RE: Review of USPS Allocation of Civil Service Retirement System Obligation

Transcription

1 Horizon Actuarial Services, LLC 8601 Georgia Avenue, Suite 700 Silver Spring, MD Phone: Fax: Mr. Fredric V. Rolando National President, AFL-CIO 100 Indiana Avenue, NW Washington, DC RE: Review of USPS Allocation of Civil Service Retirement System Obligation Dear President Rolando: Per your request, we have reviewed and hereby submit our comments on the allocation to the United States Postal Service ( USPS ) of a share of the Civil Service Retirement System ( CSRS ) obligation for certain participants, as determined by the Office of Personnel Management ( OPM ). We have conducted our reviews, based on sound actuarial practice and principles. Based upon our analysis, we have determined that there has been an inappropriate allocation of the share of the CSRS obligation to the USPS and we recommend that the issues raised in this letter be reviewed by the United States Congress to ensure a just and equitable resolution to these inequities. Overview The USPS was established in 1971, effectively as a continuation of the Post Office Department ( POD ). Chapter 83 of title 5, United States Code dictates the manner in which the federal government will retain the obligation under the CSRS for the portion of the benefits through 1971, with the USPS holding the obligation for the portion of the benefits after This chapter of the U.S. Code has been revisited and revised at various times since the establishment of the USPS, most recently under PL in 2006, giving authority to the OPM to redetermine the pro-rated share of the obligation for pre-1971 participants, in accordance with generally accepted actuarial practices and principles. While the establishment of the USPS represents a unique set of circumstances, we would emphatically argue that basic actuarial principles nonetheless apply. We would also assert that the determination of the allocation of the obligation between the USPS and the federal government, as determined by OPM, violates these basic actuarial principles on a number of key points. Specifically, OPM has argued that by following the law, they have determined that the POD is not responsible for the impact of future pay increases on the pension benefits of participants u:\nalc\ret\2010\projects\csrs\nalc_horizon_report_ docx Atlanta Cleveland Los Angeles Miami Washington, D.C

2 Page 2 based on service earned prior to the establishment of the USPS. The OPM Board of Actuaries backs this position, stating that the OPM allocation method is the most appropriate way to determine the obligations of the USPS and the POD for this liability. In its argument, the OPM Board of Actuaries emphasizes that the OPM methodology is similar to the practice observed in the private sector for allocating pension liabilities among employees transferred from one company to another. OPM has stated that the allocation of costs between the USPS and the federal government is both just and in line with actuarial practice. We respectfully disagree with these assertions and offer the following counterpoints: Sound actuarial (and accounting) principles require pension plan costs to be measured in a manner which does not unfairly defer plan costs to future stakeholders or increase risk to the beneficiaries of the plan. The reflection of future pay increases in the determination of a pension obligation earned as of a specified date is not only equitable and fair, it is a standard of practice in both the private and public sectors. To ignore reasonable pay increases is not only unrealistic, it is irresponsible, and places an unfair burden on future customers, employees and other stakeholders of the USPS. By requiring USPS to maintain benefits under the CSRS, the federal government must share in the cost of anticipated updates attributable to benefit service earned while employed with the POD that would result from reasonable pay increases to employees of the USPS while employed by the USPS. Through a historical examination of pension plan funding, and an explanation of actuarial cost methods for allocating costs, we will illustrate these counterpoints, and demonstrate that the USPS and its future stakeholders are bearing inappropriate and unfair burden through OPM s determinations. Funding Pension Plans and Actuarial Cost Methods A pension plan is a promise to pay a retirement benefit, generally in the form of an annuity for life. Long ago, pensions were funded on a pay as you go basis, with plan sponsors paying benefits to retirees using the company s income during the participant s retirement to pay the retiree s benefits directly as the payments were due. Alternatively, a plan sponsor might have purchased an annuity through an insurance provider at the participant s retirement date (referred to as terminal funding ). There are two major concerns with these approaches to meeting the pension promise.

