Pension Funding Stabilization State Association of County Auditors 2016 Annual Conference April 20, 2016
PANEL PARTICIPANTS Rob Larkins, Managing Director and Western Region Manager, Public Finance, Raymond James Dennis Yu, Senior Vice President, PARS Ellen Clark, Senior Managing Consultant, PFM Asset Management LLC Mary Beth Redding, Vice President and Senior Actuary, Bartel Associates
SETTING THE CONTEXT: WHY PENSIONS ARE A HOT TOPIC GASB 67-68 worked! - Despite some confusion caused by introducing a new set of metrics and nomenclature, GASB 67-68 materially improved the transparency of pension funding The transition of pension funding disclosure from the footnotes to the balance sheet, has resulted in greater focus on the scope of public agencies UAALs The primacy granted to pension plans and pensioneers in recent municipal bankruptcies compared to the shellacking experienced by unsecured bondholders has resulted in vastly greater emphasis on pension plans funded ratios, actuarial funding methodologies and plan sponsors funding policies In California, given the practical conclusion that PERS is a super-senior creditor, none of the bond insurers will insure conventional unsecured POBs (though they remain open to considering taxable lease revenue bonds whose proceeds are applied to pension funding) Bond investors remain reluctant to purchase unsecured POBs except from the most highly rated issuers
ADDRESSING PENSION FUNDING VOLATILITY Since the first dot.com bust in 2001, PERS has implemented at least 11 funding policy changes with an attendant impact on plan sponsors contribution rates As a result, plan sponsors have experienced significant contribution rate changes, which make long-range budget planning very challenging Like rate stabilization funds commonly incorporated in Enterprise Fund Revenue Bond indentures, Pension Stabilization Funds provide a tool for banking money during the good times to mitigate contribution rate shocks in the future CalPERS Changes since 2001 1. Demographic assumption changes a. 1997-2002 study i. First included in 6/30/03 valuation impacting 05/06 rates b. 1997-2007 study i. First included in 6/30/09 valuation impacting 11/12 rates ii. First study to reflect actual experience for enhanced benefit formulas c. 1997-2011 study i. First included in 6/30/14 valuation impacting 2016/17 rates. ii. Includes anticipation of future mortality improvement 2. Economic assumption changes a. Decreased discount rate from 8.25% to 7.75% i. Real rate of return remained at 4.75% ii. Inflation reduced from 3.5% to 3.0% iii. First included in 6/30/04 valuation impacting 2006/07 rates b. Decreased discount rate from 7.75% to 7.5% i. Real rate of return remains at 4.75% ii. Inflation reduced from 3.0% to 2.75% iii. First included in 6/30/11 valuation impacting 2013/14 rates 3. Risk Pools a. Adopted in 6/30/03 valuation impacting 2005/06 rates b. Modified in 6/30/13 valuation impacting 2015/16 rates i. Very significant rate increases for some agencies with little impact for others 4. Contribution policy changes a. Prior to 2004 valuation: i. 3 year rolling asset smoothing ii. 90%/110% corridor around market valuation b. Beginning with 6/30/2004 valuation: i. 15 year rolling asset smoothing ii. 80%/120% corridor around market valuation iii. Gains/losses amortized on rolling 30 year basis c. Direct rate smoothing i. Eliminated asset smoothing, using Market Value of Assets ii. Eliminated rolling amortization periods 5. Risk Mitigation Strategy a. Gradual shift to less risky
NEW TOOLS FOR PREFUNDING PENSIONS AND MITIGATING CONTRIBUTION RATE VOLATILITY Most California pension plans are under-funded (typically between 65-85% funded), resulting in increasing contribution rates New GASB 68 requirements to disclose Net Pension Liability on financial statements Previously, only way to reduce unfunded liability was to send excess contributions in excess of annual required contribution to pension system directly (if available) In response to the lack of options, new tools have been created to enable public agencies to pre-fund retirement obligations through a locally controlled trust separate and apart from the retirement system using a Section 115 Trust
SECTION 115 TRUST Section 115 Trust can be used by local governments to fund essential governmental functions Any income derived from a Section 115 Trust is tax exempt Trust can be setup as an irrevocable trust designed to pre-fund retirement plan obligations Once contributions are placed into trust, assets from the trust can only be used for retirement plan purposes Private Letter Ruling has been obtained by a Special District back in 2014 determined that pre-funding retirement obligations into an irrevocable trust is an essential governmental function
WHAT TYPE OF AGENCIES ARE ADOPTING THE SECTION 115 TRUST PROGRAM? Agencies that are very concerned about reducing their unfunded pension liability Agencies that are concerned about CalPERS/37 Act having too much assets without any input on risk tolerance level Agencies that are concerned about CalPERS/37 Act contribution volatility 7
