IPERS PENSION ANALYSIS & OVERVIEW OF OTHER STATE PENSION CHANGES

Iowa PERS Pension Analysis August 28, 2017 1 IPERS PENSION ANALYSIS & OVERVIEW OF OTHER STATE PENSION CHANGES Prepared by: Pension Integrity Project at Reason Foundation August 28, 2017 Prepared for: IPERS Benefit Advisory Committee

Iowa PERS Pension Analysis August 28, 2017 2 Unfunded Liabilities in IPERS Fiscal Years Ending 1996 to 2016, Market Value of Assets 120% $10,000 Funded Ratio 100% 80% 60% 40% 20% FYE 1996 94.6% Funded Ratio FYE 1996 $549 Million Underfunded FYE 2016 $6.3 Billion Underfunded FYE 2016 81.2% Funded Ratio $8,000 $6,000 $4,000 $2,000 $- $(2,000) Unfunded Liability Based on Market Value of Assets (Millions) 0% $(4,000) Source: IPERS Valuation Reports

Iowa PERS Pension Analysis August 28, 2017 3 Unfunded Liabilities Are More Than Just Losses from the Financial Crisis 25,000 20,000 Dow Jones Industrial Average Funded Ratio Markets have recovered but IPERS debt has not receded 140% 120% Down Jones Industrial Average Value 15,000 10,000 5,000 100% 80% 60% 40% 20% Funded Ratio 0 0% Source: IPERS Valuation Reports and Dow Jones Industrial Average Data

Iowa PERS Pension Analysis August 28, 2017 4 Unfunded Liability Costs as a Share of Government Spending Have Not Returned to Pre-Crisis Levels Unfunded Liability Amortization Payments as a Share of Government Outlays Amortization Payments as a Share of Payroll 6% 5% 4% 3% 2% 1% 0% Source: Pension Integrity Project Analysis of IPERS and NASBO Data

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Iowa PERS Pension Analysis August 28, 2017 6 The Causes of Current Pension Debt 20-Years: Actuarial Experience of IPERS, 1997 to 2016 Actuarial Value of Assets $6,000 $5,000 Increase/(Decrease) in Unfunded Liability in Millions $4,000 $3,000 $2,000 $1,000 $0 -$1,000 Starting UAAL Assumption Contribution Liability (Pension Debt) Changes Deficiency Experience Source: Pension Integrity Project Analysis of IPERS Valuation Reports Amortization Method Other Benefit Changes Investment Experience Current UAAL (Pension Debt)

Iowa PERS Pension Analysis August 28, 2017 7 The Causes of Current Pension Debt 15-Years: Actuarial Experience of IPERS, 2002 to 2016 Actuarial Value of Assets $6,000 $5,000 Increase/(Decrease) in Unfunded Liability in Millions $4,000 $3,000 $2,000 $1,000 $0 -$1,000 Starting UAAL (Pension Debt) Assumption Changes Contribution Deficiency Liability Experience Source: Pension Integrity Project Analysis of IPERS Valuation Reports Amortization Method Other Benefit Changes Investment Experience Current UAAL (Pension Debt)

Iowa PERS Pension Analysis August 28, 2017 8 The Causes of Current Pension Debt What time frame is best for analysis? No one point of reference should be considered on its own Any measurement in decades can change from year to year as the points in time change the difference in 1997 to 2016 data could be materially different from 1998 to 2017 data Past performance is not always the best measure of future performance if there have been material changes in current experience relative to the past, i.e.: Changes in the nature of market returns and interest rates Changes in demographic trends such as birth rates and mortality Measurements over various points in time should be considered together and weighed with forecasts of the future

Iowa PERS Pension Analysis August 28, 2017 9 IPERS Investment Returns Are Trending Down, At Best, There is Only a 50% Chance of Earning 7% IPERS Investments Must Target a Lower Return or Take on More Risk in the Asset Portfolio

Iowa PERS Pension Analysis August 28, 2017 10 IPERS Investment History 25% Market Valued Investment Return IPERS Assumed Investment Return Actuarially Valued Investment Return (Smoothed by Plan) 20% 15% 10% 5% 0% -5% -10% -15% -20% IPERS Average Returns 1997-2016 Market Value: 7.73% 2002-2016 Market Value: 6.59% 2007-2016 Market Value: 6.31% Source: Pension Integrity Project Analysis of IPERS Valuation Data

