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Financial Simulation of the Oregon PERS Plan

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Version 1-11/21/02Subject to Revision

Financial Simulation of theOregon PERS Plan

Summary Version

Jim VoytkoExecutive DirectorOregon PERS

“An Investigation, Not a Declaration”

“A Work in Progress”

- Using…
- Actual System Data
- Current Actuarial Assumptions
- Explicitly Defined Policy Choices…

- … to dynamically model the complete OPERS financial structure on a system-wide, aggregate basis to…
- Forecast the most probable future trends in financial outcomes
- Assess the financial consequences of alternative…
- Policies
- Environments
- Structural Plan Features
- Participant Behavior

Investment Return Futures

OPERS Plan Rules

OPERS Environment

Financial Outcomes

- Assumes
- Sequential Crediting
- Estimated 12/31/2002 Ending Balances
- Current Actuarial Assumptions (as of summer 2002)
- Actual PERS Membership and Employer Data
- Current Statutory and PERS OAR Provisions
- Assumed future OAR revisions to accommodate sequential crediting

- Full output and documentation available on request*
- If Board so directs, can be run with stakeholder inputs on a resource/time available basis
- Model cannot be provided to parties lacking
- Software licenses issued by Palisade, Inc. and,
- Simulation hardware (each run currently takes 40-48 hours of computation time)

*Subject to PERS OARs regarding public records requests

The Base Case

Four Categories of Inputs

Environment

Investment

Economic

Participant

Rule Set

Statutory

OAR

Actuarial

Policy

Reserve Funding Policy

Reserve Goals

Assumed Rate

Mortality Policy

Sequential Crediting

Membership Behavior

Variable Exposure

Years of Membership

Retirement Rates

Propensity to Refund

Use of One-Time Variable Transfer

Deactivation Rates

- Environment
- Investment
- Long Run Portfolio Return – Frank Russell Co.
- Volatility Forecast for OPERS Fund – Frank Russell Co.
- Correlations – Frank Russell Co.

- Economic
- Inflation of 3.25% - Milliman, USA
- Wage Growth of 4.25% - Milliman, USA

- Participant
- Tier 1 & Tier 2 Retirement Rates – Milliman, USA
- Membership Composition – PERS Database

- Investment

- Rule Set
- Current statutory provisions and OAR’s
- Sequential Crediting
- Current Actuarial Assumptions (e.g. amortization methods)

- Policy
- Board 30-month reserve goal for pre-funding Tier 1 Member Guarantee shortfalls
- All of Tier 1 Member earnings in excess of the assumed/guaranteed rate immediately available to fund Tier 1 Member Rate Guarantee reserve (after higher priority deductions and if necessary)
- Assumed Rate = 8% = Tier 1 Member Guaranteed Rate
- Mortality Policy = Current

- Member Behavior
- Variable participation by active members consistent with past trends and dynamically linked to stochastic investment returns
- All members execute one-time conversion of variable earnings to regular at retirement (assumes rational self interest)
- Retirement/Deactivation/Refund Probability consistent with actuarial assumptions

- Focus on Sequential Crediting
- Tier 1 Rate Guarantee Reserve Deficit Reserve Structure
- Only Tier 1 Member Accounts Receive Annual Guarantee
- Tier 1 Member account excess earnings tapped first for deficit account elimination and Rate Guarantee reserve funding
- All other excess earnings (excluding Tier 2, Variable, ER Lump Sum) tapped for deficit account elimination if Tier 1 member excess earnings are insufficient

- Deterministic
- If X, then Y.

- Stochastic
- Given X, the distribution of possible values for Y is:
- 5% < A1
- 10%< A2
- 15%< A3
…

- 95% < A19

- Given X, the distribution of possible values for Y is:
- Stochastic Forecast = Best Estimate of Future Outcomes

Ten Notable Conclusions from the Base Case

- There is a low probability that Tier 1 members can be credited with earnings in excess of the assumed rate over the next 10-15 years.
- Probability of at least 1 Tier 1 earnings crediting > 8%
- 2002-2006: 15 %
- 2007-2011: 45 %
- 2012-2016: 50 %

- However, the likelihood of a call eliminating the Tier 1 deficit followed by the aggressive reserving policy assumed in the forecast allows that probability to rise for very young Tier 1 members expected to retire after 2016.

- Tier 1 Replacement ratios are highly likely to rise dramatically from their current levels over the next 15 years, then begin to decline.
- Mean/Median Replacement Ratios3
- Actual1 (Tier 1 & 2 combined)
- 1990-1995: 44.83%
- 1996-2002: 58.96%

- Expected2 (Tier 1)
- 2002-2006: 55.9%
- 2007-2011: 71.6%
- 2012-2016: 94.0%
- 2017-2021: 124.2%

- Actual1 (Tier 1 & 2 combined)

1 From an analysis of PERS Replacement Ratios 8/29/2002

2 50th percentile of expected mean. Expected ratios are consistent with but not strictly comparable to 8/29/02 study mean values

3 Does not include health insurance subsidy, social security or PERS COLA

- Employer rates for PERS coverage (before pickup) are highly likely to rise sharply over the next 5-10 years and probably will remain at higher than historic levels for the next 30 years.

