A thoughtful pension funding policy provides the best way for public sector employers to keep their pension promises. The funding policy provides discipline to address unfunded pension liabilities, while respecting the many current demands for budget dollars.
The League of Arizona Cities and Towns recently sponsored a study by a special Task Force to identify areas for improvement and develop reform recommendations. The final recommendation is “Create a pension funding policy.” The Task Force emphasized that Arizona cities and counties “have a fiduciary responsibility to ensure (the) plan has sufficient financial resources to provide the benefits earned ….”
The pension funding policy is the best (and maybe the only) way for plan sponsors to meet their fiduciary duty to keep the pension promise. But developing a pension funding policy is not easy. It requires projecting unfunded pension liabilities beyond what is usually shown in existing actuarial reports. It also requires a delicate balancing of all of the various constituent interests over a variety of time frames.
The easy way out has always been to ignore the problem and leave it to someone else in the future. But a prudent few will openly address the political and budget issues inherent in developing a funding policy that keeps the pension promise.
One city recently chose to invest the time and resources to develop a pension funding policy. After years of declining funded ratios and increasing contributions, the city Finance Officer championed a study that involved the City Commission, the pension fund members, the actuary and the investment advisor. The resulting pension funding policy provided for an increase in employer and employee payroll contributions – and also provided for a third stream of contributions unrelated to payroll: a pension sustainability contribution.
We encourage every public sector plan sponsor to develop a pension funding policy. And we applaud the prudent finance officers who actually begin the process to keep their pension promises.
“Every state and local government that offers defined-benefit pensions [should] formally adopt a funding policy…,” according to the Government Finance Officers Association (GFOA) best practice recommendations. Guidelines for Funding Defined Benefit Pensions (2013) (CORBA)
SOA and GASB Provide Guidance
Blue Ribbon Panel. Last month, a blue ribbon panel formed by the Society of Actuaries went one step further to endorse risk measures, disclosures and actuarial assumptions as well as guidelines regarding plan governance and benefit changes. These recommendations come at a time when public pensions have come under mounting criticism since the “great recession” and it’s imperative that public plan sponsors be able to demonstrate that their plans are sustainable in the long-term.
GASB 67/68. Furthermore, it’s critical that public sector plan sponsors follow a written funding policy now that GASB 67 and 68 explicitly separate pension funding and pension accounting,. These accounting standards are effective for plan years beginning after June 15, 2013 and June 15, 2014, respectively. For many plan sponsors this means the fiscal years ending June 30, 2014 (!) and June 30, 2015.
Funding Policy Checklist
The place to begin is to gather the facts, actuarially and politically. Here is a checklist of items to assist in providing a basis for developing an effective funding policy:
- Assemble a history of plan benefit levels and changes.
- Develop a history of contribution levels by members and sponsors.
- Compare benefit levels, locally and nationally, to determine appropriateness.
- Consider the political history of plan changes.
- Identify the politically “hot” topics.
- Review legal constraints on plan changes.
- Analyze collective bargaining agreements and recent changes.
- Calculate the plan’s current funded status.
- Determine sustainable funding goals.
- Evaluate options for achieving goals.
We recently assisted a large Midwestern city in developing a comprehensive funding policy that linked future benefit changes to achieving a targeted funding level. In addition, the city Council adopted guidelines for amortization periods and for direct smoothing of actuarially-determined contributions. Indeed, funding policy, investment policy and pension benefit policy must be linked and reinforce one another.
The time is here for every plan sponsor to develop or review their pension plan funding policy to make sure that it is actuarially sound.
Under GASB 43 and 45, public sector employers are required to account for retiree medical benefits under special rules for Other Post-Employment Benefits (OPEB). Many have chosen to pre-fund these liabilities in a trust similar to a retirement plan trust. At the recent Minnesota School Board Association convention, Van Iwaarden Associates teamed up with an investment advisor to emphasize how actuaries and investment advisors should work together to develop a prudent investment policy based on projected benefit payments.
Most policy makers at public sector employers are not investment experts nor are they experienced with pre-funding long term liabilities. Too often, the decision is made to invest trust assets in “safe” investments just as they do with operating funds. This is potentially a major mistake, especially now with short term interest rates near zero!
The best practice is to pre-fund retiree medical liabilities and to invest the trust assets in a way that is consistent with the projected cash flow. Certainly, a substantial portion of the assets should be invested for the short term to meet short term cash flow. However, the balance of the assets should be invested for the long term to meet projected cash flows twenty to thirty years away.
The recommended action plan for decision makers includes:
1. Estimate the projected life of the OPEB Trust
2. Review investment policy and its handling of OPEB
3. Amend policy and investment strategy appropriately
A detailed actuarial report is the start of the process to manage OPEB liabilities and assets. The actuarial report can and should be much more than just a perfunctory exercise to meet GASB accounting requirements.
The full presentation can be found through this link.