Funding  Policy  

and  Actuarial  Cost  

Methods
March  22,  2013

Joseph  Newton,  FSA,  MAAA,  EA

Mark  Randall,  FCA,  MAAA,  EA

Copyright  ©  2011  GRS  –  All  rights  reserved.

 Agenda
 Definition  of  Funding  Policy
 Actuarial  Cost  Methods
 Comparison  of  Actuarial  Cost  Methods
 Other  Funding  Policy  Techniques

2
 New  GASB  Standards  are  drawing  
more  aQention  to  Funding  Policy
  More  and  more  Plans  and  employers  are  now  drafting  
funding  policies  because:
  There  will  no  longer  be  an  ARC,  a  current  de  facto  funding  standard

  Required  Supplementary  Information  (RSI)  section  of  the  CAFR  will  

include  the  disclosure  of  an  Actuarially  Determined  Employer  
Contribution  (ADC),  if  one  is  calculated,  and  compare  it  to  the  
actual  employer  contribution  made.    This  will  become  the  source  for  
researchers  to  find  out  whether  a  plan’s  funding  policy  requires  
contributions  that  are  reasonable,  systematic  and  actuarially  based
  The  funding  policy  is  the  primary  driver  of  whether  and  when  there  
is  a  “cross-­‐‑over”  date  (Fund  runs  out  of  money)  for  lowering  the  
discount  rate  in  the  GASB  blended  discount  rate  process
  Just  because  it  is  the  right  thing  to  do

3
 Funding  Policy
 The  “Funding  Policy”  of  a  Pension  Plan  is  a  
systematic  set  of  procedures  used  to  
determine  the  contributions  which  will  be  
made  in  a  specific  year  and  series  of  years
 It  is  much  broader  in  scope  than  most  people  
think
 It  must  address  how  the  contributions  will  be  
made  for  ongoing  benefits  as  well  as  how  to  
finance  gains  or  losses  as  experience  occurs

4
 Elements  of  a  Funding  Policy
  Actuarial  Cost  Method*
  Asset  Smoothing  Method*
  Amortization  Methods*
►  Level  dollar  vs  Level  Percentage  of  Payroll/Budget
►  For  initial  liabilities
►  For  changes  in  assumptions
►  For  changes  in  benefit  provisions
►  For  gains  and  losses  (deviations  from  expectation)  that  naturally  
occur
  Contribution  stabilization  techniques
  Procedures  for  Plans  with  lower  funded  ratios
  Surplus  management

*  Already  included  in  TMRS’  funding  policy

5
 Current  TMRS  Policy

  TMRS  does  have  a  current  policy

► Mostly  defined  in  statute
► Some  defined  further  by  Board  rules
  Employers  must  contribute  the  normal  cost  plus  a  
closed  amortization  of  any  UAAL  that  exists
  Ad  hoc  benefit  enhancements  are  amortized  over  a  
shorter  period  and  on  a  level  dollar  schedule
  Small  plans  have  accelerated  schedules
  For  the  new  GASB  disclosures,  these  policies  will  
need  to  be  wriQen  in  a  summarized,  concise  
format
6
 Determining  the  GASB  Discount  Rate
  The  premise…
►  The  pension  plan  is  primarily  responsible  for  paying  
pension  benefits  to  the  extent  the  plan  has  sufficient  assets
•  Assets  invested  with  long-­‐‑term  investment  horizon
►  The  employer  is  primarily  responsible  for  paying  benefits  to  
the  extent  the  plan  does  not  have  sufficient  assets
•  From  the  general  fund  or  bond  revenues
  By  having  a  stronger  funding  policy,  the  cross-­‐‑over  date  is  
pushed  back,  which  will  increase  the  blended  discount  rate  and  
lower  the  NPL  (net  pension  liability)  on  the  balance  sheet
  TMRS’  current  strong  funding  policy  precludes  the  likelihood  
of  using  the  lower  discount  rate

7
 General  Outcomes  in  GASB  Procedure

 Like  TMRS,  many  plans  contribute:

•  Normal  cost  PLUS  closed  amortization  payments
  These  probably  have  discount  rates  =  LTeROR  (Long  Term  Expected  
Rate  of  Return)

 Many  plans  contribute:

•  Normal  cost  PLUS  open  amortization  payments
  These  almost  always  have  discount  rates  less  than  LTeROR

