Legislative Testimony - PDF Free Download

Agenda Investment Return Assumption Mortality Assumption Re amortization Impact p on Teacher Salaries Sources of Savings 2

Purpose of Experience Study Assumptions are not static; they should occasionally change to reflect New information Mortality improvement Changing patterns of retirements, terminations, etc. Changing knowledge Recent experience provides strong guidance for some assumptions (for example, turnover) and weak guidance for others (for example, the investment return rate) Based on results of our experience study: Actuary recommends revised assumptions Board considers recommendations for adoption In April, Board adopted dall of our recommendations 3

Actuarial Standards of Practice Guidelines for the assumption setting process are set by the Actuarial Standards of Practice ASOP #4 Measuring Pension Obligations i ASOP #27 Selection of Economic Assumptions ASOP #35 Selection of Demographic and Other Noneconomic Assumptions ASOP #44 Selection and Use of Asset Valuation Methods 4

General Findings The funded ratio has trended down over the last decade Mostly due to investment performance, but also liability experience Contribution rates have correspondingly trended up sharply, and are expected to continue to do so Assumptions have already been strengthened in 2003 and 2006 Future economic growth likely to be suppressed compared to historical levels and current assumptions Current inflation, wage inflation, payroll growth, and investment return rate need to be lowered Retirees are living longer National trends have turned up Rhode Island experience confirms this trend Increases in life expectancy likely to continue Most of the other assumptions continue to be appropriate 5

Investment Return Assumption The most important assumption in the process The prior assumption was 8.25% Represents the return, net of all administrative and investment expenses Equals 3.00% inflation plus 5.70% real return (8.70% gross), less 0.45% for investment and administrative expenses We recommended changing the inflation to 2.75%, so that alone lowers nominal assumption to 8.00% before any adjustments to real return assumption 2.75% + 5.25% (net of expenses) We then recommended change in real return to reduced nominal assumption to 7.50% 2.75% + 4.75% (net of expenses) 6

Inflation Prior assumption was 3.00% Observations Actual average increase over the last 25 years is 2.81% Investment firms: 2.02% 3.00% Social Security Trustee s Report: 2.80% (intermediate) TIPs vs. Nominal US Treasuries: 2.54% Professional forecasters: 2.40% average We recommended decreasing to 2.75% Closer to levels expected in the bond market and professional forecaster estimates 7 Data as of Spring 2011

Retirement Systems that Recently Changed their Assumption Retirement System Prior New Change Arizona PS 8.50% 8.25% 0.25% Colorado PERA 8.50% 8.00% 0.50% Pennsylvania SERS 8.50% 8.00% 0.50% California STRS 8.00% 7.75% 0.25% Hawaii ERS 8.00% 7.75% 0.25% Illinois (ERS & URS) 8.50% 7.50% 1.00% Rhode Island ERS 8.25% 7.50% 0.75% Colorado FPPA 8.00% 7.50% 0.50% NY State and Local ERS 8.00% 7.50% 0.50% Wisconsin Retirement System 7.80% 7.20% 0.60% Indiana TRS 7.50% 7.00% 0.50% Virginia Retirement System 7.50% 7.00% 0.50% Indiana PERF 7.25% 7.00% 0.25%% 8 All of the above changes were made in 2010 or 2011.

Real Return (Above Inflation) Below is ERSRI s current target asset allocation as well as the plan s target allocation in effect during the prior assumption review Asset Category 2010 Target Asset Allocation PCA Expected Return for Asset Class Domestic Equities 36.0% 8.75% International Equities 17.5% 9.00% Domestic Fixed Income 22.0% 3.30% Real Estate 5.0% 7.00% Alternative (Private Equity) 7.5% 12.00% Real Return 10.0% 6.50% Cash and Cash Equivalent 2.0% 3.00% Total 100.0% 7.41% 9

