opeb investments the danger in playing it safe
TRANSCRIPT
OPEB Investments: The DANGER in Playing
it Safe
Mary Fedorak
MACM Regional Product Specialist
222 North LaSalle
Suite 910
Chicago, IL 60601
(312) 523-2438
www.pfm.com
Donn Hanson
Director
800 Nicollet Mall
Suite 2710
Minneapolis, MN 55402
(612) 371-3720
www.pfm.com
January 17, 2013
Mark D. Meyer, JD, FSA
Van Iwaarden Associates
840 Lumber Exchange
10 South Fifth Street
Minneapolis, MN 55402
(888) 596-5960
www.vaniwaarden.com
Tony Jacobs
Treasurer, LCWM School Board
607 Knights Lane
Lake Crystal, MN 56055
(507)726-2323
• OPEB Basics
• Actuarial Implications
• Investment Implications
• Board Implications
• Questions and Answers
Presentation Overview
2
Other
Post-Employment
Benefits
GASB Accounting for OPEB
3
Background of GASB Statements
4
OPEB in the Media
“School districts struggle to pay retirees' health benefits”
“The next retirement time bomb”
“Officials continue to grapple with liability issue”
“District is stretching out OPEB burden”
• Form of deferred compensation
• Promise to provide retiree benefits must now be accrued during the working years of employees
• Post-retirement benefit other than pension
– Including:• Retiree medical, life, vision, dental
• Implicit retiree medical subsidy
– Not Including:• Early retirement incentives, severance based on unused sick pay,
vacation and compensated absences
What is an OPEB?
5
• In health insurance plans where a government’s retirees and current employees are insured together as a group
• The premiums paid by the retirees are lower than they would have been if the retirees were insured separately
Implicit Rate Subsidies for Retirees
6
The Actuarial Model for OPEB Liability
7
Plan ProvisionsAssumptionsData Methods
Actuarial Model
Accounting Results• Balance sheet liability• Accounting expense
Liabilities• Accrued liability• Normal cost
Projected Payments
(Present Value of Benefits)
Important Actuarial Assumptions
Factors that affect liability
Economic Demographic
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Discount rate
Pay increase rates (severance)
Healthcare trend rates
Amortization method
Participation rates–Employee–Spouse–Pre/post Medicare
Retirement/turnover ratesPlan election
Distinction Between Accounting and Funding
• Accounting is required by GASB– Measure liabilities– Allocate expense to current year– Report
• Funding is a management choice– Balance assets and liabilities– Match contributions and expense– OPEB bonds now require a referendum
9
Two Methods of Funding
Actuarial Method Paying to an OPEB plan
an amount that is expected to be
sufficient to pay for the benefits of employees
after they are no longer working
Pay-as-you-go Paying an amount each
year equal to the benefits distributed or
claimed in that year
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Health Care Costs Are Age Related
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Age Monthly Cost Index to 4525 $245 55%30 284 64%35 329 74%40 382 86%45 442 100%50 513 116%55 594 134%60 689 156%65 287 65%70 333 75%75 387 88%
Difference between actual cost and premium is Implicit Subsidy
Implicit Healthcare Subsidy
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Monthly premium $400Retiree monthly contribution $200Net employer cost $200
Retiree age-specific cost $520Retiree monthly contribution $200Net employer OPEB cost $320
GASB 43/45 Interpretation
Insured Medical Plan Costs
• Groups over 200 total membership – every 2 years
• Groups under 200 – every 3rd year
• Groups under 100 – “alternative measurement method” permitted (intended to make it possible to do calculations without using an actuary)
GASB Actuarial Valuation Required
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• Annual Required Contribution (ARC) – Normal cost + amortization of unfunded actuarial accrued liability over
maximum 30 year period
• Net OPEB Obligation (NOO)– The cumulative difference since implementation between the annual
OPEB cost and the employer’s contributions
• If Net OPEB Obligation exists…– Annual OPEB Cost=ARC + one year’s interest on NOO + adjustment to
ARC•ARC adjustment is the discounted value of the balance of the net OPEB obligation
Annual OPEB Cost Definitions
14
• GASB’s requirements for a funded plan– Employer contributions irrevocable– Assets dedicated to providing retiree benefits (establishing a Trust)– Assets protected from creditors
• Trust funding vehicles– 501(c)(9) trust, aka VEBA – Section 115 Trust– Insurance Contract
OPEB Funding Rules
15
• Potential higher discount rate• Greater flexibility in investments• Smaller ARC and Net OPEB Obligation• Better credit rating
Implications of Funding
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* Note that pre-funding is not required
• Permitted ‘NON’ OPEB Trust considerations– Short term horizon
– Uncertain cash flow
– 1st priority…protect investment principal
– Limited by M.S. 118A• Bank Deposits and Certificates of Deposit
• Local Government Investment Pools
• Municipal Notes
• Commercial Paper, etc.
– Local investment policy guides investment strategy• MSBA model policy
• Often written with no consideration of OPEB Trusts
Authorized Investment Considerations
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• OPEB Trust considerations– Long term horizon– Predictable cash flow needs– 1st priority…achieve long term growth– Limited by M.S. 356A
• All provisions of 118A permitted
• Equity exposure permitted
– Local investment policy guides investment strategy• Identify asset allocation targets
• Clarify liquidity needs
• Portfolio limitations
Authorized Investment Considerations (cont.)
