OPEB Investments:            The DANGER in Playing it Safe                                           January 17, 2013     ...
Presentation Overview• OPEB Basics• Actuarial Implications• Investment Implications• Board Implications• Questions and Ans...
GASB Accounting for OPEB              Other     Post-Employment             Benefits                           3
Background of GASB Statements     OPEB in the Media        “School districts struggle to pay retirees health benefits”    ...
What is an OPEB?• Form of deferred compensation• Promise to provide retiree benefits must now be accrued  during the worki...
Implicit Rate Subsidies for Retirees• In health insurance plans where a government’s retirees  and current employees are i...
The Actuarial Model for OPEB Liability         Data          Assumptions                      Methods         Plan Provisi...
Important Actuarial Assumptions                    Factors that affect liability  Economic                           Demog...
Distinction Between Accounting and Funding• Accounting is required by GASB   – Measure liabilities   – Allocate expense to...
Two Methods of Funding     Pay-as-you-go           Actuarial Method   Paying an amount each       Paying to an OPEB      y...
Health Care Costs Are Age Related               Age    Monthly Cost     Index to 45               25        $245          ...
Implicit Healthcare Subsidy              Insured Medical Plan Costs        Monthly premium                  $400        Re...
GASB Actuarial Valuation Required• Groups over 200 total membership – every 2 years• Groups under 200 – every 3rd year• Gr...
Annual OPEB Cost Definitions• Annual Required Contribution (ARC)– Normal cost + amortization of unfunded actuarial accrued...
OPEB Funding Rules• GASB’s requirements for a funded plan   – Employer contributions irrevocable   – Assets dedicated to p...
Implications of Funding•   Potential higher discount rate•   Greater flexibility in investments•   Smaller ARC and Net OPE...
Authorized Investment Considerations• Permitted ‘NON’ OPEB Trust considerations   – Short term horizon   – Uncertain cash ...
Authorized Investment Considerations (cont.)• OPEB Trust considerations   –   Long term horizon   –   Predictable cash flo...
Long-term Equity and Bond Returns Have Outpaced Inflation                                    Annualized 5 Year Rolling Equ...
Pre-Funding Advantage• Best practices in managing OPEB liabilities include  funding  – Pay-as-you-go funding basis is unse...
Discount Rate Advantage• Discount rate is based on expected rate of return• OPEB Trust assets will earn a higher rate of r...
Discount Rate Advantage Example                                 6% Return 4% Return IncreaseRetiree liability - for       ...
Predictable Long Term Cash Flow  Why invest for the short term when the cash flows are long term?                         ...
How Long Will the Assets Last?                                 24
Properly Structured Portfolios are KeySource: Bloomberg                                          25
Short term strategy for long term obligation                    An investment strategy based upon M.S.                    ...
Projected Total OPEB Liability                                 27
2.5% Return Depletes the Trust Rapidly!                                          28
Asset Allocation and Diversification are Critical                                                    29
S&P 500 Has Generated Inconsistent Historical Returns                        Frequency of S&P 500 Calendar Year Returns si...
Diversification: There is no substitute                                          31
Great Opportunities Exist Outside The U.S.                                                   World Market Capitalization  ...
Board Member Implications• Fiduciary Responsibility   – Know the Investment Policy   – Monitor the Investment Performance ...
DANGER in Playing it Safe• Safe does not automatically mean prudent    – Fiduciary duty to be prudent•   Bond proceeds may...
School Board Action Plan• Estimate the projected life of the OPEB Trust• Review investment policy and its handling of OPEB...
Actuarial Caveats• Retiree medical cash flows are less predictable than  retirement benefits• Changes in federal health ca...
DisclaimersAny investment advice in this document is provided solely by PFM AssetManagement LLC. PFM Asset Management LLC ...
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OPEB Investments: The Danger in Playing it Safe

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Considerations for investing OPEB trust assets under GASB 45.

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OPEB Investments: The Danger in Playing it Safe

