers versus the PEPRA Tier. 20/20 hindsight tells us that the pricing of benefits has been significantly too low. How do we know that? The ongoing wave of significant experience losses, largely associated with the Tier(s) that PEPRA replaced.
Assume that a PEPRA hire has exactly the same characteristics as a Classic active 10 years ago including the exact same benefit structure. The same age, the same demographics, etc. The current normal cost for the PEPRA hire will be greater than for the parallel Classic active a decade ago. Simply because the assumptions during the past decade have become more conservative for every System in California. In other words, even with identical benefits, there would have been different calculated costs for the two parallel actives.
OBJECTION #4: The PEPRA Tier should pay its fair share for the UAL attributed to current retirants.
RESPONSE: For retirants in closed Tiers with no current active members, I would agree. For other Tiers, I would strongly disagree. The PEPRA Tier should not shoulder the burden of financing the underpricing for the Tier(s) it replaced.
I offer an example as to how Alternative #1 would work. Suppose a System is 80% funded at the time PEPRA was implemented with $10 billion in accrued liabilities and $8 billion in assets. For simplicity, I assume only 2 Tiers. The annual UAL amortization is calculated $20 million, all of which is attributable to the “Classic” closed Tier (Unlike the baby in my nightmare, no new hire has an unfunded liability).
The Valuation One Year Later (“PEPRA + 1”):
The unfunded liability has grown to $250 million.
An experience loss of $50 million is calculated. This results in an added layer of UAL amortization of $5 million. The accrued liabilities have grown to $ 10.4 billion – $36 million for the PEPRA tier and $10.364 billion for the Classic Tier. As a result, the PEPRA Tier has 0.35% of the total accrued liabilities.
This new $5 million dollar amortization layer would be allocated between the Tiers, as follows:
PEPRA Tier: = 0.0035 * 5 million = $ 17,500
Classic Tier = 0.9965 * 5 million = $4,982,500
The total UAL amortization for the Classic Tier in Year PEPRA +1 will total:
$21,000,000 (attributable to amortization layers at date of PEPRA. Remember that with level-percent-of-pay financing, the dollars in each amortization layer will annually increase)
4,982,500
$25,982,500
As years pass, the percentage of accrued liabilities associated with the PEPRA Tier will keep increasing.
As a society, we have become increasingly critical of government. Frequently, with excellent reason. My son, a student at Emory University in Atlanta, recently returned to California for the summer after completion of his freshman year. Having gotten used to lower gas prices in other states, he moaned about our high gas taxes and how costly it was to fill a tank in California. I shared my perspective with him. My alma mater, University of Michigan, was playing in the 1972 Rose Bowl. I flew out for the game. On a postcard-perfect January 1, I thought Pasadena was glorious. 18 months later, I had a job as an actuarial intern in Los Angeles. When I visited Pasadena, I was absolutely appalled at the air quality. How could heaven morph into hell, I thought? Then I explained to my son that, “Yes, our gas taxes are super high but that I am quite appreciative that the air quality in Southern California has decidedly improved over the past half-century. I am content with the trade off.”
Sometimes, government works. Jerry Brown and the Legislature came to the conclusion that pension costs were skyrocketing out of control. PEPRA resulted. They deserve credit for taking an action that may have taken political courage in a state where labor has significant clout. If Let’s give them full credit by recognizing the real cost-savings due to PEPRA. Let’s supply decision makers with the best information we can if and when proposals are made to change benefits down the road. An additional benefit of accurately allocating costs to the PEPRA Tier relates to the collective bargaining process. The value of fringe benefits is a often a key element in negotiations.