3 Page 3 1. A pension plan should be funded according to actuarial principles. Companies are not everlasting institutions. When pension plans use pay as you go or terminal funding, the risk of failing to meet the pension promise is pronounced. For unfunded or underfunded pension plans, a company failure will result in an inappropriate deferral of costs. This deferral will lead to exploding costs, and result in the inability to pay all or a portion of a retiree s pension. Waiting until a person reaches retirement to fund the pension, especially when a participant earns a vested right to receive that pension, is irresponsible. 2. Pension costs should be attributed to the period in which the pension benefit is earned. A pension is earned over a participant s working lifetime, not during his retirement years. Therefore, the cost of the benefits earned by the participant should be attributed to, and paid for, during his working years. The overall cost of company operations in any given year should reflect the cost of the pension benefit that was earned in that year. In response to the shortcomings of the funding principles of pay as you go and terminal funding of pension plans, the actuarial profession developed actuarial cost methods. These methods attribute pension benefits to the periods of service in which the benefits were earned. Using actuarial cost methods enables plan sponsors to adequately measure and understand their pension obligations, and thereby fund them in an appropriate manner. Attributing pension costs to the year in which the benefit is earned is necessary in establishing the costs associated with operating a business or providing a service. When the costs of funding pensions are inappropriately allocated to current and future stakeholders or ratepayers, generational inequities will arise. Why should the customer purchasing a product today pay an additional cost for funding the pension earned in years past? A stockholder should not receive an extraordinary dividend due to obscured pension costs. Improperly allocating costs is unfair, and should rightly result in moral outrage from current and future stakeholders. While there are numerous cost methods for attributing pension obligations, all cost methods determine the actuarial present value of a participant s projected benefit at retirement through the use of an actuarial model. Most cost methods then attribute this obligation to three periods of a participant s career the past, the upcoming year, and the remaining years of his career. Conceptually, the obligation attributed to each period would be funded by the plan sponsor in that period. One common cost method utilized in the actuarial profession is the Unit Credit cost method. Under this method, the actuary attributes the obligation to the past by ignoring each participant s future service in the determination of the pension benefit. For the obligation attributed to the upcoming year, only service earned in the upcoming year is reflected. Any remaining obligation is then attributed to future years. In simplistic terms, for a participant who will work a thirty year career for an employer and then retire, 1/30 th of his benefit is attributed to each year of his working career. If this participant currently has worked five years of his thirty year career, 5/30 th

4 Page 4 of his benefit will be attributed to the past, 1/30 th to the upcoming year, and 24/30 th to the remainder of his career. An additional component of the cost method attribution relates to the manner in which pay is factored into a participant s ultimate pension benefit. Many pension plans use an employee s pay at or near retirement in calculating the employee s benefit. For these types of pension plans, actuaries use projected pay when attributing the obligation under the Unit Credit cost method, in all but a limited number of circumstances. For all other cost methods, the obligation is attributed using projected pay in all circumstances. Accounting rules mandate the use of projected pay. Why Use Projected Pay in the Determination of Pension Obligations? In order to understand why actuaries use projected pay in attributing the pension benefit to various periods, we must first describe the benefit accrual in a pay related plan, using the benefit under the Civil Service Retirement System (CSRS) as an example. The CSRS benefit is one of the most common types of benefit provided by a traditional pension plan. This type of benefit is referred to as a high-three pay pension, and as the name implies, the participant s benefit is ultimately based on his highest average salary. Specifically, the benefit is determined as follows: 1. The participant s annual salaries are averaged in order to determine his highest three-year average. We will refer to this average as the final average pay or FAP. In most cases, a participant s FAP will be based on his pay in the three years preceding retirement. 2. Once determined, the FAP is applied to all years of service in order to determine the benefit at retirement. For the first five years of employment, the FAP is multiplied by 1.50%, for the next five years, the FAP is multiplied by 1.75%, and for all subsequent years, the FAP is multiplied by 2.00%. 3. The amounts determined for each of the years in item #2 above are then summed to determine the participant s benefit. The use of final average pay as a component of pension plan design is driven by the motivation to provide a percentage of replacement income to retiring participants. Sponsors of these types of plans generally target replacing a percentage of a participant s pay at retirement for long service employees, allowing them to retire with a reasonable replacement income. Under this type of design, the overall amount of a final average pay-based pension will increase sharply as a participant nears retirement. As one would expect, the benefit will increase each year as the participant accrues an additional year of benefit service. However, a pronounced portion of the annual increase in the benefit will occur as a direct result of the increases in participant s pay being reflected in each year of past service. The chart below illustrates a sample participant under the CSRS plan. We have divided the annual change in the participant s benefit into two components:

