pension funding white paper final

8/20/2019 Pension Funding White Paper Final

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AN EVIDENCE-BASED APPROACH TO

PENSION FUNDING REFORM

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Te state’s current payment schedule or paying off ununded liabilities in the state’s two largest pension systems, theState Employees’ Retirement System (SERS) and the eachers’ Retirement System (RS) is unsustainable. Te annualincreases in Annual Required Contributions (ARC) have outpaced revenue growth in recent years and the trend isexpected to continue throughout the remaining years o the current amortization schedule. ARC payments to meetoutstanding ununded liabilities under the current actuarial unding policy will become increasingly volatile as the endo the current amortization period approaches in FY 2032. Te rapidly rising ARC payments have contributed to thestate’s budget instability in recent years and the problem projects to grow more acute. Reorming the unding policyor SERS and RS now can bring greater predictability to uture ARC payments, thereby improving long-term budget

stability.

Te Office o the State Comptroller has worked with actuaries and pension experts to analyze various reorms to ouractuarial unding policy or the SERS system. Te analysis ocuses specifically on SERS because the Comptrolleradministers SERS benefits and is the administrative home to the policy board that oversees the program, theConnecticut State Employees Retirement Commission (Retirement Commission). Te Comptroller is also an ex-officiomember o the Retirement Commission. Funding scenarios or RS were not included as the Comptroller’s office hasno direct relationship to RS.

Te goal o the analysis was to determine a responsible, evidence-based and prudent pension unding reorm option

that utilizes accepted actuarial principles and best practices or pension unding policy. o that end, this report detailsthree pension unding scenarios, as well as a baseline scenario that shows current unding methodology or comparison.All o the scenarios analyzed retain all retirees in the existing StateEmployees’ Retirement Fund with benefits preunded through employerand employee contributions. In addition, all scenarios utilize closedamortization periods, setting a date certain by which current UAAL

will be paid off. In addition, scenarios were developed and analyzed inaccordance with their ability to meet the ollowing core principles:

• Ensuring adequate payments to meet obligations,

• Achieving cost stability and predictability,• Maximizing investment returns to offset uture state obligations,

and

• Preserving and strengthening the state’s bond rating

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PAGE 1JANUARY 14, 2016

Te goal of the analysis was to determa responsible, evidence-based and prudent pension funding reform

option that utilizes accepted actuari

principles and best practices for pens funding policy.

“

Kevin Lembo Office of the State Comptroller


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KEVIN LEMBO OFFICE OF THE STATE COMPTROLLER

AN EVIDENCE-BASED APPROACH TO PENSION FUNDING REFORM

Ensuring adequate payments to meet obligations

Achieving cost stability and predictability

New unding policies or our state’s major pension plans must require adequate ARC payments to pay off the state’sununded actuarial accrued liabilities (UAAL) in a reasonable time period. Our current unding policy established ARC

payments that were too low to reduce the UAAL in the early years o the amortization period, resulting in a growing,

rather than declining, UAAL despite the state ofen paying most or the entire ARC. Te result is back-loaded paymentsthat are now rising rapidly as the end o the amortization period approaches. A new unding policy should establishARC payments adequate to reduce UAAL throughout the amortization period and pay off existing and new UAAL in areasonable time rame.

Cost stability and predictability, in particular, must be the ocus o any conversation about Connecticut’s budget, tax policy and – in this case – pension unding. Te significant annual increases required by our actuarial unding policy and

amortization schedule result in pension obligations that are growing as a percentage o total state expenditures. Pension payments or SERS and RS, including payments toward pension obligation bonds or RS, accounted or 12 percento the state General Fund budget in FY 2015 and the percentage is growing annually. Te growing pension obligationsrequire reductions elsewhere in the budget or increases in revenue to cover the growing costs.

In addition to the projected growth in ARC payments over the remaining term o the amortization schedule, thecalculated ARC payments are subject to significant volatility due to the state’s current actuarial unding policy andadopted actuarial assumptions. Currently, all actuarial gains and losses are incorporated into the initial amortizationschedule. Tis approach can result in significant

volatility in ARC payments as the end o theamortization schedule approaches (see attachment

I). Moreover, the actuarial assumptions currentlyutilized by the plan, specifically an overly aggressiveinvestment return assumption, increase the likelihoodactuarial losses will occur in the uture. Actuariallosses that result rom missed projections will requirehigher ARC payments than currently projected.