 Other  plans:
•  A  flat  statutory  percent  of  pay,  or
•  Target  cost  methods,  or
•  Pursuant  to  a  more  complex  model
  These  might  have  discount  rates  lower  than  LTeROR
8
 Actuarial  Cost  Method
  There  are  several  policies  that  could  be  utilized  
to  fund  the  expected  benefit  payments
►  Pay-­‐‑as-­‐‑you-­‐‑go
►  Lump  sum  at  hire
►  Fully  funded  at  time  of  vesting
►  Various  career  accrual  strategies
  Like  TMRS,  almost  all  retirement  systems  utilize  a  career  
accrual  strategy
►  Contributions  are  made  throughout  the  career  to  fully  fund  the  
benefit  at  the  time  of  retirement
  We  are  going  to  discuss  a  few  of  these  strategies  today,  
but  first  we  need  to  define  some  terms

9
 First,  some  definitions
 Present  Value  of  Benefits  (PVB)
 Normal  Cost
 Actuarial  Accrued  Liability  (AAL)
 Unfunded  Actuarial  Accrued  Liability  
(UAAL)
 Funded  Ratio
 Annual  Required  Contribution  (ARC)
 Amortization  Period/Policy
10
 Example
 A  City  hires  an  employee  and  agrees  to  pay  
the  employee  $1,000  the  day  he  retires  in  20  
years
 No  investments  are  available
► (earnings  =  $0)  
 The  City  would  like  to  save  up  for  this  
payment  throughout  the  20  years  instead  of  
having  to  come  up  with  $1,000  at  the  end  of  
the  agreement
► The  $1,000  is  the  Present  Value  of  Benefits  (PVB)
► With  interest,  PVB  =  $1,000  /  (  1+I)  ^  (RetAge-­‐‑Age)

11
 Normal  Cost
 Therefore,  the  City  would  save  $50  per  year  
to  accumulate  the  $1,000
► $1,000  /  20  years  =>  $50  per  year
► The  $50  can  be  defined  as  the  Normal  Cost
 The  Normal  Cost  can  be  defined  as:
► The  cost  of  accruing  next  year’s  benefit
► The  cost  of  providing  benefits  to  a  new  employee
► What  the  contribution  requirement  would  be  if  
everything  always  had  been  and  everything  
always  will  be  perfect

12
 Actuarial  Accrued  Liability
 Therefore,  10  years  into  the  arrangement  the  
City  should  have  saved  $500
► $50  each  year  for  10  years
► The  $500  can  be  defined  as  the  Actuarial  Accrued  
Liability  (AAL)
 The  Actuarial  Accrued  Liability  represents  
the  target  value  of  assets  at  a  specific  point  in  
time  based  on  the  funding  objectives
► AAL  at  time  5  =  $250
► AAL  at  time  20  =  $1,000

13
 Unfunded  Actuarial  Accrued  Liability
 What  if  the  City  had  only  saved  $400  by  year  
10?
► AAL  (target  assets):        $500
► Actual  asset  level:                  400
► UAAL        $100
► The  $100  can  be  defined  as  the  Unfunded  
Actuarial  Accrued  Liability  (AAL)
 The  Funded  Ratio  is  the  actual  asset  value  as  
a  percentage  of  the  target  asset  value
► $400  /  $500  =  80%

14
 Amortization  Payment
 Additional  contributions  will  be  made  so  
that  the  UAAL  will  be  amortized  over  a  
desired  period  of  time
► In  this  example,  lets  assume  5  years
► Amortization  payment  =  $100  /  5  =  $20
 Therefore,  the  total  contribution  
requirement  for  year  11  will  be  the  normal  
cost  plus  the  amortization  of  any  UAAL
► $50  +  $20  =  $70

15
 Annual  Required  Contribution  (ARC)

  The  contribution  is  set  to  be  the  sum  of:

► The  normal  cost  for  the  year  and
► The  amortization  of  the  UAAL

  Another  way  to  look  at  it:

► The  contribution  for  the  current  year
plus
► The  contribution  to  make  up  any  shortfall  that  may  
have  occurred  due  to  past  experience  or  plan  changes

16
 Comparing  Cost  Methods
  There  are  several  cost  methods  which  all  have  the  
same  ultimate  goal:  make  sure  there  is  enough  
money  available  to  pay  the  benefits  when  they  come  
due
  However,  each  funding  method  has  characteristics  
which  may  make  one  more  appropriate  than  others  
in  certain  situations  
►  Front  load  (EAN)
►  Back  load  (PUC)
►  Level  payroll  (TMRS,  except  Ad  Hoc)  
►  Level  contributions  (TMRS  Ad  Hoc)
►  Cover  termination  liability  at  all  times  

