The opinions expressed in this presentation are those of the speaker. The International Foundationdisclaims responsibility for views expressed and statements made by the program speakers.

Interest Assumptionsin Public Sector Plans

Keith BrainardResearch DirectorNational Association of StateRetirement AdministratorsGeorgetown, Texas

Larry F. Langer, FCA, ASA, EA, MAAAPrincipal and Consulting ActuaryBuck Consultants, a Xerox CompanyChicago, Illinois

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The Universal Retirement Equation

C + I = B + E

• Contributions plus Investment Earnings equals Benefits plus Expenses

• Over the life of the pension plan, the money that goes out must equal the money that comes in

• Investment earnings typically account for the majority of revenue for a public pension fund

• This fact illustrates the important role the investment return assumption plays in financing a pension plan

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The Valuation Process

Over the short term, contributions are determined by the actuarial valuation based upon estimated investment return, benefits and expenses using assumptions and methods recommended by the actuary and adopted by the Board. Over the long term, contributions are adjusted to reflect actual investment return, benefits and expenses.

INPUT

• Member Data

• Asset Data

• Benefit Provisions

• Actuarial Assumptions

• Funding Methodology

RESULTS

• Actuarial Value of Assets

• Normal Cost and Actuarial   Accrued Liability

• Funded Ratio/UAAL

• Required Contributions

• Accounting Results

• Sensitivity Projections

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The Actuarial Valuation

• An actuarial valuation is the mathematical process of determining a pension plan’s liabilities, cost and condition

• The investment return assumption is one of many projections of future events used in an actuarial valuation

• Other assumptions include how long plan participants will work, how long they’ll live, and at what rate salaries will grow

• The investment return assumption typically is the single most consequential of all assumptions

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Immediate Impact of Change in Return Assumption

The above illustrates the impact the impact of a one-percent decrease in the assumed rate of return. The immediate impact is quite large. Reductions in the assumed return tend to range from 25 to 50 basis points.

Illustrative Impact  of Decrease in Interest Rate Assumption ‐ not fully funded

7.50% 6.50% % $Employer Contribution1.    Normal Cost 8.7 10.7 23% 2.02.    Amortization Payment for UAAL 21.0 26.7 27% 5.73.    Member Contribution 5.5 5.5 0% 0.04.   Employer Contribution (1. + 2. ‐ 3., minimum 0) 24.2 31.9 32% 7.75.   Projected Payroll 82.2 82.2 0%6.   Employer Contribution as a % of Payroll 29.44% 38.81% 32%

7.    Actuarial Accrued Liability 1,000 1,097 10% 1,0978.    Actuarial Value of Assets (AVA) 750 750 0% 1,0009.   Unfunded Actuarial Accrued Liability (UAAL) (7. ‐ 8.) 250 347 39% 9710.   Funded Ratio (8. / 7.) 75.00% 68.37% ‐9%

change

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Illustrative Impact  of Decrease in Interest Rate Assumption ‐ fully funded plan

7.50% 6.50% % $Employer Contribution1.    Normal Cost 8.7 10.7 23% 2.02.    Amortization Payment for UAAL 0.0 7.5 ∞ 7.53.    Member Contribution 5.5 5.5 0% 0.04.   Employer Contribution (1. + 2. ‐ 3., minimum 0) 3.2 12.7 297% 9.55.   Projected Payroll 82.2 82.26.   Employer Contribution as a % of Payroll 3.89% 15.45%

7.    Actuarial Accrued Liability 1,000 1,097 10% 1,0978.    Actuarial Value of Assets (AVA) 1,000 1,000 0% 1,0009.   Unfunded Actuarial Accrued Liability (UAAL) (7. ‐ 8.) 0 97 ∞ 9710.   Funded Ratio (8. / 7.) 100.00% 91.16% ‐9%

change

Immediate Impact of Change in Return Assumption

For a fully funded plan, the decision to reduce the interest rate assumption can result in in a much larger percent and even dollar increase in contributions.

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Long Term Impact

2,140  2,030  1,910  1,862  1,775  1,676 

362  498  636 889  1,004  1,120 

 ‐

 500

 1,000

 1,500

 2,000

 2,500

7.50% 7.00% 6.50% 7.50% 7.00% 6.50%

Returns

Contribution

The expected impact of lowering the interest rate assumption on contributions and return over the longer term – 20 years here – is demonstrated below.

Not Fully Funded Fully Funded 

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Discounting Pension Liabilities

• A discount rate is the interest rate used to determine the present value of future cash flows

• The lower the investment return assumption, or discount rate, the higher the liabilities (and cost)

• The higher the discount rate, the lower the liabilities (and cost)

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Discounting Pension Liabilities

• Public pension plans generally discount their liabilities using the expected, or assumed, rate of investment return

• The purpose for using the expected investment return to discount liabilities is to promote budget stability and predictability

• Each one percent reduction in a public pension investment return assumption increases liabilities by approximately 11 percent

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Discount Rates:Public Plans

• For GASB reporting purposes, plans that are projected to run out of money must discount their liabilities post-fund exhaustion using a rate based on high-grade municipal bonds

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Discount Rates:Corporate Plans

• Corporate pension plans discount their liabilities differently than public plans

• Unlike public plans, corporate plans are governed by ERISA, which prescribes the use of current interest rates to discount liabilities

• This method makes required contributions more volatile: as interest rates rise, plan costs drop; as rates fall, plan costs rise

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Discount Rates:Corporate Plans (continued)

• Congress has provided relief to corporate pension plans to ameliorate the effects of low interest rates

• For example, in 2012, Congress permitted corporations to base their pension costs using an interest rate based on a 25-year average

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Interest Rates Since 2003

Yields on 10‐year government‐issued bonds; Wall Street Journal

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The Public PensionInvestment Return Assumption

• The process for setting the investment return assumption is prescribed in Actuarial Standards of Practice No. 27: Selection of Economic Assumptions for Measuring Pension Obligations

• ASOP 27 directs the actuary to consider a range of economic and financial factors: inflation, interest rates, historic and project asset class returns, etc.