Reorming the pension unding policy presents a significant opportunity to improve cost stability and predictabilityin the ARC payments and, as a consequence, the state budget at large. Strategies or reducing the volatility in ARC

payments should be incorporated into any actuarial unding policy reorm considered. wo important considerationsare 1) adopting more conservative actuarial assumptions in order to reduce the risk o actuarial losses rom missedassumption targets and 2) adopting a layered fixed-period amortization o either 15 or 20 years or actuarial gainsand losses to moderate the impacts o actuarial gains and losses over time on ARC payments. Layered fixed-periodamortization would amortize annual actuarial gain and losses incurred over a closed amortization period on theirown closed-fixed amortization schedule. By amortizing gains and losses over a longer period the annual impact onARC payments is lessened and, over time, assuming reasonable actuarial assumptions and disciplined payments by thelegislature, gains and losses are likely to even out, urther reducing the volatility o ARC payments. For more detail andan example o the utility o layered fixed-period amortization or gains and losses, see attachment I.

GOALS

• Ensure adequate payments to meet obligations • Preserve and strengthen the state’s bond rating • Achieve cost stability and predictability• Maximize investment returns to offset General

Fund obligations


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Maximizing investment returns to offset future state obligations

Preserving and strengthening the state’s bond rating

Investment returns achieved rom investing pension unds provide an important and significant source o revenue orboth SERS and RS. Revenues rom investment returns reduce the revenue required rom state resources throughannual ARC payments. Te structure o a pension unding policy has a significant impact on the total investment return

that will ultimately be achieved by the unds. More resources allotted to unds in the orm o ARC payments in the nearterm result in lower total pension costs over the long-term as the compounded interest earned on the additional dollarsinvested offsets uture state obligations. Te total cost o state contributions under various reorm alternatives must be akey consideration in evaluating the merits o potential options.

Te state’s bond rating as determined by major rating agencies has a direct impact on state borrowing costs. Recently,the rating agency Standard & Poor’s (S&P) warned that i pension unding reorm “led us to conclude that actuarial

ununded pension liabilities were likely to grow substantially over time, [it] could prompt us to lower the state’s [bondrating] by one notch.”1 o deend against a bond rating down grade, pension unding reorm should not be used toalleviate immediate budget pressures by pushing pension obligations into the uture as S&P warns against. Instead anew unding policy should set up a responsible payment schedule that matches or increases payments toward the UAALin the short-term while flattening out the balloon payments required at the end o the current amortization period andcommitting to pay off the UAAL in a reasonable time rame.

o measure the perormance o each scenario presented in this report in relation to the core principles described above,the ollowing measures were applied to each scenario:

• Funding percentage – the percentage o assets held by the pension und in comparison to the assets required tocover earned benefits. Funding percentage can be used to measure unding policy adequacy. Absent significantshocks to the system, an adequate unding policy should improve the unding percentage rom year to year.

• Annual Required Contributions – the employer’s periodic required contribution to a defined benefit plan tocover the normal cost (the cost o benefits attributable to the current year o service and the amortization payment(a catch-up payment or past service costs to und the ununded actuarial accrued liability - UAAL). Te ARC

payment represents the direct budget impact o the unding policy in a given fiscal year. Volatility in the ARCcan create budget challenges as can ARC payments that increase year over year. Te stability o ARC paymentsthroughout the amortization period is a direct measure o cost stability and predictability.

• Compound Annual Growth Rate (CAGR) of ARC payments – Te growth rate o ARC payments over a

specified time period. Here the CAGR is used to measure the growth rate o ARC payments rom the initial yearo implementation o any new unding policy against select uture fiscal years. Te measure gives an indicationo how the ARC is growing in nominal dollars over the selected time period. CAGR is another measure o coststability and predictability.