Iowa PERS Pension Analysis August 28, 2017 11 IPERS Investment History IPERS has historically assumed a 7.5% rate of return, and recently adopted a 7% assumed return. A 20-year analysis shows returns met expectations However, over the past 15 years the plan has averaged just a 6.59% return on a market basis (2001-02 to 2015-16) Actuarially valued returns have averaged just 6.7% since 2001-02 Market forecasts suggest the next decade will see lower returns Average Market Valued Returns 20-Years (1997-2016): 7.73% 15-Years (2002-2016): 6.59% 10-Years (2007-2016): 6.31% Average Actuarially Valued Returns 20-Years (1997-2016): 8.2% 15-Years (2002-2016): 6.73% 10-Years (2007-2016): 6.74% Note: past performance is not the best measure of future performance, but it does help provide some context to the problem created by having an excessively high assumed rate of return. Source: Pension Integrity Project analysis of IPERS valuation reports and CAFRS

August 28, 2017 Iowa PERS Pension Analysis 12 New Normal: Forecasts for Future Returns are Significantly Lower than Past Returns Image & Data Source: McKinsey & Company, Diminishing Returns: Why Investors May Need To Lower Their Expectations (May 2016)

Iowa PERS Pension Analysis August 28, 2017 13 New Normal: Market Trend Towards Risk Average Portfolio Asset Allocation Necessary for a 7.5% Expected Return Has Required Shifting from 100% Bonds to a Riskier Mix of Asset Classes 100%# 90%# 1995# 2005# 2015# 12%# Bonds# 80%# 70%# 52%# 33%# U.S.#Equi9es#Large#Cap# 60%# U.S.#Equi9es#Small#Cap# 50%# 40%# 30%# 20%# 10%# 0%# 100%# 8%# Bonds# 20%# 22%# 5%# 14%# 13%# 5%# 4%# 12%# Expected#Return###7.5%###################7.5%##################7.5%# Standard#Devia<on###6.0%###################8.9%#################17.2%# NonDU.S.#Equi9es# Real#Estate# Private#Equity# Source: Callan Associates, Wall Street Journal

Iowa PERS Pension Analysis August 28, 2017 14 IPERS Assumed Return Has Required an Increase the Relative Risk of Assets Plan Discount Rate 30-Year Treasury Yield 8% 7% 6% 5% 4% 3% 2% 1% 0% Source: Federal Reserve of St. Louis, IPERS Valuation Data

Iowa PERS Pension Analysis August 28, 2017 15 Probability Analysis: Measuring the Likelihood of IPERS Achieving Various Rates of Return Probability of Achieving the Return Wilshire (10-Years) Wilshire (30-Years) Horizon (10-Years) Horizon (20-Years) 5% 8.35% 8.52% 25% 6.41% 6.56% 50% 4.33% 5.09% 4.29% 5.21% 75% 3.78% 3.88% 95% 1.92% 1.99% Plus Inflation Assumption 1.95% 2.33% 2.16% 2.31% IPERS Old: [4.5% Real Return] + [3.0% Inflation] = 7.5% Assumed Return IPERS New: [4.4% Real Return] + [2.6% Inflation] = 7.0% Assumed Return Source: IPERS Economic Experience Study, March 2017

Iowa PERS Pension Analysis August 28, 2017 16 Probability Analysis: Measuring the Likelihood of IPERS Achieving Various Rates of Return Probability of Achieving the Return IPERS Based on BNY Mellon 10-Year Forecast IPERS Based on JP Morgan 10-15 Year Forecast IPERS Based on Research Affiliates 10-Year Forecasts 5% 6.80% 6.50% 6.25% 25% 5.10% 4.85% 4.40% 50% 3.90% 3.75% 3.10% 75% 2.75% 2.50% 1.75% 95% 1.00% 0.90% 0.00% Plus Inflation Assumption 2.2% 2.25% 2.10% IPERS Old: [4.5% Real Return] + [3.0% Inflation] = 7.5% Assumed Return IPERS New: [4.4% Real Return] + [2.6% Inflation] = 7.0% Assumed Return Source: Pension Integrity Project Monte Carlo model based on IPERS asset allocation and reported expected of returns by asset class. Forecasts of returns by asset class generally from BNYM, JPMC, and Research Affiliates were used and matched to the specific asset class of IPERS. Probability estimates are approximate as they are based on the aggregated return by asset class. For complete methodology contact Reason Foundation.

Iowa PERS Pension Analysis August 28, 2017 17 Analytical Approaches to Pension Investment Risk Risk Consideration Perspective 1: How risky should the asset portfolio be? What is an unacceptable target allocation of assets across investment vehicles that have varying degrees of risk? Risk Consideration Perspective 2: How risky should the assumed rate of return be? What is an unacceptable threshold of probability in achieving a given assumed rate of return that taxpayers and plan members should accept? Should the assumed return have at least a 25% chance of being achieved? 50%? 75%?

