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California Pension Systems: Ranking their Funding Assumptions

Roeder Financial       April 2016

This is the seventh 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.

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 in this millenium. 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. 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 2016 survey, for the fourth straight year, continues to be the lowering of both assumed investment returns and inflation assumptions. Number of entities lowering assumed investment return:

Survey Year	Reductions
2016	6
2015	12
2014	16
2013	21

The ongoing lowering of discount rates is ironic because of a strong bull market in 2009-2014. Despite the mediocre returns earned for the 12-month period ending June 30, 2015, a number of systems still have unrecognized investment gains for funding purposes. What a refreshing change compared to the aftermath of the 2007-08 financial

meltdown! More than half now use an assumed investment return of 7.5%. In seven 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%. In this 2016 survey, only three entities have an assumed rate above 7.50% and no rate exceeds 7.75%.

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. A significant minority of 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. These recent accounting disclosures require that the impact of a 1% increase or 1% decrease in the assumed investment return be shown.

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 legislation significantly reduces benefits for County systems and PERS, only post-2012 hires are impacted. To date, PEPRA has had small impact and will only have significant impact years down the road. Nationally, the mainstream media has generally not connected all the dots in linking the unprecedented level of pension contributions to its impact on events as disparate as toxic pipes in Flint, skyrocketing tuition fees, decaying infrastructure and reductions in numerous social services.

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(619) 300 - 8500 or via roederfinancial.com.

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