1Keith Phaneu, “S&P warns Malloy’s pension plan could cause bond rating cut”, C Mirror. Dec. 16, 2015.ctmirror.org/2015/12/16/sp-threatens-to-lower-cts-bond-rating-i-malloys-pension-plan-is-adopted


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2 An inflation assumption o 3 percent was selected to comport with the inflation assumption currently used or SERS actuarial reporting.

3 Real dollars reers to a value that has been adjusted or inflation to make dollar amounts comparable across time. All real dollar calculations in this analysis use 2016 as the base year and adjust all uture years byassumed inflation rate o 3 percent.

• Te total principal and financing costs of paying off the UAAL – the total cost expressed in terms o net present value in paying off the UAAL over the entire amortization period. Future payments against UAAL are discountedusing a 3-percent inflation assumption.2 Using the net present value measure, it is possible to compare the estimatedtotal budget cost o paying down the UAAL in real 2016 dollars between various unding-policy scenarios.3

In addition to a table displaying the measures above at key uture dates, each scenario is also accompanied by line graphthat compare the projected payment schedule and estimated uture unded ratios o each scenario to a baseline scenario(described below). An inflation-adjusted ARC payment line is also incorporated to provide a visual indication o thelevel o effort making the estimated ARC payments will require in the uture under each scenario.

No one measure is used to determine the effect o policy alternatives on the state’s bond rating. Generally ratingagencies take into account the totality o actors in evaluating a pension unding policy. As a result, each o the abovemeasures is relevant in determining the potential impact on the state’s bond rating rom a proposed change to SERS

pension unding policy.

Recently, the rating agency Standard& Poor’s (S&P) warned that if pension

funding reform “led us to conclude that

actuarial unfunded pension liabilitieswere likely to grow substantially over

time, [it] could prompt us to lower the state’s [bond rating] by one notch.”

“


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ANALYSIS

Four distinct policy options or scenarios are analyzed below, including a baseline scenario which incorporates the currentactuarial unding policy or SERS and three alternative options or scenarios. Te components o the actuarial unding

policy analyzed are included in a summary table or each scenario. Changes rom the baseline scenario are highlightedin bold. In addition, each scenario is accompanied by a short description, a table o the descriptive statistics describedabove, and two graphs displaying ARC payments over time and the unded ratio. Finally, each scenario is accompaniedby a short discussion o how it perorms relative to the baseline scenario and other scenarios presented on the measuresselected or analysis.

SERS currently utilizes the ollowing unding policy, payment schedule and actuarial assumptions.

Recently, State reasurer Denise Nappier has indicated that the appropriate investment return assumption or state pension und investments is 7 percent.4 o comport with the reasurer’s assessment o the most reasonable uture perormance o pension und investments, the current investment return assumption o 8 percent is reduced to 7 percentto produce the baseline unding scenario or this analysis. As mentioned above, in each additional scenario changes romthe baseline will be in bold.

Holding all actuarial assumptions constant is necessary to make inormed comparisons across various unding options.Funding scenarios must be compared using the same actuarial assumptions, otherwise differences in ARC payments,

unding ratios, CAGR and total principle and financing costs are incomparable. Scenarios with the most aggressiveassumptions will perorm the best on most measures, but the better perormance is merely the result o assumed betteruture perormance o actors unrelated to the pension unding policy. Under any uture scenarios in which there arelong-term investment gains, more conservative assumptions will result in lower total pension costs as the interest earnedon the additional contributions will offset uture pension payments.

CURRENT

Actuarial cost method: Projected Unit Credit

Amortization method: Level percent of payroll, closed

Remaining amortization period 16 years

Asset valuation method 5-year smoothed actuarial value

ACTUARIAL ASSUMPTIONS:

Investment rate of return 8%

Inflation rate

Wage growth

3%

3.5%

4 Office o the State reasurer. “State reasurer Nappier Presents Preliminary Analysis o Governor’s Pension Funding Proposal s Calls or Iron-Clad Guarantee o State’s Payments to Retirees.” Press Release.December 14, 2015. www.ott.ct.gov/pressreleases/press2015/PR121415PensionAlternativesRev.pd


