State Actuary Presents a LEOFF 1 Review
http://www.leoff1.net/articles/60/1/State-Actuary-Presents-a-LEOFF-1-Review/Page1.html
By Jerry Taylor
Published on 09/8/2009
Matt Smith, the State Actuary made this presentation to the LEOFF 1 Medical Benefits Committee at the August 25, 2009 meeting. It is an interesting review that demonstrates how the pension funding is viewed actuarially.
Matt Smith, the State Actuary made this presentation to the LEOFF 1 Medical Benefits Committee at the August 25, 2009 meeting. It is an interesting review that demonstrates how the pension funding is viewed actuarially.
Historical
LEOFF 1 was created on March 1, 1970 (Chapter 209, Laws of 1979). It was a consolidation of municipal police and fire pension plans into a state-wide retirement system for law enforcement officers and fire fighters. In absorbing a number of jurisdictions that had no pension systems it created a system that had a significant unfunded liability. The state was and is responsible for paying off any unfunded liability
The first actuarial valuation recommended a state pension contribution of 33% of salaries for the state to combine with the statutory 6% for individuals and 6% for employers. Recognizing this large unfunded liability, the Stated did exactly what one would expect. They made no contributions for the first five years of the plan.
The original LEOFF 1 law (Chapter 209, Laws of 1969) mandated an amortization of unfunded liability over a period not to exceed 40 years from March 1, 1970. A fixed an amortization date of June 30, 2024 to reach full funding status was establish in 1989 (Chapter 273, Laws of 1989).
The State began contributions, finally, in 1976 and continued those contributions through 1999. The State contributions averaged just over 40% of pay. However, it is unclear whether or not that was 40% of total pay or 40% of the pay for the 1976 through 1999.
Fully Funded
LEOFF 1 reached a fully funded status in 1997. The legislature suspended state contributions in July 1999. Member and employer contributions were suspended in May 2000.
Health Assessment
Matt Smith explained that a health pension plan has sufficient assets to pay earned benefits. Measured by the “funded status”, healthy plans are those that are considered to be at least 80% funded. In contrast unhealthy are those with at least 60% but less than 80% funding.
Poor health and at risk plans are those with less than 60% funding. They are considered as being at risk of running out of assets prematurely.
LEOFF 1 is a healthy plan. Its last evaluation was as of June 30, 2007. At that time, it was 114% funded. It had a preliminary funded status of 129% as of June 30, 2008. But a lot has changed since the last valuation.
It was really an unprecedented change in a short period of time. Assets dropped almost 24% since the last actuarial valuation—that is $1.5 billion for LEOFF 1. Overall, the state is anticipating a 30% decline in funded status over the next eight to ten years.
Pension systems are facing unprecedented challenges. Currently the actuary is predicting a likely return of unfunded liability in the LEOFF 1 system at some point in the future. Much will depend on future investment performance and funding.
Since the extent of future losses in unknown, the actuary tracks three scenarios for the plan. Those are projections of expected returns on investments, a pessimistic outlook and an optimistic outlook.
Continued on next page...
Historical
LEOFF 1 was created on March 1, 1970 (Chapter 209, Laws of 1979). It was a consolidation of municipal police and fire pension plans into a state-wide retirement system for law enforcement officers and fire fighters. In absorbing a number of jurisdictions that had no pension systems it created a system that had a significant unfunded liability. The state was and is responsible for paying off any unfunded liability
The first actuarial valuation recommended a state pension contribution of 33% of salaries for the state to combine with the statutory 6% for individuals and 6% for employers. Recognizing this large unfunded liability, the Stated did exactly what one would expect. They made no contributions for the first five years of the plan.
The original LEOFF 1 law (Chapter 209, Laws of 1969) mandated an amortization of unfunded liability over a period not to exceed 40 years from March 1, 1970. A fixed an amortization date of June 30, 2024 to reach full funding status was establish in 1989 (Chapter 273, Laws of 1989).
The State began contributions, finally, in 1976 and continued those contributions through 1999. The State contributions averaged just over 40% of pay. However, it is unclear whether or not that was 40% of total pay or 40% of the pay for the 1976 through 1999.
Fully Funded
LEOFF 1 reached a fully funded status in 1997. The legislature suspended state contributions in July 1999. Member and employer contributions were suspended in May 2000.