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Experience Studies

• Many public pension plans are required by law or board rule to periodically conduct an experience study

• An experience study compares the actuarial experience of a pension plan with the plan’s assumptions

• Experience studies often produce recommended changes to actuarial assumptions

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Creating the Actuarial Review Framework

• GFOA Best Practice: Enhancing Reliability of Actuarial Valuations for Pension Plans

• Describes steps pension plan fiduciaries should take to enhance the reliability of actuarial valuations

• Suggested measures include a regular actuarial experience review/study

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Nominal vs. Real Rate of Return

• The investment return assumption typically contains two components: inflation, and the real rate of return

• The real rate of return is the return above the rate of inflation; the return produced by taking investment risk

• This is the “building-block” approach• The sum of inflation and the real return is

the nominal rate of return

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Nominal vs. Real Rate of Return

• ASOP 27 says the return assumption should be consistent with– Other actuarial assumptions and methods,

and– The plan’s investment policy

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Building Block Approach

Inflation Inflation Inflation

Productivity Productivity

Real Rate of Return Merit & 

longevity

Interest Rate Salary Increase Payoll Growth

Each economic assumption has two or three components, which should be applied consistently.

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Building Block Approach

The return assumption is based on the plans investment policy. ASOP 27 allows for a provision for adverse deviation, which allows for a discount rate that is lower than the expected return that is expected for a plan with a long time horizon, selecting a return of 7.00% suggests a provision for adverse deviation of 0.92%

10 Year 20 Year 30 YearExpected Expected Expected

Asset Class Allocation Return Return ReturnGlobal Equity 50.00% 8.68% 9.20% 9.42%Aggregate Bonds 30.00% 2.40% 3.54% 4.14%US High Yield 5.00% 4.79% 5.87% 6.49%NCREIF 5.00% 7.79% 8.19% 8.49%Private Equity 9.00% 11.13% 12.50% 13.16%Cash 1.00% 2.10% 2.94% 3.36%Total 100.00%Expected Return 6.71% 7.52% 7.92%

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Building Block Approach

A ranking of projected returns based on the asset allocation can be helpful in determining the amount of deviation as well as give an indication of any stress testing that may be helpful for decision makers.

1 year 10 year 20 year 30 year95th Percentile 16.80% 12.24% 11.86% 11.50%75th Percentile 10.59% 9.08% 9.31% 9.51%60th Percentile 8.25% 7.87% 8.19% 8.53%50th Percentile 6.36% 7.06% 7.65% 7.92%40th Percentile 4.69% 6.20% 7.02% 7.36%25th Percentile 1.59% 4.83% 5.99% 6.45%5th Percentile ‐6.77% 1.33% 3.49% 4.40%

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80%

82%

84%

86%

88%

90%

92%

94%

96%

98%

100%20

1620

1720

1820

1920

2020

2120

2220

2320

2420

2520

2620

2720

2820

2920

3020

3120

3220

3320

3420

3520

3620

37

Assume 7.50%/actual 6.50%

Assume 6.50%/actual 6.50%

Long Term Impact “If Wrong”

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Long Term Impact “If Wrong”

1,6801,910

712636

288 0

0

500

1000

1500

2000

2500

3000

Assume 7.50%/actual 6.50% Assume 6.50%/actual 6.50%

UAAL

Contribution

Returns

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Asset Allocations: Public vs. Corporate Pension Funds

Public Fund Survey; Wilshire Associates, based on 2015 data

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Change in Distribution of Public Pension Investment Return Assumptions

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Public Pension Average Inflation Assumption and Real Rate of Return

Public Plans Database

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62nd Annual Employee Benefits ConferenceNovember 13-16, 2016Orlando, Florida

Session #PE1

Interest Assumptions in Public Sector Plans

• Public pension plans discount their liabilities using the expected investment return

• The assumed return is the single-most consequential of all actuarial assumptions

• Lower interest rates and lower projected investment returns are pressuring public plans to reduce their return assumptions

• Lower return assumption = Higher cost

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2017 Educational ProgramsPublic Plans

63rd Annual Employee Benefits Conference October 22-25, 2017 | Las Vegas, Nevadawww.ifebp.org/usannual

Public Sector Benefits InstituteHeld in conjunction with Trustees and Administrators Institutes

February 20-22, 2017Lake Buena Vista (Orlando), Floridawww.ifebp.org/psbinstitute

Benefits Conference for Public EmployeesSystem Highlight: Ohio Public Employees Retirement System (OPERS) April 25-26, 2017 | Columbus, Ohiowww.ifebp.org/publicemployee

Certificate of Achievement in Public Plan Policy (CAPPP®)Part I and Part II, June 13-16, 2017 San Jose, CaliforniaPart II Only, October 21-22, 2017 Las Vegas, Nevadawww.ifebp.org/cappp

Fraud Prevention Institute for Employee Benefit PlansJuly 17-18, 2017 | Chicago, Illinoiswww.ifebp.org/fraudprevention

Related ReadingVisit one of the on-site Bookstore locations or see www.ifebp.org/bookstore for more books.

Employee Benefits Glossary, 13th EditionItem #7570www.ifebp.org/glossary

816

NEW!

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