Guidelines have been developed over time to assist in the analysis of this factor. They are:

Transcription

1 Exhibit 14 To: Board of Trustees From: Judith A. Parker and Daniel L. Allen Date: November 19, 2009 Re: Effective Rate of Interest Background In the past, the SURS Board of Trustees determined the Effective Rate of Interest (ERI) each fall for the academic year beginning the following September 1 st, taking into account the System s most recent fiscal year-end results. The effective rate is, among other things, the interest rate that is applied to member contribution balances. The member contribution balance is an integral part of the Rule 2 (money purchase) formula, used in calculating retirement benefits for persons who joined the system prior to July 1, The effective rate of interest and its method for determination are set forth in 40 ILCS 5/15-125(2), which defines the effective rate of interest as: The rate of interest for all or any part of a fiscal year that is determined by the board based on factors including the system s past and expected investment experience; historical and expected fluctuations in the market value of investments; the desirability of minimizing the volatility in the effective rate of interest from year to year; the provision of reserves for anticipated losses upon sales, redemptions or other disposition of investments and for variations in interest experience (emphasis added). Public Act 94-4 was signed by Governor Blagojevich on June 1, This act provides that the effective rate of interest for purposes of the Rule 2 calculation shall be determined for fiscal year 2006 and subsequent fiscal years by the State Comptroller rather than the SURS Board of Trustees. However, the ERI must also continue to be determined by the SURS Board of Trustees for all other purposes. These other purposes include the calculation of purchases of service credit, refunds for excess contributions, traditional refunds and lump sum portable retirements. Public Act , effective June 30, 2006, extended the deadline for the Comptroller to certify the effective rate of interest to the board and to the Commission on Government Forecasting and Accountability. The Comptroller must make the certification for each fiscal year no later than January 31 immediately preceding the start of that fiscal year. The Trustees and the Comptroller s determination of the ERI for any year is governed by the statutory factors. Statutory factors Past and expected investment experience The first factor focuses on the System s long-term rate of return. Two measures of long-term investment return experience have been utilized consistently by the Trustees. The first is the rate of return on assets since the System began investing a meaningful portion of the assets in equities (since 1972). The second is based upon the average participant s length of service at the time of retirement (approximately 22 years). Guidelines have been developed over time to assist in the analysis of this factor. They are:

2 Page 2 Exhibit 14 When the average long-term rate of return on SURS investment portfolio is above the current effective rate of interest, a modest increase in the ERI is warranted. When the average long-term rate of return on SURS investment portfolio is at or near the current effective rate of interest, the ERI should remain unchanged. When the average long-term rate of return on the SURS investment portfolio is below the current effective rate of interest, then a modest decrease in the ERI is warranted. Further, the statute requires that the Trustees take into account the expected future investment return on assets. The variable used for this portion of the statutory analysis is the actuarial assumed rate for future investment earnings (currently 8.5%). The significant increase in the markets since the beginning of the current fiscal year has triggered the need for a subsequent events disclosure in the Comprehensive Annual Financial Report being prepared for FY Given that the market increase in this fiscal year to date has been sufficient to trigger a subsequent events footnote, staff has also prepared a subsequent events analysis (Table 3) assuming a 20% investment return for FY Historical and expected fluctuations in the market value of investments The statute indicates that historical and expected fluctuations in the market value of assets are to be considered in setting the ERI. The actuarial assumed rate for future investment earnings is a geometric average rate of return. Geometric returns account for fluctuations in the rates of return as values are assumed to be fluctuating due to changes associated with investment cash flows and market impact on values. Provision of reserves for anticipated losses upon sales, redemptions or other disposition of investments and for variations in interest experience The undistributed investment income reserve account is a general ledger account that has been established to absorb the gains or losses on System assets. Gains during a fiscal year increase the reserve balance, while losses lower the balance. Historically, guidelines have been developed over time to assist in the analysis of this factor. In the past the undistributed investment income reserve account was compared to the net assets of the system, and a percentage analysis was used with a 20-30% range being considered normal. 2 Further analysis and review has demonstrated that a better comparison is of the undistributed investment income reserve account to the liabilities of the system. It is the liabilities that must ultimately be paid by the system to its beneficiaries. Looking at the reserve account as a percentage of the liabilities gives a better measure of the adequacy of the level of the reserve. We are not aware of any objective standard for setting the appropriate level of the reserve at a certain percentage. For purposes of determining the effective rate of interest, we believe that it is most 1 The assumed 20% return for FY 2010 was derived by blending the estimated actual investment return through September 30, 2009, of 13.5% with the remainder of the fiscal year prorated monthly at an annualized rate of 8.5%.