  1. 1. OPEB Investments: The DANGER in Playing it Safe January 17, 2013 Tony Jacobs Mark D. Meyer, JD, FSA Mary Fedorak Donn HansonTreasurer, LCWM School Board Van Iwaarden Associates MACM Regional Product Specialist Director 607 Knights Lane 840 Lumber Exchange 222 North LaSalle 800 Nicollet Mall Lake Crystal, MN 56055 10 South Fifth Street Suite 910 Suite 2710 (507)726-2323 Minneapolis, MN 55402 Chicago, IL 60601 Minneapolis, MN 55402 (888) 596-5960 (312) 523-2438 (612) 371-3720 markm@vaniwaarden.com fedorakm@pfm.com hansond@pfm.com www.vaniwaarden.com www.pfm.com www.pfm.com
  2. 2. Presentation Overview• OPEB Basics• Actuarial Implications• Investment Implications• Board Implications• Questions and Answers 2
  3. 3. GASB Accounting for OPEB Other Post-Employment Benefits 3
  4. 4. Background of GASB Statements 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” 4
  5. 5. What is an OPEB?• 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 5
  6. 6. Implicit Rate Subsidies for Retirees• 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 6
  7. 7. The Actuarial Model for OPEB Liability Data Assumptions Methods Plan Provisions Actuarial Model (Present Value of Benefits) Liabilities Accounting Results • Accrued liability • Balance sheet liability Projected Payments • Normal cost • Accounting expense 7
  8. 8. Important Actuarial Assumptions Factors that affect liability Economic Demographic  Discount rate  Participation rates – Employee  Pay increase rates (severance) – Spouse  Healthcare trend rates – Pre/post Medicare  Amortization method  Retirement/turnover rates  Plan election 8
  9. 9. 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
  10. 10. Two Methods of Funding Pay-as-you-go Actuarial Method Paying an amount each Paying to an OPEB year equal to the plan an amount that is benefits distributed or expected to be claimed in that year sufficient to pay for the benefits of employees after they are no longer working 10
  11. 11. Health Care Costs Are Age Related Age Monthly Cost Index to 45 25 $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 11
  12. 12. Implicit Healthcare Subsidy Insured Medical Plan Costs Monthly premium $400 Retiree monthly contribution $200 Net employer cost $200 GASB 43/45 Interpretation Retiree age-specific cost $520 Retiree monthly contribution $200 Net employer OPEB cost $320 12
  13. 13. GASB Actuarial Valuation Required• 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) 13
  14. 14. Annual OPEB Cost Definitions• 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 14
  15. 15. OPEB Funding Rules• 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 15
  16. 16. Implications of Funding• Potential higher discount rate• Greater flexibility in investments• Smaller ARC and Net OPEB Obligation• Better credit rating* Note that pre‐funding is not required 16
  17. 17. Authorized Investment Considerations• 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 17
  18. 18. Authorized Investment Considerations (cont.)• 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 18
  19. 19. Long-term Equity and Bond Returns Have Outpaced Inflation Annualized 5 Year Rolling Equity & Bond Returns Return Values 30.0% 28.0% 26.0% 24.0% 22.0% 20.0% DOMESTIC EQUITY DOMESTIC EQUITY 18.0% Geometric Mean: 10.67% Geometric Mean: 10.67% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% AGGREGATE AGGREGATE -2.0% FIXED INCOME U.S. INFLATION FIXED INCOME U.S. INFLATION Geometric Mean: 5.60% -4.0% Geometric Mean: 5.60% Geometric Mean: 3.86% Geometric Mean: 3.86% -6.0% -8.0% -10.0% Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2012 Interval: 60 S&P 500 TR Barclays Aggregate Bond (1976-2011) and 50% Intermediate Corporate; 25% Int. Govt; and 25% US Long-term Govt (1950-1976) _____ Consumer Price Index Source: Morningstar En Corr/ Ibbotson Associates 19
  20. 20. Pre-Funding Advantage• 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 20
  21. 21. Discount Rate Advantage• 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 21
  22. 22. Discount Rate Advantage Example 6% Return 4% Return IncreaseRetiree liability - for $478,311 $499,169 4%payments before age 65Active liability $594,320 $686,001 15%Total liability $1,072,631 $1,185,170 10% The higher the investment return the smaller the liability and the less assets needed to pay for the promised benefits. 22
  23. 23. Predictable Long Term Cash Flow Why invest for the short term when the cash flows are long term? 23
  24. 24. How Long Will the Assets Last? 24
  25. 25. Properly Structured Portfolios are KeySource: Bloomberg 25
  26. 26. Short term strategy for long term obligation An investment strategy based upon M.S. 118A restrictions will likely deplete OPEB Trust prematurely! 2‐Year U.S. Treasury Note YieldSource: Bloomberg 26
  27. 27. Projected Total OPEB Liability 27
  28. 28. 2.5% Return Depletes the Trust Rapidly! 28
  29. 29. Asset Allocation and Diversification are Critical 29
  30. 30. S&P 500 Has Generated Inconsistent Historical Returns Frequency of S&P 500 Calendar Year Returns since 1926 Only 5 out of 87 calendar year periods has the S&P 500 return been between 8%‐12% Number 7 6 5 4 3 2 1 0 -44.0% -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% 54.0% Return Source:  Morningstar EnCorr/ Ibbotson Associates 30
  31. 31. Diversification: There is no substitute 31
  32. 32. Great Opportunities Exist Outside The U.S. World Market Capitalization 1970 1 2012 2 2030 3 2012 Total Market Capitalization: $29.5 Trillion 2 1) Data from BlackRock, Inc. which includes developed only 2) Data from MSCI: includes total U.S. ($13.4 Trillion), ACWI ex US ($16 Trillion) 3) Projection from Goldman Sachs 32
  33. 33. Board Member Implications• 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 33
  34. 34. 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 34
  35. 35. 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 appropriatelyA detailed actuarial report is the start of the process 35
  36. 36. Actuarial Caveats• 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 36
  37. 37. DisclaimersAny investment advice in this document is provided solely by PFM AssetManagement LLC. PFM Asset Management LLC (“PFMAM”) is an investmentadvisor registered under the Investment Advisers Act of 1940. PFM Advisors isa division of PFM Asset Management LLC. Public Financial Management Inc. isnot providing and is not responsible for any investment advice herein.This material is based on information obtained from sources generally believedto be reliable and available to the public, however PFM Asset Management LLCcannot guarantee its accuracy, completeness or suitability. This material is forgeneral information purposes only and is not intended to provide specific adviceor a specific recommendation. All statements as to what will or may happenunder certain circumstances are based on assumptions, some but not all ofwhich are noted in the presentation. Assumptions may or may not be provencorrect as actual events occur, and results may depend on events outside ofyour or our control. Changes in assumptions may have a material effect onresults. Past performance does not necessarily reflect and is not a guaranty offuture results. The information contained in this presentation is not an offer topurchase or sell any securities. 37

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