Iowa PERS Pension Analysis August 28, 2017 18 Estimating the Value of Liabilities By Using the Risk in Plan Assets (i.e. the Assumed Rate of Return) as a Proxy for the Discount Rate Likely Understates the True Amount of Benefits Promised By Iowa Taxpayers

Iowa PERS Pension Analysis August 28, 2017 19 Revaluing the 2016 Liabilities: Funded Ratio and Unfunded Liabilities Assuming Alternative Discount Rates IPERS Total Funded Ratio (Market Value) Unfunded Liabilities Accrued Liabilities 7.5% Discount Rate (Old Baseline) 81.82% $6.29 billion $34.62 billion 7% Discount Rate (New Baseline) 76.42% $8.75 billion $37.11 billion 6% Discount Rate 67.43% $13.70 billion $42.06 billion 5% Discount Rate 59.45% $19.34 billion $47.71 billion Note: Accrued liability figures are approximate estimates based on re-discounting the baseline accrued liability figure. Accrued liabilities for the Main, Sheriffs, and Protection plans were re-discounted separately and then combined. See Appendix for individual plans.

Iowa PERS Pension Analysis August 28, 2017 20 Revaluing 2016 Liabilities: Sheriffs Plan Funded Ratio and Unfunded Liabilities Assuming Alternative Discount Rates IPERS Sheriffs Plan Funded Ratio (Market Value) Unfunded Liabilities Accrued Liabilities 7.5% Discount Rate (Old Baseline) 93.64% $39.75 million $624.79 million 7% Discount Rate (New Baseline) 87.72% $81.89 million $666.93 million 6% Discount Rate 76.92% $175.58 million $760.63 million 5% Discount Rate 67.36% $283.52 billion $868.57 million Note: Accrued liability figures are approximate estimates based on re-discounting the baseline accrued liability figure.

Iowa PERS Pension Analysis August 28, 2017 21 Revaluing 2016 Liabilities: Protection Class Funded Ratio and Unfunded Liabilities Assuming Alternative Discount Rates IPERS Protection Plan Funded Ratio (Market Value) Unfunded Liabilities Accrued Liabilities 7.5% Discount Rate (Old Baseline) 98.39% $22.76 million $1,417 million 7% Discount Rate (New Baseline) 92.18% $118.35 million $1,513 million 6% Discount Rate 80.82% $330.89 million $1,725 million 5% Discount Rate 70.78% $575.75 million $1,970 million Note: Accrued liability figures are approximate estimates based on re-discounting the baseline accrued liability figure.

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Iowa PERS Pension Analysis August 28, 2017 23 Reform Case Studies: Michigan Teachers (2017) Why? Underperforming investment returns Back-loaded debt payments escalating (due to use of level-percent amortization method and payroll growth assumption failing to match actual experience) Prior reforms (2010, 2012) having limited effect on growth in unfunded liability amortization payments History of failing to pay the actuarially determined contribution rate What? Plan to phase-in lower assumed rate of return New choice-based retirement system (DC or DB) for new hires Lower assumed return, new amortization method, cost-sharing contribution rate policy for new-hire DB plan One-time money added to reduce unfunded liability Legislative commitment to future amortization method changes Source: Pension Integrity Project analysis of Michigan Public School Employees Retirement System and SB 401 (2017)

Iowa PERS Pension Analysis August 28, 2017 24 Reform Case Studies: Arizona Police & Fire (2016) Why? Underperforming investment returns Permanent benefit increase (PBI) program was skimming investment returns and destabilizing asset growth Prior reforms (2011) had negative effect on growth in unfunded liabilities and vesting requirements; reforms making retroactive benefit changes found unconstitutional by AZ Supreme Court What? New choice-based retirement system for new hires (DB or DC) New amortization method, cost-sharing contribution rate policy, and graded multiplier for new-hire DB plan Constitutional ballot measure to change the PBI to a pre-paid COLA that adjusts based on funded ratio Retroactive benefit improvement for post-2011 employees Change board composition to align with risks within the system and incentivize better future funding policy Source: Pension Integrity Project analysis of Arizona Public Safety Personnel Retirement System and SB 1428 & SCR1019