10 Last 30 years was a Historic Bond Bull Market and Current Bond Yields at Historical i Lows 18% 16% 14% 12% 10% 8% 6% 4% 2% History of 10 Year Treasury Yield 0% 1981 07 1986 07 1991 07 1996 07 2001 07 2006 07 2011 07 With 24% of allocation in Fixed Income and Cash with a target return of 3.00% 3.30%, 30% to achieve 8.25% total portfolio return, the other 76% of the portfolio would have to achieve returns of approximately 10.40% per year, net of expenses

Historical P/E Ratios 11 Current valuations are average at best, while 30 years ago they were historically low

Real Return (Above Inflation) To analyze the expected real return, we combine: The plan s target asset allocation with Economic capital market expectations We used the most recent capital market return assumptions developed by seven investment consulting firms: Callan JP Morgan PCA (ERSRI s consultant) Hewitt Ennis Knupp R. V. Kuhns Towers Watson NEPC 12

Real Return (Above Inflation) Average net real return for the assumptions from the seven consulting firms is 4.84% Investment Consultant 1 2 3 4 5 6 7 Avg. Real Return 4.66% 4.90% 5.08% 5.33% 5.37% 5.52% 5.84% 5.24% Expected Plan Expenses (0.40%) (0.40%) (0.40%) (0.40%) (0.40%) (0.40%) (0.40%) (0.40%) Net Real Return 4.26% 4.50% 4.68% 4.93% 4.97% 5.12% 5.44% 4.84% Anticipated Inflation 2.75% 2.75% 2.75% 2.75% 2.75% 2.75% 2.75% 2.75% Net Investment Return 7.01% 7.25% 7.43% 7.68% 7.72% 7.87% 8.19% 7.59% Based on the numbers above, 7.59% becomes the top end of the reasonable range for this assumption Prior 5.25% real return assumption only supported by one assumption set Prior 8.25% nominal assumption not supported by any of the assumption sets 13 Note: Returns represent arithmetic averages.

Real Return (Above Inflation) Investment returns are uncertain and volatile. Therefore, it is also important tto review the expected distribution ib ti of returns based on the capital market assumptions Below is a table with the 25 th to 75 th percentile range of the expected long term return, the best estimate range. Return Percentile Return Components 25th 50th 75th (1) (2) (3) (4) Real Return 2.73% 4.54% 6.37% Plan Expenses -0.40% -0.40% -0.40% Expected Inflation 2.75% 2.75% 2.75% Net Investment Return 5.08% 6.89% 8.72% Note: Return percentiles are the averages for the seven firms of the returns compounded over 20 years 14 Based on the numbers above, 6.89% becomes the bottom end of the reasonable range for this assumption Note: The probability of exceeding an average return of 8.25% over a 20 year period is only 31%.

Actuary Recommendation Therefore, GRS recommended decreasing the current net investment t return assumption from 8.25% to 7.50% Due to differences in time horizon, we were comfortable to be at the high end of the arithmetic (7.59%) and geometric (6.89%) return estimates using capital market assumptions Development of the Return Assumption Current Recommended Change Inflation 3.00% 2.75% (0.25%) Real Return 5.25% 4.75% (0.50%) Net Nominal Return 8.25% 7.50% (0.75%) 15

Post retirement mortality Life expectancies in Rhode Island (in New England in general) are among the longest in the country Approximately age 78, when measured from birth The pension plan does not measure life expectancy from birth, however, it measures it from retirement age (benefit commencement) For consistency, we typically use age 65 Therefore, in our report, when it is disclosed that the life expectancy for Male Employees is 83.8, that is for a member who has already lived to age 65 Traditionally for this assumption, setting a static assumption with a 10% and 20% margin was preferred to allow for future increases in life expectancy State Employees are combined with MERS for this purpose Separate assumption for Teachers 16

