Trends and Threats Facing Public Pension Systems Mark Randall, FCA, MAAA, EA Executive Vice President

December 1, 2011 Copyright © 2011 GRS – All rights reserved.

Objectives  Discuss national trends in public

employee retirement systems  Provide information about recent significant plan changes  Identify potential threats facing public employee retirement systems  Briefly discuss some recent studies and findings 2

National Trends

3

Where Are We Now?  Sharp investment declines (but also

rebounds) coupled with improvements in mortality  Falling funded ratios  Increasing contribution rates  Increasing fiscal pressures on plan sponsors  Political antagonism toward public plans

4

Investment Declines & Rebounds State and Local Government Retirement Funds by Major Investment Type (1982 - 2011:Q1) 3,500

Other 3,000

Corp. Equities Corp. & Foreign Bonds

Billions of Dollars

2,500

U.S. Govt. Securities

2,000

1,500

1,000

500

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011:Q1

0

Source: Board of Governors of the Federal Reserve, Flow of Funds, annual.

5

Long-Term Rates of Return  Several states have recently lowered their long-

term rate of return assumption ► Many more are currently considering it

6

Plan

Prior

New

Change

Virginia

7.50%

7.00%

-0.50%

South Carolina

8.00%

7.50%

-0.50%

Colorado

8.50%

8.00%

-0.50%

California STRS

8.00%

7.75%

-0.25%

New York

8.00%

7.50%

-0.50%

Illinois

8.50%

7.75%

-0.75%

Indiana

7.25%

7.00%

-0.25%

Utah

7.75%

7.50%

-0.25%

National Historical Trends Life Expectancy in Years, Current Age 65 25.0 20.0 15.8

16.8

18.4

19.0

15.0 10.0

13.0

13.0

1960

1970

14.2

15.1

19.1

16.1

20.0 17.3

5.0 0.0 1980 Male National Vital Statistics Reports, Vol 59, No 4, March 2011 7

1990 Female

2000

2009

8

FY 10

FY 09

FY 08

FY 07

FY 06

FY 05

FY 04

FY 03

FY 02

FY 01

FY 00

FY 99

FY 98

FY 97

FY 96

FY 95

FY 94

FY 93

FY 92

FY 91

FY 90

Funded Ratio

Declining Funded Ratios Public Pension Funded Ratios

120

100

80

60

40

20

0

Increasing Contributions State & Local Government Contributions for Retirement Benefits As a Percent of General Revenues, Operating Expenditures, and Salaries & Wages (1982 - 2008) 13.0%

ER Contributions as % of General (Own Source) Revenues

12.0%

ER Contributions as % of Operating Expenditures

11.0%

ER Contributions as % of Salaries & Wages

10.0% 9.0%

8.0% 7.0% 6.0%

5.0% 4.0% 3.0%

2.0% 1.0%

Source: U.S. Census Bureau, State and Local Government Finances, annual. Percentages calculated by author.

9

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

0.0%

Contribution Experience Annual Required Contribution Experience 120

100

Percent of Plans

80

60

40

Average ARC Paid % Plans Receiving 90%+ of the ARC

20

0 FY 01

FY 02

FY 03

FY 04

FY 05

FY 06

FY 07

FY 08

Source: Keith Brainard, Public Fund Survey Summary of Findings for FY 2009, November 2010. FY 2010 data based on updated information presented at 2011 NASRA Annual Conference.

10

FY 09

FY 10

How Did We Get Here?  External factors: ► Financial market declines ► Rising unemployment ► Economic decline ► Falling housing values ► Falling state and local revenues  Internal factors: ► Benefit increases in late 1990s ► Investment risks ► Employers contributing less than the ARC

11

Investment Returns Accumulated Value of a Portfolio Consisting of 60/40 Stocks and Bonds Compared with Long-Term Government Bonds 35 60S/40CB 30

LTG Bonds

25

20

15

10

5

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

0

12

Unemployment Rates U.S. Unemployment Rate 1990 - 2011 (January Rates) 12.0

Unemployment Rate (%)

10.0

8.0

6.0

4.0

2.0

Source: U.S. Bureau of Labor Statistics, Current Population Series, annual.

