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Public Pensions
Actuarial 101
2008 SACRS Fall Conference
New Trustee Training
November 11, 2008
Paul Angelo, FSA
The Segal Company
San Francisco
5015007
SACRS Fall Conference 2008
SACRS Fall 2008 – Actuarial 101
Outline
 Pension Funding Concepts and Terminology
 Actuarial Facts and Myths
 Asset Smoothing
 UAAL Amortization
 Excess Earnings Mechanics
Slide 2
SACRS Fall 2008 – Actuarial 101
Basic Questions
 Purposes of an actuarial valuation


Primary:
 Contribution requirements
 Funded status
Secondary:
 Disclosure requirements
 Basis for pricing plan changes
 Analysis of demographic experience
 Analysis of financial experience
Slide 3
SACRS Fall 2008 – Actuarial 101
Basic Questions
 Why fund?




Legal requirements
Security of benefits
Allocation of cost to appropriate time period
 Inter-generational equity
 Includes pattern of cost
Reduction in pension costs
Slide 4
SACRS Fall 2008 – Actuarial 101
Valuation Input
Member Data
Financial Data
Actuarial
Valuation
Actuarial Assumptions
Plan Provisions
Actuarial Cost Method
%
Slide 5
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Member Data

Member Status
 Sex
 Date of Birth
 Date of Hire
 Pay
 Contributions
 Beneficiary Data
 Benefit Amount
 Payment Form/Duration
Slide 6
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Financial Data

Statement of Account
 Reconciliation from Prior Year
 Employer Contributions
 Member Contributions
 Benefit Payments & Expenses
 Investment Return
 Market Value
 Book (Cost) Value
 Actuarial Value
Slide 7
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Plan Provisions




Who Can Get Benefits
Under What Conditions
How Much, and
For How Long
Slide 8
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Actuarial Assumptions

Two types
 Demographic assumptions


When benefits will be payable
Amount of benefits
 Economic assumptions


How assets grow
How salaries increase
Slide 9
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Demographic Assumptions



Rates of “Decrement”
 Termination, Mortality, Disability, Retirement
Termination
 Withdrawal
 Deferred Vested
Mortality:
 before and after retirement
 service connected or not
 service, disability, beneficiary
Slide 10
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Demographic Assumptions



Rates of “Decrement”
 Termination, Mortality, Disability, Retirement
Disability
 Service connected or not
Other demographic assumptions
 Percent married
• Domestic Partners!
 Member/Spouse age difference
 Reciprocity
Slide 11
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Economic Assumptions



Inflation - component, plus COLA
Investment Return
 Inflation
 Real return
 Expenses - administrative and/or investment
Salary Increases
 Inflation
 Real increases (“across the board”)
 Merit and promotion
Slide 12
SACRS Fall 2008 – Actuarial 101
Selection of Actuarial Assumptions
 Objective, long term
 Experience analysis
 Recent experience or future expectations


Demographic: recent experience
Economic: not necessarily!
 Client specific or not
 Consistency among assumptions
 Desired pattern of cost incidence

Beware “results based” assumptions!
Slide 13
SACRS Fall 2008 – Actuarial 101
Role of Assumptions and Methods
C+I=B+E
Contributions + Investment Income
equals
Benefit Payments + Expenses
 Actuarial valuation determines the current or
“measured” cost, not the ultimate cost
 Assumptions and funding methods affect only the
timing or pattern of costs
Slide 14
SACRS Fall 2008 – Actuarial 101
Role of Assumptions (and Methods)
 Suppose fund will actually earn 7%, forever
 Suppose we assume 8%
Current year’s cost will be lower
 Each year, 1% actuarial loss on investments
 Future costs will gradually increase

 Suppose we assume 6%



Current year’s cost will be higher
Each year, 1% actuarial gain on investments
Future costs will gradually decrease
 Good assumptions produce Level Cost
Slide 15
SACRS Fall 2008 – Actuarial 101
QUESTIONS
Slide 16
SACRS Fall 2008 – Actuarial 101
Valuation Input
 Actuarial Cost (Funding) Methods