5 Page 5 1. The increase in the benefit due to the accrual of a year of service, (Service Update Component) and 2. The increase in the benefit due to the updates to past service benefits as a result of increases in final average pay (Past Pay Update Component). As illustrated by the Chart I below, both components increase the participant s benefit each year. Twenty-one years into the participant s career, the annual Service Update and Past Pay Update components are within 3% of each other. However by the thirtieth year of the participant s career, the annual Past Pay Update component is more than 50% greater than the Service Update component. Over the course of the last seven years of this sample participant s career, the Service Update Component of his benefit tracks the annual increase in his pay, while the Past Pay Update Component increases at an exponential rate. Year CHART I Illustration of CSRS Benefit Components Service Average Pay Pension Benefit Service Update Component Pay Update Component Percent Difference Pay and Service Update , , % , , % , , % , , % , , % , , , % , , , % , , , % , , , % , , , , % Having current stakeholders pay for the Service Update component is likely appropriate, though some cost methods levelly allocate the Service Update over the participant s career. However, forcing future stakeholders to meet the burden of paying for the exponentially increasing cost of pay updates to past service is unfair and inappropriate. The use of projected pay in a cost method attribution results in an equitable distribution of costs among the stakeholders. In most examples of measuring pension costs, the reflection of future pay increases in current costs is mandated by law or required by accounting standards.

6 Page 6 Examples of the Mandated Use of Projected Pay Employee Retirement Income Security Act of 1974 The loss of the pensions of thousands of workers that resulted from the failure of Studebaker in the late 1960 s prompted the federal government to take notice and require adequate funding of company pension plans. Through the Employee Retirement Income Security Act of 1974 (ERISA), the government mandated and codified minimum requirements for funding a pension plan. These standards were based on sound actuarial principles for the funding of a defined benefit plan already present in the actuarial community, although prior to ERISA, these principles were not embraced fully by plan sponsors in the private sector. ERISA mandated the use of reasonable cost methods for determining minimum pension funding standards. When determining the minimum contribution requirements for a pay related multiemployer pension plan, the actuary is required to use projected pay in determining future costs. If an actuary ignored pay increases, the cost method would not only be deemed unreasonable, but the actuary would also likely face disciplinary action from the Joint Board for the Enrollment of Actuaries, and potential legal action from the Internal Revenue Service. See most recently Internal Revenue Service - Revenue Procedure Section Thus it is illegal to ignore future pay increases in current costs. Financial Accounting Standards (FAS) Company sponsors of pension plans are subject to standards for reporting the company s pension obligation on the financial statements. These standards are developed by the Financial Accounting Standards Board, and promulgated to ensure transparent, equitable, and comparable reporting for pension costs. Companies are required to disclose the pension obligation under the Statement of Financial Accounting Standards ( SFAS ) No The actuary must use the Unit Credit cost method, reflecting future pay increases, when disclosing this obligation on the company s balance sheet. The annual costs that are disclosed as part of the profit and loss statement reported under SFAS 87 for these pension plans must also reflect projected pay. This treatment fairly attributes the cost of the benefit to the year in which it is accrued and appropriately values the worth of the company on an on-going concern basis. The reporting of pension costs under SFAS 87 enables companies that sponsor defined benefit plans to accurately measure the costs of providing a pension in a given year, thus allowing for a more precise determination of the company s profitability in a given year. Accurately quantifying pension costs for a given year allows companies to monitor and adjust operating costs and budgets appropriately. Additionally, disclosure under SFAS 158 is necessary in determining shareholder value. If obligations were disclosed ignoring projected pay, purchasers of company stock would be ill informed with regard to the true value of a company on an ongoing concern basis.

7 Page 7 Therefore, it is a violation of generally accepted accounting principles to ignore future pay increases in determining current costs. See SFAS No. 87, paragraph 17. Plan Terminations, Sales, and Spinoffs In certain instances, reflecting pay increases in measuring pension obligations may not be appropriate. Examples may include a plan termination, a sale of a business, or the spinoff of a segment of a pension plan. When a pension plan is terminating, no future pay increases will be reflected in the participants benefits, so there is no need to reflect pay increases in measuring the plan obligation. It would be unreasonable to reflect pay increases in determining an obligation when those pay increases will never be reflected in the ultimate pension benefit. For a business sale, if the purchaser intends to continue the pension plan, reflecting projected pay in the determination of the obligation is appropriate, where the purchaser intends to continue to reflect pay increases on past service benefits (earned during the employment period with the selling employer). In many instances, a selling employer will require a maintenance of benefits provision in the sale agreement. This provision ensures the continuation of the pension plan by the purchasing employer, thereby protecting the value of the pension benefit for transferring employees. A purchaser who plans on terminating or freezing a pension plan, once the sale is complete, might not reflect projected pay in measuring the plan obligation, as there is no intent to update past service benefits for future increases in pay. However, transferring employees may require some level of reciprocity upon transfer, in response to their lost potential for past service updates for future pay increases. In other words, the purchasing employer will often realize that additional benefits must be provided to make up the shortfall incurred by transferring employees as a result of the pension freeze. Lastly, a plan spinoff occurs when a group of participants leaves a pension plan, taking both assets and liabilities to a new pension plan, or merging these assets and liabilities with another pension plan. During plan spinoffs, asset allocations are first determined using the accrued benefit to date, irrespective of future pay increases. This is the case even if the intent is for the spun-off participants to continue to receive past service updates as a result of pay increases reflected in the new plan. The intent of the law is to first ensure that all participants in the original pension plan have been treated equitably. The value of each spun-off participant s benefit accrued to date is covered by the plan s assets transferred to the new plan, and the value of each remaining participant s benefit accrued to date is also covered by the assets remaining in the original plan. However, if the assets in the original plan exceed the value of the accrued benefits of all parties (not reflecting future pay), the excess assets are allocated among the participants on a prorated basis relative to the obligation determined using projected pay. That is, once the assets have been

