pfm february 25, 2011 csmfo presented by: carlos oblites, senior managing consultant opeb and...

PFM

February 25, 2011CSMFO

Presented By: Carlos Oblites, Senior Managing

Consultant

OPEB and Pre-Funding for California Agencies

PFM Asset Management LLC50 California StreetSuite 2300San Francisco, CA

© 2011 PFM Asset Management LLC

PFM

Alternatives for Attacking the OPEB Issue

Fund?Not Fund?

Multi-employer trust?Single employer trust?

VEBA?Section 115 Trust?

© 2011 PFM Asset Management LLC 2

PFMTypical Goals

3

• Ensure adequate liquidity to pay retiree benefits

• Generate sufficient return to minimize need for additional contributions

• Maintain reasonable level of safety through diversification

• Maintain administrative ease and continuity in managing cash flow and investments

• Achieve flexibility in adapting the investment to changing market conditions, cash flows, and actuarial valuations


PFMGeneral Observations

• The liability of every OPEB fund is different in its construction

– Different benefits (health, dental, life, etc.);

– Inconsistent vesting and retirement ages; and

– Employer payment structures (explicit/implicit).

• Medical inflation has far outstripped CPI

• National healthcare (as currently constructed) will not relieve employers of their liabilities; in fact it may preclude future reductions in benefits

• Bonds have not been widely used to fund liabilities, except where taxing authority has been expanded

• Asset management trends:

– Asset/liability management being used only minimally;

– Pension-like investing most pervasive; and

– Life insurance, viatical and other non-traditional investment being pushed.


PFM

Managing OPEB Assets:

You Have Choices

5© 2011 PFM Asset Management LLC

PFMFunding Option #1: PAYGO

Pros

• Minimizes current year expenditures throughout the life of the benefits

• Requires minimal outside professional assistance

• Actuary every other year

• Auditor

• Operationally simple, requires no changes to current processes

Cons

• Structure creates largest possible Unfunded Actuarial Accrued Liability (“UAAL”) and Annual Required Contribution (“ARC”)

• Does not address rising cost of providing retiree benefits

• No assets to invest, so no mitigation of future liabilities

• For actuarial valuation and financial reporting

– Must use lower discount rate

– Have no assets to offset liabilities

• Not really a funding option, but a budget strategy

• Retiree benefits are paid for as an annual budget item

• Need a coherent story for rating agencies and financial statement users about use of this strategy


PFM

Funding Option #2: Internal Service Fund

Pros

• Begins to provide funding for future benefits that begins to address intergenerational equity

• Earns a return on assets that can help mitigate future cost increases

• Operationally similar to other Internal Service Funds, requires only minimal changes to current processes

Cons

• Structure does not improve UAAL or ARC over PAYGO structure due to lower discount rate and lack of assets to offset liabilities on balance sheet

• More expensive than PAYGO but addresses rising cost of providing retiree benefits in only a limited manner

• Typically must be invested according to governmental investment statutes

• Likely requires additional outside professional assistance of an investment advisor and custodial bank

• Minimalist funding option, but gets the process started

• Retiree benefits may be paid from the fund or may reimburse the employer for costs

• Helps to create a “better” story for rating agencies and financial statement users


PFM

Funding Option #3: Irrevocable Trust

Pros

• Provides funding for future benefits in a formal, segregate manner addressing intergenerational equity

• Generally, trust assets allowed to invested in “prudent person” investments which can improve returns over the long-term helping to mitigate future cost increases

• Structure improves UAAL and ARC reporting using higher discount rate and having Trust assets directly offset liabilities on balance sheet

Cons

• Significantly higher costs than PAYGO on a year to year basis to provide full funding, but may limit total future costs

• Likely requires changes to current operational processes

• Will require additional external professional assistance

• Best of the funding options

• Retiree benefits may be paid from the Trust or may reimburse the employer for costs

• Creates the best funding story for rating agencies and financial statement users


PFMTypes of Trusts

9

VEBA 401(h) Section 115

StructureVoluntary

adoption by employers

Separate account under pension trust

Governmental trust

No IRS Approval Required

No IRS Annual Filings

No Contribution Caps

Investment Earnings Non-taxable

Benefits Non-taxable


PFMDifferent Trust Options

• Multi-employer options

– Ease of use

– Cost-effective

– Least amount of control

– “Cookie-cutter” approach

• Single-employer options

– More control over actuarial assumptions and process

– Customization to your needs

– More control of risk and return parameters

– Will generally require external professional assistance


PFM

Management of OPEB Trust


PFM

Differentiated OPEB Trust Components

Non-discretionary ModelNon-discretionary Model

Initial Responsibilities

• Create Governance Charter

• Create By-Laws

• Board Member Selection (with substantial/majority of unaffiliated members)