Employer Rate - % of Payroll(Before Pickup)

15.56%

1990-2002 Average9.73%

- There is a material chance of a “call”, a considerably smaller chance of a second one, and the probability of any call declines sharply after 15 years.

- Likely Magnitude of a Call: Between $1.5 Billion and $2.5 Billion (PV)*

* PV = present value in today’s dollars

- The system’s UAL is highly likely to rise sharply in the next 5 years and decline slowly over the next 20-25 years
- Rates may need to be kept in the 16% to 19% range after this period to keep the UAL stable in nominal terms (and declining as a percentage of total plan assets)

90%

System UAL(Billions of $’s)

System Funded Ratio

80%

70%

60%

50%

- The relative contribution funding burden (ratio of employer contributions to employee contributions) rises steadily over the next 10 years from approximately 3.4 to one to roughly 5.0 to one, then declines over the next 25 years.
- The ratio of employer contributions to employee contributions should trend toward approximately 2.7-3.1 to one sometime after 35 years.

2.36

- An acceleration of Tier 1 member retirements or terminations while the system has a Tier 1 deficit account balance raises the probability of a “call” and may shift the periodic cost of deficit elimination more toward employers.
- Slower than anticipated Tier 1 Member retirements allow Tier 1 account balances to grow longer thus enlarging the costs of Tier 1, both at time of retirement and in the 15-20 years which follow. These longer lived Tier 1 accounts, however, retain assets whose excess earnings can continue to contribute to deficit elimination.

- A continuous stream of annual 8% investment returns is not sufficient to:
- eliminate the likelihood of employer rates reaching at least 22-24% before pickup, nor
- eliminate a possible call in excess of $2 billion, nor
- prevent a persistent but small UAL, even beyond the Tier 1 era.

- At this point in time, a less aggressive Board policy for funding the Tier 1 Rate Guarantee reserve has almost no effect on the probability of multiple system “calls”, but slightly increases their size.

- Misestimating the assumed rate has significant consequences for employer costs

1 – AR=Assumed Rate2 – CMR=Capital Market Returns

What Does the Simulation Suggest About Tier 2?

- Tier 2 Becomes Important With Respect to:
- Recruitment: 100% controlling as of 1997
- PERS Membership: 55% of PERS Members are Tier 2 as of 2005
- Pre-Retirement Assets: 55% of member non-retiree assets are Tier 2 as of 2018

- Tier 2 is not Full Formula; It is Money Match Driven under the Base Case Assumptions.
- However, there will always be some members who get Full Formula based benefits

- Specifically: Tier 2 produces average replacement ratios approximately 10 percentage points higher than the Full Formula..
- Why?
- An 8% investment return coupled with the expected duration of member service consistently produced sufficient account growth to ensure Money-Match based benefits exceed the Full Formula for most members.

- If Tier 2 benefits do become predominately Full Formula driven in the period 2020-2040, employer rates will be already beginning a new and substantial rise beyond that forecast in the base case.
- Why?
- While the bulk of members retiring during this period are Tier 2, the system will also be financing a considerably larger Tier 1 driven BIF whose fixed financial demands rest on an assumed rate of 8%. If investment returns have been low enough during 2002-2020 to “kick in” Full Formula as the dominant benefit and effective benefit floor, they will also have been too low to finance the then much larger BIF without even higher employer contributions

- Tier 2 is less costly than Tier 1

- Base Case Tier 2 Mean Replacement Ratio Equilibrium
- Approximately 50 - 52% of FAS2

1 From an analysis of PERS Replacement Ratios 8/29/2002

2 Does not include health insurance subsidy, social security or PERS COLA

- Tier 2 can still produce 65 to 100+% replacement ratios for long service Tier 2 members

(a) Under the new entry termination scenario, these ratios reflect those expected under money match for current Tier 2 members who retire in these periods.

(b) These ratios are a blend of the long service Tier 2 employees already in service, plus post 2002 shorter service hires that are also projected to retire at these times

- The Full Formula Floor—
- Immunizes Tier 2 member benefits from the possibility of low investment returns yielding low Money Match driven benefits.
- The guaranteed floor adds approximately $1.2 billion to the present value of system costs versus Tier 2 Money Match alone

- Why does the Full Formula guaranteed floor generate $1.2 Billion in additional costs versus Money Match alone?
- All the benefit outcomes in the lower portion of the distribution get shifted upward to the Full Formula outcome…

Observed Full Formula “Floor” at approximately 40% Replacement Ratio

Theoretical Tier 2 Money Match Replacement Ratio Distribution

- …producing a new, more costly benefit structure that drops the low outcomes but retains the high ones.