Health Assessment
Matt Smith explained that a health pension plan has sufficient assets to pay earned benefits. Measured by the “funded status”, healthy plans are those that are considered to be at least 80% funded. In contrast unhealthy are those with at least 60% but less than 80% funding.
Poor health and at risk plans are those with less than 60% funding. They are considered as being at risk of running out of assets prematurely.
LEOFF 1 is a healthy plan. Its last evaluation was as of June 30, 2007. At that time, it was 114% funded. It had a preliminary funded status of 129% as of June 30, 2008. But a lot has changed since the last valuation.
It was really an unprecedented change in a short period of time. Assets dropped almost 24% since the last actuarial valuation—that is $1.5 billion for LEOFF 1. Overall, the state is anticipating a 30% decline in funded status over the next eight to ten years.
Pension systems are facing unprecedented challenges. Currently the actuary is predicting a likely return of unfunded liability in the LEOFF 1 system at some point in the future. Much will depend on future investment performance and funding.
Since the extent of future losses in unknown, the actuary tracks three scenarios for the plan. Those are projections of expected returns on investments, a pessimistic outlook and an optimistic outlook.
Continued on next page...
Expected Investment Outlook
The expected outlook graph shows the status of pension funding if the state meets the legislative assumption of an annual return of 8% over time. Remember, that 8% is a “smoothed” assumption. That means that on years with very high return on investment the full amount of the return is not counted but a bit of the extra is applied to each of the years over a four-year period. So, when earnings are less than 8% that previous excess absorbers some of the loss. Hence, the earnings/losses are smoothed.
Other factors also come into play. For example, the actuarial accounting assumes a 4% increase in the CPI. In recent years it has been less than that. In fact, we might even see a negative or near zero CPI this year. A lower CPI will mean lower liabilities and hence better funding.
In the “Expected Investment Outlook” scenario, the actuary assumes an 8% return on investment. This is the assumption mandated by the legislature. Also, it is one that is supported by the long-term investment history of the State Investment Board. The plan would remain fully funded through 2015 and then dip barely into the underfunded status until about 2021. Future contributions could be required to maintain the healthy status.
Other factors also come into play. For example, the actuarial accounting assumes a 4% increase in the CPI. In recent years it has been less than that. In fact, we might even see a negative or near zero CPI this year. A lower CPI will mean lower liabilities and hence better funding.
In the “Expected Investment Outlook” scenario, the actuary assumes an 8% return on investment. This is the assumption mandated by the legislature. Also, it is one that is supported by the long-term investment history of the State Investment Board. The plan would remain fully funded through 2015 and then dip barely into the underfunded status until about 2021. Future contributions could be required to maintain the healthy status.
Pessimistic Investment Outlook
The “Pessimistic Investment Outlook” assumes a 5.6% rate of return over 15 years. This is a rate generally considered by actuaries as conservative. In this case, the system would remain fully funded through 2013. Like the “Expected Outlook” scenario, this projection assumes that pension contributions would resume when the system falls out of full funding status. Even under this projection, the system remains in the healthy range for all but a few years.
So what good does it do to resume pension contributions? Nobody or very few people will still be working by 2014. The last LEOFF 1 hired will have 37 years of service. Little money would be raised from contributions from employees or employers. There is nobody to pay the tab.
Well, not quite. The state is responsible to fund the system to a fully funded status. Hence, the state would be the one making the contributions—not the employees.
So what good does it do to resume pension contributions? Nobody or very few people will still be working by 2014. The last LEOFF 1 hired will have 37 years of service. Little money would be raised from contributions from employees or employers. There is nobody to pay the tab.
Well, not quite. The state is responsible to fund the system to a fully funded status. Hence, the state would be the one making the contributions—not the employees.
Optimistic Investment Outlook
The “Optimistic Investment Outlook” assumes a 10.3% rate of return over 15 years. Under this scenario, the system would remain fully funded. No resumption of contributions would be required. In fact, the system would have a significant excess that increases as it ages.
Given our bleak current financial situation, few people subscribe to the optimistic view. However, it is still a possibility and particularly so when you look at the long-term history of return on investment going all the way back to before the depression. Obviously, if this case proves the winner, there will be a lot of folks lining up to get a chunk of that surplus sometime in the next few years.
What Are The Health Risks in LEOFF 1?
Obviously, the possibility of a future unfunded liability is a concern. The state is facing large budget deficits. No doubt, the legislature will be reluctant to pour money into the retirement system. The potential of future investment losses remains a concern even in the face of some evidence of a recovering economy.
