Graham Schmidt, ASAVice President, EFI Actuaries

2/6/2007 1

Fundamental Differences◦ Purposes◦ Revenue◦ Budget obligations◦ Longevity

Actuarial Differences◦ Private sector requirements (FASB / PBGC / IRS)◦ Governmental approaches (level cost, transfers,

funding rules)◦ Public vs. private

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“Why Governmental Accounting and Financial Reporting is – and should be – different” – GASB White Paper

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Purpose◦ For-Profit Business Enterprise: Generate a

financial return on investment◦ Government: “Focus on providing services and

goods to constituents in an efficient, effective, economical and sustainable manner.”

Revenue◦ For Taxpayer, amount of taxes paid does NOT

bear direct relationship to services received Budget Obligations

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Longevity◦ Number of municipal bankruptcy filings 0.02% of

business filings◦ Long-term outlook leads to focus on “trends in

operations, rather than on short-term fluctuations, such as in fair values of certain assets and liabilities.” Short-term fluctuations result in less “decision-

useful” measurements For businesses, short-term more important because

of current value of equity

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Methods, Measurements and Other Issues

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Accounting◦ Governed by FASB (FAS 87, 106, 132 & 158)◦ Measure Projected Benefit Obligation (PBO)

Based on Projected Unit Credit actuarial funding method

Prescribed to improve comparability, but mismatch between accounting/funding

◦ Rate used to discount liabilities based on “settlement rates” based on annuity rates or high-quality fixed income average ~ 5.5–6.0% in FY 05 can be quite variable from year-to-year

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Accounting Continued◦ Use different rate for “expected return on assets”

used to calculate reported pension expense average ~ 8.0-8.5% in FY 05 may change due to future FASB projects

◦ Amortization / Smoothing Most elements amortized over average remaining

service of current actives Only have to amortize portion of g/l Max smoothing period for assets is 5 years

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Funding◦ Basis

Companies offer “qualified” plans to obtain tax advantages

IRS makes rules to ensure funding status (protect PBGC and participants) and ensure “fairness” (non-discrimination, etc)

Rules define minimum / maximum contributions Pension Protection Act (PPA) changed rules

significantly

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Funding (new rules)◦ PPA defines “Funding Target” – 100% of PV of

accrued benefits (was 90%) [using Unit Credit method]

◦ Unfunded liability must be amortized over 7 years◦ Discounting based on yield curve (different rates

for different payment durations)◦ Mortality rates dictated by IRS (very large plans

can use own experience)

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Funding◦ Max asset smoothing is 24 months, with 10%

corridor◦ Plans with low funding levels (“At-Risk Plans”)

subject to additional restrictions / requirements: Contributions Benefit improvements / changes Forms of payment (no lump sums)

◦ PPA also increased maximum contribution limits◦ Changes to multi-employer rules not as significant

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Not one-size-fits-all◦ Governmental plans not subject to most of ERISA

rules◦ More difficult for IRS to enforce through tax policy◦ No Federal restrictions on funding (occurs at State

or Local level)◦ GASB defines accounting standards (GASB 25, 27,

43, 45) - contain more flexibility than FASB (funding methods, amortization, etc)

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General Actuarial Characteristics◦ Funding Methods

Most pre-fund Cost methods split cost into past costs (accrued

liability), current year’s cost (normal/service cost), future normal costs

Most common method is Entry Age Normal Goal is to determine level normal cost needed to fund

each individual’s benefit GASB allows 6 methods

Proposed GASB change: if use Aggregate method, must show funding ratio using EAN

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General Actuarial Characteristics◦ Amortization / Smoothing

Most amortize unfunded accrued liability (UAL) Again, no federal rules, but GASB has some restrictions

Max period 30 years, level $ or % of pay, open or closed period

With long period and level % of pay, current payment may be less than interest on UAL

Assets generally smoothed Most common to use 3-5 years (CalPERS using 15)

◦ Discount Rate Generally use expected return on assets Most common: 8.0% in ‘05 (NASRA survey)

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Private sector moving towards discounting liabilities at market rates (yield curve)◦ Influenced by “Financial Economics”

Price of liability is asset consisting of matching cashflows (use yield curve) “Mark-to-Market” liabilities

$1 of bond = $1 of stock: why would value of liabilities be different?

Discounting of liabilities at 8% anticipates “risk premium” -> transfers risk to future generations

Existence of PBGC has introduced moral hazard – encouraging investment in overly-risky portfolios

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Why important for Private Sector?◦ Value of equity/debt important (companies

bought & sold)◦ Earnings and contributions (accounting and

funding) directly impacted by fluctuations in interest rates because of FASB / IRS rules Large penalties for missing earning targets

◦ Liability-Driven Investing (LDI) attempts to reduce volatility due to interest rate risk by taking into account payment structure of liabilities

◦ Generally results in increased allocation to long-duration bonds

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Why could be different for governments?◦ GASB: “Information on fair values of capital assets

is of limited value” (less likelihood of bankruptcy / termination)

◦ In current practice (accounting & funding), fluctuations in interest rates do NOT impact government plans Do you measure it? Does measurement matter?

◦ Assuming plans invest in “risky” assets, current practice does better job determining level contributions

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Issues with current practice for governments◦ Discounting at expected rate of return (8%) does

not reflect risk of investing◦ Could measure/contribute using risk-free rate and

invest in “matching” portfolio However, certainty has cost! Remember purpose: “providing services and goods to

constituents in an efficient, effective, economical and sustainable manner”

◦ Alternatively, could project future asset returns / cashflows (including impact of uncertain inflation) using simulation or other methods Shifts emphasis from liabilities to range of future costs

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Smoothing / Amortization◦ Financial Economics approach says smoothing

disguises volatility: “When followed by a corporate bankruptcy, this policy of ignoring

economic reality and failing to make needed contributions can lead to devastating losses of retirement income for long-serving employees” – Bradley Belt

◦ With reduced likelihood of bankruptcy / termination in public sector, does argument against still hold? May cause some shifts in cost between generations,

but overall contribution level does not change and is more stable

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Likelihood of Change?◦ If government plans forced to measure interest

rate volatility (and measurement matters), then changes to investments may result

◦ Important users of financial statements (bond-rating agencies) are not currently demanding changes

Ability to meet cashflow future requirements more important than consideration of “economic” value of plan

◦ Series of high-profile municipal bankruptcies could prompt demand for funding rules (PBGC-type entity?)

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