ADVANTAGES OF PRE-FUNDING THROUGH COUNTY-CONTROLLED TRUST Complete Local Control over Assets - Account can be accessed at anytime as long as it is used to pay the employer s pension obligation Offset Net Pension Liability - Assets in the trust could lower County s Net Pension Liability under GASB 68 Pension rate stabilization - Assets can be transferred to CalPERS/37 Act plan at the County s direction, which will eliminate large fluctuations in Employer contributions and better prepare for future increases Rainy Day Fund - Emergency source of funds when Employer revenues are impaired based on economic or other conditions Lower Costs 115 Trust can have lower overall administrative and investment management costs compared to the CalPERS/37 Act pension program
POTENTIAL DISADVANTAGES County retains fiduciary responsibility over assets Add administrative complexity (i.e., burden of new program to administer) Market Volatility Could add additional pension costs to the County if CalPERS/37 Act System earns a greater net return compared to the locally controlled trust over the long term Assets are not completely accessible for any purpose, must be used only for retirement plan purposes Retirement System would not factor in contributions held in the locally controlled trust
SECTION 115 TRUST INVESTMENT FLEXIBILITY Access to a broader universe of investments than allowed by California Government Code Sec 53601, including stocks, longer-term bonds Agency has oversight responsibility for investment of the assets Agency customizes investment policy based upon risk tolerance and return objectives
INVESTMENT POLICY BEST PRACTICES Background & Purpose: Identifies the fiduciaries and purpose of the trust. Roles and Responsibilities: Defines roles of investment committee, investment advisor, custodian, and trustee, if applicable. Statement of Objectives and Investment Guidelines: Documents and establishes investment time horizon, expected long-term rate of return, asset allocation targets and ranges, risk tolerances, and performance benchmarks. Selection of Investment Managers: Describes the criteria for selecting investment managers. Guidelines for Portfolio Holdings: Clear definition of permitted and prohibited investments. Establishes the criteria for portfolio holdings in equities, fixed income, cash, and other asset classes. Control Procedures: Documents the procedure for reviewing investment objectives, investment performance, the voting of proxies, and the execution of security trades.
EFFICIENT FRONTIER BASED ON PFMAM S LONG-TERM CAPITAL MARKET ASSUMPTIONS 11 10 Emerging Markets Equity 9 International Developed Equity Domestic Equity Arithmetic Mean 8 7 6 5 Emerging Markets Debt PFMAM 50/50 Model Core Fixed Income Bank Loans PFMAM 30/70 Model Investment Grade Corporate High Yield PFMAM 70/30 Model 4 9 14 19 24 Risk: Standard Deviation
PFMAM S 2016 CAPITAL MARKET ASSUMPTIONS Forward-Looking Based on Economic Fundamentals Intermediate: Next 5 Years Long Term Projections Expected Return Expected Risk Expected Return Expected Risk US Equity 7.1% 17% 7.7% 16% International Developed Equity Emerging Markets Equity 7.3% 18% 7.7% 17% 6.5% 24% 8.1% 20% Core Bonds 1.5% 4% 5.5% 5% Intermediate Investment Grade Emerging Markets Debt 2.6% 6% 6.3% 7% 4.4% 10% 7.3% 10% High Yield 5.7% 10% 6.8% 10% Bank Loans 4.5% 6% 5.2% 6% REITs 5.5% 12% 6.4% 12% Private Equity Real Estate 6.8% 15% 7.7% 15% Commodities 3.0% 16% 5.3% 16% Hedge Funds 6.5% 15% 7.4% 15% Private Equity 9.5% 25% 9.8% 25% Cash 1.0% 1% 3.3% 1% For the intermediate term (up to 5 years), our capital market assumptions are derived from our assessment of current economic conditions, including corporate profits, balance sheets, etc., and current valuations for various asset classes. Our long-term assumptions are derived using an economic building block approach that projects economic and corporate profit growth and takes into consideration the fundamental factors driving long-term real economic growth, our expectation for inflation, productivity and labor force growth. Please refer to PFMAM s 2016 Capital Market Assumptions for a complete description of the methodology used to develop these assumptions and important disclosures.
OTHER POLICY CONSIDERATIONS Funding Policy Determined by each entity Examples: 1) Contribute any excess contribution budgeted not paid to pension system, 2) Contribute X% of budget surplus Distribution Policy May access funds at any time to pay pension contribution to pension system
WHY CONSIDER A SECTION 115 TRUST? Desire to stabilize budgetary impact of pension contributions mitigate contribution rate shocks Assets allocated to trust access broader, more diverse universe of investments Addresses GASB 68 - assets in trust directly offset net pension liability Agency retains investment control of assets asset allocation is customized
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