17
 Projected  Unit  Credit  (PUC)

 Projected  Unit  Credit  aQempts  to  fund  the  

“true”  present  value  of  the  benefits  as  it  
accrues,  no  spreading  of  costs
► Considered  a  “benefit  accrual”  method
► Creates  lower  costs  early  in  an  employee’s  
career
► Costs  increase  as  retirement  nears  (larger  
accruals  and  shorter  discount  period)
► Used  to  be  the  most  common  method  in  
private  sector  valuations
18
 PUC:  Numerical  Example
  Using  7%  interest  in  our  prior  example:
►  PVB  at  hire  =  $1,000  /  (1.07)  ^  (20)  =  $258
  Normal  Cost  for  Year  1  will  be:
►  $258  /  20  =  $13
►  Thus,  the  employer  would  contribute  $13  in  year  1
  This  calculation  occurs  every  year  with  exponent  
reduced  by  one  year
  At  year  10
►  PVB  =  $1,000  /  (1.07)  ^  10  =  $508
►  Normal  Cost  =  $508  /  20  =  $25
►  AAL  =  $508  *  10  /  20  =  $254
  In  the  final  Year
►  Normal  Cost  =  $935  /  20  =  $47
The above calculations assume beginning of year payments
19
 PUC  Normal  Costs  over  time

Normal  Cost
$50
$45
$40
$35
$30
$25
$20
$15
$10
$5
$0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Year

20
 Entry  Age  Normal  (EAN)
 Entry  age  normal  aQempts  to  create  level  
contributions  throughout  the  working  career  
of  the  employee
► Considered  a  “contribution  accrual”  method
► Can  be  level  dollar  or  a  level  percentage  of  
payroll
► By  far  the  most  utilized  funding  method  in  the  
public  sector
► More  costly  early  in  the  career  of  an  employee
•  Pay  higher  contributions  early  to  not  have  a  spike  in  
contributions  as  the  member  nears  retirement

21
 EAN:  Numerical  Example
  Using  7%  interest  in  our  prior  example:
►  PVB  at  hire  =  $1,000  /  (1.07)  ^  (20)  =  $258
  Normal  Cost  will  be  the  20  level  payments  that  will  
accumulate  to  $1,000  with  interest  at  retirement
►  Similar  to  a  mortgage
►  A  20  year  PV  factor  at  7%  =  11.34
►  $258  /  11.34  =  $23
►  Thus,  the  employer  would  contribute  $23  each  year
  At  time  10
►  PVB  =  $1,000  /  (1.07)  ^  10  =  $508
►  Normal  Cost  =  $23  from  above
►  AAL  =  accumulated  value  of  10  payments  of  $23  =  $337
  In  the  final  Year
►  Normal  Cost  still  equal  $23

The above calculations assume beginning of year payments

22
 Comparison  of  Normal  Costs  over  time

$50
$45
$40
$35
$30
$25
$20
$15
$10
$5
$0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Year

PUC EAN

23
 Percentage  of  Payroll  Contributions

  Instead  of  using  the  simplistic,  fixed  dollar  

example  from  before,  the  calculations  get  a  liQle  
more  complicated  when  the  ultimate  benefit  and  
the  contributions  are  based  on  a  growing  salary  
and  termination  assumptions  are  applied
► The  same  aQributes  hold,  but  actually  become  more  
amplified
► The  Normal  Cost  under  PUC  will  increase  
substantially  as  a  percentage  of  the  salary  as  the  
employee  ages
► The  Normal  Cost  under  EAN  will  be  calculated  so  
that  the  contribution  is  a  level  percentage  of  salary  
instead  of  a  level  dollar  amount

24
 Comparisons  of  Funding  Methods:  
Normal  Cost  as  a  Percentage  of  Salary
New  Member:  Entry  Age  25
40%

30%
%  of  Payroll

20%

10%

0%
 25    29    33    37    41    45    49    53  
Age
EAN PUC

25
 AAL  accrues  over  the  entire  career  
of  the  member
New  Member:  Entry  Age  25

800%

600%
%  of  Payroll

400%

200%

0%
25 28 31 34 37 40 43 46 49 52

PVB AAL  EAN AAL  PUC

26
 Total  Group
 The  valuation  uses  the  sum  of  the  normal  
costs  and  accrued  liabilities  of  each  
member  in  the  population
► By  design,  the  AAL  under  EAN  is  ALWAYS  
larger  than  the  AAL  under  PUC
•  Thus,  EAN  compared  to  PUC  will  have  a  larger  
UAAL  and  a  lower  funding  ratio