Liability Method - allocates costs to time periods, past vs.
future
Asset Method - assigns a value to assets for determining
contribution requirements
Amortization Period - how long to fund difference
between liabilities and assets
Slide 17
SACRS Fall 2008 – Actuarial 101
Pension 101
Actuarial Liability
Normal Cost
Slide 18
SACRS Fall 2008 – Actuarial 101
Actuarial Concepts and Terminology
 Present Value (PV) of Future Benefits
 PV of Past Contributions - Assets
 PV of Future Contributions
 PV of Future Normal Costs
 Actuarial Accrued Liability
 Unfunded Actuarial Accrued Liability (UAAL)
 Normal Cost
 Amortization of UAAL/Surplus
 Actuarial Gains and Losses
Slide 19
SACRS Fall 2008 – Actuarial 101
Present Value (PV)
Slide 20
SACRS Fall 2008 – Actuarial 101
Present Value Example
 Promise to pay $100 in ten years to each of 10
subscribers
 Investments will double in ten years
(interest rate is 7.2%)
 3 out of 10 subscribers will survive to collect
Slide 21
SACRS Fall 2008 – Actuarial 101
Present Value Example
 Consider Interest only


Collect $50, invest it, pay $100
We say $50 is the “present value” of the $100
“discounted at 7.2% interest” for 10 years
 Consider Survival only

Collect $30 from each, use $300 to pay each of the 3
survivors
 We say $30 is the “present value” of the $100
“discounted at survivorship” for 10 years
Slide 22
SACRS Fall 2008 – Actuarial 101
Present Value Example
 Consider both Interest and Survival



Collect $15 from each subscriber
Invest the $150, have $300 in 10 years
Pay $100 to each of the 3 survivors
 We say $15 is the “present value” of the $100,
“discounted at interest and survivorship”
for 10 years
Slide 23
SACRS Fall 2008 – Actuarial 101
Present Value of Future Benefits
Member Data
Actuarial
Assumptions
Benefit
Provisions
Present Value of
Future Benefits
Interest Discount
Slide 24
SACRS Fall 2008 – Actuarial 101
Actuarial Cost Method
Present Value of Future Benefits
Current Year Normal Cost
Actuarial Accrued
Liability
Entry Age
Present Value of
Future Normal Costs
Current Age
Retirement Age
Slide 25
SACRS Fall 2008 – Actuarial 101
Present Value of Future Benefits
Actuarial Accrued Liability
Present Value of
Future Normal Costs
Slide 26
SACRS Fall 2008 – Actuarial 101
Unfunded Actuarial Accrued Liability
Assets
Unfunded
Actuarial Accrued
Liability
Present Value of
Future Normal Costs
Slide 27
SACRS Fall 2008 – Actuarial 101
Annual Cost
Assets
Amortization of Unfunded
Actuarial Accrued Liability
Unfunded
Actuarial Accrued
Liability
Present Value of
Future Normal Costs
Normal Cost
Slide 28
SACRS Fall 2008 – Actuarial 101
Benefit Increase or Actuarial Loss
Assets
Unfunded
Actuarial
Accrued Liability
Present Value
of Future Costs
Slide 29
SACRS Fall 2008 – Actuarial 101
Unfunded Liability Leverage
 For well funded plans, small increases in Accrued
Liability can cause big (percentage) increases in
Unfunded Accrued Liability
Before
Amendment
After
Amendment
Percent
Change
Accrued Liability
$100 million
$110 million
+10%
Assets
$90 million
$90 million
+0%
Unfunded Liability
$10 million
$20 million
+100%
Slide 30
SACRS Fall 2008 – Actuarial 101
Actuarial Gains and Losses
 Gain - experience that is financially more favorable
to the plan (e.g., more deaths than expected).
 Loss - experience that is financially less favorable
to the plan (e.g., higher salaries than expected).
 Results in a larger (for a loss) or smaller (for a
gain) unfunded actuarial accrued liability than
expected.
 Cost is recognized through amortization of
unfunded actuarial accrued liability.
Slide 31
SACRS Fall 2008 – Actuarial 101
QUESTIONS
Slide 32
SACRS Fall 2008 – Actuarial 101
What exactly is the Normal Cost?
 Normal Cost is a budgeting tool
 Portion of total PV allocated to a year
 Normal Cost = series of amounts needed each active
year that will fund PV of projected benefits at retirement
 Depends on method: PUC or EAN
 Normal Cost is NOT the “value of benefit earned or
accrued that year”
Slide 33
SACRS Fall 2008 – Actuarial 101
What exactly is the Actuarial Accrued Liability?
 Actuarial Accrued Liability = Accumulated value of
past Normal Costs
 AAL is what you would have in fund if:



