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P2F2. “Reducing Contribution Volatility” October 20, 2008. Setting The Stage. Root cause of contribution volatility is experience that varies from expected Main source of experience swings is actual investment returns compared to the long-term expected rates of return

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P2F2

“Reducing Contribution Volatility”

October 20, 2008

setting the stage
Setting The Stage
  • Root cause of contribution volatility is experience that varies from expected
  • Main source of experience swings is actual investment returns compared to the long-term expected rates of return
  • Positive experience leads to contribution reductions and/or benefit improvements
  • Negative experience leads to increased contributions with limited ability or no ability to reduce benefits
good times
Good Times
  • Market value exceeds actuarial value
  • Asset gains
  • Write-up in actuarial value of assets
  • Ability to improve benefits
  • Ability to decrease contributions
improve benefits
Improve Benefits
  • Pros
    • Competitiveness of benefits
    • Meet desires of membership
    • Recruiting and retention tool
  • Cons
    • Spend temporary gains on permanent benefits
    • If gains are spent they are not available to offset future losses, resulting in increased pressure on contribution rates when times are bad
spending gains
Spending Gains
  • Assumed rate of return 7.50%
  • Actual return for first five years 8.00%
  • Actual return for next five years 7.00%
  • Actual return for ten year period

(if gains are not spent) 7.50%

  • Actual return for ten year period

(if gains are spent) 7.25%

decrease contributions
Decrease Contributions
  • Pros
    • Generate good political will
    • Fund other non-pension benefits
      • Retiree health care
  • Cons
    • Viewed negatively by membership
    • Will decrease in contributions be restored when needed?
    • When times are bad, required increases in contributions will be relatively larger
    • If assumptions are accurate in the long term, the contribution rates will equal the Normal Rate
the problem bad times
The Problem – Bad Times
  • Market value of assets is less than actuarial value of assets
  • Losses may be mounting
  • If gains have been spent they’re not available to offset current/future losses
  • Call by some to reduce benefits
  • Need to increase contributions
  • Politically charged environment
  • No budget surpluses available
the problem bad times continued
The Problem – Bad Times (continued)
  • States looking for givebacks in employer contributions at a time when increases are required
  • Pressure from members for enhanced benefits due to lack of pay increases
  • Pressure from advocates – “if you had a DC plan, this would not happen”
is asset smoothing the answer
Is Asset Smoothing The Answer?
  • Reduces volatility but does not eliminate cyclical contributions
  • Good times – market value exceeds actuarial value, budget surpluses, low contribution rate
  • Bad times – actuarial value exceeds market value, budget deficits, high contributions
wouldn t it be nice if we could
Wouldn’t It Be Nice If We Could…
  • Increase contributions during good times
  • Reduce contributions during bad times
  • Retain gains to offset losses
  • Maintain actuarial soundness
  • Comply with GASB and actuarial standards of practice
smoothed valuation interest rate
Smoothed Valuation Interest Rate
  • Set a discount rate as currently done
  • Establish the system’s long term time horizon
  • Smooth the interest rate used to develop liabilities and contributions (similar to smoothing assets)
    • Look back period equal to asset smoothing period
    • Look forward period equal to time horizon less look back period
  • Smoothed Valuation Interest Rate is the rate needed over the look forward period so that you will have earned the discount rate over the time horizon
  • US Patent: 20050015284 - Ed Macdonald
discount rate
Discount Rate
  • Based on asset allocation
  • Based on capital market assumptions
  • Changes only when capital market assumptions (long term) and/or asset allocation changes
  • Does not change based on using this method
  • Is used in determining smoothed valuation interest rate
no earnings gains losses
No Earnings Gains/Losses

Smoothed valuation interest rate

Equals

Discount rate

earnings losses
Earnings Losses
  • Smoothed valuation interest rate is higher than discount rate
  • Assume
    • 7.50% discount rate
    • 5 year asset smoothing
    • 5 year look back period
    • 25 year long term time horizon
    • 20 year look forward period
    • Last 5 years: 6% average return
  • Smoothed valuation interest rate = 7.88%
    • Liabilities decrease
    • Contributions decrease in poor economic times
    • Average annual investment return increased because contributions are lowered in a deteriorating market
earnings gains
Earnings Gains
  • Smoothed valuation interest rate is lower than discount rate
  • Assume
    • 7.50% discount rate
    • 5 year asset smoothing
    • 5 year look back period
    • 25 year long term time horizon
    • 20 year look forward period
    • Last 5 years: 10% average return
  • Smoothed valuation interest rate = 6.88%
    • Liabilities increase
    • Contributions increase in good economic times
    • Short term gains not spent on long term obligations
    • Average annual investment return increased because contributions are increased during an improving market
benefits of smoothed valuation interest rate
Benefits of Smoothed ValuationInterest Rate
  • Counter cyclical employer contributions
  • Reduced volatility in the funded ratio of the plan
  • Since employers have little will or ability to increase contributions in poor economic times this method allows for lower employer contributions. However it will require them to contribute more in good times.
  • Increased investment return will lower total required contributions
  • Improved bond rating since there is a comprehensive plan to address funding needs
  • Defeats some of the DC proponents attack