What is Smoothing of Assets

What is Smoothing of Assets PowerPoint PPT Presentation

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The process by which investment earnings/losses are gradually released into income for purposes of determining assets utilized for funding. What is Smoothing of Assets. To reduce fluctuations in contribution rates due to fluctuations in short-term investment experience. Purpose of Smoothing. Unrealized Capital Gains/LossesAll Capital Gains/LossesAll Investment Income above/below the assumed rate of return.

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What is Smoothing of Assets

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3. To reduce fluctuations in contribution rates due to fluctuations in short-term investment experience Purpose of Smoothing

4. Unrealized Capital Gains/Losses All Capital Gains/Losses All Investment Income above/below the assumed rate of return What is Smoothed

5. Types of Gain/Loss Subject to Smoothing Length of Smoothing Period Width of Corridors Type of Corridors Smoothing Parameters

6. Amortization concerns the long-term phase-in of gains or losses Smoothing determines when the amortization process begins for asset gains and losses Differences Between Smoothing and Amortization of Gains & Losses

7. Short-term under/over funding of Plan Disconnect between the direction of contribution rates and the direction of investment markets Potential investment inefficiencies Undesirable Side Effects of Smoothing

8. Type of Funding Method Used Gain/Loss Amortization Term Gain/Loss Amortization Type (level vs. increasing) Subsequent Investment Experience Growth Rate of Average Salary Membership Growth Factors Determining Smoothing Runoff

9. Aggregate Funding Method Net Non-Investment Cash Flow = 0 Assumed Rates of Return = 8.00% Actual Rate of Return = 8.00% except one year with -25% rate of return Actual Contribution = Required Contributions Model Plan Assumptions

12. Seven Year Smoothing of Asset Value No “Corridors” Uses Net External Cash Flow and Actuarial Investment Return Assumption Actual Case Study

13. Effect of Asset Smoothing 7 yr. Smoothing vs. Market Value of Assets

14. Effect of Asset Smoothing

15. Budgeting: Plan Contribution Determination Accounting/Disclosure (FASB/GASB) Plan Termination Valuation Perspectives

16. Primary goal of annual actuarial valuation Annually self-adjusting process Budgeting: Plan Contribution Determination

17. Pension Plan as Asset/Liability of Sponsor Pension Cost as an Expense Post-Enron Governance and Disclosure Accounting/Disclosure (FASB/GASB)

18. Limited applicability in Public Sector Actuarial value of accrued benefits vs. plan assets Plan Termination

19. Traditional Actuarial View: Funding is Sinking Fund to Pay Benefits Financial Economics View: Pensions are “Debt Obligations” MVL: The Great Controversy

20. Pension Plan is Ongoing Concern “Long Term” is 60+ Years “Interest Rate” Assumption is Long Term Expected Return on Assets (ROA) Traditional Actuarial View

21. Snapshot “Mark to Market” Valuation of Liabilities “Long Term” Effectively Ignored Asset Value Smoothing Abhorred Financial Economics View

22. F.E.’s Highly Critical GASB 25/27 Especially Hit Use of ROA as “Discount Rate” for Liabilities Ridiculed by F.E.’s FASB/GASB

23. Market Value of Liabilities (MVL)

24. Background Discount Rate Used to determine the actuarial liability, which affects funded status of plan, and employer contribution rates Also used to determine present value of cost of additional benefits, including COLA’s Current actuarial practice: base discount rate on expected long-term investment return, based, in part, on system’s investment allocation

25. Market Value of Liabilities Reflects a pension plan’s settlement cost – the amount the plan would owe if it were terminated and required to settle its liabilities with a “risk-free” portfolio of bonds Differs from conventional method for determining public sector liabilities in 3 ways: The present value of accrued benefits is discounted at a risk-free rate, based on long-term government bond yields, such as 30-year US Treasury bond rate, currently below 5% Use of accrued benefit (plan termination) obligation, which excludes projected future service and salary increases Marking assets to market, which precludes smoothing of assets

26. Market Value of Liabilities Corporate pension plans are required to calculate a MVL, chiefly so that in the case of bankruptcy or sale of the firm, the plan's liabilities are known The Governmental Accounting Standards Board (GASB)has issued an Invitation to Comment pertaining to the measurement and reporting of public pension liabilities. Possible changes to standards may include elements of MVL Some actuaries and economists believe public pension plans should measure and disclose MVL

27. Arguments For MVL Provides a standardized “market” measure of liabilities, so would simplify comparisons between plans. MVL higher than conventional approach, resulting in higher contribution requirements. This would: Reduce temptation to increase benefits Reduce extent contributions deferred to future taxpayers (intergenerational equity). Promote long-term sustainability.

28. Arguments Against MVL Inconsistent with nature of public sector and public pension plans, which are going concerns (versus terminated plans) Increase cost volatility Risk-free rates are volatile. Small changes in bond rate could result in large changes in reported plan liabilities. Increased contribution requirements Could lead to lower investment return, if shift from equities to fixed income investments. Currently, investment income accounts for approximately 75% of assets. Lower investment return => higher contributions.

29. Arguments Against MVL Increased confusion Could create false impression that well funded plans are underfunded (Typical plan with 100% funded ratio would have 87% funded ratio) Difficult to explain to lawmakers and public the difference between the two liabilities Excludes projected future service and salary increases MVL is a termination liability, and public plans don’t terminate Next logical step could be to pressure plans to invest in risk-free bonds.

30. Impact of using MVL Typical plan with current 8% discount rate, using 5.5% risk-free rate: Liability would be 15% higher Funded percentage of 86% would be 75% with MVL Funded percentage of 100% would be 87% with MVL Total contribution rate increase of 35% Source: GRS Insight, April 2008, Page 2-3. This source sites: Richard Ennis, “What Ails Public Plans? And How Can They Become Strong Again?” Ennis Knupp & Associates, 2007.

31. Where does the issue stand? In response to GASB’s ITC – Invitation to Comment (deadline July 31, 2009) NASRA, NCTR, etc. wrote letter in opposition, and asked public systems to do the same Many actuaries wrote papers either in support, in opposition, or suggesting alternatives Society of Actuaries sponsored a symposium where papers were presented, and debated by actuaries GASB projects a 2013 completion date for this project May require only disclosure of MVL only, not used for funding, or could have funding impact

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