13

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

0.0

Key Economic Variables Rates of Change in Key Economic Variables 10.0

8.0

Annual Rates of Change

6.0 4.0 2.0

0.0 -2.0 -4.0

Gross Domestic Product

-6.0

Personal Consumption

Disposable Personal Income -8.0

Source: U.S. Bureau of Economic Analysis, Survey of Current Business, August 2011. (Seasonally adjusted annual rates deflated using the implicit price deflator for personal consumption expenditures)

14

2011Q2

2011Q1

2010Q4

2010Q3

2010Q2

2010Q1

2009Q4

2009Q3

2009Q2

2009Q1

2008Q4

2008Q3

2008Q2

2008Q1

2007Q4

2007Q3

2007Q2

2007Q1

2006Q4

2006Q3

2006Q2

2006Q1

2005Q1

2005Q3

2005Q2

2005Q1

-10.0

Falling Local Revenues  National League of Cities survey of city

fiscal conditions projects: ►In 2010, city general fund revenues were

down -3.2% while expenditures were -2.3%. ►To cover budget shortfalls, cities will freeze or reduce personnel, delay infrastructure projects, and reduce services.

15

Where are We Going?  Benefit changes – largely for new hires  Changing GASB standards

 Proposed federal disclosures of public

pension funding status

16

Benefit Changes

17

Benefit Changes  According to the National Conference of State

Legislatures, 27 state legislatures enacted significant retirement system changes in 2011 (21 in 2010).  Since some states revisited the topic, in all, 40 states enacted significant retirement legislation in 2010 or 2011.  Key benefit changes in 2011 include: ► Higher employee contributions as a percent of salary ► Reduced benefits for new employees ► Some changes to COLAs 18

2011 State Retirement Legislation Type of Benefit Change

Number of States

Increased Employee Contributions Increased Vesting Requirements Increased Age/Service Requirements for Normal Retirement Extended Period for Final Average Salary Reduced Post-Retirement Benefit Increases Source: Ron Snell, Pension and Retirement Plan Enactments in 2011 State Legislatures, National Conference of State Legislatures, September 30, 2011.

19

16 7 15 6 10

Employee Contributions  16 states increased employee contributions in 2011 

 



20

(11 in 2010). In 12 states, the increases applied to current employees. In 4 cases the increases applied to new employees. In 8 states, the increased employee contributions offset (in whole or in part) employer contributions. Many increased the employee contribution rate by 2 or 3 percentage points, spread over two or more years. In 3 states, the increases were temporary, with the expectation that contributions would be lowered in the future.

Age/Service Requirements  15 states increased their age and service

requirements for normal retirement.  Generally, the increases applied to people hired after the legislation’s effective date (and to nonvested employees in a few states).  The changes move retirement age closer to age 65 and often increase required service (e.g., age/service combinations like 62/5 were changed to 65/10).  Many also increased the reduction factor for early retirement benefits (e.g., reduction factor of 0.2% per month prior to age 60 increased to 0.4% per month). 21

Vesting Periods  7 states increased vesting periods (5 in

2010).  Generally the changes were from 3 to 5 years or from 5 or 6 years to 8 or 10 years.

22

Final Average Compensation  6 states increased the averaging period for final 

 



23

average compensation (8 in 2010). In most cases, the change was from highest 3 years to highest 5 years. In all cases, this was applied to people hired after the effective date of the legislation. Several states restricted final average compensation by limiting overtime or bonus payments or specifying certain averaging methods. New Hampshire limited retirement benefits to the lower of 85% of final average compensation or $120,000. The $120,000 limit was in existing law.