27
 Total  Group  Contributions
  Younger  populations  will  have  lower  contribution  
requirements  under  PUC  than  EAN
  Typically,  growing  or  stable,  non-­‐‑aging  population  
will  have  lower  contribution  requirements  under  
PUC  than  EAN
  However,  as  the  population  ages,  the  contribution  
requirements  under  EAN  will  remain  more  stable  
and  PUC  will  drift  up
  If  the  population  matures,  ages,  and/or  stops  
growing,  the  contribution  requirements  under  PUC  
will  eventually  pass  the  EAN
► They  have  to  since  both  methods  are  funding  to  the  
same  benefit  at  retirement

28
 Normal  Costs  as  a  Percentage  of  Payroll

Open  Group  of  New  Entrants

16.00%
14.00%
12.00%
10.00%
8.00%
EAN
6.00%
PUC
4.00%
2.00%
0.00%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Year

29
 Example  TMRS  City  under  EAN  and  PUC  
(Illustrative  based  upon  December  31,  2011  results)

EAN PUC
(1) (2)
1. Present  Value  of  Benefits $    140,186 $            140,186
2. Less  PV  Future  Normal  Costs          (23,860)                  (31,457)
3. Total  actuarial  accrued  liability  (1  -­‐  2) $    116,326 $            108,729
4. Actuarial  value  of  assets      (107,232)              (107,232)
5. UAAL  (3  -­‐  4) $              9,094 $                    1,497
6. Funded  ratio  (4  /  3) 92.2% 98.6%
7. UAAL/Payroll 45.3% 7.5%

FY2013  Contribution  Rate

8. Full  retirement  rate
a. Normal  cost 8.31% 9.52%
b. Amortization  Payment 2.85% 0.47%
c. 25  Year  ARC 11.16% 9.99%

9. Estimated  Contributions $              2,241 $                    2,005

$ in thousands
30
 Comparison  of  Plan-­‐‑wide  Funded  Status

PUC
EAN

Present  Value  of  Benefits $29,183

$29,183

Actuarial  Accrued  Liability $21,563

$23,490

Actuarial  Value  of  Assets $18,347
$18,347

Unfunded  Actuarial  Accrued  Liability
$3,216
$5,143

Funded  Ratio 85.1%
78.1%

Full  Retirement  Rates:

Straight  Average   8.35%

9.61%

Payroll  Weighted  Average 13.22%

14.19%

$ amounts in millions

31
 Distribution  of  Impact  on  Rates  (All  
Cities)
120

100

80

60

40

20

The above comparison only includes a difference in the actuarial cost

method (PUC vs EAN), all other assumptions, methods, and policies
are unchanged.
32
 Distribution  of  Impact  on  Rates  for  
Cities  with  100  or  More  Actives
30

25

20

15

10

The above comparison only includes a difference in the actuarial cost

method (PUC vs EAN), all other assumptions, methods, and policies
are unchanged.
33
 Comparison  of  Volatility
Actuarial  Cost  Method Normal  Cost   UAAL   Total  
Volatility Volatility* Contribution  
Rate  Volatility
Aggregate +++++ -­‐‑ +++++++
Unit  Credit ++++ ++ ++++++
Projected  Unit  Credit +++ +++ ++++++
Individual  EAN + +++ ++++

* Depends on amortization policy

Aggregate and Unit Credit are two other actuarial cost methods.

34
 Contribution  Rate  Stabilization  
Techniques
  It  is  important  for  employers  to  recognize  there  will  be  some  level  of  
natural  volatility  in  the  contribution  rate
►  Could  be  +/-­‐‑  0.10%  or  as  much  as  +/-­‐‑  0.20%  on  an  annual  basis
  To  combat  this  expected  volatility,  some  plans  have  implemented  
stabilization  techniques
  Examples  
►  Fixed  Rate  Plans,  whether  permanent  or  reset  every  few  years
►  +/-­‐‑  corridors:  Rate  stays  the  same  until  the  actuarially  determined  rate  reaches  a  
certain  level  above  or  below,  then  the  rate  moves  in  that  direction
►  +/-­‐‑  limitations  in  a  given  year:  rates  can’t  go  up  or  down  more  than  X%  in  1  year
  Another  way  is  to  slow  the  pace  the  contribution  rate  is  allowed  to  
decrease  in  a  given  year
  Examples  include:
►  Not  allowing  the  actual  contribution  decrease  by  more  than  0.10%  in  a  year,  even  
if  the  actuarially  determined  rate  would  allow  for  more  than  that
►  A  simpler  and  more  direct  method  would  be  to  adopt  a  look  back  period  and  
always  contribute  the  highest  contribution  rate  determined  during  the  period
•  Example,  always  contribute  the  highest  rate  from  the  last  3  or  5  valuations
►  Or,  don’t  let  the  contribution  rate  decrease  until  X%  funding  is  reached