- Employer rates during the Tier 2 “era” of the simulation (2036-2051) range from 16.2% to 21.5%.
- This rate reflects amortization of continuing UAL and the normal cost of Tier 2.
- Simulation estimate of the Tier 2 Era (2042-2051) Rate Components:

*All rates are before pickup

- Why is there so large an abnormal add-on to the Tier 2 normal rate in this period?
- This outcome is not yet fully understood
- Until we understand the dynamic completely, we will neither conclude this is a solid estimate of 2041-2051 era outcomes nor that it is a modeling anomaly
- We have already begun to investigate this outcome and have learned that…

- Possible answers may include:
- Contribution rates were too low during the 2026-2041 period?
- Volatility in the investment returns has a tendency to produce residual UAL when benefits are annuitized at the theoretical assumed rate?
- Increasing presence of retiree obligations alters the financial dynamics of the system when combined with Money Match features and the COLA?
- All of the above?

- Annual fluctuation in Tier 2 investment returns interacts with the money match methodology, the full formula floor, and the increasing retiree reserve to produce rates above normal costs

- That volatility plays at least some role is borne out when it is completely removed

Volatility in Investment Returns

ROI

T2 – FF Floor

The Downside Removed by the Full Formula Floor for Benefits Only

…but with…

…combined with…

…tends to produce…

T2 – MM

UAL

Small but Persistent Slices of New Unfunded Liability

Money Match Investment Driven Benefits

- So why not just invest in zero volatility securities?
- Generally speaking, they don’t exist in the quantity and credit quality PERS would need
- The returns for low volatility investments are substantially lower than our current portfolio; much too low to fund current and projected member benefits
- 10 yr US Treasury Note: 4.000%
- 30 yr US Treasury Bond(inflation adjusted): 3.375%

- It would cause employer rates to rise explosively (due to lower projected investment returns)

What Does the Simulation Suggest About Outcomes Under a Partitioned System?

- Partitioning describes a structure under which the OPERS assets are divided into separate pools dedicated to serving specific PERS liabilities (Tier 1, Tier 2, BIF) and invested in a manner most consistent with those liabilities.

- Assets dedicated to Tier 1 member liabilities are invested more conservatively than the rest of the OPERS fund.
- Specifically

- All other Base Case factors remain unchanged

Four Notable Conclusions From the Partitioned Base Case Stochastic Simulation

- Moderate Partitioning Lowers System Costs (and therefore employer costs) by over $4 billion.

- Moderate Partitioning Lowers the Tier 1 Member Assumed Rate, Guaranteed Rate, and Replacement Ratios

- Moderate partitioning moderately lowers employer rates over the next 30 years

- Partitioning has no effect on current retirees or Tier 2 members – active or retired

What Does the Simulation Suggest About the Consequences of a Maturing OPERS?

- From a financial dynamics point of view, the PERS we knew then (1975-1990), or know now (1991-2002), is not exactly the PERS we must manage in the years ahead

In 1980:

- Ratio of active members to retirees: 3.71 to 1
- Ratio of BIF assets to active assets: $.58 to $1
- Ratio of Benefits Outflows to Contributions Inflows: $.41 to $1

In 2001:

- Ratio of active members to retirees: 2.53 to 1
- Ratio of BIF assets to active assets: $.75 to $1
- Ratio of Benefits Outflows to Contributions Inflows: $1.58 to $1

In 2040:

- Ratio of active members to retirees: .82 to 1
- Ratio of BIF assets to active assets: $1.38 to 1
- Ratio of Benefits Outflows to Contributions Inflows: $1.96 to $1

- The System’s Financial Maturation is Inevitable and Inexorable Absent a Dramatic and Sustained Growth in Public Sector Employment and Compensation

- There are Many….
- A few examples are:
- An increase in the COLA formula becomes far more expensive
- Why? Substantially greater $ flows affected by COLA change

- Employer Rates become more sensitive to investment returns and accurate estimation of the assumed rate
- Why? Retiree (BIF) obligations are fixed and inflexibly dependent on investment returns at least meeting the assumed rate

- An increase in the COLA formula becomes far more expensive

What Does the Simulation Suggest About Equal vs. Sequential Crediting?

- The Simulation does not allow direct quantitative comparison of Sequential vs. Equal crediting
- We believe from inspecting the earnings crediting paths under each statutory theory and the model’s results that
- the financial outcomes to Tier 2 members and member variable accounts are identical
- Employer pre-retirement balances in aggregate should stay solvent provided the system can flex $’s between the BIF and employer accounts as necessary
- sequential crediting may shift some Tier 1 member deficit costs from Tier 1 members to employers but the change is highly likely to be marginal

What Does the Simulation Suggest About Contraction in the Relative Size of the Public Sector?

- Zero absolute growth in PERS employment (and therefore a steady decline in the relative size of the sector) lowers pension costs but the savings is modest until the current UAL is paid off

What Does the Simulation Suggest About the Consequences of a New Entry Plan Termination?

- Terminating new entry to the PERS plan “frees up” approximately $11.5 billion in employer costs versus the base case forecast…

- … but the cost savings emerge gradually over time
- …and we assume there will be cost associated with providing pension coverage to new hires under a successor plan.