Life Expectancy by State (Measured from Birth) Rank State Life Expectancy Rank State Life Expectancy 1 Hawaii 80.0 11 Vermont 78.2 2 Minnesota 78.8 12 Colorado 78.2 3 Utah 78.77 13 Washington 78.2 4 Connecticut 78.7 14 Wisconsin 77.9 5 Massachusetts 78.4 15 Idaho 77.9 6 New Hampshire 78.3 16 Nebraska 77.8 7 Iowa 78.3 17 Oregon 77.8 8 North Dakota 78.3 18 South Dakota 77.7 9 Rhode Island 78.3 19 New York 77.7 10 California 78.2 20 Maine 77.6 17 Source: http://www.businessweek.com/bwdaily/dnflash/content/sep2006/db20060913_099763.htm

Post retirement mortality Prior assumption for State Employees and MERS was based on the 1994 Group Annuity Mortality Table Rates are then adjusted to fit Rhode Island s observed experience Assumption for Teachers based on a GRS developed table specific to teachers Rates are also adjusted to fit experience Overall, actual experience has overtaken all margin for future improvement in life expectancy Assumptions in prior experience study included a 10% margin This trend has been consistent across most of our clients and disclosed in recent national surveys It is becoming more widely accepted that the trend of everincreasing life expectancies is likely to continue 18

Post retirement Mortality Life Expectancy has been increasing across the country 1 25.0 20.0 15.0 10.0 5.0 0.0 15.8 Life Expectancy in Years, Current Age 65 16.8 13.0 13.0 18.4 19.0 19.1 14.2 Retirees of ERSRI have shown this same pattern 15.1 16.1 20.0 17.3 1960 1970 1980 1990 2000 2009 Group Public School District Employees General Employees Gender Males Females Males Females Life Expectancy at Age 65 (Years) Experience from 2000-2006 18.9 21.5 16.4 20.2 Experience from 2004-2010 20.1 22.6 18.0 21.2 Increase in Life Expectancy +1.2 +1.1 +1.6 +1.0 Male Female 19 1 Source: National Vital Statistics Reports, Vol 58, No 21, June 2010, National Vital Statistics Reports, Vol 59, No 4, March 2011

Actuarial Standard of Practice No. 35 Selection of Demographic and Other Noneconomic Assumptions for Measuring Pension Obligations From Background Section: As mortality rates have continued to decline over time, concern has increased about the impact of potential future mortality improvements on the magnitude of pension commitments. Section 3.5.3 of current ASOP No. 35 lists the likelihood and extent of mortality improvement in the future as a factor for the actuary to consider in selecting a mortality assumption. In the view of many actuaries, the guidance regarding mortality assumptions should more explicitly recognize estimated future mortality improvement as a fundamental and necessary assumption, and the actuary s provision ii for such improvement should ldbe disclosed d explicitly itl and transparently. tl From Section 3.5.3: Mortality and Mortality Improvement Assumptions The actuary should consider factors such as the following in the selection of both mortality and mortality improvement assumptions: the actuary should consider the effect of mortality improvement both prior to and subsequent to the measurement date. With regard to mortality improvement, the actuary should do the following: i. adjust mortality rates to reflect mortality improvement prior to the measurement date. For example, if the actuary starts with a published mortality table, the mortality rates ae may need to be adjusted to reflect e mortality improvement from the effective date of the table to the measurement date. Such an adjustment is not necessary if, in the actuary s professional judgment, the published mortality table reflects expected mortality rates as of the measurement date. 20 ii. include an assumption as to expected mortality improvement after the measurement date. This assumption should be disclosed in accordance with section 411 4.1.1, even if the actuary concludes that an assumption of zero future improvement is reasonable as described in section 3.1. Note that the existence of uncertainty about the occurrence or magnitude of future mortality improvement does not by itself mean that an assumption of zero future improvement is a reasonable assumption.

