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California Pension Systems: Ranking their Funding Assumptions

Rick Roeder       May 2017

This is the eighth 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.

Since current employer contribution rates are often reaching levels thought unimaginable 20 years ago, an analysis as to the reasons are instructive. Traditional actuarial methodology created two unintended problems. In the late 1990’s, the funding ratios of many Systems approached or exceeded 100%. As a result, generous benefit increases were granted. The concept of saving money for a rainy day was generally discarded in favor of the ongoing euphoria that accompanied the longest bull market in American history. PEPRA’s benefit cutbacks for post–January 1.2013 hires will definitely help funding — in the long run. However, the relentless increase in contributions is somewhat unsettling given that the current bull market is now seven years in duration.

Nor does traditional actuarial funding address a paradox: other factors equal, more contribution volatility exists for better funded plans than those with lower funded ratios. Actual investment returns can diverge wildly from assumed returns during a market cycle. The greater the assets, the greater the dollar magnitude of actuarial gains or losses. After the learning experience brought about by the 2001-2009 bear market, some Systems established policies which would keep a greater reserve during the good times when and if funded ratios again exceed 100%. Other entities, such as CalPERS, have decided that traditional smoothing methods did not achieve desired stability and have used a blunt approach which directly smoothes contribution changes over a period of years — on top of other smoothing methods. Segments of the actuarial community believe that current professional standards, if in place during the 1990’s, might have precluded today’s environment. Perhaps so. Such changes will certainly help but the political risk of benefit decisions during the good times will remain.

Ironically, a System which is reasonably well funded, with a funded ratio in the 80-90% range may prove more stable than a System which achieves a 100% funded ratio. Traditional actuarial work has generally targeted a long-term funded ratio of 100%. While certainly a laudable target, 21st century experience–to–date indicates that some rethinking on this objective may be appropriate.

Not all Systems have experienced dramatic contribution increases. The City of Fresno deserves kudos. Two decades ago, the City adopted an innovative program that returned some of the excess assets to retirants but retained a very healthy buffer that has kept both Systems’ funded ratio above 100%. The foresight of the City, retirement staff and its Trustees has been truly impressive.

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 potential 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 2017 survey, for the fifth 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
2017	18
2016	6
2015	12
2014	16
2013	21

The ongoing lowering of discount assumptions is somewhat head scratching because of the strong bull market from 2009-2016.

More than half now use an assumed investment return in the 7-7.25% range. Fourteen entities employ a 7.25% assumption. In eight years the standard has decreased by 0.75% from 8%. In our initial 2009 survey, 60% of the entities used an investment assumption of at least 8%. In this 2017 survey, no assumed rate exceeded 7.60%. Likely, no System has seen its investment assumption be reduced in the past decade more than the City of San Jose General System. Its current assumption of 6.875% is markedly lower than the 8.25% assumption used in their 2007 valuation.

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.

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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