Benefit Multipliers  4 states changed benefit multipliers  Hawaii reduced the multiplier for new

employees from 2.00% to 1.75%  Maryland reduced the multiplier for new employees to 1.5% (formerly 1.8%)  Mississippi changed its formula from: ► 2% for the first 25 years of service and 2.5% thereafter

to ► 2% for the first 30 years of service and 2.5% thereafter 24

Postemployment COLAs  10 states revised their automatic post-

retirement COLAs (8 in 2010).  In 3 states, the changes affect current benefit recipients.  In all cases, the legislation reduced future COLAs.  In Oklahoma, the change required future COLAs to be funded at time of enactment. 25

Postemployment COLAs  In Arizona, the COLA is constrained by the

funded ratio:

► 2% if the funded ratio is at least 60% growing

incrementally to 4% if the funded ratio is at least 80%.

 In addition, the COLA must be funded by

investment earnings in excess of 10.5% in the year before the year the COLA is given.  If the earnings in excess of 10.5% are not sufficient to fund the COLA, the increase is limited to only the amount that can be funded.  Any excess over the amount needed to fund the COLA in a given year are not available for future years. 26

“Two Part Hybrid”  Retirement benefits are provided by half

DB and half DC.  8 states now offer a two part hybrid: IN, WA, OH, OR, GA, MI (public schools), UT  …and now Rhode Island.  The Rhode Island Retirement Security Act makes broad changes to all plans effective July 1, 2012. 27

Cash Balance Plans  Some states like Texas and Nebraska have

successfully managed the cash balance arrangement in proving retirement benefits.  In 2011, 4 states considered a move to a cash balance plan, but did not implement: ► Kansas ► Maryland ► Montana

► Pennslyvania 28

Potential Issues and Threats

29

Changing GASB Standards  In 2011, GASB released its Exposure

Drafts of potential changes to public pension accounting and reporting: ►Accounting and funding would be decoupled. ►The unfunded pension liability (or “net

pension liability”) would be included on the employer’s financial statement rather than solely in the supplemental information.

30

Changing GASB Standards (cont.)  Potential implications of changing the

standards include: ► Creation of separate accounting and funding

measures may cause additional confusion about the “real” costs and funded status of a public pension plan. ► The net pension liability will likely be more volatile than the unfunded actuarial accrued liability that is currently disclosed. ► The EDs, if adopted, would likely increase the size of pension liabilities and expense reported in the employer’s financial statement. 31

Proposed Federal Disclosures  In February 2011, the Public Employees Pension Transparency

Act (PEPTA) was reintroduced by Reps. Devin Nunes (R-CA), and supported by Paul Ryan (R-WI) and Darrel Issa (R-CA).

 It would require sponsors of State and local government

employee pension plans to report funding information annually to the Secretary of the Treasury. Governments failing to report this information would lose their ability to issue tax-exempt debt until they comply.

 The legislation would not alter existing funding standards for

State and local plans or require Federal funding standards.

 It would prohibit the federal government from accepting any

current or future obligations of State and local pension plans.

32

Proposed Federal Disclosures (cont.) Proposed annual reporting requirements: A. B. C. D. E. F. G. H.

33

Schedule of funding status – including “current liability,” assets, and plan’s funding percentage; Schedule of contributions by the plan sponsor; Alternative projections of annual contributions, fair market value of assets, current liability over next 20 years; Statement of actuarial assumptions; Statement of plan participants; Statement of plan investment returns – including actual rate of return for past 5 years; Statement of “degree and manner in which the plan sponsor expects to eliminate any unfunded current liability;” and Statement of outstanding pension obligation bonds.

Proposed Federal Disclosures (cont.)  Additionally, the following would have to be remeasured if the

annual report does not measure assets at fair value or if liabilities are not discounted using U.S. Treasury bond yields: ► ► ► ►

Schedule of funding status; Alternative projections; Statement of plan investment returns; and Degree and manner plan sponsor expects to eliminate current unfunded liability.

 This would result in yet another set of measures that are different

from those used to fund the plan or are used for accounting and financial reporting purposes.

 Overall these measures would be very different from current

measures of public plans’ funded status.