3 Page 3 Exhibit 14 appropriate to look at whether the reserve is at level such that it could absorb a multi-year cycle of investment losses while minimizing volatility in the effective rate of interest. Table 1 shows the recent variation in the undistributed investment income reserve account in comparison to the liabilities of the system. The undistributed investment income reserve declined significantly both in dollar amount and as a percent of liabilities in FY 2009, providing reasoning for a reduction in the effective rate of interest. As measured under this factor, a decrease in reserves occurred, both in absolute terms and on an historical basis, for anticipated losses upon sales, redemptions or other disposition of investments and for variations in interest experience. Table 1 As of June 30, Account balance ($ s in billions) As a % of liabilities % % % % % % % % % % Minimizing the Volatility of the Effective Rate The statute indicates that maintaining a stable ERI is desirable. The Trustees recognize this key concept and have historically approved only minor adjustments in the credited rate. Up until the downturn in the equity markets in fiscal years 2001 and 2002, the Trustees had elected to adjust the rate in 0.5% increments. However, the sharp decline in the financial markets in fiscal years 2001 and 2002 prompted a larger than normal rate of adjustment. The ERI was reduced by 1.0% in each of the two crediting periods (academic years beginning September 1, 2002 and 2003). This rate remained stable for the academic year beginning September 1, The ERI was increased for the fiscal year beginning July 1, 2005, to 8.5%. The ERI remained at this level for the 2007 through 2009 fiscal years. For fiscal year 2010, the ERI was reduced to 8.0%. The recent global market downturn resulted in investment performance for the fiscal year of -19.7% thus the recommendation to reduce the ERI for fiscal year The guidelines previously used were: If the undistributed investment earnings account is large (i.e., greater than 30% of net assets) and has increased over the prior year, then a modest increase in the ERI is warranted. If the undistributed investment earnings account is normal (i.e., between 20% and 30% of net assets) and is about the same as it was in the prior year, then ERI should be held constant. If the undistributed investment earnings account is small (i.e., less than 20% of net assets) and has decreased when compared to the prior year, then a modest decrease in the ERI is warranted.