The LEOFF 1 system is mature and closed. That means we have to do with what we have. Liabilities are starting to decline but there is not new money coming in from employees and employers or the state.
There are some possible solutions. The state could provide additional funding to further shore up the system. That, practically speaking, is not an option until we recover from the current economic crisis. There will be a great deal of political pressure to restore programs they have cut or reduced to meet the crisis. Lurking in the background will be the need to restore lost funding in the other pension systems. Remember, the legislature cut contributions on everything except LEOFF 2. That money will need to be made up. I see little likelihood in the state putting more money into LEOFF 1.
Of course, the state will need to resume contributions when the plan is no longer fully funded. Our experience with the first five years of the LEOFF 1 plan suggests the state might not step up to that plate in an expeditious manner. The actuary thinks the simple resumption of the prior funding policy would likely be insufficient.
Obviously, benefit improvements are unlikely.
One possible scenario would be to “lock in” the funded status after recovery. That means removing the funds from the combined pension trust and managing them under some different plan. Such plans would base investment returns on bonds or some other stable instrument instead of equities and real estate. That would mean less income but a more stable base. Any prospect of a surplus would be eliminated.
I do not think this is a likely solution. It would take a pretty big surplus to provide enough funding to switch from an 8% return on investment assumption to a 4.5% to 5.5% assumption for a bond portfolio. We are not likely to see that kind of surplus in the near term. Even before the meltdown there would not have been enough money to make that switch and stay fully funded.
Another factor against such a switch is the fact that our health status in the larger pool of unhealthy systems mitigates the state of health for the other systems and adds investment leverage for the State Investment Board. So the hit of removing us from the common pool would impact the other systems in a negative way.
Given our bleak current financial situation, few people subscribe to the optimistic view. However, it is still a possibility and particularly so when you look at the long-term history of return on investment going all the way back to before the depression. Obviously, if this case proves the winner, there will be a lot of folks lining up to get a chunk of that surplus sometime in the next few years.
What Are The Health Risks in LEOFF 1?
Obviously, the possibility of a future unfunded liability is a concern. The state is facing large budget deficits. No doubt, the legislature will be reluctant to pour money into the retirement system. The potential of future investment losses remains a concern even in the face of some evidence of a recovering economy.
The LEOFF 1 system is mature and closed. That means we have to do with what we have. Liabilities are starting to decline but there is not new money coming in from employees and employers or the state.
There are some possible solutions. The state could provide additional funding to further shore up the system. That, practically speaking, is not an option until we recover from the current economic crisis. There will be a great deal of political pressure to restore programs they have cut or reduced to meet the crisis. Lurking in the background will be the need to restore lost funding in the other pension systems. Remember, the legislature cut contributions on everything except LEOFF 2. That money will need to be made up. I see little likelihood in the state putting more money into LEOFF 1.
Of course, the state will need to resume contributions when the plan is no longer fully funded. Our experience with the first five years of the LEOFF 1 plan suggests the state might not step up to that plate in an expeditious manner. The actuary thinks the simple resumption of the prior funding policy would likely be insufficient.
Obviously, benefit improvements are unlikely.
One possible scenario would be to “lock in” the funded status after recovery. That means removing the funds from the combined pension trust and managing them under some different plan. Such plans would base investment returns on bonds or some other stable instrument instead of equities and real estate. That would mean less income but a more stable base. Any prospect of a surplus would be eliminated.
I do not think this is a likely solution. It would take a pretty big surplus to provide enough funding to switch from an 8% return on investment assumption to a 4.5% to 5.5% assumption for a bond portfolio. We are not likely to see that kind of surplus in the near term. Even before the meltdown there would not have been enough money to make that switch and stay fully funded.
Another factor against such a switch is the fact that our health status in the larger pool of unhealthy systems mitigates the state of health for the other systems and adds investment leverage for the State Investment Board. So the hit of removing us from the common pool would impact the other systems in a negative way.
Results of the LEOFF 1 Pension Check-Up
Obviously, the significant investment losses in the past year have seriously threatened the financial health of the system. The uncertain investment outlook does not promise a quick return to large surpluses. Combine that with fairly extreme budget pressures facing the state and we know it is important to keep a close watch on the system and to look for new ways to safeguard the plan.
We do know that LEOFF 1, even with all the losses, remains a health pension system. The state may need to contribute in the future but the treat is small compared to the challenges facing other systems.