Current plan, data and assumptions were always so
Always funded the Normal Cost
All assumptions always came true
(no past gains or losses)
 AAL is NOT the “value of the member’s accrued or
earned benefit”
Slide 34
SACRS Fall 2008 – Actuarial 101
What exactly is the UAAL?
 Compare AAL (“as if” assets) to actual assets (after
smoothing)
 If assets are less, difference is UAAL
 UAAL comes from four sources




Initial AAL when plan first set up
Plan amendments affecting past service
Assumption and/or method changes
Actuarial losses
Slide 35
SACRS Fall 2008 – Actuarial 101
What exactly is the UAAL?
 UAAL is another budgeting tool
 UAAL = Zero means all you need in the future are
the Normal Costs
 UAAL measures contributions that are needed
above the Normal Cost
 UAAL does not measure:



solvency of the plan or security of benefits
termination liability
amount assets are short of “what fund is obligated to pay
members”
Slide 36
SACRS Fall 2008 – Actuarial 101
Entry Age Normal Method (EAN)
 Direct allocation of cost
 Designed to produce Normal Cost that stays level
as a percentage of pay
 Normal Cost Percentage = percentage of payroll
paid each active year needed to fund PV of
projected benefits at retirement
 Normal Cost = NC% times current pay
Slide 37
SACRS Fall 2008 – Actuarial 101
Normal Cost vs Earned Benefit
Value of
Benefit
Earned
Each Year
Normal Cost
under EAN
method
Cost
(% of
pay)
25
35
45
Age
55
65
Slide 38
SACRS Fall 2008 – Actuarial 101
Funded Status
 Funded ratio = assets / liabilities
 Funded status = assets - liabilities
 Assets > liabilities
 Assets < liabilities
==> surplus
==> unfunded liability
Slide 39
SACRS Fall 2008 – Actuarial 101
Funded Status: various measures
 Assets


Termination: Market value
Funding: Actuarial value
 Liabilities



Funding: actuarial accrued liability (AAL)
 Entry Age Normal method (EAN)
 Projected Unit Credit method (PUC)
Present value of accrued benefits (PVAB)
 AAL under Unit Credit method
Ongoing or “settlement” assumptions
Slide 40
SACRS Fall 2008 – Actuarial 101
Funded Status
(all $ figures in millions)
Actuarial Accrued Liability
Entry Age Normal
Projected Unit Credit
Unit Credit
Funding
(EAN AAL)
Funding
(PUC AAL)
PVAB
(UC AAL)
$5,083
$4,848
$4,296
Assets
Actuarial Value
Market Value
$4,606
Funded Ratio (assets/liabilities)
90.6%
95.0%
113.7%
Funded Status (assets-liabilities)
$477
$242
($588)
$4,606
$4,884
Slide 41
SACRS Fall 2008 – Actuarial 101
Funded Ratio (or “Funding Ratio”)
 Not used to determine contribution rate

Amortization cost based on UAAL ($)
 For public plans, no “bright line” test

For corporate Current Liability, 80% and 90%
 Useful to track progress
 Not useful as a simple test of Plan’s health

Like UAAL, does not measure solvency or benefit
security
Slide 42
SACRS Fall 2008 – Actuarial 101
Significance of Funding Ratio
 Which Plan would you rather be in?
Funding Ratio
Valuation Date
Plan A
Plan B
2007
73%
82%
Slide 43
SACRS Fall 2008 – Actuarial 101
Significance of Funding Ratio
 Which Plan would you rather be in?
Funding Ratio
Valuation Date
Plan A
Plan B
2007
73%
82%
2006
61%
89%
2005
57%
93%
2004
2003
46%
38%
102%
118%
2002
24%
132%
Slide 44
SACRS Fall 2008 – Actuarial 101
Why the focus on Funding Ratios?
 Imported from corporate pensions