Post Retirement Mortality Average Life Expectancy in Years from Current Age 65 30.0 25.0 20.0 15.0 10.00 5.0 18.0 18.2 18.8 19.6 20.3 22.5 23.0 22.7 21.2 21.6 22.1 20.1 20.7 21.4 22.1 22.6 23.4 24.2 24.8 25.3 Ml Male Statet Female State t Ml Male Teacher Female Teacher Actual 2004 2010 Proposed Static Assumption (2010) Proposed Projected Assumption, Baseline 2010 Proposed Projected Assumption, Baseline 2020 Proposed Projected Assumption, Baseline 2030 21

Mortgage Illustration 19 Year, Level Dollar Amortization Amortization Actual UAAL UAAL UAAL Amortization i Payment Rate of Contribution i Toward Towards (Market) Time Market Deferred Smoothed Period Factor Calculated Payroll Payroll Dollars Interest Principal /Payroll (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (2) (3) (4) / (6) (7) / (8) (8) * (9) (4) * 7.5% (10) (11) (2) / (8) 0 1,000 1,000 19 9.97 100 2,500 4.01% 100 75 25 40.0% 1 975 975 18 9.71 100 2,500 4.01% 100 73 27 39.0% 2 947 947 17 9.44 100 2,500 4.01% 100 71 29 37.9% 3 918 918 16 9.15 100 2,500 4.01% 100 69 32 36.7% 4 887 887 15 8.83 100 2,500 4.02% 100 66 34 35.5% 5 853 853 14 8.49 100 2,500 4.02% 100 64 36 34.1% 6 816 816 13 8.13 100 2,500 4.02% 100 61 39 32.7% 7 777 777 12 7.74 100 2,500 4.02% 100 58 42 31.1% 8 735 735 11 7.32 100 2,500 4.02% 100 55 45 29.4% 9 690 690 10 6.87 100 2,500 4.02% 100 52 49 27.6% 10 641 641 9 6.38 100 2,500 4.02% 100 48 52 25.6% 11 589 589 8 5.86 100 2,500 4.02% 100 44 56 23.5% 12 532 532 7 5.30 100 2,500 4.02% 100 40 61 21.3% 13 472 472 6 4.69 100 2,500 4.02% 100 35 65 18.9% 14 407 407 5 4.05 100 2,500 4.02% 100 30 70 16.3% 15 337 337 4 3.35 100 2,500 4.02% 100 25 75 13.5% 16 261 261 3 2.60 101 2,500 4.02% 101 20 81 10.5% 17 180 180 2 1.80 101 2,500 4.02% 101 14 87 7.2% 18 94 94 1 0.93 101 2,500 4.02% 101 7 94 3.7% 19 0 22 $1,000 liability at time 0

Mortgage Illustration 19 Year, Level Percentage of Payroll UAAL UAAL Amortization Amortization Payment Amortization Rate of Actual Contribution Toward Towards UAAL (Market) Time Market Deferred Smoothed Period Factor Calculated Payroll Payroll Dollars Interest Principal /Payroll (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (2) (3) (4) / (6) (7) / (8) (8) * (9) (4) * 7.5% (10) (11) (2) / (8) 0 1,000 1,000 19 13.08 76 2,500 3.06% 76 75 1 40.0% 1 999 999 18 12.59 79 2,594 3.06% 79 75 4 38.5% 2 994 994 17 12.08 82 2,691 306% 3.06% 82 75 8 36.9% 3 986 986 16 11.56 85 2,792 3.06% 85 74 11 35.3% 4 975 975 15 11.01 89 2,897 3.06% 89 73 15 33.7% 5 960 960 14 10.45 92 3,005 3.06% 92 72 20 31.9% 6 940 940 13 9.86 95 3,118 3.06% 95 70 25 30.1% 7 915 915 12 9.25 99 3,235 3.06% 99 69 30 28.3% 8 885 885 11 8.62 103 3,356 3.06% 103 66 36 26.4% 9 848 848 10 7.97 106 3,482 3.06% 106 64 43 24.4% 10 806 806 9 7.29 110 3,613 3.06% 110 60 50 22.3% 11 756 756 8 6.59 115 3,748 3.06% 115 57 58 20.2% 12 698 698 7 5.87 119 3,889 3.06% 119 52 67 17.9% 13 631 631 6 5.12 123 4,034 306% 3.06% 123 47 76 15.6% 14 555 555 5 4.34 128 4,186 3.06% 128 42 86 13.3% 15 469 469 4 3.53 133 4,343 3.06% 133 35 98 10.8% 16 371 371 3 2.69 138 4,506 3.06% 138 28 110 8.2% 17 261 261 2 1.83 143 4,675 3.06% 143 20 123 5.6% 18 138 138 1 0.93 148 4,850 3.06% 148 10 138 2.8% 19 0 23 $1,000 liability at time 0, payroll grows at 3.75% per year

