LAPERS Seminar 2015 ACTUARIAL ASSUMPTIONS AND METHODS:

WHAT IS REASONABLE?John Garrett, ASA, MAAA, FCAPrincipal and Consulting ActuaryCavanaugh Macdonald Consulting, LLC

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Perception of the Actuarial Valuation

PopulationData

Plan Provisions

ContributionRates

FinancialReportingAssumptions &

Methods

Actuary

Basic Funding Equation: C + I = B + E

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INFLOW: Employee

Contributions+

Employer Contributions

+ Investment

Income

OUTFLOW: Benefit Payments

+ Expenses

Purpose of ValuationsBenefits payments are defined by plan Employee contributions are typically defined by planInvestment Income (net of expenses) is “assumed”Employer contributions usually the dependent variable

◦ Requires an actuarial valuation to determine the employer contribution necessary to solve the funding equation over the long term future.◦ Most employer’s desire stability in the rate

◦ Based on the actuarial assumptions and methods recommended by the actuary and adopted by the Board.

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Actuarial Assumptions

Economic Assumptions

Price Inflation ◦ May also be the COLA assumption

Wage Inflation◦ Price Inflation◦ Real Rate of Wage Increase

Investment Return◦ Price Inflation ◦ Real Rate of Investment Return

Payroll Growth Rate

Demographic Assumptions • Retirement Rates• Disability• Turnover/Withdrawal• Mortality• Promotional/Step Pay Increases• Miscellaneous

Assumptions are utilized to estimate unknown future events in order to calculate the actuarial present value of future plan benefits

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Things That Happen to PeopleKNOWN at valuation date:

1. Age

2. Salary

3. Gender

4. Service to date

5. Occupation

Date of Hire

(Age 30)

ValuationDate

(Age 45)

RetirementDate

(Age 60)

Date of Death

(Age 85)

15 Years15 Years 25 Years

30 Years

An Individual’s Valuation Timeline

Calculation of Expected Future Benefits

20122013

20142015

20162017

20182019

20202021

20222023

20242025

20262027

20282029

20302031

20322033

20342035

20362037

20382039

20402041

20422043

20442045

20462047

20482049

20502051

20522053

20542055

20562057

20582059

20602061

2062$0.0

$500,000,000.0

$1,000,000,000.0

$1,500,000,000.0

$2,000,000,000.0

$2,500,000,000.0

$3,000,000,000.0

$3,500,000,000.0

$4,000,000,000.0

Expected Total Benefit Payments of Current Members

Current Retirees Current Actives

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Impact of AssumptionsThe timing of future benefit payments is impacted by demographic assumptions such as rates of retirement, withdrawal, disability and death.

The size of future plan payments to actives is impacted by salary increase assumptions, the size of future payments to both actives and retirees is impacted by mortality, COLA assumptions.

The present value of every future payment is impacted by the assumed rate of investment return.

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Assumptions are Precisely Wrong Many demographic assumptions use probabilities

◦ Rates of deaths, retirements, disabilities…etc.

Reality is binary – 0 or 1, yes or no, did or did not◦ This results in assumptions which are not realistic for the individual◦ But….

The goal is that demographic assumptions applied to large populations accurately reflect the experience of that population

◦ Law of Large Numbers

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What Are The Right Assumptions?Assumptions ideally are the best estimate of future experienceBased on sufficient experience or related experience of similar populations

◦ Example: Mortality Assumptions of Small Public Plans

Not too heavily based on recent experience and reflects future expectations◦ Example: Investment Returns

Assumption should be unbiased – not overly pessimistic or optimistic“Reflects Actuary’s professional judgment”

◦ “Common Sense” based on statistical analysis

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How Do We Know We Have Good Assumptions?

Actuarial valuations should report the actuarial gains and losses due to material assumptions

Investment return, salary increases, post-retirement mortality, rates of retirement and other material assumptions

Well performing assumptions should result in offsetting gains and losses overtime

Lower impact to unfunded accrued liabilities Lower resulting contribution volatility Smaller plans have less opportunity for offsetting experience

Periodic review of assumptions (Experience Studies) to make adjustments as necessary

Never meant to be forever

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Example of Actuarial Gains and Losses by Source

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Actuarial Methods Actuarial Methods are the various techniques employed by actuaries to allocate program costs to specific periods Three primary types of methods used in public pension valuations

• Actuarial Cost Method• Actuarial Asset Smoothing Method• UAAL Amortization Method

Usually defined in the plan’s funding policy

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Actuarial Cost Methods

Allocate cost of pension benefit accruing over a career Accrued liability – value of benefits allocated to past serviceNormal cost – cost of this year’s benefit accrual (actual or average)

ExamplesEntry Age Normal oNormal cost is the average annual rate over careeroAccrued liability is the accumulation of past normal cost

Projected Unit CreditoAccrued Liability is the present value of accrued benefitoNormal cost is the expected accrual earned in upcoming year

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Actuarial Asset Smoothing Why smooth investment experience?

Long-term Expected Return

1 Std Dev Above Mean

1 Std Dev Below Mean

1 5 10 1520 25 30Years

Range of Return Expectation

8.00%

22.00%

(6.00)%

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Actuarial Asset Smoothing Typically 3 to 5 year smoothingSpreads “unexpected” returns

Unexpected market returnUnexpected actuarial returnDifference between market and

actuarial values

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Market Market Related 5 Write-Up 25%

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UAAL Amortization MethodsAmortization Payment Amount AttributesLevel as a dollar amount

Similar to most loan financing (home mortgage, car loans, etc.)Level as a percentage of payroll

Increasing dollar amountsRequires payroll growth assumption

Amortization Payment Period AttributesClosed amortization period

Similar to most loan financingOpen amortization period

Annual refinancing of loan

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UAAL Amortization Methods

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

$ m

illi

on

s

Unfunded Liability Balance - Level Dollar

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UAAL Amortization Methods

0

1,000

2,000

3,000

4,000

5,000

6,000

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

$ m

illi

on

s

Unfunded Liability Balance -Level Percent of Payroll

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UAAL Amortization Methods

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Un

fun

ded

in $

mil

lio

ns

Open Amortization Period

Level Dollar Level % of Pay

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Who’s Methods Are These?

Methods utilized in valuations should best fit the funding objectives of the Board

Balance of cost stability and desired funding progress

Methods utilized should make sense Level percent of pay amortization for a plan closed to new entrants?Does an open amortization period make sense?

As with assumptions - actuary recommends but Board selects

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What Is Going On With Actuaries? American Academy of Actuaries (actuary.org)

◦ Issue Brief on “Objectives and Principles for Funding Public Sector Pension Plans”

Society of Actuaries (soa.org)◦ “Report of the Blue Ribbon Panel on Public Pension Plan Funding”

Actuarial Standards Board (actuarialstandardsboard.org)◦ Currently considering whether Actuarial Standards of Practice (ASOPs) specific to public

pension plan funding are necessary

Conference of Consulting Actuaries (ccactuaries.org)◦ White Paper - “Actuarial Funding Policies and Practices for Public Pension Plans”◦ http://www.ccactuaries.org/communities/ppc/library/Public-Plans-Community-347-41187.PDF◦ Provides “Model”, “Recommended”, “Acceptable”, “Acceptable with Conditions”, “Non-

recommended” and “Unacceptable” practices for each of the three common methods.