Settlement liabilities built into funding and accounting
rules (IRC §412 and FAS 87)
Appropriate for plans that can be terminated
 But watch for self fulfilling rulemaking!
 Quest for unattainable simplicity

Reduce all of pension funding to one variable
 “Put all your eggs in one basket –
and watch that basket!”
Slide 45
SACRS Fall 2008 – Actuarial 101
QUESTIONS
Slide 46
SACRS Fall 2008 – Actuarial 101
Contribution Rate stabilization
 Longer asset smoothing periods
 Longer amortization periods for gains/losses
 Minimum contribution for plans in surplus
 Interest Fluctuation Reserves

Mainly for 1937 Act county systems
Slide 47
SACRS Fall 2008 – Actuarial 101
Annual Cost
Amortization of Unfunded
Actuarial Accrued Liability
Actuarial
Value of
Assets
Unfunded
Actuarial Accrued
Liability
Present Value of
Future Normal Costs
Normal Cost
Slide 48
SACRS Fall 2008 – Actuarial 101
Asset Smoothing Methods
 Objectives



Reflect market value of assets
Smooth out fluctuations in market values
Produce smoother pattern of contributions
 Features





Practical to both understand and model
Consistently lead or lag market
Treatment of realized vs. unrealized gains
Consistency with other investment policies
“Return to Market” conditions
Slide 49
SACRS Fall 2008 – Actuarial 101
Income Smoothing Methods
 Contributions and benefits recognized immediately
 Split income into Immediate and Deferred portions

Deferred portion gets “smoothed”
 Smooth over n years, n = 3, 4 or 5 … or 10 or 15!
 Decide what part of earnings gets smoothed



Unrealized gains/losses
All capital gains/losses
Total return above or below assumed earnings
Slide 50
SACRS Fall 2008 – Actuarial 101
Example: one good year
Year
1
2
MVA return
13% 8%
Deferred
(5%)
3
4
5
6
8%
8%
8%
8%
Recognized
1%
1%
1%
1%
1%
AVA return
9%
9%
9%
9%
9%
8%
Slide 51
SACRS Fall 2008 – Actuarial 101
Example: one good, then one bad year
Year
1
2
MVA return
13% 3%
Deferred
(5%) 5%
Recognized
AVA return
1%
9%
3
4
5
6
7
8%
8%
8%
8%
8%
1% 1% 1% 1%
(1%) (1%) (1%) (1%) (1%)
8%
8%
8%
8%
7%
8%
Slide 52
SACRS Fall 2008 – Actuarial 101
Asset Smoothing Method:
12/31/2007 Valuation ($ thousands)
Yearend
Market Value
Gain/(Loss)
Percent not
recognized
$236,111
Dec-07
$324,132
Dec-06
$19,435
Dec-05
$181,713
Dec-04
Net total GAINS not yet recognized
80%
60%
40%
20%
Net Market value of assets
LESS GAINS not yet recognized
Actuarial value of assets (incl. non-val reserves)
Amount not
recognized
$188,889
$194,479
$7,774
$36,343
$427,485
$7,719,690
($427,485)
$7,292,205
Slide 53
SACRS Fall 2008 – Actuarial 101
Asset Smoothing Method:
12/31/2008 Valuation ($ thousands) - ILLUSTRATION ONLY!
Yearend
Market Value
Gain/(Loss)
Percent not
recognized
Dec-08
($600,000)
80%
Dec-07
$236,111
60%
Dec-06
$324,132
40%
Dec-05
$19,435
20%
Net total LOSSES not yet recognized
Net Market value of assets
PLUS LOSSES not yet recognized
Actuarial value of assets (incl. non-val reserves)
Amount not
recognized
($480,000)
$141,667
$129,653
$3,887
($204,793)
$8,000,000
$204,793
$8,204,793
Slide 54
SACRS Fall 2008 – Actuarial 101
Asset Smoothing Methods
 Asset smoothing only delays effect of losses
(and gains)
 Delay allows cycles to offset each other
 Metaphor for these bad times: choose between...


