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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
2/6/2007 2
“Why Governmental Accounting and Financial Reporting is – and should be – different” – GASB White Paper
2/6/2007 3
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
2/6/2007 4
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
2/6/2007 5
Methods, Measurements and Other Issues
2/6/2007 6
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
2/6/2007 7
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
2/6/2007 8
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
2/6/2007 9
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)
2/6/2007 10
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
2/6/2007 11
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)
2/6/2007 12
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
2/6/2007 13
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)
2/6/2007 14
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
2/6/2007 15
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
2/6/2007 16
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
2/6/2007 17
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
2/6/2007 18
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
2/6/2007 19
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?)
2/6/2007 20
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