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BASELINE SCENARIO

BASELINE







Inflation rate

Wage growth

3%

3.5%

BASELINE SELECT MEASURES

FY

2017

2026

2032

2036

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1st Year

10 Yr. Projection

End 16 Yr.Amortization

20 Yr. Projection


FundedRatio

39%

61%

91%

100%

100%

Total StateContribution

1,817,419

2,638,952

3,850,675

447,083

540,161

(Savings)/Costfrom Current State

Contributions

248,276

354,727

542,232

110,723

132,854

CAGR of StateContribution

relative to 2017

0.00%

4.23%

5.13%

-7.12%

-4.93% 27,133,320

Net PresentValue of UAAContribution

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4,500,000

4,000,000

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 3 5

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 3 7

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 3 9

2 0 1 7

2 0 2 3

2 0 2 9

2 0 3 6

2 0 4 3

2 0 1 9

2 0 2 5

2 0 3 1

2 0 3 8

2 0 4 5

2 0 2 1

2 0 2 7

2 0 3 4

2 0 4 1

2 0 3 3

2 0 4 0

STATE CONTRIBUTIONS ARC

BASELINE % BASELINE % INFLATION ADJUSTED

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Te challenges with the baseline scenario are clearly indicated in the line graph above. Assuming actuarial assumptionsare met, the baseline scenario requires significant increases in ARC payments each fiscal year, which will place significantstress on the state budget. In addition, the current pension unding policy incorporates all actuarial gains and losses intothe base amortization period, thus as the end o the amortization period approaches substantial fluctuations in gains andlosses will have significant impacts on the ARC payments projected above (see example in attachment I). Te volatility

will urther challenge state budget makers as they try to meet growing uture ARC payments.

Te scenarios below explore options to alleviate the significant growth in ARC payments over the remaining period

o our current amortization schedule. Some scenarios perorm better than others; the benefits and weaknesses o eachoption are discussed below.

BASELINE SCENARIO

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SCENARIO #1

SCENARIO #1





SCENARIO #1 SELECT MEASURES

FY

2017

2026

2032

2036

2041

1st Year

10 Yr. Projection


20 Yr. Projection


Funded

Ratio

39%

46%

55%

67%

92%

Total State

Contribution

1,416,856

1,939,677

2,427,139

2,881,075

3,940,299


Contributions

(400,563)

(699,275)

(1,423,536)

2,433,992

3,400,138


relative to 2017

0.00%

3.55%

3.65%

3.81%

4.35% 31,079,349


Scenario 1 simply extends the closed amortization period rom the remaining 16 years to 25 years while continuing toutilize a level percent o payroll to amortization method.

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4,500,000

4,000,000

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 3 5

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 3 7

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 3 9

2 0 1 7

2 0 2 3

2 0 2 9

2 0 3 6

2 0 4 3

2 0 1 9

2 0 2 5

2 0 3 1

2 0 3 8

2 0 4 5

2 0 2 1

2 0 2 7

2 0 3 4

2 0 4 1

2 0 3 3

2 0 4 0


BASELINE % SCENARIO # SCENARIO # INFLATION ADJUSTED

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120%

100%

80%

60%

40%

20%

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 4 6

2 0 3 6

2 0 3 8

2 0 3 4

2 0 4 0

SCENARIO # FUNDED RATIO

BASELINE % SCENARIO #

Spreading out the ARC payments and retaining a level percent o payroll amortization method creates immediatebudgetary relie and more manageable ARC payments over the next 16 years – the period remaining on our currentamortization schedule. As a tradeoff, the extension o the amortization period results in a significantly lower unded ratiover the term o the extended amortization period and an increase in the principle and financing costs associated with

paying off the UAAL o almost $3 billion in real 2016 dollars.

In addition, the exponential growth in ARC payments at the end o the amortization period is not eliminated, but ratherdelayed. Te annual growth in ARC payments is more limited as indicated by the CAGR measure in fiscal years 2026

and 2032 than under the baseline scenario, but annual ARC payments will still rise over this period and continue to risethrough the new close o the amortization period in FY 2042.