A full day, crippling migraine headache
A week-long dull throb in the back of your head
 Total pain remains the same
 The trouble starts on day three...
Slide 55
SACRS Fall 2008 – Actuarial 101
Practical and Political Insights
 Problems when AVA and MVA pull apart
 When MVA scores, AVA is less than MVA

MVA - AVA puts off recognizing gains
 We pretend we have less money than we really have
 Costs overstated? Increase benefits?
 When MVA tanks, AVA is greater than MVA



AVA - MVA puts off recognizing losses
We pretend we have more money than we really have
UAAL understated? Future taxpayers!
Slide 56
SACRS Fall 2008 – Actuarial 101
Practical and Political Insights
 Actuaries see these as two sides of same coin
 Constituents and Local Press may not agree
 Key: understand future impact of those deferred
losses (AVA - MVA)


If no future gains, this amount will show up in Unfunded
Liability over the smoothing period
Contributions will increase by amount need to amortize
this UAAL, unless offset by future gains
 “Mark to Market” or stabilize costs: not both!
Slide 57
SACRS Fall 2008 – Actuarial 101
Amortization of Unfunded Liability
 Source of Unfunded Liability



Plan changes
Assumption or method changes
Gains / losses
 Amortization period


Fixed period (closed) or rolling (open)
One layer (uniform) or multiple
 Amortization method


Level dollar amount (corporate)
Level percentage of pay (public)
Slide 58
SACRS Fall 2008 – Actuarial 101
Illustration of Amortization Methods
8.00% interest
4.00% salary incr.
30 years
Flat dollar
Increase in AAL
1,000,000
1,000,000
1,000,000
1,000,000
Amortization factors
(first year)
Amortization amount
Year 1
Year 10
Year 15
Year 20
Total Amount Paid
Principal
Interest
0.0888274
0.0590249
0.0754861
0.0925353
Total
$
$
$
$
88,827
88,827
88,827
88,827
30 years
% of pay
$
$
$
$
59,025
84,011
102,212
124,357
20 years
% of pay
$
$
$
$
75,486
107,440
130,718
159,038
15 years
% of pay
$
$
$
$
92,535
131,707
160,241
0
$ 1,000,000
1,664,822
$ 1,000,000
2,310,408
$ 1,000,000
1,247,831
$ 1,000,000
852,889
$ 2,664,822
$ 3,310,408
$ 2,247,831
$ 1,852,889
Slide 59
SACRS Fall 2008 – Actuarial 101
Negative Amortization
 $1,000,000 liability, 8.0% interest
 First year interest only is $80,000
 With level dollar payments, payments are always
greater than interest
 With level percentage payments, early payments
can be less than interest


UAAL increases
Eventually larger payments cover interest plus increased
UAAL
Slide 60
SACRS Fall 2008 – Actuarial 101
Asset Smoothing and UAAL amortization
 Each year’s gain/loss gets amortized in UAAL



Asset G/L, Liability G/L
Asset G/L based on AVA return, not MVA return
UAAL says: Deferred MVA G/L “hasn’t happened yet”
 So MVA cost volatility is dampened twice


Much of the volatility is removed by asset smoothing
Remaining AVA volatility is amortized with other G/L’s
 MVA volatility is greater than other experience

Needs its own shock absorber to get its volatility down to
a level comparable to other experience
Slide 61
SACRS Fall 2008 – Actuarial 101
Contributions when Plan has surplus
 Usual contribution is NC plus UAAL amortization
 Surplus: contribute NC minus Surplus amortization
 Short amortization periods meant contribution
holidays, even with modest surplus
 CalPERS 2005 approach: minimum contribution

30 year amortization of surplus
Slide 62
SACRS Fall 2008 – Actuarial 101
Interest Fluctuation Reserve
 Mainly for 1937 Act systems
 Current: requires 1% “contingency reserve” before
excess earnings used to fund new benefits
 Consider: increase 1% of assets to higher level


1% level set when assets were invested in bonds
Stocks are more volatile, so need larger reserve
Slide 63
SACRS Fall 2008 – Actuarial 101
QUESTIONS
Slide 64
SACRS Fall 2008 – Actuarial 101
1937 CERL Systems Excess Earnings
C+I=B+E
Contributions + Investment Income
equals
Benefit Payments + Expenses
 Anything that increases benefits increases
contributions
(compared to what they would have been without
those benefits)
Slide 65
SACRS Fall 2008 – Actuarial 101
Overfunding vs. Excess Earnings
 What constitutes Good News (“gains”) to be shared
with members?
 Cumulative Good News