Mortgage Illustration 30 Year, Level Percentage of Payroll UAAL UAAL Amortization Amortization Payment Amortization Rate of Actual Contribution Toward Towards UAAL (Market) Time Market Deferred Smoothed Period Factor Calculated Payroll Payroll Dollars Interest Principal /Payroll (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (2) (3) (4) / (6) (7) / (8) (8) * (9) (4) * 7.5% (10) (11) (2) / (8) 0 1,000 1,000 30 17.48 57 2,500 2.29% 57 75 (18) 40.0% 1 1,018 1,018 29 17.14 59 2,594 2.29% 59 76 (17) 39.2% 2 1,035 1,035 28 16.80 680 62 269 2,691 229% 2.29% 62 78 (6) (16) 38.5% 3 1,051 1,051 27 16.44 64 2,792 2.29% 64 79 (15) 37.6% 4 1,066 1,066 26 16.07 66 2,897 2.29% 66 80 (14) 36.8% 5 1,079 1,079 25 15.69 69 3,005 2.29% 69 81 (12) 35.9% 6 1,091 1,091 24 15.29 71 3,118 2.29% 71 82 (10) 35.0% 7 1,102 1,102 23 14.88 74 3,235 2.29% 74 83 (9) 34.1% 8 1,111 1,111 22 14.46 77 3,356 2.29% 77 83 (6) 33.1% 9 1,117 1,117 21 14.02 80 3,482 2.29% 80 84 (4) 32.1% 10 1,121 1,121 20 13.56 83 3,613 2.29% 83 84 (1) 31.0% 11 1,122 1,122 19 13.08 86 3,748 2.29% 86 84 2 29.9% 12 1,121 1,121 18 12.59 89 3,889 2.29% 89 84 5 28.8% 13 1,116 1,116 17 12.08 92 4,034 2.29% 92 84 9 27.7% 14 1,107 1,107 16 11.56 96 4,186 2.29% 96 83 13 26.5% 15 1,095 1,095 15 11.01 99 4,343 2.29% 99 82 17 25.2% 20 952 952 10 7.97 119 5,220 2.29% 119 71 48 18.2% 25 623 623 5 4.34 144 6,275 2.29% 144 47 97 9.9% 30 0 7,544 0.00% 0.0% 24 $1,000 liability at time 0, payroll grows at 3.75% per year

Mortgage Illustration 25 Year, Level Percentage of Payroll UAAL UAAL Amortization Amortization Payment Amortization Rate of Actual Contribution Toward Towards UAAL (Market) Time Market Deferred Smoothed Period Factor Calculated Payroll Payroll Dollars Interest Principal /Payroll (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (2) (3) (4) / (6) (7) / (8) (8) * (9) (4) * 7.5% (10) (11) (2) / (8) 0 1,000 1,000 25 15.69 64 2,500 2.55% 64 75 (11) 40.0% 1 1,011 1,011 24 15.29 66 2,594 2.55% 66 76 (10) 39.0% 2 1,021 1,021 23 14.88 69 2,691 2.55% 69 77 (8) 37.9% 3 1,029 1,029 22 14.46 71 2,792 2.55% 71 77 (6) 36.9% 4 1,035 1,035 21 14.02 74 2,897 2.55% 74 78 (4) 35.7% 5 1,039 1,039 20 13.56 77 3,005 2.55% 77 78 (1) 34.6% 6 1,040 1,040 19 13.08 79 3,118 2.55% 79 78 1 33.4% 7 1,039 1,039 18 12.59 82 3,235 2.55% 82 78 5 32.1% 8 1,034 1,034 17 12.08 86 3,356 2.55% 86 78 8 30.8% 9 1,026 1,026 16 11.56 89 3,482 2.55% 89 77 12 29.5% 10 1,014 1,014 15 11.01 92 3,613 2.55% 92 76 16 28.1% 11 998 998 14 10.45 96 3,748 2.55% 96 75 21 26.6% 12 977 977 13 9.86 99 3,889 2.55% 99 73 26 25.1% 13 952 952 12 9.25 103 4,034 2.55% 103 71 31 23.6% 14 920 920 11 8.62 107 4,186 2.55% 107 69 38 22.0% 15 882 882 10 7.97 111 4,343 2.55% 111 66 45 20.3% 20 577 577 5 4.34 133 5,220 2.55% 133 43 90 11.1% 25 0 25 $1,000 liability at time 0, payroll grows at 3.75% per year

