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California Pension Systems: Ranking their Funding Assumptions

Roeder Financial       May 2010

This is the second annual 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 #40.

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 current financial crisis facing most entities, 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 also has a “cost” for actives. Excepting Alameda-Contra Costa Transit District, all plans in the survey are contributory. 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 layoffs.

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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	Longer Amortization
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.

Two recent studies from Stanford and Northwestern would opine that none of the assumptions for the 40 surveyed entities are the least bit conservative! Both studies used discount rates of 4+% to determine liabilities based on rates currently available on long-term Treasuries. We think it is “crazy wrong” to assume that long-standing public entities will not receive long-term reward from 60% or so equity exposure (Click on the July 2009 Ramble at roederfinancial.com -- which was the basis of our testimony last August in front of the Government Accounting Standards Board (GASB)). However, GASB is aware of increasing commentary that public funds are being underfunded and are using unprecedented levels of risk to attempt to achieve assumed investment returns.

This perception may be a factor in the Government Accounting Standard Board's (GASB) current deliberations on potential revisions to current accounting standards. While a change in accounting standards need not necessarily affect funding, two significant impacts would occur if GASB opts to make changes. A significant increase in reportable liabilities and the Net Pension Obligation may well make borrowing costs more expensive if there is a downgrade in an entity's credit rating. Also, there would be some push to conform funding assumptions to changes in accounting standards.

The significant 2008 market decline resulted in 21 surveyed entities making their funding less conservative than in last year's survey. Thirteen entities, including CalPERS, loosened the restriction as to how much market value can deviate from “smoothed” actuarial assets. The previous policy of most such entities was that market value could not deviate more than 20% from actuarial value. When this deviation exceeded 20% after the recent market slide, a number of entities decided to expand their 20% corridor in order to minimize contribution increases. San Mateo County and the City of San Diego were two of the entities that, after careful study, elected not to expand their 20% maximum deviation. Eight other entities either lengthened their amortization period, increased their asset smoothing period or treated recent market declines in some extraordinary manner. Are there any limits to the extent of smoothing that can be used in the actuarial process? Yes, but those limits are fuzzy. Actuarial Standard of Practice #44 was issued in 2007 and opines in Section 3.3, “The actuary should select an actuarial value method designed to produce actuarial values that bear a reasonable relationship to market value.”

It is important to note that the survey's assumed actuarial rates of return are almost always net of expenses incurred. The City & County of San Francisco System and the Alameda – Contra Costa Transit District are virtually the only Systems which have an explicit load for expenses as part of its computed contribution.

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 it is best practice for an individual's benefit to be fully funded at their anticipated retirement date, it is a sound practice 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. 16 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.

Rick Roeder, FSA

The source for survey data has largely been from 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 roederfinancial.com. Thanks to the many who helped update the survey. If you have any questions, I can be reached at (619) 300 – 8500 or via roederfinancial.com.

Guest authors are welcome to submit articles and their thoughts to the ROEDER RAMBLE for potential viewing on this site.