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Public Pension Finance Symposium

May 2009


Session 2: The Rationale for Traditional Actuarial
Models

Actuarial Methods and Public Pension Funding Objectives:
An Empirical Examination

Norman L. J ones, Brian B. Murphy, Paul Zorn






ActuarialMethodsand
PublicPensionFunding
Objectives
PresentedattheSOAPublicPension
FinanceSymposium
byBrianB.Murphy
May18,2009 Chicago,Illinois
PresentationOverview
Introduction
Methodology
Results:Overall
Results:AdditionalAnalyses
Discussion:PublicPlanFundingObjectives
Conclusions
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Introduction
MostargumentsforandagainsttheMVLare
basedontheoreticalconstructs
Toprovidemoreempiricalinformation,ourpaper
comparestheMVLapproachtoaconventional
approachusedbythemajorityofpublicplans
Thecomparisonismadebyapplyingboth
approachestoamodeledpublicplanbasedon
historicalinformation
Weconsiderourresultsillustrativeratherthan
definitive.Nevertheless,webelievetheyoffer
usefulinsights.
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Methodology PlanCharacteristics
Themodeledplanisbasedonamediumsized
statewideplanforgeneralemployeesusing
valuationdataovertheperiodfromJune1978to
June2008
1978 2008
#Actives 33,000 54,000
#Annuitants 6,600 30,000
Avg.AgeofActives 41 45
Avg.YearsofService 9 11
Avg.AgeatRetirement 64 60
Avg.AgeofAnnuitants 71 69
BenefitMultiplier 1.25% 1.70%
AutomaticCOLABasedonCPI
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Methodology ConventionalApproach
Resultsundertheconventionalapproach
werelargelyderivedfromactualvaluation
resultsover1984 2008,using:
Entryagenormalcostmethod
Expectedlongtermreturn
30yearopenamortizationofUAL
Investmentreturnbasedondiversifiedportfolio
Assetssmoothedover5years
Foryearspriorto1984,resultswere
extrapolatedbasedontrendsinthevaluation
reports,annualfinancialreports,andother
sources
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Methodology MVLApproach
ResultsunderMVLapproachderivedfrom
valuationresults,adjustedtoreflect:
Unitcreditactuarialcostmethod
Discountrate:30yearTreasuryyieldasofJune
eachyear
30yearopenamortizationofUAL
Investmentreturnbasedondiversifiedportfolio
Marketvalueofassets(nosmoothing)
Additionalanalysesoftheseassumptionsare
providedlaterinthispresentation
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Methodology DerivationofMVL
Step1:ConvertEANCAALatexpectedreturntoUC
ABOatexpectedreturnusingfactorsdevelopedfrom
plandata
Step2:ConvertABOatexpectedreturntoABOat30
yearTreasuryrate(i.e.,MVL)usingformulas
reflectingthedurationandconvexityoftheliabilities
Step3:DetermineMVLnormalcostsbymultiplying
MVLforactivemembersbyconversionfactorbased
onplandata
Werecognizetheprocesswillnotexactlyreplicatean
MVLvaluation,butwebelieveitissufficienttoshow
relevantpatterns
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DiscountRates
Sincediscountrateshaveastronginfluence
ontheresults,itisusefultoreviewthem
first
Keyobservations:
Conventional(CVL)discountratesincreased
twiceduringthestudyperiodandrangedfrom
7.0%to8.5%
MVLdiscountrateschangedeveryyearduring
thestudyperiodandrangedfrom4.3%to13.9%
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0%
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ConventionalandMVLDiscountRates
ConventionalDiscountRate MVLDiscountRate
1982:
MVL rate =13.9%
CVL rate =7.0%
2005:
MVL rate =4.3%
CVL rate =8.5%
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Results:Overall
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$0
$2,000
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ConventionalandMVLAccruedLiabilities
ConventionalAccrued Liabilities MVLAccrued Liabilities
MVL liabilities are more
volatile than conventional
liabilities due to impact of
discount rates
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Results FundedLevels
Fundedlevelsaredeterminedbydividingthevalueof
planassetsbyaccruedliabilities
Undertheconventionalapproach,investmentgains
andlossesaresmoothedintothevalueofassetsover5
years
UndertheMVLapproach,themarketvalueofassets
isused(nosmoothing)
Tofacilitatecomparison,assetsunderbothapproaches
areassumedtobeinvestedinaccordancewiththe
plansinvestmentpolicywhichshiftedovertime:
Late1970s:35%equities;65%bonds
Late2000s:70%equities;30%bonds
Laterinthepresentationweexploreinvesting100%of
MVLassetsinTreasurybonds
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ConventionalandMVLFundedPercents
(MVLAssetsInvestedConventionallyandValuedatMarket)
Conventional MVL(MVA ConventionalAsset Mix)
MVL funded level is more volatile
than under the conventional
approach due to both the discount
rates and use of the market value of
assets
MVL funded level is over
100% at times when
conventional funded level is
below 100%, due primarily to
discount rates
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Results ContributionRates
Contributionratesaredeterminedby
addingnormalcostsandtheamortized
valueofunfundedaccruedliability
Tosimplifytheanalysis,a30yearopen