Re amortization Impact on UAAL Projected UAAL $4,000,000,000 UAAL in 2010: UAAL in 2025: $2.68B $3.28B $3,500,000,000 53% funded ratio UAAL in 2031: $3,000,000,000 $2.68B 64% funded ratio $2,500,000,000 $2,000,000,000 $1,500,000,000 80% funded ratio in 2036 $1,000,000,000 $500,000,000 $ 2010 2015 2020 2025 2030 2035 Current Provisions, 19 Year Amortization Current Provisions, 30 Year Amortization Proposed Provisions, 19 Year Amortization Proposed Provisions, 25 Year Amortization 26 State Employees Only

$1,400.0 $1,200.0 $1,000.0 Re amortization Total lcontribution i Dollars $17.0 B Projected Contributions $ in millions Cost of Re-amortization: Current Provisions to 30 years: $7.2B Proposed Provisions to 25 years: $1.8B $24.2 B $800.0 $600.0 $400.0 $200.0 0 $12.2 B $14.0 B $ 2010 2015 2020 2025 2030 2035 2039 Current Provisions, 19 Year Amortization Proposed Provisions, 19 Year Amortization Current Provisions, 30 Year Amortization Proposed Provisions, 25 Year Amortization 27 State and Teachers Combined

Re amortization Discounted for Inflation $800.0 $700.0 Projected Contributions in Todayʹs Dollars $ in millions Cost of Re-amortization: Current Provisions to 30 years: $2.7 Proposed Provisions to 25 years: $0.8B $600.0 $12.6 B $500.0 $15.3 B $400.0 $300.0 $200.0 $100.0 $8.8 B $9.6 B $ 2010 2015 2020 2025 2030 2035 2039 Current Provisions, 19 Year Amortization Proposed Provisions, 19 Year Amortization Current Provisions, 30 Year Amortization Proposed Provisions, 25 Year Amortization 28 State and Teachers Combined, assumes 2.75% inflation per annum

Impact on Teacher Salaries Salary Fiscal Year Ending June 30, Current RI RSA Difference Pct Increase (1) (2) (3) (4) (5) 2011 $ 989 $ 989 $ 00% 0.0% 2012 1,021 1,021 0.0% 2013 1,055 1,055 0.0% 2014 1,090 1,090 0.0% 2015 1,126 1,130 3 0.3% 2018 1,241 1,244 3 0.2% 2021 1,367 1,378 12 0.8% 2024 1,503 1,540 37 2.5% 2027 1,665 1,734 69 4.1% 2030 1,850 1,928 79 4.3% 2033 2,069 2,129 60 2.9% 2036 2304 2,304 2350 2,350 46 20% 2.0% 2039 2,567 2,596 29 1.1% 29

Sources of Change in UAAL State Employees and Teachers Description UAAL ($M) UAAL savings ($M) FY2013 Employer Contribution FY 2013 Savings ($M) Current Provisions 6,833 615 Change in COLA Provisions 2,300 200 Change in Retirement Eligibilities 400 45 All Other Changes 300 35 RI RSA 3,929 2,905 353 262 30 Numbers above are rounded estimates Removing one change has a domino impact on other changes

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