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SCENARIO #2

SCENARIO #2


Amortization method: Level dollar, closed




FY

2017

2026

2032

2036

2041

1st Year

10 Yr. Projection


20 Yr. Projection


Funded

Ratio

39%

57%

71%

81%

97%

Total State

Contribution

1,914,951

1,997,853

2,009,685

2,032,174

1,955,554


Contributions

97,532

(641,099)

(1,840,990)

1,585,091

1,415,393


relative to 2017

0.00%

0.47%

0.32%

0.31%

0.09% 28,091,336


Scenario 2 extends the closed amortization period rom the remaining 16 years to 25 years and changes the amortizationmethod rom level percent o payroll to level dollar.

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4,500,000

4,000,000

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 3 5

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 3 7

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 3 9

2 0 1 7

2 0 2 3

2 0 2 9

2 0 3 6

2 0 4 3

2 0 1 9

2 0 2 5

2 0 3 1

2 0 3 8

2 0 4 5

2 0 2 1

2 0 2 7

2 0 3 4

2 0 4 1

2 0 3 3

2 0 4 0



$ thousands


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120%

100%

80%

60%

40%

20%

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 4 6

2 0 3 6

2 0 3 8

2 0 3 4

2 0 4 0



Changing to level dollar amortization and extending the amortization results in a significant improvement in perormance on several measures. It creates substantial predictability in the payment schedule by moving to a leveldollar amortization method. Under level dollar the UAAL is paid down in essentially equal parts over the term o theamortization period. Te result is an ARC payment that is flat in nominal dollar terms and significantly declines overtime in real dollar terms. Moreover, the higher ARC payments in the short-term help to offset the cost o extending theamortization period rom 16 to 25 years, adding less than $1 billion as measured in real 2016 dollars to total principleand financing costs o paying off the UAAL, (see the net present value o UAAL contributions).

Scenario 2 perorms significantly better than Scenario 1 in terms o the unded ratio throughout the extended 25- year amortization period. Te contrast between Scenario 1 and Scenario 2 is most stark in FY 2032 when Scenario 2

is projected to provide a unded ratio o 71 percent compared to 55 percent under Scenario 1 and requires an ARC payment o approximately $400 million less than Scenario 1; more than $1.8 billion less than the Baseline Scenario.

Te analysis o Scenario 2 indicates that moving to a level dollar amortization pays big dividends in the long-term andoffsets some o the negative impacts o extending the amortization period. Under Scenario 2, cost predictability andstability are improved, uture pressure on the state budget as a result o SERS pension payment growth is alleviated, andthe increase in total principle and financing costs o paying off the UAAL increase, but significantly less than would occurom extending the amortization period without adjusting the amortization method to level dollar as in Scenario 1.


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SCENARIO #3

SCENARIO #3


Amortization method: Level dollar, closed

Remaining amortization period 16 years – Statutory Base (4.2billion) and Assumption Changes –

7% investment return ($3.3 billion)

25 Years – Remaining UAAL

balance of $10.6 billion



FY

2017

2026

2032

2036

2041

1st Year

10 Yr. Projection

End 16 Yr.Amoritization

20 Yr. Projection

End 25 Yr.Amoritization

FundedRatio

39%

61%

79%

91%

98%

Total StateContribution

2,038,297

2,129,106

2,137,081

1,230,261

1,253,342


Contributions

220,878

(509,846)

(1,713,594)

783,178

713,181


relative to 2017

0.00%

0.49%

0.32%

-2.62%

-2.01% 26,652,221


Scenario 3 splits the UAAL into two categories; a statutory base and an experience base, and applies differentamortization periods to each. Te statutory base is the UAAL that had accumulated as o December 31, 1983, (the date

ier I employee benefits closed to new enrollment).5 Under this scenario the state would commit to paying off thestatutory base as well as the additional costs associated with adjusting the investment return assumption rom 8 percentto 7 percent within the current amortization schedule. Te remaining UAAL o $10.6 billion, the experience base,

would be amortized over a 25-year closed amortization period. Te amortization method is changed to level dollar as inScenario 2.