Iowa PERS Pension Analysis August 28, 2017 25 Reform Case Studies: Pennsylvania State & Teachers (2017) Why? Underperforming investment returns History of failing to pay the actuarially determined contribution rate Prior reforms having a limited effect on the growth in unfunded liability amortization payments What? Create new choice-based retirement system (Hybrid or DC) for new hires Cost-sharing contribution rate policy for DB component of new Hybrid plans Create commission to target savings by lowering investment fees paid to asset managers Require that any savings resulting from these changes be put back into the fund to pay down unfunded liabilities Source: Pension Integrity Project analysis of Pennsylvania Public School Employees Retirement System and Pennsylvania Public Employees Retirement System and SB 1 / Act 5 of 2017

Iowa PERS Pension Analysis August 28, 2017 26 Reform Case Studies: Limits of Recent Pension Reforms Michigan Teachers Plan to lower the assumed return requires future action by the MPSERS board, state treasurer, and legislature and that could be politically reversed Choice-based approach has a one-time option without ability to change the choice within three to five years once a teacher better understands their own career trajectory No guarantee of future amortization policy changes Arizona Police/Fire & Probation More conservative funding policy is needed and will require future action by the PSPRS board, and there is no guarantee the incentive approach will work New defined benefit plan uses the same assumed rate of return as the legacy plan, instead of starting at a lower rate Pennsylvania State and Teachers New defined benefit plans (within the DB/DC Hybrid plans) use the same assumed rate of return, amortization method, and other funding policies of the legacy plan instead of starting with better assumptions and methods Default for all members is into the max hybrid plan option instead of into the plan option that best aligns with the demographics and participation rates of each group of members within PPSERS and PSERS DC-Only plan option has just a 2% employer match, which may not be enough to ensure the plan option can provide for retirement security No plan for changes to the existing assumed return or amortization policy

Iowa PERS Pension Analysis August 28, 2017 27 Pension Reforms and Addressing the Legacy Unfunded Liability Positive Approaches to Addressing Legacy UAL Utah (2014), Oklahoma (2015) included in statute a requirement that employers make amortization payments as a percentage of total payroll; effect has been that unfunded liability amortization payments in dollars have been effectively the same as if there had been no changes Arizona Police & Fire (2016), Arizona Corrections (2017), Michigan Teachers (2017) included in statute a requirement that employers make amortization payments as a percentage of total payroll + required future UAL to be paid off over 10-year, level-dollar layered amortization bases Negative Approaches to Addressing Legacy UAL Michigan State Employees (1996), Alaska State & Teachers (2005), Kentucky State and Local (2014) made no change with respect to legacy UAL, then made limited or no changes to the assumed rate of return and amortization method + failed to pay 100% of actuarially determined rate, collectively leading to a growth in the legacy UAL Arizona Elected Officials (2013) created a fixed payment schedule for legacy UAL + no change to assumed return over time; led to insufficient funding deemed unconstitutional by trial court in 2017

Iowa PERS Pension Analysis August 28, 2017 28 The Landscape of Changes to Pension Systems Over Past 20 Years Systems creating choice-based DB or DC plans Default to DB: South Carolina State & Local (2012), Arizona Police/Fire (2016), Arizona Corrections (2017) Default to DC: Michigan Teachers (2017) Systems creating choice-based Hybrid or DC plans Utah (2014), Pennsylvania State & Teachers (2017) Systems creating DC-only plans Michigan State (1996), Alaska State (2005), Alaska Teachers (2005), Arizona Elected Officials (2013), Arizona Probation (2017) Systems creating CB-only plans Nebraska State (2002), Nebraska Local (2002), Kansas State (2012), Kentucky State & State Police (2014), Kentucky Local (2014) Systems creating Hybrid-only plans Oregon State & Teachers (2003), Georgia State (2008), Rhode Island State & Teachers (2011), Virginia (2012), Tennessee (2013) Note: The Arizona Corrections Officers Retirement System was divided into two tiers prospectively, subsequently known as the Corrections and Probation tiers. As a result of the 2017 reform for

Iowa PERS Pension Analysis August 28, 2017 29 Objectives of Good Reform Keeping Promises: Ensure the ability to pay 100% of the benefits earned and accrued by active workers and retirees Retirement Security: Provide retirement security for all current and future employees Predictability: Stabilize contribution rates for the long-term Risk Reduction: Reduce pension system exposure to financial risk and market volatility Affordability: Reduce long-term costs for employers/taxpayers and employees Attractive Benefits: Ensure the ability to recruit 21st Century employees Good Governance: Adopt best practices for board organization, investment management, and financial reporting

Iowa PERS Pension Analysis August 28, 2017 30 Questions? Pension Integrity Project at Reason Foundation Anthony Randazzo, Managing Director anthony.randazzo@reason.org Len Gilroy, Senior Managing Director leonard.gilroy@reason.org Daniel Takash, Policy Analyst daniel.takash@reason.org