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California Pension Systems: Ranking their Funding Assumptions

Roeder Financial       March 2014

This is the fifth 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 most 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 also has 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.

Regardless, a significant decline in funded ratios over the past decade is unmistakable. This February, the Society of Actuaries released a report by its Blue Ribbon Panel on Public Pension Funding. In their survey of large State and Municipal Systems, the average reported funding ratios are as follows:

1990:	79%
2000:	103%
2012:	73%

The most significant development in the 2014 survey continues to be the lowering of both assumed investment returns and inflation assumptions. 16 of California’s 37 independent systems lowered their assumed investment return since the last survey in March 2013. 21 of the entities had lowered assumed investment returns in the previous 16–month survey period. 70% now use an assumed investment return in the 7.5%–7.75% range. No entity uses the “former standard” of 8%. In our initial 2009 survey, 60% of the entities used an investment assumption of at least 8%.

It is important to note that the survey’s assumed actuarial rates of return are generally net of all expenses incurred.

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. Over half the surveyed entities, 21, 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. Statement #67 replaces Statement #25 and becomes effective for fiscal years ending after June 30, 2014. Statement #68 goes into effect one year later. 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. Thus, assuming GASB’s coming change will spook the investment community or spur governmental entities to start making greater pension contributions is premature.

One unsettling issue is 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 five 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 some reluctance 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 will have minimal impact on rates over the next five years.

Tulare County has adopted a unique phase–in approach on its investment assumption. The Retirement Board has agreed to reduce its current valuation interest rate of 7.90% by 5 basis points for each of the next 18 years.

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.

This survey is the first in which all 37 surveyed entities are using Entry Age Normal funding. Bye, bye, Projected Unit Credit!

While assumptions have become more conservative in recent years, the State Teachers Retirement System is underfunding its plan by 15% of payroll – even after one assumes a lengthy 30–year amortization period. Their fiduciaries will have some interesting decisions in the near term.

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 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.

Roeder Financial is the only actuarial entity in California whose practice is restricted to one–shot work.

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