8 Page 8 distributed between the two groups, if these assets are sufficient to cover both groups benefit obligations based on the benefits determined using pay to date, the excess assets are distributed taking into account projected pay. See IRS Regulation 1.414(l). OPM s Methodology By only reflecting the benefit accrued to date (as of 1971) in determining the POD s pro-rated share of the benefit obligation, OPM fails to acknowledge the significantly increased costs of updating past service for increases in pay. The following charts illustrate the increase in two hypothetical participants benefits due to pay updates on service earned prior to the establishment of the USPS. Sample Participant A 20 Years of Service at Establishment of USPS Year Service Average Pay Pension Benefit POD Service - Update for Pay Total Benefit for POD Service $ 17,000 $ 6,163 $ 6, $ 18,020 $ 6,893 $ 370 $ 6, $ 19,102 $ 7,688 $ 762 $ 6, $ 20,248 $ 8,555 $ 1,177 $ 7, $ 21,463 $ 9,497 $ 1,618 $ 7, $ 22,750 $ 10,522 $ 2,084 $ 8, $ 24,115 $ 11,636 $ 2,579 $ 8, $ 25,562 $ 12,845 $ 3,104 $ 9, $ 27,096 $ 14,158 $ 3,660 $ 9, $ 28,722 $ 15,582 $ 4,249 $ 10, $ 30,445 $ 17,125 $ 4,874 $ 11,036 Under OPM methodology, USPS pays for $4,874 of POD benefit Sample Participant A had 20 years of service under the POD in 1971 when the USPS was established, and eventually earned 30 years of combined USPS service. Under the OPM methodology, the POD is only responsible for $6,163 of Sample A s benefit. However, the portion of the retirement benefit eventually paid to Sample A that is attributable to service with the POD is $11,036. Using the more conventional method of reflecting future pay increases in determining the obligation, the POD s share of Sample A s benefit would increase by 80%.

9 Page 9 Sample Participant B 10 Years of Service at Establishment of USPS Total POD Service - Benefit for Year Service Average Pay Pension Benefit Update for Pay POD Service $ 17,000 $ 2,763 $ 2, $ 18,020 $ 3,289 $ 166 $ 2, $ 19,102 $ 3,868 $ 341 $ 3, $ 20,248 $ 4,505 $ 528 $ 3, $ 21,463 $ 5,205 $ 725 $ 3, $ 22,750 $ 5,972 $ 934 $ 3, $ 24,115 $ 6,813 $ 1,156 $ 3, $ 25,562 $ 7,733 $ 1,391 $ 4, $ 27,096 $ 8,738 $ 1,641 $ 4, $ 28,722 $ 9,837 $ 1,905 $ 4, $ 30,445 $ 11,036 $ 2,185 $ 4, $ 32,272 $ 12,344 $ 2,482 $ 5, $ 34,208 $ 13,769 $ 2,796 $ 5, $ 36,261 $ 15,320 $ 3,130 $ 5, $ 38,436 $ 17,008 $ 3,483 $ 6, $ 40,742 $ 18,843 $ 3,858 $ 6, $ 43,187 $ 20,838 $ 4,255 $ 7, $ 45,778 $ 23,003 $ 4,676 $ 7, $ 48,525 $ 25,354 $ 5,123 $ 7, $ 51,436 $ 27,904 $ 5,596 $ 8, $ 54,522 $ 30,669 $ 6,097 $ 8,860 The situation for Sample B is similar to that for Sample A, except that Sample B only has ten years of POD service at the 1971 transition date. Under the OPM methodology, the POD would only be responsible to pay $2,763 of Sample B s pension. However, the amount of Sample B s benefit attributable to POD service is $8,860. OPM expects USPS and the future USPS ratepayers to pay $6,097, or 220% of the amount POD pays, for service with the POD. Once again, under the OPM methodology, the POD is not held accountable for this increase. In both examples, the burden of this increase on past service falls directly upon the ratepayers and other stakeholders of the USPS. Conventional actuarial practice would assign these costs to the POD. Under reasonable cost methods, we would expect to see the allocation of the obligation between the POD and the USPS to be approximately pro-rated based on the relative service with each entity. For example, Sample A worked twenty of his thirty years with the POD, and the remaining ten years of service was as an employee of the USPS. We would therefore expect that under a reasonable actuarial allocation of the obligation, the POD would be responsible for twothirds (20 of 30 total years) of the cost of the benefit. However, under OPM methodology, the