5 Connecticut General Statutes - Section 5-162-h(b)(2)

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4,500,000

4,000,000

3,500,000

3,000,000

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 3 5

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 3 7

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 3 9

2 0 1 7

2 0 2 3

2 0 2 9

2 0 3 6

2 0 4 3

2 0 1 9

2 0 2 5

2 0 3 1

2 0 3 8

2 0 4 5

2 0 2 1

2 0 2 7

2 0 3 4

2 0 4 1

2 0 3 3

2 0 4 0



$ thousands


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120%

100%

80%

60%

40%

20%

0

2 0 1 6

2 0 2 2

2 0 2 8

2 0 4 2

2 0 1 8

2 0 2 4

2 0 3 0

2 0 4 4

2 0 2 0

2 0 2 6

2 0 3 2

2 0 4 6

2 0 3 6

2 0 3 8

2 0 3 4

2 0 4 0



As the analysis indicates, combing a shif to level dollar amortization and splitting the UAAL into two bases hascertain advantages. By requiring more contributions in the early years o the amortization period total principle andinterest costs o paying off the UAAL are reduced. In act total principle and interests costs are lower in real 2016dollars compared to the Baseline Scenario, despite extending the amortization period or a portion o the unundedliability. Moreover, Scenario 3 offers a flat payment schedule in nominal dollars through FY 2032, the end o the currentamortization schedule, while also providing significant budgetary relie beyond FY 2032 as compared to Scenario 1 or

Scenario 2. Finally, Scenario 3 provides higher projected unded ratios than either Scenario 1 or Scenario 2 over the termo the amortization period and higher projected unded ratios than the Baseline Scenario through FY 2026.

Scenario 3 does require a significant increase in ARC payments over the baseline in the near term, an increase in the ARCo more than $220 million in the first year o the amortization period.


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DISCUSSION

Te analysis above reveals that certain reorms to SERS pension unding policy would better meet the core principlesidentified while establishing a schedule o achievable ARC payments or paying off existing UAAL by a date certain. Teanalysis reveals that the key components o an improved pension unding policy include:

• Adoption o a more conservative investment return assumption

• A change in amortization method rom level percent o payroll to level dollar

• An extension o the amortization period rom 16 to 25 or paying off the at least part o the UAAL

Combined, the adoption o a more conservative investment return assumption, the change in amortization method andthe extension o the amortization period result in an achievable ARC payment schedule, and comport with the core

pension unding policy principles identified.

Te combined reorms ensure adequate payments to meet obligations as indicated by projected consistent year-over-yearimprovement in the unded ratio, particularly in the early years o the amortization schedule when ARC payments canofen be inadequate to improve the unded ratio. In addition, the adoption o a more conservative investment returnassumption will reduce the chances o actuarial losses due to inadequate investment returns. Actuarial losses associated

with lower investment returns than assumed in the SERS unding policy have been a big contributor to the increasein SERS ununded liabilities since FY 2000. ARC payments calculated using overly aggressive investment returnassumptions were inadequate to improve the unded ratio o SERS or most o this time period.

Te combined reorms also achieve cost stability and predictability by establishing a schedule o ARC payments that isessentially flat in nominal dollar terms over an applicable amortization period and declines in real 2016 dollar terms. Inaddition, the adoption o a more conservative actuarial investment return assumption that better matches current market

conditions reduces the chances o actuarial gains and losses associated with investment returns. Actuarial gains and losseimpact uture ARC calculations, negatively impacting the cost stability and predictability o ARC payments. Reducing the investment return option and changing the amortization method to level dollar both result in increasedARC payments in the short-term and thereore more money in the SERS pension und available or investment. Tecombined impact o the changes to the investment return assumption and amortization method are somewhat offset bythe extension o the amortization period. Still, the total principal and interest cost or paying off the UAAL is similarto the baseline scenario, when the above reorms are instituted. Te combined reorms maximize investment returns incomparison to other options that create more affordable and stable long-term ARC payments. Te above reorms are within actuarial best practice and represent a reasonable and responsible strategy or creatingstable, predictable and manageable SERS ARC payments in the uture. Viewed in totality, it is likely such reorms wouldbe viewed positively by independent bond rating agencies.