amortizationperiodwasappliedunder
bothapproaches
MVLproponentswouldlikelyadvocatea
muchshorteramortizationperiod,which
isexploredlaterinthepresentation
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T
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ConventionalandMVLTotalContributionRates
(AssetsInvestedinConventionalPensionPortfolio)
ConventionalRates MVLRates(Conventional AssetMix)
MVL contributions largely driven by
discount rates. Note that even with a
30-year open amortization of UAL, MVL
contribution rates are highly volatile.
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Results:AdditionalAnalyses
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AdditionalAnalysis 1
MVLAssetsInvestedinLongTermGovernmentBonds
VolatilityintheMVLfundedlevelmightbeminimizedby
investingMVLassetsinaportfolioofmatchingsecurities
withdurationsalignedwiththeplansliabilities
ThefollowingchartshowstheMVLfundedlevelbasedon
assetsinvestedinlongtermgovernmentbondsearning
totalreturns(incomepluspriceappreciation).
Note,however,twocaveats:
Thedurationsofthelongtermgovt.bondsandtheliabilitiesarenot
perfectlyalignedduetolimitsonavailabledata.
Indeterminingplancontributions,theMVLUALisamortizedover a
30yearopenperiod.
ThismaybewhytheMVLfundedratiounderthe
governmentportfolioprojectiondoesnotconvergeto100%.
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0%
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MVLFundedLevels Diversifiedvs.Govt.BondPortfolio
MVLDiversifiedPortfolio MVLGovt.BondPortfolio
MVL funded ratio with
government bond portfolio
appears to converge to
about 90%
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AdditionalAnalysis 2
MVLContributionsBasedonShorter
AmortizationPeriods
MVLproponentsmayargueforan
amortizationperiodshorterthan30years
Thefollowingchartshowstheimpacton
MVLcontributionratesofusing5and10year
amortizationperiods
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0%
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MVLContributionRatesUnderDifferentAmortizationPeriods
(ConventionalAssetAllocation)
MVL(10yearAmortization Period) MVL(30yearAmortization Period)
MVL(5yearAmortization Period)
Generally, shortening the
amortization period
increases contribution rate
volatility
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Discussion:
PublicPlanFundingObjectives
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Objective1:ValuationReflectsPlan
Dynamics
Thefundingmeasureshouldreflectthe
dynamicsoftheplan
UnderMVL
Liabilitiescanincreasesignificantlydueto
changesinthediscountrate,evenintheabsence
ofchangesinplanbenefits
Thisalsoleadstosignificantswingsinnormal
costsandcontributionrates
Underconventionalapproach
Normalcosts,liabilities,andcontributionrates
aremuchmorestable
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Objective2:StableContributionRates
Increasingpensioncontributionssubject
tolengthypoliticalprocessandso
governmentspreferstablecontribution
rates
UnderMVL contributionsare,attimes,
muchhigherandmorevolatilethan
underconventionalapproach andare
thereforeconsiderablymoredifficultto
fund
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Objective3:EquitableAllocationof
PensionCosts
Becausetaxesareobligatory,fairnessplaysa
roleindetermininghowpensioncosts
shouldbeallocated
Undertheconventionalapproach,normal
costsareallocatedasalevel%ofcovered
payroll,andthereforeremainatroughlythe
same%ofrealincomeovertime
UnderMVL,thediscountratechanges
overwhelmtheadditionalcostsassociated
withaccruedbenefits
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Objective4:CoordinationofAccounting
andFundingMeasures
Currently,governmentalaccountingand
reportingstandardscallforcoordination
ofaccountingandfundingmeasures
IfMVLweresubstitutedforconventional
funding(oraccounting),confusionwould
result notonlyinthetransitionyear,but
onanongoingbasis
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Conclusions
MVLfundingwouldresultinfrequent,
rapid,anderraticchangesinplan
contributions,accruedliabilities,andfunded
levels
Bycontrast,conventionalfundingismore
stableovertimeandbetterreflectsthe
dynamicsoftheplan
IftheMVLapproachwereappliedtopublic
planfunding,itwouldleadtoerratic
demandsongovernmentresourceswhich
couldleadtoplanterminationortothe
ultimateabandonmentoftheMVLapproach
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Disclaimers
Circular230Notice:PursuanttoregulationsissuedbytheIRS,to
theextentthispresentationconcernstaxmatters,itisnotintended
orwrittentobeused,andcannotbeused,forthepurposeof(i)
avoidingtaxrelatedpenaltiesundertheInternalRevenueCodeor
(ii)marketingorrecommendingtoanotherpartyanytaxrelated
matteraddressedwithin.Eachtaxpayershouldseekadvicebased
ontheindividualscircumstancesfromanindependenttax
advisor.
Thispresentationshallnotbeconstruedtoprovidetaxadvice,
legaladviceorinvestmentadvice.
Thispresentationexpressestheviewsoftheauthoranddoesnot
necessarilyexpresstheviewsofGabriel,Roeder,Smith&
Company.
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