Actuarial Valuations & Unfunded Liabilities

Derek Osborne, Horizonow Consultants

Atlantic Connection, Miami

July 11, 2012

Agenda1. The Actuary & Actuarial Valuations 2. Are all future obligations liabilities?3. Should all liabilities be pre-funded?4. ALM for public sector pensions5. Closing thoughts

Role of the Actuary Demographic/Financial

Demographic projections Cash flow projections Estimate present values, surpluses/deficits Recommend future contribution rates

Policy (only sometimes) Assess relevance of rules Assess level of key parameters Assess asset-liability matching (not investment

advice) Assess operational effectiveness & efficiencies Recommend reforms

Actuarial Valuations

Public Pension Plans Private Pension Plans

Open group Includes future new

entrants Projected cash flows

& projected assets Results seldom have

effect on financials but they help drive policy

Closed group Includes only those on

hand on valuation date

Present value of future benefits & current assets

Results affect balance sheet and P&L and also drive policy

Social Security Populations

General Populati

on

Labour Force

Employed

Population

Insured Persons (Contributo

rs & pensioners

)

Contents of Actuarial Report(CAA Standard of Practice)

Executive Summary Introduction Summary of

ProvisionsData

Documentation

Assumption Documentation

Methodology Documentation

Projection Results

Sensitivity Tests

Analysis of Design,

Investments, Operations

Recommendations

Attestation & Reliance Signature

Pension Terms – DB plans Accrued Benefit:

benefit earned to date using past service and current salary

Projected Accrued Benefit: benefit earned to date using past service and

projected salary Past Service or Accrued Liability:

Present value of accrued benefits (projected or unprojected)

Unfunded Liability: Excess of accrued liabilities over assets

Primary Assumptions

CountrySocial Security

System

Demographic Births Deaths Migration

Economic GDP growth Productivity growth Labour force

participation Inflation

Demographic New entrants Leaving and re-

entering Retirement rates

Financial Ceiling adjustments Pension adjustments Return on

investments Admin expense rates

Interest/Discount Rate Assumption Interest/Discount Rate

May be prescribed Should reflect the expected return on the current

pool of assets and investment policy

It is not the rate of return that the actuary says your investments should

or needs to earn!

Are All Future Obligations Liabilities?

Case #1 Janet is 65 and receives a pension of

$1,000 per month. What is the plan’s liability for Janet?

A. $12,000B. Present value of $1,000 per month for the

rest of her lifeC. Present value of $1,000 per month for

next 10 years

Case #2 John has been employed with ABC for 15

years and is now 50 years old. He has already earned a pension of 30% of his projected final average salary which has a present value of $90,000. If he quits now, however, he will be entitled to only $30,000. What is the plan’s liability for John?

A. $30,000B. $90,000C. Something in between

Case #3 The government just signed an agreement with

a large investor to build a resort on a remote part of the island. The government needs to build access roads over the next 10 years at an estimated cost of $1 billion. What amount should the government recognise as a liability today?

A. $0B. $1 billionC. Present value of estimated road costs (< $1

billion)

Case #4 Jane just gave birth to a baby boy, Jude. The

government promises 12 years of free schooling and health care from the cradle to the grave. Regarding its future obligations for Jude the government should:

A. Ignore them as these are not recognizable liabilities

B. Value theses promises but do not pre-fund them

C. Value these promise and reflect them in public finances

Why Estimate Future Obligations? It’s good to know what they are It’s required

Statutory Regulatory Accounting Standards

Allows for orderly pre-funding (if appropriate) Enhances policy advice & reforms Gives actuaries work to do

Should All Liabilities Be Pre-Funded?

Financing Future Liabilities

• Assets < 1 year’s payout• Contribute what’s required to

meet payout

Pay-as-you-go

• Assets < Accrued Liabilities• Contribution depends on law

and/or funding goals

Partially Funded

• Assets >= Accrued Liabilities• Contribute enough to

maintain this

Fully Funded

18

Funding Considerations Will funding change the overall cost of

system? Will funding add or reduce risk of meeting

obligations? Investment risk Interest rate risk Insolvency risk Political risk

Will funding create investment opportunities for economy?

19

Public Sector Pensions are Different1. Perpetual plan 2. Guaranteed pool of tax payers & contributors

Gov’t/SSS can always raise tax/contribution rates to cover pensions expense

3. Why borrow at 9% and earn 6% on investments?4. It all boils down to economy

Changing demographics affects both alternatives If funded, investments must perform well If not funded, wages need to grow faster than

pensions

5. We don’t pre-fund highways, health care and education. Are pensions different?

Unfunded Liabilities Social Security

PV Future Benefits – Assets – PV Future Contributions

Employer Pension Plans PV Accrued Projected Benefits - Assets

ALM For Public Pension Funds Different from ALM for private pension funds

PV of Accrued Benefits doesn’t matter There’s guaranteed money coming in every year

(contributions) Asset maturities should be matched with

income-expenditure shortfalls, not benefit payouts

Need projected net cash flows on open group basis

Closing Thoughts Public liabilities and private liabilities are

different Not all future obligations need to be

recognised as liabilities Not all liabilities need to be pre-funded Regardless of how liabilities are recognised or

funded, sustainable systems require:a) Strong economy b) Good designc) Efficient & effective administration d) Honest & responsible government