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6 GASB. “Sustainable Funding Practices o Defined Benefit Pension Plans”. October 2009. www.goa.org/sustainable-unding-practices-defined-benefit-pension-plans

Equally as important to a prudent reorm o the SERS pension unding policy is the adoption o a layered fixed periodamortization policy or gains and losses. As discussed earlier, and demonstrated in appendix I, amortizing gains andlosses independently rom the base amortization period significantly reduces the volatility o uture ARC payments.Finally, a newly adopted unding policy should be accompanied by a commitment to regular independent comprehensiveaudits o the plans’ actuarial valuations to determine the reasonableness o the actuarial methods and assumptions being

used. Such regular audits will help right the ship should the plan begin to veer off course again. GASB recommends suchaudits every 5 to 8 years. 6

CONSIDERATIONS FOR IMPLEMENTATION

Te initial increase in ARC payments that would be required rom lowering the investment return assumption to 7 percent and moving to level dollar amortization on the current amortization schedule or SERS creates immediatebudget challenges. Te initial budget impact o such changes can be partially offset by extending the amortization

period or some or all o the UAAL to 25 years, however even with the extension o the amortization period, lowering

the investment return option and changing to level dollar will not be easy. It will require a short-term increase in ARC payments at a time when the state is struggling to und other priorities. Still, the long-term benefits are significant. Byadopting these policies now the state has the opportunity to put pension unding issues in the rearview mirror as pensioncosts would become a declining, rather than increasing, percentage o uture budgets, reeing up vital resources to undother budget priorities and increasing budget stability. Tere are several reasonable options to reduce the immediate budget impact o adopting the policies recommendedabove, including phasing in the increased ARC payments over a 2- or 3-year period or utilizing a small pension obligationbond (POB) to acilitate a phase-in o ull ARC payments rom the budget. POBs are generally controversial as many

jurisdictions have used them to engage in market speculation in effort to achieve arbitrage, earn higher returns on themoney raised rom the bond sale than paid in interest on the bonds. Te strategy is risky and does not always panout. However, in this case the goal would not be to achieve arbitrage, but rather to acilitate the ramp up in state ARC

payments to accommodate a reduced investment return assumption and moving to a level dollar amortization method.Additionally, and perhaps as important, the POBs would present an opportunity to ensure uture ARC payments areresponsibly made by incorporating a bond covenant requiring ull unding o the ARC over the lie o the bonds. Such acovenant currently exists or POBs in RS and has resulted in ull ARC payments by the legislature in every year since itsadoption.


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CONCLUSION AND RECOMMENDATION

Te analysis and discussion detailed above clearly indicate that reasonable options exist to reorm the SERS actuarial pension unding policy to create more manageable uture ARC payments while meeting certain core principles:

• Ensuring adequate payments to meet obligations,

• Achieving cost stability and predictability,

• Maximizing investment returns to offset uture state obligations, and

• Preserving and strengthening the state’s bond rating

Specifically, Scenario 2 and Scenario 3 analyzed above best comport with the identified core principles and result inmanageable projected ARC payments. While both Scenario 2 and Scenario 3 represent reasonable and responsible

proposals or reorming the SERS pension unding policy, Scenario 3 stands out as the most fiscally prudent option.Scenario 3 incorporates the reorms listed above, but only extends the amortization period or paying off a portion o the

UAAL. By committing to pay down a portion o the UAAL on the current amortization schedule Scenario 3 is the onlyreorm option analyzed that actually reduces, in real 2016 dollars, the total principle and financing costs o paying offUAAL as compared to the Baseline Scenario. In addition Scenario 3 will provide uture legislatures significant budgetaryrelie in both FY 2033 and FY 2042. Lastly, Scenario 3 improves the unded ratio or SERS more quickly in the short-term than any other option analyzed, putting the plan in the strongest financial position over the next several years.

It is recommended that labor and management adopt a new actuarial unding policy or SERS that embraces the policychanges modeled in Scenario 3, including:

• Changing the amortization method rom level percent o payroll to level dollar,

• Committing to pay off a portion o the UAAL on our current amortization schedule, and• Extending the amortization period to a maximum o 25 years or the remaining UAAL.

