1

Governmental EmployerFunding of Defined Benefit Plans

andCalPERS Employer Rate Smoothing Policies

Ron SeelingCalPERS Chief Actuary

2

Key MessagesThe long term nature of actuarial work and the ongoing nature of governmental employers allows a long term approach to funding post employment preferable for governmental employers.

Employers sponsoring plans at CalPERS stated emphatically that they desired more stability and predictability in the contributions to their pension plan.

The strong markets of the late 1990s resulted in a substantial surplus across all of CalPERS.

3

Key Messages

While some surplus was used for benefit improvement, about 80% of the decline in the funded status was due to the long and deep market downturn in the early 2000s.

The markets have done well over the past several years and the plans at CalPERS are quickly returning to 100% funded.

4

The Nature of Pension Actuarial Work

By their very nature, actuarial calculations for post employment benefits are very long term in nature, not year by year predictors.

The work is based on long term average demographic and economic assumptions.

Investment return assumption and experience has a large impact on employer contributions.

The 20 year compound return for CalPERS Public Employees Retirement Fund is in excess of 9%, but individual yearly returns included a negative 7.23% and a positive 20.1%.

The current long term investment return assumption is 7.75%.

5

Basic Definitions

When a new employee is hired, there is created an obligation to pay that individual “something” at “sometime” after the employee terminates.

The “something” and “sometime” depends on when and how the employee terminates and most often on some unknown future salary.

The actuarial assumptions produce a probability of occurrence for each of hundreds of possible futures for the employee.

6

Basic DefinitionsThree important values are computed based on having all actuarial assumptions met (a big if).

Present Value of Benefits – The total dollars needed today to pay for all future benefits for all current (but not future) employees without the need for future contributions at all.

Normal Cost - The “annual premium” needed each year of the employee’s career to pay for an employee’s total benefit.Accrued Liability - The assets that would be on hand now if all Normal Costs had been collected in the past had all actuarial assumptions had been met. This is also the Present Value of Benefits less the Present Value of future Normal Costs.

7

Funded Status

The plan’s Funded Status is equal to the plan’s assets divided by the plan’s accrued liability.When assets are less than the accrued liability, the plan is simply behind schedule in accumulating assets and contributions in excess of normal cost must be collected.When assets are more than the accrued liability, the plan is ahead of schedule in accumulating assets and contributions less than normal cost can be collected.It is the nature of actuarial work and investing in assets that rise and fall in value that sometimes the plan is sometimes ahead of schedule and sometimes behind schedule.

8

Funded Status

Too much is made of a plan’s current funded status.

• One should look for progress in returning to 100% funding not the current funded status at any one point in time.

• The average funded ratio of CalPERS’ plans was about 138% (on a market value basis) at the height of the stock market boom, through about June 30, 2000.

• Some surplus was used for benefit enhancements, but about 80% of the surplus remained to reduce future employer contributions.

9

Funded Status

Then came one of the deepest and longest declines in the stock market’s history.

CalPERS experienced two fiscal years in a row of negative returns for the first and only time in its 75 year history.

The average funded ratio of CalPERS dropped to 80% (on a market value basis).

The markets have experienced a significant rebound since their low point and the average CalPERS plan’s funded ratio stands at approximately 93% (on a market value basis) as of June 30, 2006.

The investment return for fiscal 2006-07 is again superior and the plans will continue to march toward 100% funding.

10

Funded Status versus Smoothing

Any “smoothing” in the employer rate setting process comes at the expense of the funded status of the plan.The more you smooth, the slower you return to 100% funded whether you start above or below 100% funded status. There is a funding methodology spectrum

The goal must be to strike the proper balance between protecting the plan’s funded status and producing stable employer contributions.

Funding Methodology SpectrumReturn to 100% funded status slowly with much lower volatility in employer contributions.

Return to 100% funded status quickly with much higher volatility in employer contributions.

11

There are significant differences between private sector and public sector employers with respect to the appropriate choice of where to be on this funding spectrum.

In many instances, the life expectancy of private sector employers is shorter than the life expectancy of the pension promises made by the company.

Recent trends in federal legislation regarding the funding of private sector defined benefit plans have been strongly slanted toward short term solvency rather than long term funding.

Funded Status versus Smoothing

12

On the other hand, most public sector employers will be there to back up their pension promises for the long term.