• Hire Investment Managers (Two to Ten)

Ongoing Responsibilities

• Periodically Review Results

• Hire/Fire Investment Managers

• Report to Governing Body

Discretionary Manager Discretionary Manager ModelModel

Initial Responsibilities

• Can create advisory board/oversight committee

• Hire Discretionary Advisor/Manager(One)

Ongoing Responsibilities

• Periodically Review Results

• Hire/Fire Investment Managers

• Report to Governing Body


PFMNon-discreationary Model

13

• Basically directed trustee

overseeing holding of

assets

• Not typically a fiduciary over all aspects of investments

• Fiduciary with direct

responsibility for investments

• Provides independent valuation of

assets


PFMDiscretionary Manager Model

14

• Fiduciary overseeing holding of

assets

• Fiduciary overseeing investment functions

• General Oversight, but

no direct investment

duties• Provides independent valuation of

assets


PFM

Discretionary Managers Should be Independent & Conflict Free

15

• Independence

– When offering asset allocation advice, investment options, and rebalancing decisions

• No conflicts of interest

No soft dollar arrangements

No directed brokerage arrangements

No financial arrangement with investment managers of any type


PFMWhat Will You Need?

• Most Agencies do the following:

―Create trust

―Hire trustee/custodian bank

―Create governing/oversight board

―Discretionary versus Non-Discretionary Model

―Review asset/liability profile

―Create appropriate asset allocation

―Create investment policy statement

―Select investments

―Discretionary versus Non-Discretionary Model

―Non-discretionary: Board hires money managers

―Discretionary: Fiduciary investment advisor hires money managers

―Continued oversight and rebalancing

16

PFM

Common OPEB Trust ComponentsRegardless of Trust and Governance Model

• Governing Body Authorization to Create the Trust

• OPEB Trust

– Document

– Tax ID Number

– Private Letter Ruling (not required)

• Investment Policy and Asset Allocation

• Hire Custodian

– Form W-9

– Authorized Signers


PFMOPEB Implementation process

• You should begin with the numbers:

– Perform an asset-liability analysis

– Portfolio decisions should align with the plan’s liability structure

– This protects the plan sponsor from claims of underperformance based on “cookie cutter” solutions

• For example, why would a plan with 50% or more of its liabilities aligned with retirees with an average expected life of 9-10 years invest 74% of its portfolio in stocks, equities, and real estate? Would any rational financial adviser suggest to a 65-year old that a portfolio like that is suitable under FINRA regulations?

• Asset allocation decisions then take into account client risk tolerances and perspectives

– Conduct portfolio planning survey process

– Develop a customized Investment Policy Statement with appropriate asset allocation targets and ranges


PFM

Multi-Asset Class Managed Fixed Income / Cash

19

Case Study: “A/L Based” Asset Allocation

$14.6 million56%

$11.8 million44%

Vested Participant Liabilities

Unvested Participant Liabilities

Would you establish a 70/30 asset allocation for this plan?


PFM

Task

• Customized portfolio questionnaire designed to assist staff and Committee members in gaining consensus around investment and financial decisions

• Achieve expectations for future portfolio strategy and manager decisions

20

1. How often are you prepared to accept the probability of a loss of greater than (-10%)? Once every?

a. Three years b. Five years c. Ten years d. Other _____________________

2. Another measure of risk tolerance is the extent to which the fund’s financial decision makers are comfortable with year to

year volatility of investment returns. How concerned are you with variability in the market value of the pension fund? a. Very concerned with variability in the fund value b. Somewhat concerned with year-to-year variability, but more concerned with long-term growth c. Focused on the long-term growth of the fund, unconcerned with short-term variability

3. The time frame selected to meet your return goal will affect your ability to do so. Due to the cyclical nature of the market,

the longer the time frame, the more likely you are to meet the goal. This is because market upswings and downswings will average out. What period of time do you think is reasonable to wait to achieve your return goal?

a. Three years b. Five years c. Ten years d. Market Cycle

4. Investment "risk" can be viewed in many different ways. Please circle any of the following which most closely define your

view of risk. a. The possibility of not achieving a targeted rate of return. b. Wide swings in the market value of your portfolio over short (1 year) periods of time. c. Wide swings in the market value of your portfolio over long (3 years) periods of time. d. Loss of principal