Disclosure
The information in Matt Smith’s presentation was prepared for the LEOFF 1 Medical Benefits Committee in order to assist in the study and review. It was prepared during the 2009 interim and should not used beyond that period. All of the data, methods and assumptions match those used in the 2007 Actuarial Valuation Report. Actual investment returns through June 30, 2009 as reported by the Washington State Investment Board were used. The actuary reports he believes the data, methods and assumptions are reasonable and in conformity with generally accepted actuarial principles and standards of practice as of August 2009. Matt Smith does state that another set of assumptions and methods could also be reasonable and could produce materially different results.
Summary
As we have seen the values in the pension trust drop over this last year I have heard many doom and gloom stories. Obviously, it is an area of concern, but we are fortunate in that our pension system remain healthy. Anytime you start playing with these pension numbers there is a risk of misinterpretation. It is important to remember that the state is obligated under law to honor our pensions. The amount of money in the system is more a measurement of how difficult it will be for the state to meet its obligation than it is a threat that they will not make the pension payments.
A more interesting result of this review is a clearer understanding that the “surplus” is a moving number. The likelihood of LEOFF 1 members ever seeing a distribution or an increase in benefits from the surplus is severely diminished. Of course, the state has always asserted that the surplus was not available for such things anyway.
What we do know is that given the limited recovery time occasioned by the fact that our system is closed and mature there is not much time left for the system to return to a sizable surplus status. Only the most optimistic forecast would suggest that and by the time those large surpluses would materialize most of us will be gone.
On the positive side, this review makes it very clear to the various groups that have sought to raid our pension that that is no longer and can never be an option. There was a general agreement on the part of everyone on the Medical Benefits Committee that the pension fund is simply not available as a vehicle to fund medical benefit.
For myself, I remain optimistic. I keep looking at the long term history of the rate of return on pension fund investments. We came through the depression and recovered. I believe we will recover from our current recession. Our problem is not long-term recovery but the fact that the system is near its end and we don’t have the long-term needed to guarantee the full recovery. The near-term situation is a bit more iffy. Still, the system is healthy and the Actuary is comfortable with our status.
We do know that LEOFF 1, even with all the losses, remains a health pension system. The state may need to contribute in the future but the treat is small compared to the challenges facing other systems.
Disclosure
The information in Matt Smith’s presentation was prepared for the LEOFF 1 Medical Benefits Committee in order to assist in the study and review. It was prepared during the 2009 interim and should not used beyond that period. All of the data, methods and assumptions match those used in the 2007 Actuarial Valuation Report. Actual investment returns through June 30, 2009 as reported by the Washington State Investment Board were used. The actuary reports he believes the data, methods and assumptions are reasonable and in conformity with generally accepted actuarial principles and standards of practice as of August 2009. Matt Smith does state that another set of assumptions and methods could also be reasonable and could produce materially different results.
Summary
As we have seen the values in the pension trust drop over this last year I have heard many doom and gloom stories. Obviously, it is an area of concern, but we are fortunate in that our pension system remain healthy. Anytime you start playing with these pension numbers there is a risk of misinterpretation. It is important to remember that the state is obligated under law to honor our pensions. The amount of money in the system is more a measurement of how difficult it will be for the state to meet its obligation than it is a threat that they will not make the pension payments.
A more interesting result of this review is a clearer understanding that the “surplus” is a moving number. The likelihood of LEOFF 1 members ever seeing a distribution or an increase in benefits from the surplus is severely diminished. Of course, the state has always asserted that the surplus was not available for such things anyway.
What we do know is that given the limited recovery time occasioned by the fact that our system is closed and mature there is not much time left for the system to return to a sizable surplus status. Only the most optimistic forecast would suggest that and by the time those large surpluses would materialize most of us will be gone.
On the positive side, this review makes it very clear to the various groups that have sought to raid our pension that that is no longer and can never be an option. There was a general agreement on the part of everyone on the Medical Benefits Committee that the pension fund is simply not available as a vehicle to fund medical benefit.
For myself, I remain optimistic. I keep looking at the long term history of the rate of return on pension fund investments. We came through the depression and recovered. I believe we will recover from our current recession. Our problem is not long-term recovery but the fact that the system is near its end and we don’t have the long-term needed to guarantee the full recovery. The near-term situation is a bit more iffy. Still, the system is healthy and the Actuary is comfortable with our status.