10 Page 10 POD is allocated only 36% of the obligation for Participant A. At the very least, the POD s allocation should be determined using reasonable expectations for future pay. The following graphs summarize the allocation of the obligation for Participant A & B using the OPM methodology, a projected pay Cost Method Allocation, and a pro-rated allocation based on service. For Sample A, the allocation of the obligation to POD increases by roughly 75% - 85% under the two actuarial allocation approaches. For Sample B, the allocation to POD is three to four times the allocation determined by OPM. Allocation of Liability to USPS and POD - Sample A: Postal Worker with 20 Years of Service in 1971 POD Share of Obligation USPS Share of Obligation 64% 36% 33% 36% 64% 67% OPM Method Reflecting Projected Pay Service Proration Allocation of Liability to USPS and POD - Sample B: Postal Worker with 10 Years of Service in 1971 POD Share of Obligation USPS Share of Obligation 91% 71% 67% 9% 29% 33% OPM Method Reflecting Projected Pay Service Proration

11 Page 11 Lastly, at a recent fact finding meeting with the actuaries of the OPM, it was disclosed that for purposes of assessing the long term financial health of the CSRS, a dynamic actuarial model is used. In this model, the OPM actuaries affirmed their use of reasonable projections of future pay in allocating costs based on current service. If this model is appropriate for determining the overall CSRS liability, why is the use of projected pay inappropriate for the allocation of the pre obligation? CONCLUSION OPM argues that using the accrued benefit without reflecting pay increases is appropriate based on attestations of the OPM Board of Actuaries regarding similar practice in the private sector. While there may be situations where ignoring pay increases in the measurement of a pay related benefit obligation is appropriate, the unique circumstances pertaining to the establishment of the USPS requires the inclusion of projected pay in determining the POD s obligation. Had the USPS been permitted to cease participation in the CSRS, the OPM methodology of only reflecting 1971 pay may have been appropriate. However, upon its establishment, the USPS was required to continue participation in the CSRS, and as such, expensive past service pay updates would be required. This requirement for continued CSRS participation was instituted in order to bring about a seamless transition from the POD to the USPS, with no loss of benefit for participants. We argue that requiring USPS to continue participation in the CSRS, is akin to mandating a maintenance of benefits provision. As is the case for plans in the private sector, a provision of this type should effectively require the inclusion of reasonable future pay increases in the measurement of the obligation for which the POD is responsible. Although the magnitude of these increasing costs may have been misunderstood by the architects of the USPS in 1971, clearly the inequity that results from ignoring projected pay was recognized by the drafters of PL This law allowed the issue of an appropriate allocation to be revisited by the OPM. Nevertheless, a party with a vested interest in the outcome of a decision, even one with the best intentions, will be hard pressed to act in an impartial manner. While we will not address OPM s motivation for the determination of the POD allocations, we conclude that their reasoning is suspect and fails to consider generally accepted actuarial principles that pertain to these unique circumstances. We respectfully request that, in light of the concerns raised in our analysis, the United States Congress, as an impartial decision maker, address the allocation of the CSRS liability between the USPS and the POD to ensure equitable and fair treatment for all parties.

12 Page 12 Please feel free to contact us if you have any questions with regards to our analysis, or if you need any additional assistance. We look forward to continuing our work with you and your Association. Sincerely, Stanley I. Goldfarb, F.S.A., M.A.A.A., E.A. Actuary and Managing Consultant Brian A. Dailey, F.S.A., M.A.A.A., E.A. Consulting Actuary James M. Locey, M.A.A.A., E.A. Consulting Actuary