So, public sector employers can afford to focus on long term funding, and corresponding significantly lower contribution volatility than their private sector counterparts.

There is also a lack of symmetry in this spectrum.A policy set to eliminate unfunded liability quickly (a conservative approach when the plan is behind schedule) essentially backfires when applied to the same plan in a surplus position. Nevertheless, the Board’s fiduciary counsel has opined on multiple occasions that symmetry is required.

Funded Status versus Smoothing

13

The CalPERS Studyof Smoothing Methods

CalPERS’ actuarial staff set about studying the impact of various asset smoothing and amortization methods on the plan’s funded status as well as employer contribution rates.

We studied 32 different methods.

We generated 1,500 scenarios of future asset returns using a statistical normal distribution based on CalPERS asset allocation to generate the scenarios.

Each of the 1,500 scenarios consisted of 50 years worth of future investment returns.

For each of these 1,500 scenarios we computed the plan’s funded status and employer contribution rate for each of the next 50 years.

14

We set the following objectives:Seek the smoothing method that “best”simultaneously:⌧Minimizes any negative impact on the funded

status of the plans.⌧Minimizes the volatility in the employer’s

contribution.⌧Minimizes the average future employer

contribution.Select a method that produces employer rates that comply with generally accepted accounting standards as provided by Governmental Accounting Standards Board Statement No. 27 (GASB 27).

The CalPERS Studyof Smoothing Methods

15

Comparison of Prior and New Methods

20 Year Declining 20 Year Declining Amortization of Plan Amendments, Changes in Methods or Assumptions

Normal Cost less 30 year amortization of any

surplus

None Minimum Contribution

30 Year rolling (about 6% of unamortized amount)

10% of Unamortized Amount

Amortization of Gains/Losses

80% - 120% 90% - 110% Actuarial Value Corridor

15 year asymptotic 3 year asymptotic Spread of Asset Gains/Losses

New MethodPrior Method

16

Impact of New Methods onFunded Status and Employer Rates.

The new methods:Reduce the standard deviation of the annual change in employer rates (the volatility) by 52%.Increase the average employer contributions by .2% of payroll.Produce employer rates that are compliant with GASB 27.Produce only a minor impact on the potential funded status of the plan. See next slide.

17

Impact of New Methodson Funded Status

IMPACT OF RATE STABILIZATION METHODS ON FUNDED STATUS

PLAN WITH LIABILITY TO PAYROLL RATIO OF 6

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

300% 200% 140% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Funded Status

Prob

ability

Current Methods New Method

Probability of Funded Status Falling BELOW a Certain Level(Over a 50 year Period)

Probability of Funded Status Rising ABOVE a

Certain Level(Over a 50 Year Period)

The x-axis in the funded status of the plan and the y axis is the probability of the plans hitting that funded status at some point during the 50 year projection period.

18

History of Investment Returnsat CalPERS

3.9%

15.7%

9.7%

6.5%

12.5%

14.5%

2.0%

16.3%15.3%

19.5%

10.5%

-6.1%

3.7%

11.5%12.8%

11.3%

-7.2%

11.8%12.3%

12.5%

20.1%

16.6%

13.1%

9.3%9.7%8.2%

9.3%

12.8%

9.0%

10.0%9.6%9.4%9.4%9.4%

-10%

-5%

0%

5%

10%

15%

20%

25%

87-88 88-89 89-90 90-91 91-92 92-93 93-94 94-95 95-96 96-97 97-98 98-99 99-00 00-01 01-02 02-03 03-04 04-05 05-06

Annual Return Rolling 10 Year Compounded Return Rolling 15 Year Compounded Return

Despite the volatility in the annual investment returns, the longer compound investment returns surpass the actuarially assumed return.