4 Page 4 Exhibit 14 Current Period Analysis Based upon the factors and guidelines set forth above, our analysis for the current rate-setting period indicates the following: Long-term investment earnings The long-term rate of earnings measures take into account actual returns through FY See Table 2, looking at the average annualized return for the 22-year period and the post-1971 period for the fiscal year ending June 30, The 22-year period measure has decreased to 7.5%, a level not seen since fiscal year 1987, resulting in a lesser amount than the current ERI of 8.0%. The post-1971 measure is 8.1%, as it includes a longer time period over which the average annualized return is measured. The statute indicates that the future expected returns on investments, as well as fluctuating market values of investments should be considered when setting the effective rate of interest. SURS current investment earnings assumption, as determined by the System s actuary, used in the actuarial valuation process remains at 8.5%. The actuarial future expected return of 8.5% is reflected in Table 2 on page six of the document. The market declines experienced during fiscal years 2008 and 2009 have provided dramatic fluctuations in investment performance. In fiscal year 2010 to date, the investment performance has rebounded significantly. As a result, staff has included Table 3 on page seven, showing the effect on the average annualized return measures should the system incur a 20% investment gain in FY We believe that a Table such as this, showing an expected return on investment different from the actuarial investment earnings assumption, should be used only in years where there has been sufficient market volatility to warrant a subsequent events footnote in the system s comprehensive annual financial report. Undistributed investment income reserve account The undistributed investment income reserve account decreased dramatically during fiscal year Table 1 shows that the undistributed investment income reserve account decreased approximately $3.4 billion during fiscal year 2009 and now represents 17.1% of liabilities versus 39.0% of liabilities for fiscal year 2007, two years ago. While liabilities have grown significantly over the past several years, the measure shows declining reserves. This factor suggests that the effective rate of interest be decreased. Volatility minimization The statute expresses a public policy preference for minimal volatility in the effective rate of interest credited over time. The Board of Trustees has been consistent in its application of this statutory factor, and has not subjected the effective rate to frequent or dramatic swings. This factor suggests a statutory preference for maintaining the status quo unless a change is clearly justified. In this memorandum, an ERI decrease for fiscal year 2011 is recommended in the amount of 0.5%. This is a modest change in the effective rate and consistent with past actions by the Trustees. Therefore, volatility in the rate would be minimal. Conclusion and Recommendation

5 Page 5 Exhibit 14 Staff believes it is prudent at this time to recommend a decrease of one-half percent in the ERI for fiscal year 2011, to 7.5%. The past and expected investment experience suggests a slight decline in the effective rate of interest, as does the status of the undistributed investment income reserve account. SURS staff recommends that the Effective Rate of Interest (ERI) be set at 7.5% to be applied to account balances for fiscal year 2011, beginning July 1, 2010.

6 Page 6 Exhibit 14 Table 2 Schedule of Investment Rates of Return & ERI Credited Investment Returns Credited Rate Fiscal Year 1 Year 22 Years Post 1971 Fiscal Year 1 Year 22 Years Post % 7.8% 8.1% % 7.5% 8.1% % 8.5% 8.0% % 9.3% 9.0% % 8.5% 8.0% % 10.8% 9.4% % 8.5% 8.0% % 11.0% 9.1% % 8.5% 8.0% % 10.2% 9.0% % 8.5% 8.0% % 11.5% 9.0% % 8.5% 8.0% % 10.7% 8.8% % 8.4% 8.0% % 10.7% 9.0% % 8.4% 8.0% % 11.0% 9.5% % 8.4% 8.0% % 11.8% 10.2% % 8.4% 7.9% % 11.4% 10.1% % 8.2% 7.9% % 11.0% 10.0% % 8.1% 7.8% % 11.0% 9.7% % 7.9% 7.7% % 10.8% 9.3% % 7.8% 7.6% % 9.2% 8.9% % 7.7% 7.6% % 8.4% 8.6% % 7.7% 7.5% % 9.0% 9.0% % 7.7% 7.5% % 9.3% 8.8% % 7.5% 7.5% % 8.7% 8.8% % 7.3% 7.5% % 8.2% 9.0% % 7.2% 7.5% % 8.0% 8.9% % 7.0% 7.4% % 7.6% 8.5% % 7.4% % 7.1% 8.9% % 7.4% % 6.5% 8.4% % 7.4% % 5.6% 7.2% % 7.3% % 4.8% 5.9% % 7.3% % 5.3% 6.9% % 7.2% % 3.7% 4.2% % 7.1% % 4.1% 4.5% % 7.1% % 4.0% 4.9% % 7.0% % 4.0% 5.4% % 6.9% % 3.7% 5.3% % 6.7% % 3.5% 5.3% % 6.7% % 3.3% 5.6% % 6.7% % 2.9% 2.8% % 6.7% % 2.1% -1.5% % 6.9% % 3.0% 6.2% % 6.8% % 3.0% 12.6% % 6.2% % 4.5% Note 1: Rates of returns are annualized for periods longer than 1 year is chosen as a reference point since it represents the point in time where SURS investment program began investing in equity securities in a meaningful allocation -- (greater than 40%). Note 2: Rates of return from a completed fiscal year are utilized in setting the ERI for the academic year that begins the second following year. The returns from the fiscal year ended June 30, 2009, are utilized in the ERI credit for the fiscal year beginning July 1, Note 3: The ERI was credited on an academic year cycle until fiscal year 2006, beginning July 1, Since then, the ERI is set on a fiscal year basis. The 8% ERI for 2004 was credited for a 10-month period from September 1, 2004, through June 30, Note 4: The credited rate for fiscal year 2011 reflects the recommendation from staff to reduce the ERI from 8.0% to 7.5%.