34

Results of some recent studies

35

CRR 2010 Funding Study  In May 2011, the Center for Retirement Research

at Boston College (CRR) released its report on “The Funding of State and Local Pensions in 2010” based on sample of 126 state and local plans.  Key findings include: ► Overall funded status was 77%, with $2.7 trillion in

actuarial assets and $3.5 trillion in total liabilities. ► The slight decline in funded status from 79% in 2009 to 77% in 2010 was due to moderate increases in liabilities while actuarial assets grew more slowly (due partly to asset smoothing).

36

CRR 2010 Funding Study (cont.)  Key findings continued: ► Financial crisis resulted in higher unfunded liabilities increasing the amortization component of the annual required contribution. ► The average ARC increased from 11.8% in 2008 to 12.7% in 2009 and 13.5% in 2010. ► The higher ARC and substantial decline in state and local tax revenues resulted in falling employer contributions as a percent of the ARC. ► Employer contributions ARC fell from an average of 92% of the ARC in 2008 to 84% in 2009 and 78% in 2010. ► Many states are working to improve funding by reducing payroll, decreasing benefits for new hires, and increasing employer and employee contributions.  Link: http://crr.bc.edu/images/stories/slp_17_508.pdf 37

GFOA Best Practice on New Benefit Tiers  In May 2011, the GFOA Executive Board approved a

new Best Practice on Designing and Implementing Sustainable Pension Benefit Tiers. For jurisdictions considering new benefit tiers, GFOA recommends: ► Examining the government’s authority to revise its

pension benefits; ► Identifying the overall goals in doing so; ► Understanding the effects of the change on the workforce; ► Determining the financial impacts of the change on the government and its employees; ► Soliciting input from actuaries regarding forecasting benefit costs and determining funding adequacy; and ► Understanding key plan design elements. 38

GFOA Best Practice on New Benefit Tiers (cont.)  With regard to plan design changes, the BP suggests considering: ► Recalibrating normal and early retirement ages; ► Reviewing benefit multipliers in light of all income expected in

► ► ► ► ►

retirement, including Social Security, Medicare, and personal savings; Providing COLAs that are actuarially funded and financially sound; Clearly stating new tier benefits enhancements will be prospective only; Basing service credit purchases on actuarial cost; Excluding extraordinary income from final average compensation; Providing ample time and sufficient notice for employees to adapt to the changes.

 Link: http://www.gfoa.org/downloads/GFOA_BP_Newbenefittiers.pdf

39

EBRI 2011 Retirement Confidence Survey  In March 2011, the Employee Benefit Research Institute (EBRI)

released its issue brief titled, The 2011 Retirement Confidence Survey: Confidence Drops to Record Lows, Reflecting “the New Normal.”  Key findings include: ► 27% of active workers are “not at all confident” about having

enough money for a comfortable retirement, the highest level ever measured by the survey (up from 22% in 2010). ► 13% workers are “very confident” about having a financially secure retirement (down from 16% in 2010). ► The expected retirement age of workers remains relatively unchanged from 2010. However, the percent of workers who expect to retire after age 65 has increased from 11% in 1991 to 20% in 2001 to 36% in 2011. ► 74% of workers expect to work for pay in retirement (up from 70% in 2010). This is three times higher than the percent who reported they actually worked for pay in retirement. 40

Conclusion  How Do We Get Where We Want to Go? ►Design sufficient and sustainable benefits ►Establish sound funding policy ►Make reasonable valuation assumptions ►Make required contributions

►Avoid basing benefits on “excess assets” ►Mitigate investment and other risks

41

Questions and Comments?

42

Disclosures  Circular 230 Notice: Pursuant to regulations issued by the IRS, to the

extent this presentation concerns tax matters, it is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) marketing or recommending to another party any tax-related matter addressed within. Each taxpayer should seek advice based on the individual’s circumstances from an independent tax advisor.

 This presentation shall not be construed to provide tax advice, legal

advice or investment advice.

 Readers are cautioned to examine original source materials and to

consult with subject matter experts before making decisions related to the subject matter of this presentation.

 This presentation expresses the views of the authors and does not

necessarily express the views of Gabriel, Roeder, Smith & Company.

43