19

Comparison of State Contributionsfor the Largest State Plan

Old vs. New Smoothing Methods

ACTUAL EMPLOYER CONTRIBUTION RATES VS ESTIMATED RATES UNDER RATE STABILIZATION METHOD

State Miscellaneous (Average of Tier 1 and Tier 2)

0%

5%

10%

15%

20%

25%

30%

1995

-199

6

1996

-199

7

1997

-199

8

1998

-199

9

1999

-200

0

2000

-200

1

2001

-200

2

2002

-200

3

2003

-200

4

2004

-200

5

2005

-200

6

2006

-200

7

2007

-200

8

Old Method Employer Rate Employer Normal Cost Estimated Smoothed Employer Rate

Recognition of SB 400

20

History of Public AgencyEmployer Contribution Rates

History of Average Employer Contribution Rates for Public Agency Miscellaneous Plans

0%

5%

10%

15%

20%

25%

30%

1980

- 19

81

1982

- 19

83

1984

- 19

85

1986

- 19

87

1988

- 19

89

1990

- 19

91

1992

- 19

93

1994

- 19

95

1996

- 19

97

1998

- 19

99

2000

- 20

01

2002

- 20

03

2004

- 20

05

2006

-200

7

2008

-200

9(e

stim

ated

)

Total Rate Normal Cost

21

History of Average Employer Contribution Rates for Public Agency Safety Plans

0%

5%

10%

15%

20%

25%

30%

1980

- 19

81

1982

- 19

83

1984

- 19

85

1986

- 19

87

1988

- 19

89

1990

- 19

91

1992

- 19

93

1994

- 19

95

1996

- 19

97

1998

- 19

99

2000

- 20

01

2002

- 20

03

2004

- 20

05

2006

-200

7

2008

-200

9(e

stim

ated

)

Total Rate Normal Cost

History of Public AgencyEmployer Contribution Rates

22

General Results of Smoothing

CalPERS implemented smoothing in response to great market volatility.There was no way to know then, nor is there any way to know now the future direction of the markets.

It is equally likely that the new smoothing methods will help ease future increases in rates as it is that the new methods will slow down decreases in rates.

That being said, the impact on employer rates has been very positive so far. For example, about 75% of all local public agency plans experienced an employer rate change of less than 1% of pay between 2005-06 and 2006-07. The remaining 25% of plans included those that improved benefits and had a planned change in employer rate.

23

From these graphs that follow it can be clearly seen that the funded status of all plans at CalPERS dropped significantly upon the market crash is early 2000.

But market returns have improved dramatically and the smoothing techniques have not allowed employer rates to drop as quickly.

All plans are recovering nicely and marching back to one hundred percent funded status fairly quickly.

General Results of Smoothing

24

Funded Status of State PlansHistory of Funded Ratio - MVA Basis

State Plans

95.3% 97.8%

90.7%94.0%

99.8%

114.4%

126.3%131.2%

115.4%

96.5%

82.1%76.4%

82.9% 85.5%88.6%

0%

20%

40%

60%

80%

100%

120%

140%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

Fund

ed R

atio

25

History of Funded Ratio - MVA BasisSchools Pool

107.5% 110.2%

101.6%105.4%

112.1%

133.6%

142.9% 145.7%

130.7%

108.4%

88.5%83.4%

91.4%96.2% 98.7%

0%

20%

40%

60%

80%

100%

120%

140%

160%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

Fund

ed R

atio

Funded Status ofThe School Pool Plan

26

History of Funded Ratio - MVA BasisPublic Agencies

85.0%

101.0% 100.6%

110.0% 107.5%

130.0%

139.3% 140.9% 138.4%

112.4%

91.7%

82.2%87.0%

92.2% 95.2%

0%

20%

40%

60%

80%

100%

120%

140%

160%

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006(estimated)

Year

Fund

ed R

atioFunded Status of

Public Agency Plans

27

History of Funded Ratio - MVA BasisPERF

93.9%101.2%

96.4%102.0% 105.0%

123.7%

134.4%137.7%

126.9%

104.8%

87.1%80.0%

86.1%90.2% 93.1%

0%

20%

40%

60%

80%

100%

120%

140%

160%

1992 1994 1996 1998 2000 2002 2004 2006 (estimated)Year

Fund

ed R

atioFunded Status

Across all Plans at CalPERS

28

Next Steps at CalPERS

CalPERS is studying a remaining question regarding smoothing.• “How do we bring the employer’s rates back towards

normal cost as the plans approach one hundred percent funding?”

• We want a mechanism that avoids having employer contributions “stuck” too high or too low when the plan approaches one hundred percent funding on a market value of assets basis.

• Actuarial staff at CalPERS should complete this work and deliver it to the CalPERS Board by the end of this calendar year, in time for next rate setting at CalPERS.