Portfolio Planning Survey Identifies Needs


PFM

21

Task• Creation of customized portfolio options specific to the goals, objectives and risk tolerances of each entity

Reason

• Quantify trade-off between risk and return to create efficient portfolios

• Extend diversification of investment strategies and money managers

• Portfolio AND organization/headline risk management

2.0%1.5%

0.5%

4.9%5.3% 5.4%

7.0%

7.9%

8.7%9.2%

10.6%

12.2%12.4%

14.9%

17.8%

0%

5%

10%

15%

20%

Conservative Balanced Aggressive

Retu

rn (%

)

Distribution of Projected 5 Year Returns

Standard Deviation (Risk)

Expec ted Return

5.0 22.06.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 14.0 15.0 16.0 17.0 18.0 19.0 20.0 21.0

4.5

13.0

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

Large Cap Domestic Equity

Small/M id Cap Domestic Equity

International Equity

Real Es tate

Commodities

Aggregate Fixed Income

Portfolio 1

Portfolio 2

Portfolio 3

FRONTIER BASED ON HISTORICAL ASSET CLASS RETURNS

FRONTIER BASED ON PFM ADVISORS’ LONG-TERM PROJECTIONS

Customized Asset Allocation Analysis


PFM

22

Case Study: Proposed Portfolios

Domestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / CashDomestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / CashDomestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / CashDomestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / Cash

Domestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / Cash

Conservative Liability-Driven

Portfolio A

Balanced Liability-Driven

Portfolio B

Comparative Portfolio C

Comparative Portfolio D

Multi-Asset Class 44% 44% 44% 44%Domestic Equity 28% 33% 42% 55%International Equity 17% 21% 26% 35%Other Equity 5% 6% 7% 10%Fixed Income 50% 40% 25% 0%

Managed Fixed Income 56% 56% 56% 56%1-3 Year 100% 100% 100% 100%Cash TBD TBD TBD TBD

Combined Portfolio 100% 100% 100% 100%Equity 22% 26% 33% 44%

Fixed Income 78% 74% 67% 56%Cash TBD TBD TBD TBD


PFM

Manager Selection: Structuring an Efficient Multi-Asset Class Portfolio

Manager Sourcing: 1,500 Managers;

5,500 Separate Accounts; and 14,000 Mutual Funds

Universe Creation: 200+ Managers

Quantitative Analysis 10-20 Managers

Qualitative Review5-6 Managers

DiversificationAnalysis

3 Managers

Finalists for inclusionIn Portfolio

• Managers for each asset type must be selected

• For most trusts, investments will be in the form of mutual funds

• Recommendations:

• Select best-in-class

• Institutional shares

• Consider active/passive strategy

• Review performance and risk parameters


PFMSample Money Managers

Domestic EquityActive Management Davis NY Venture (DNVYX) American Fundamental Investors

(RFNFX) FMI Common Stock (FMIMX) Columbia Acorn (ACRNX)

Passive Management Vanguard Total Stock Market Index

(VTSSX)

International EquityActive Management Dodge & Cox International Stock

(DODFX) American EuroPacific Growth (RERFX) Oppenheimer

Passive Management Vanguard Total International Index

(VGTSX)

Real Estate & Inflation Hedged Vanguard REIT Index (VGRSX) PIMCO Commodity Real Return

(PCRIX)

Domestic Fixed IncomeActive Management PIMCO Total Return (PTTRX) Metropolitan West Total Return

(MWTIX) Touchstone Core Plus (TCPNX) Artio Global High Income (JHYIX)

Passive Management Vanguard Total Bond Market Index

(VBTSX) Vanguard Short-Term Bond Index

(VBSSX)


PFMFinal Thoughts

• When setting up an OPEB Trust

– Ensure that the trust and governance documents are appropriate for you

– Clearly separate the trust and asset management from the employer to protect assets from creditors

– Create an investment policy that takes your specific liability profile into account

– Use a third-party custodian/trustee to provide a good governance structure (asset manager/advisor should not also be your custodian)

• When managing an OPEB Trust

– If you are using a discretionary manager/advisor, make sure they are a fiduciary investment advisor to help mitigate your potential liabilities

– Make sure the fiduciary investment advisor/consultant is independent

– Make sure your advisor/consultant is migrating the asset allocation to match the liability profile over time

– Monitor your advisor/consultant for compliance with your investment policy


pfm february 25, 2011 csmfo presented by: carlos oblites, senior managing consultant opeb and...

Documents

pfm alternatives

pfm funding option

asset management trends

future benefits

pfm general observations

pfm typical goals

assetliability management

opeb assets