35
 Illustrated  Scenario
13.50% Contribution Rate Held Up

Budget does not have to absorb a

13.00% material increase in the contribution rate

12.50%

12.00%
Lower year-to-year volatility
11.50%

11.00%
2013 2018 2023 2028
Actuarial  Determined  Contribution  Rate
Actual  Budgeted  Contribution  Rate  Equal  to  Highest  of  Last  5  years
The above scenario is not a projection of expected results
36 The year-to-year returns were randomly generated to illustrate the strategy
 Plans  with  an  Unfunded  Liability
  Some  Systems  have  implemented  a  more  accelerated  funding  
policy  if  the  Plan’s  funded  ratio  has  fallen  below  a  certain  
level
►  A  more  extreme  situation  is  a  plan  that  is  geQing  close  to  pay-­‐‑as-­‐‑
you-­‐‑go  would  be  considered  “in  distress”  
  Usually,  it  mean’s  a  liQle  less  flexibility  for  contribution  and/
or  benefit  policies
►  For  example,  a  City’s  contribution  rate  cannot  decrease  until  its  Plan  
reaches  80%  funding
►  Some  Plans’  are  precluded  from  any  ad  hoc  benefit  enhancements  at  
this  time,  as  well
•  Under  TMRS  statutes,  the  Board  probably  does  not  have  the  
authority  to  not  allow  a  City  to  grant  an  ad  hoc  enhancement.    
However,  the  amortization  period  could  be  shortened  to  ensure  
contributions  are  coming  in  to  the  Plan  fast  enough  to  improve  
the  funding  status
►  The  Pension  Protection  Act  (for  private  sector  plans)  has  several  
triggers  that  occur  when  a  Plan  is  less  than  80%  funded

37
 Surplus  Management  Techniques
  After  the  run  up  in  the  90’s  followed  by  the  lower  market  
returns  in  the  last  decade,  many  Plans  have  realized  that  they  
would  be  in  a  beQer  position  today  if  “surpluses”  from  the  
90’s  weren’t  spent  on  benefit  enhancements  and  contribution  
decreases
  Individual  employer  plans  can  use  their  asset  allocation  to  de-­‐‑
risk  the  Plan  in  times  of  surplus
  However,  that  is  more  difficult  for  a  multiple  employer  
System  that  has  some  plans  that  are  “overfunded”  and  others  
that  are  “underfunded”
  Thus,  the  surplus  management  falls  to  the  contribution  
strategies

38
 Surplus  Management  Techniques
  If  a  TMRS  city  has  a  surplus  (UAAL  less  than  zero),  then  their  
contribution  requirement  is  decreased  from  the  normal  cost  equal  to  
a  25  year  amortization  of  the  current  surplus
  There  are  217  Plans  in  TMRS  with  a  surplus,  and  37  have  eliminated  
their  contribution  requirement  entirely  
  While  this  is  substantially  beQer  than,  for  example,  allowing  a  City  
to  offset  its  contribution  by  the  entire  surplus,  this  policy,  by  design,  
pushes  a  City’s  funded  status  back  towards  100%  and  thus  
eliminating  the  surplus
  Several  Plans  have  put  policies  in  place  to  make  the  hurdle  higher
►  For  example,  in  the  private  sector,  the  normal  cost  (new  accruals)  must  
always  be  contributed  and  no  credit  is  given
►  In  Utah,  the  credit  does  not  begin  until  a  Plan  is  110%  funded,  basically  
acting  like  a  reserve

39
 Combination  of  Techniques
Funding  Ratio Funding  Policy

<80% Employer  rate  cannot  decrease  until  reaching  80%  funding  target
Any  ad  hoc  enhancements  amortized  over  a  five  year  period

80-­‐‑90% Employer  rate  is  equal  to  the  highest  of  the  last  5  calculated  annual  rates

90-­‐‑100%

100-­‐‑110% Employer  rate  equal  to  the  highest  of  the  last  5  calculated  annual  normal  cost  rates

>110% Employer  rate  equal  to  the  highest  of  the  last  5  calculated  rates  with  amortization  
credits  back  to  110%  based  on  25  year  rolling  schedule

40
 In  Summary
  The  current  TMRS  funding  policy  is  already  
ahead  of  most  of  its  peers
  With  the  new  GASB  Standards,  TMRS  should  
consider  consolidating  in  one  place  its  wriQen  
funding  policy
  In  consolidation,  this  may  be  a  good  time  to  look  
at  the  different  provisions  and  see  if  some  
changes  make  sense,  such  as  further  rate  
stabilization  and  other  management  techniques

41
 Other  questions?

Thank  you  for  the  opportunity  

to  meet  with  you  today

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