7 Page 7 Exhibit 14 Table 3 Schedule of Investment Rates of Return & ERI Credited Investment Returns Credited Rate Fiscal Year 1 Year 22 Years Post 1971 Fiscal Year 1 Year 22 Years Post % 8.3% 8.4% % 7.5% 8.1% % 8.5% 8.0% % 9.3% 9.0% % 8.5% 8.0% % 10.8% 9.4% % 8.5% 8.0% % 11.0% 9.1% % 8.5% 8.0% % 10.2% 9.0% % 8.5% 8.0% % 11.5% 9.0% % 8.5% 8.0% % 10.7% 8.8% % 8.4% 8.0% % 10.7% 9.0% % 8.4% 8.0% % 11.0% 9.5% % 8.4% 8.0% % 11.8% 10.2% % 8.4% 7.9% % 11.4% 10.1% % 8.2% 7.9% % 11.0% 10.0% % 8.1% 7.8% % 11.0% 9.7% % 7.9% 7.7% % 10.8% 9.3% % 7.8% 7.6% % 9.2% 8.9% % 7.7% 7.6% % 8.4% 8.6% % 7.7% 7.5% % 9.0% 9.0% % 7.7% 7.5% % 9.3% 8.8% % 7.5% 7.5% % 8.7% 8.8% % 7.3% 7.5% % 8.2% 9.0% % 7.2% 7.5% % 8.0% 8.9% % 7.0% 7.4% % 7.6% 8.5% % 7.4% % 7.1% 8.9% % 7.4% % 6.5% 8.4% % 7.4% % 5.6% 7.2% % 7.3% % 4.8% 5.9% % 7.3% % 5.3% 6.9% % 7.2% % 3.7% 4.2% % 7.1% % 4.1% 4.5% % 7.1% % 4.0% 4.9% % 7.0% % 4.0% 5.4% % 6.9% % 3.7% 5.3% % 6.7% % 3.5% 5.3% % 6.7% % 3.3% 5.6% % 6.7% % 2.9% 2.8% % 6.7% % 2.1% -1.5% % 6.9% % 3.0% 6.2% % 6.8% % 3.0% 12.6% % 6.2% % 4.5% Note 1: Rates of returns are annualized for periods longer than 1 year is chosen as a reference point since it represents the point in time where SURS investment program began investing in equity securities in a meaningful allocation -- (greater than 40%). Note 2: Rates of return from a completed fiscal year are utilized in setting the ERI for the academic year that begins the second following year. The returns from the fiscal year ended June 30, 2009, are utilized in the ERI credit for the fiscal year beginning July 1, Note 3: The ERI was credited on an academic year cycle until fiscal year 2006, beginning July 1, Since then, the ERI is set on a fiscal year basis. The 8% ERI for 2004 was credited for a 10-month period from September 1, 2004, through June 30, Note 4: The projected investment return for fiscal year 2010 is 20.0%. This reflects the actual investment return through September 30, 2009, of 13.5% with the remainder of the fiscal year prorated monthly at an annualized rate of 8.5%. Note 5: The credited rate for fiscal year 2011 reflects the recommendation from staff to reduce the ERI from 8.0% to 7.5%.