Tese changes combined with the adoption o layered fixed period amortization or gains and losses and a commitmentto regular independent comprehensive audits o the plans’ actuarial valuations to determine the reasonableness o theactuarial methods and assumptions being used create a strong oundation or a responsible reorm to SERS actuarialunding policy.

Moving to a responsible pension unding policy now will pay huge dividends or the state in the uture. I am hopeul thathe state will heed the Governor’s call to action and make the changes necessary to SERS pension unding policy to create

real cost stability and predictability. Doing so will protect uture generations rom ballooning costs and ensure SERS hasthe resources necessary to ulfill incurred obligations.


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APPENDIX I - IMPACT OF AN ASSET SHOCK IN THE

FINAL YEARS OF AN AMORTIZATION PERIOD

In order to display the importance o moving to a layered amortization or actuarial gains and losses as part o pensionunding reorm or SERS we worked with pension experts at PEW Charitable rusts to demonstrate the impact o an

economic shock in the final years o a closed amortization period. Te demonstrations below assume an economic shockthat results in a 15% reduction in pension plan assets 5 years prior the end o the amortization period under our currentactuarial unding policy (demonstration 1), an assumed reorm o the policy that adopts a level dollar amortizationmethod, lowers the investment return assumption to 7 percent and expands the amortization period to 25 years inthe absence o layered amortization (demonstration 2) and the same reorms as demonstration 1 but with layeredamortization or gains and losses (demonstration 3). 7

Te current unding policy (demonstration 1) requires the hypothetical asset shock to be amortized over just 5 years. Tshort amortization period combined with the level percent o payroll unding methodology results in exponential growthin the ARC payments over the final ew years o the amortization schedule culminating in a final balloon payment o ove$7 billion.

Te policy changes adopted in demonstration 2, a level dollar amortization method, a reduced investment returnassumption and the extension o the amortization period to 25 years, only moderately reduce ARC payments ollowingthe modeled asset shock. Under both the current unding policy (demonstration 1) and the assumed changes indemonstration 2 the ARC payments jump to levels that would likely be unachievable or a uture legislature to meet.

Adopting layered amortization or actuarial gains and losses would mute large increases in required contributions afera significant loss in assets. Demonstration 3 models the stabilizing impact o layered amortization or gains and lossesollowing a significant asset shock on ARC payments.

In demonstration 3 the adoption o layered amortization or actuarial gains and losses results in a required an ARC payment the year immediately preceding the end o the amortization period that is less than hal the ARC in thedemonstrations in which layered amortization was not utilized.

Te demonstrations below clearly indicate adding layered amortization or actuarial gains and losses significantlyincreases cost predictability and stability and should be adopted with any unding policy changes that utilize a closedamortization period.

7 Tese examples are stylized to show only the effects o a one-time asset shock that would occur in reality amongst many yearly gains and losses, possibly leading the system to experienceresults much different than those depicted below.


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SERS CONTRIBUTIONS AND FUNDED RATIODEMONSTRATION


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DEMONSTRATION 1: CURRENT POLICY







Inflation rate

Wage growth

3%

3.5%

Demonstration 1

Utilizes the current unding policy and introduces a shock to plan assets o 15% five years beore the completion o theamortization schedule.

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DEMONSTRATION 2: LEVEL DOLLAR


Amortization method: Level Dollar, closed





Inflation rate

Wage growth

3%

3.5%

Demonstration 2

Tis scenario depicts what the system’s contributions would be under a level dollar amortization method, when an assetshock o 15% occurs five years beore the completion o the amortization schedule.

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Demonstration 3

Tis scenario utilizes the same amortization method as Scenario 2, but now includes the introduction o layered bases toany new gains or losses on assets, thus allowing the asset shock o 15% that occurs five years beore the completion o the

amortization schedule to be paid over an additional 20-year period.

DEMONSTRATION 2: LEVEL DOLLAR


Amortization method: Level percent of payroll, closed,layered bases





Inflation rate

Wage growth

3%

3.5%

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pension funding white paper final

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