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California Pension Systems: Ranking their Funding Assumptions

Rick Roeder, FSA       September 2011

This is the third 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 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.

In June, GASB issued an Exposure Draft on potential changes to pension accounting standards in GASB Statements #25 and #27. Two years ago, after the issuance of Preliminary Views, we were asked to give testimony to the Board. It appears that the draconian view of using a discount rate based on “risk-free” debt instruments has been thwarted. We would like to think that the comments made in 2009 testimony helped in this regard. However, there are several potential changes which could have significant accounting impact.. In the Exposure Draft, any unfunded liabilities would no longer be confined to disclosure status. Such amount would need to be shown on the balance sheet. It will be interesting to see how the bond rating issuers react to such change, if implemented, and whether plan sponsors are significantly motivated to accelerate funding.

The most significant development in the 2011 survey is the lowering of both assumed investment returns and inflation assumptions. 15 of California‘s 40 independent systems lowered their assumed investment return since the 2010 survey. The result is that the median investment assumption is that 21 systems now use 7.75%. As Hugo Wildman, administrator for the Alameda-Contra Costa Transit System plan accurately quipped, “7.75% is the new 8%.” The median correlates closely with the median assumed rate of 7.7% in the 2011 NCPERS survey of 215 governmental plans. We suspect that “7.5% will become the new 7.75%” in a couple years.

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. 18 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. The GASB Exposure Draft mandates significantly shorter amortization periods for changes in pension liability than under current standards.

Rick Roeder, FSA

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 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.

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