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Is Actuarial Funding Good Enough?Trustee Education Session

Gregory M. Curran, FCA, MAAA, ASA, EAConsulting ActuaryG. S. Curran & Company, Ltd.10555 N. Glenstone PlaceBaton Rouge, Louisiana 70810(225)769-4825

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The Promises Embedded in LawLouisiana statutes make promises to members of our public employee

retirement systems regarding payments that will be made under many different scenarios:Retirement – a lifetime monthly benefitDisability – a monthly benefit until retirement eligibility or, in some

circumstances, a lifetime monthly benefitVested Termination – a lifetime monthly benefit to begin upon reaching

a particular ageNon-Vested Termination – a refund of employee contributionsDeath – a variety of potential benefits from a refund of contributions

payable to the family of the deceased to a lifetime of benefits payable to a named beneficiary or spouse.

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Funding the promisesIn order to financially support the promises made by a

retirement system, plans must collect contributions (from employees, employers, tax sources) and earn investment returns on plan assets.

The question for stakeholders is what is the appropriate level of contributions to build up enough assets to meet the obligations detailed by statute.

The Louisiana constitution answers this question by stating that public retirement systems in the State must be actuarially funded.

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What does the Louisiana Constitution Say?The actuarial soundness of state and statewide retirement

systems shall be attained and maintained and the legislature shall establish, by law, for each state or statewide retirement system, the particular method of actuarial valuation to be employed for purposes of this Section.

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Actuarial Funding BasicsEach actuarial funding method determines a minimum

level of contribution to fund benefits over a “reasonable period” either determined by the demographics of the plan or by a preset funding policy set in statute or by the Board of Trustees responsible for the plan.

Actuarial funding will provide sufficient assets to pay benefits if the population is stable and the assumptions embedded within the actuarial model are reasonable.

Minimum actuarial contributions must include:

1. Payment of the normal cost to account for the cost of an additional year of service accrual for all members

2. Payment of an amount sufficient to pay off any unfunded accrued liability computed under the funding method being used

3. Payment of an amount necessary to offset the year’s administrative cost

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Minimum actuarial funding as a concept is based upon the funding method, amortization period for any unfunded accrued liability, and any actuarial assumptions.

Given this fact, there are a range of possible contribution levels that can result based upon the method and assumptions selected to best fund the benefits of the system.

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A plan that always collects the minimum actuarial contribution will be funded properly in the long run if assumptions are set properly.

Despite this fact, the question remains - How much volatility will there be in the required contribution rate in times where the actual experience differs with the assumptions?

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The required contributions will only remain level if all assumptions are met.

This leads to a particular problem - Although assumptions are set at a level deemed to be appropriate over the long-term, when contributions are reset annually based upon the results of an actuarial valuation, requirements can change significantly in the short to medium term as gains and losses affect the level of required contributions.

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A look at plan rates of return over the past forty years shows us that plans don’t earn the average every year. Instead, plans go through periods of outperformance and periods of underperformance.

● It’s important to consider that, if the employer contribution rate decreases due to gains, it would be expected that there will also be future years where rates will increase due to losses.

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Over the period from 1986 to the present, the stock market (represented here by the S&P 500) may have averaged about 8%, but it certainly saw periods of significant outperformance and periods of significant underperformance.

Consider This:

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During periods of outperformance, is there a tendency to increase benefits? To offer more cost of living increases to retirees? This was certainly true in the late 1990’s.

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Louisiana’s constitution states that the accrued benefits of members of any state or statewide public retirement system shall not be diminished or impaired.

This means that there are limitations on undoing what was added in the “good times” when the system faces increasing costs.

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How can a plan prepare in periods of outperformance?

If statutes state simply that the plan must collect the actuarially required contribution, in good times employers may enjoy some relief, but they have to deal with cost increases in bad times with little ability to impact costs.

This leads to a natural conflict between employer budgets and proper actuarial funding.

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Boards, and/or legislators, may feel pressure to look for a way to manage results in an attempt to exert some control on costs to employers in rising contribution rate periods.

This can lead to conflict related to maintaining appropriate assumptions and amortization periods.

Actuarial assumptions set properly are not driven by a desire for a particular outcome. Instead, the proper contribution level comes from plan demographics, plan provisions, and assumptions set based upon actuarial standards and an ultimate goal of plan solvency.

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What can be done about the cycle of Employer Contribution Rate Changes?

Historically, legislation has been changed to defer cost increases in reaction to times of stress on employer budgets.

Collecting less cannot actually fix the problem.

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One Solution:By asking employers to pay more than the minimum

actuarial contribution (especially during periods where the employer rate is declining), and holding these additional contributions in a side fund which is excluded from the determination of the minimum actuarial contribution, these funds can be used during periods of increasing minimum contributions.

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Despite the volatility in the markets between 1986 and 2015, the average return looks a lot like the long-term assumed rates of return. If systems could have held the employer contribution rate above the minimum rates as excess returns in the late 1990’s caused minimum contribution rates to decline, they could have better managed the difficulties that occurred in 2000 and 2008.

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A number of systems have enacted legislation to allow such a side fund. In Louisiana, it is called the Funding Deposit Account.

By collecting more than the minimum actuarially required contributions and holding those excess contributions in a side fund, Boards give themselves the ability to manage the difficult times.

These funds have been used to pay off unfunded accrued liabilities, to reduce the long-term cost of the plan, or to offset employer contributions on a year by year basis.

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● Changes to the Funding Deposit Account statute in 2015 will allow some systems to prefund cost of living increases by using this side fund. Funds can be collected from employers to cover the cost of the COLA before the COLA is granted. By releasing the present value of the cost of living benefits granted at the time the COLA is granted, the employer contribution rate can be protected from increases directly due to the COLA.

● In the end, this is simply one possible structure to allow the Boards of Trustees or the legislature to better manage the employer contribution rate changes inherent within a defined benefit pension plan.

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In Summary:From a theoretical perspective, collecting the actuarially

required contribution will always fund the plan if assumptions are met. However, from the practical standpoint, maintaining actuarially required contributions in times of economic stress produces pressure to reverse engineer changes in assumptions and methods to lower contribution requirements.

Accumulation of reserve side funds can mitigate this pressure to reset assumptions and methods for the sake of expediency.