Overfunding, AKA “surplus”
“Gainsharing” policies in other states
 Year-by-Year Good News


“Excess Earnings”, regardless of funded status
Distinctive feature of 1937 CERL systems (and others)
Slide 66
SACRS Fall 2008 – Actuarial 101
Generic Funding Mechanics
employer contributions
$
$
$
investments
$
$
$
$
$
$
$
$
$
$
$
$
employee
contributions
$
$
$
$
Assets
$
$
$
$
$
$
expenses
$
PENSION
FUND
$
$
$
$
benefits
Slide 67
SACRS Fall 2008 – Actuarial 101
Plumbing for Excess Earnings
Ad-Hoc
Benefits
Undistributed
Excess Earnings
Investment Income
Contingency Reserve
County
Contributions
Valuation
Assets
Member
Contributions
Drawing Not
to Scale!
Expenses
Benefits
Slide 68
SACRS Fall 2008 – Actuarial 101
“Excess Earnings” Mechanics
 Two-Step process for Excess Earnings benefits

Used by most but not all systems
 First, “park” Excess Earnings in a “non-valuation”
reserve


Excluded from Valuation Assets
Prevents decrease in amortization cost
 Later, “spend” Excess Earnings on ad hoc benefits


No sudden impact on contribution rate
A form of forced budgeting!
Slide 69
SACRS Fall 2008 – Actuarial 101
Historical Focus on Excess Earnings
 Brand new systems, unfunded liabilities
 Fixed income investments

Buy and hold strategies
 Very predictable returns

Excess current income or realized gains reasonably
viewed as “found money”
 Introduction of equity investments


1966: initiative to allow 25% equity investments
1984: Prop. 21 “Prudent Man” investments
Slide 70
SACRS Fall 2008 – Actuarial 101
Changing Investment Policies
 Acceptance of equity investments

Especially since 1984 and Prop. 21
 Policy impact on “smoothed” value of assets



First, smooth only unrealized gains
Affected by trading activity
Focus on smoothing total return
 Similar impact on Excess Earnings measure


Change from book value to smoothed market return
Measure excess earnings consistent with valuation
Slide 71
SACRS Fall 2008 – Actuarial 101
Recent Challenges to Excess Earnings
 Equity investments mean more volatility

Highs and Lows offset each other, unless highs are
diverted for ad hoc benefits
 San Diego City “Kroll” Report

Highly critical of excess earnings funded benefits
 Actuarial Standards of Practice

Should assumed earnings rate be reduced?
 Especially for systems like CERL SRBR systems
 Legal opinions requiring cost studies
 Hard fact: Volatility is not a source of funding
Slide 72
SACRS Fall 2008 – Actuarial 101
Universal Rule of Pension Plans: No free lunch!
C+I=B+E
Contributions + Investment Income
equals
Benefit Payments + Expenses
 Every dollar of excess earnings funded
benefits increases employer cost …

Above what it would have been if that benefit were
not paid
Slide 73
SACRS Fall 2008 – Actuarial 101
Current Excess Earnings Benefits
 Purchasing Power COLAs


“STAR” COLAs, “Dollar Power” COLAs
Compare CPI with COLAs since retirement
 Determine Inflation not matched by COLAs
 Bring benefit up to some percentage of CPI (80%)
 Flat dollar subsidy benefits
 Health benefits, various formulas

Special provisions needed to pay as non-taxable
 Contribution rate relief – members and/or employers
 Survivor benefits
Slide 74
SACRS Fall 2008 – Actuarial 101
Sample Excess Earnings Benefits
Orange
San Diego
Alameda
San Bernardino
Sacramento
Contra Costa
Fresno
Ventura
Sonoma
Imperial
none
PPCOLA, health
PPCOLA, health, burial, survivor
$230 supplement, burial
none
PPCOLA, $200 supplement (both vested)
flat supplement, special tier rate reduction
PPCOLA, $27.50 supplement
Regular COLA, PPCOLA (vested)
PPCOLA, rate reductions
Slide 75
SACRS Fall 2008 – Actuarial 101
Section 31874.3: Purchasing Power COLAs
 “Purchasing Power COLA” authority is now 80%
 Allows for “prefunded” PPCOLAs, if sufficient
excess earning are available