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Annualized 5 Year Rolling Equity & Bond Returns
Interval: 60
Return Values
-10.0%
30.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
22.0%
24.0%
26.0%
28.0%
Dec1950
Dec2012
Dec1955
Dec1960
Dec1965
Dec1970
Dec1975
Dec1980
Dec1985
Dec1990
Dec1995
Dec2000
Dec2005
DOMESTIC EQUITYGeometric Mean: 10.67%
DOMESTIC EQUITYGeometric Mean: 10.67%
AGGREGATEFIXED INCOME
Geometric Mean: 5.60%
AGGREGATEFIXED INCOME
Geometric Mean: 5.60%U.S. INFLATION
Geometric Mean: 3.86%
U.S. INFLATION
Geometric Mean: 3.86%
Long-term Equity and Bond Returns Have Outpaced Inflation
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_____ Consumer Price Index
S&P 500 TR Barclays Aggregate Bond (1976-2011) and 50% Intermediate Corporate; 25% Int. Govt; and 25% US Long-term Govt (1950-1976)
Source: Morningstar En Corr/ Ibbotson Associates
• Best practices in managing OPEB liabilities include funding– Pay-as-you-go funding basis is unsecured borrowing
against future revenues– Fund OPEB at the same time as other compensation
• Major advantages to having an OPEB trust:– Improved credit rating– Uses current tax dollars to pay for current compensation– Prudent long term investments reduces the cost
Pre-Funding Advantage
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• Discount rate is based on expected rate of return• OPEB Trust assets will earn a higher rate of return
– Higher rate of return means higher discount rates– Higher discount rate means lower liabilities– Lower liabilities produces a stronger balance sheet
• Unfunded OPEB liabilities come from general assets – Internal School District assets are severely restricted to the
safest and lowest return investments– Lower discount rate means higher liabilities
Discount Rate Advantage
21
6% Return 4% Return Increase
Retiree liability - for payments before age 65
$478,311 $499,169 4%
Active liability $594,320 $686,001 15%
Total liability $1,072,631 $1,185,170 10%
Discount Rate Advantage Example
22
The higher the investment return the smaller the liability and the less assets needed to pay for the promised benefits.
Predictable Long Term Cash Flow
23
Why invest for the short term when the cash flows are long term?
How Long Will the Assets Last?
24
Properly Structured Portfolios are Key
25
Source: Bloomberg
Short term strategy for long term obligation
Source: Bloomberg
2-Year U.S. Treasury Note Yield
An investment strategy based upon M.S. 118A restrictions will likely deplete OPEB Trust prematurely!
26
27
Projected Total OPEB Liability
28
2.5% Return Depletes the Trust Rapidly!
29
Asset Allocation and Diversification are Critical
S&P 500 Has Generated Inconsistent Historical Returns
Source: Morningstar EnCorr/ Ibbotson Associates
30
IA S BBI S &P 500 T R US D: De ce m b e r 1926 - De ce m b e r 2012
Return
Num berIA S BBI S &P 500 T R US D: De ce m b e r 1926 - De ce m b e r 2012
-44.0% 54.0%-38.0% -32.0% -26.0% -20.0% -14.0% -8.0% -2.0% 4.0% 10.0% 16.0% 22.0% 28.0% 34.0% 40.0% 46.0%
0
7
1
2
3
4
5
6
Only 5 out of 87 calendar year periods has the S&P 500 return been between 8%-12%
Frequency of S&P 500 Calendar Year Returns since 1926
Diversification: There is no substitute
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Great Opportunities Exist Outside The U.S.
World Market Capitalization
2012 Total Market Capitalization: $29.5 Trillion 2
1) Data from BlackRock, Inc. which includes developed only2) Data from MSCI: includes total U.S. ($13.4 Trillion), ACWI ex US ($16 Trillion)3) Projection from Goldman Sachs
1970 1970 11 2012 2012 22
20302030 33
• Fiduciary Responsibility– Know the Investment Policy– Monitor the Investment Performance– Rely on the Experts
• Investment Expertise– No requirement to be an expert– Hire expertise
• Administration Expertise– Experts at school administration are probably not experts on OPEB
investments
Board Member Implications
33
DANGER in Playing it Safe
• Safe does not automatically mean prudent– Fiduciary duty to be prudent
• Bond proceeds may be depleted prior to final bond payment • Investment earnings may be lower than bond interest• Disappointed constituents• Less money for school operations• Lost opportunity cost• Headline risk
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School Board Action Plan
• Estimate the projected life of the OPEB Trust• Review investment policy and its handling of OPEB• Amend policy and investment strategy appropriately
A detailed actuarial report is the start of the process
• Retiree medical cash flows are less predictable than retirement benefits
• Changes in federal health care laws and benefits materially affect the projected benefits
• Changes in investment policy materially affect investment return expectations and the discount rate
• Health care cost inflation is higher and more variable than general consumer price inflation
Actuarial Caveats
36
Any investment advice in this document is provided solely by PFM Asset Management LLC. PFM Asset Management LLC (“PFMAM”) is an investment advisor registered under the Investment Advisers Act of 1940. PFM Advisors is a division of PFM Asset Management LLC. Public Financial Management Inc. is not providing and is not responsible for any investment advice herein.
This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.
Disclaimers
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