One big transfer, then smaller catch-ups
 Adds PPCOLAs to statutory benefit


Often called “vesting” the PPCOLA
 Reduces COLA bank
 Future statutory COLAs then apply to PPCOLA
Future shortfalls funded by employer contributions(!)
Slide 76
SACRS Fall 2008 – Actuarial 101
QUESTIONS
Slide 77
SACRS Fall 2008 – Actuarial 101
Actual Interest Crediting Process
 Determine “Available Earnings” for the period



All current period earnings
Minimum and/or Additional Contingency Reserves
Maybe some or all prior undistributed excess earnings
 Determine earnings needed to credit reserves
 If Available Earnings is enough, do the credits



Then restore Contingency Reserves
Balance to “Undistributed Earnings Reserve” (UER)
Excess Earnings Policy determines use of this
“excess earnings”
Slide 78
SACRS Fall 2008 – Actuarial 101
“Available Earnings” Measure
 Most systems now use same measure of earnings
for reserves and for funding
 Total Reserves = Actuarial Value of Assets
 Valuation Reserves = Valuation Value of Assets

Excludes “Non-valuation” Reserves
 Excess Earnings <==> Actuarial Investment Gain
 Alternative: Earnings based on “Book Value”

More on this under “History”
Slide 79
SACRS Fall 2008 – Actuarial 101
Non-Valuation Reserves
 Most exclude Contingency, Undistributed



Policy issue, not statutory requirements
Including means no forced budgeting
 Puts funds to work until Board exercises discretion
Recent litigation and arbitration
 All exclude specific benefit reserves

Note that including reserve and liability is the same as
excluding reserve (for costs)
Slide 80
SACRS Fall 2008 – Actuarial 101
Undistributed Earnings Distribution Priorities
 Restore Contingency Reserve(s) to target levels
 Restore prior interest shortfalls (Contra Account)

Some say these (especially Contingency Reserves) are
required before earnings are “excess”
 Allocation to UAAL to fund for regular benefit

Especially if funded ratio is below some target level
 Supplemental COLA, retiree health benefits,
flat dollar subsidies, etc.
 Hold over for next interest crediting cycle
Slide 81
SACRS Fall 2008 – Actuarial 101
Level of Contingency Reserve (CR)
 In effect, statute requires 1% minimum CR

A form of “smoothing” short term earnings fluctuations
 Additional CR provides further cushion against
future earnings shortfalls


Additional CR is consistent with equity investing
Various practices among 1937 Act Systems
 Earnings are not “excess” until CR is restored
Slide 82
SACRS Fall 2008 – Actuarial 101
Contra Account Concept
 Used to track interest crediting shortfalls
 Does not ignore the bad investment returns

After a bad year, same impact on employer rates,
funding ratios and member balances
 Difference comes when good year follows bad
Slide 83
SACRS Fall 2008 – Actuarial 101
Contra Account Concept
 Consider this policy thought experiment




forget about Contingency Reserve for now
Scenario X: earn zero, then 16%
Scenario Y: earn 8%, then 8%
Scenario Z: earn 16%, then zero
 Should Board’s excess earnings discretion be any
different in these scenarios?
Slide 84
SACRS Fall 2008 – Actuarial 101
Contra Account Concept
 Contra Account tracks interest shortfall
 Policy issue: Do we restore past shortfalls with
later excess earnings before any other priorities?

Should later gains reverse prior losses before allowing
ad hoc benefits?
 If “yes”, then track shortfall in Contra Account

In future years, use available earnings to restore prior
shortfalls (by reducing Contra Account) before funding
any ad hoc benefits
Slide 85
SACRS Fall 2008 – Actuarial 101
Contra Account Concept
 In effect, this measures “excess” earnings on a
cumulative basis


Responds to critics of “excess earnings” concept
Reduces risk that excess earnings benefits will cause
systematic increase in plan cost over time
 Legal requirement or preferred practice?

Most 1937 Act systems either do not track or do not
require priority restoration.
Slide 86
SACRS Fall 2008 – Actuarial 101
C+I=B+E!
FREE
LUNCH
Slide 87
SACRS Fall 2008 – Actuarial 101
QUESTIONS
Slide 88