OPEB Investments: 
The DANGER in Playing it Safe 
Mary Fedorak 
MACM Regional Product Specialist 
222 North LaSalle 
Suite...
Presentation Overview 
• OPEB Basics 
• Actuarial Implications 
• Investment Implications 
• Board Implications 
• Questio...
GASB Accounting for OPEB 
Other 
Post-Employment 
Benefits 
3
Background of GASB Statements 
4 
OPEB in the Media 
“School districts struggle to pay retirees' health benefits” 
“The ne...
What is an OPEB? 
• Form of deferred compensation 
• Promise to provide retiree benefits must now be accrued 
during the w...
Implicit Rate Subsidies for Retirees 
• In health insurance plans where a government’s retirees 
and current employees are...
The Actuarial Model for OPEB Liability 
7 
Data Assumptions Methods Plan Provisions 
Actuarial Model 
Accounting Results 
...
Important Actuarial Assumptions 
Factors that affect liability 
Economic Demographic 
8 
Discount rate 
Pay increase rat...
Distinction Between Accounting and Funding 
• Accounting is required by GASB 
– Measure liabilities 
– Allocate expense to...
Two Methods of Funding 
Actuarial Method 
Paying to an OPEB plan 
an amount that is 
expected to be 
sufficient to pay for...
Health Care Costs Are Age Related 
11 
Age Monthly Cost Index to 45 
25 $245 55% 
30 284 64% 
35 329 74% 
40 382 86% 
45 4...
Implicit Healthcare Subsidy 
12 
Insured Medical Plan Costs 
Monthly premium $400 
Retiree monthly contribution $200 
Net ...
GASB Actuarial Valuation Required 
• Groups over 200 total membership – every 2 years 
• Groups under 200 – every 3rd year...
Annual OPEB Cost Definitions 
• Annual Required Contribution (ARC) 
– Normal cost + amortization of unfunded actuarial acc...
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 flow ne...
Long-term Equity and Bond Returns Have Outpaced Inflation 
Annualized 5 Year Rolling Equity & Bond Returns 
DOMESTIC EQUIT...
Pre-Funding Advantage 
• Best practices in managing OPEB liabilities include 
funding 
– Pay-as-you-go funding basis is un...
Discount Rate Advantage 
• Discount rate is based on expected rate of return 
• OPEB Trust assets will earn a higher rate ...
Discount Rate Advantage Example 
6% Return 4% Return Increase 
Retiree liability - for 
payments before age 65 $478,311 $4...
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 
An investment strategy based upon M.S. 
118A restrictions...
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 
7 
6 
5 
4 
3 
2 
1 
0 
Frequency of S&P 500 Calendar Year Returns ...
Diversification: There is no substitute 
31
32 
Great Opportunities Exist Outside The U.S. 
World Market Capitalization 
11997700 11 22001122 22 
22003300 33 
2012 To...
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...
35 
School Board Action Plan 
• Estimate the projected life of the OPEB Trust 
• Review investment policy and its handling...
Actuarial Caveats 
• Retiree medical cash flows are less predictable than 
retirement benefits 
• Changes in federal healt...
Disclaimers 
Any investment advice in this document is provided solely by PFM Asset 
Management LLC. PFM Asset Management ...
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Opeb investments the danger in playing it safe

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OPEB Investments: The Danger in Playing it Safe

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  • Many headlines about OPEB since GASB 45 was announced.
    Pensions have taken the brunt of criticism recently. Recession depleted funding levels, but OPEB was generally not prefunded anyways. Good time to start?
    More malleable than pensions.
  • Retirement income/unrestricted payment vs. enhancement to retiree medical plan.
    Contract split benefits between insurance and severance, but GASB thinks in terms of pension vs. OPEB vs. compensated absence.
    GASB 47 utilizes calculation methods of other statements, but requires at least a footnote disclosure explanation of effect of termination benefit.
  • Modified accrual basis accounting for governments
  • Opeb investments the danger in playing it safe

    1. 1. 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 fedorakm@pfm.com www.pfm.com Donn Hanson Director 800 Nicollet Mall Suite 2710 Minneapolis, MN 55402 (612) 371-3720 hansond@pfm.com 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 markm@vaniwaarden.com www.vaniwaarden.com Tony Jacobs Treasurer, LCWM School Board 607 Knights Lane Lake Crystal, MN 56055 (507)726-2323
    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 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”
    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 7 Data Assumptions Methods Plan Provisions Actuarial Model Accounting Results • Balance sheet liability • Accounting expense Liabilities • Accrued liability • Normal cost Projected Payments (Present Value of Benefits)
    8. 8. Important Actuarial Assumptions Factors that affect liability Economic Demographic 8 Discount rate Pay increase rates (severance) Healthcare trend rates Amortization method Participation rates –Employee –Spouse –Pre/post Medicare Retirement/turnover rates Plan election
    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 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 10
    11. 11. Health Care Costs Are Age Related 11 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
    12. 12. Implicit Healthcare Subsidy 12 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
    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 16 * Note that pre-funding is not required
    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 DOMESTIC EQUITY Geometric Mean: 10.67% U.S. INFLATION U.S. INFLATION Geometric Mean: 5.60% In t e r v a l: 6 0 R e t u r n V a l u e s 3 0 . 0 % 2 8 . 0 % 2 6 . 0 % 2 4 . 0 % 2 2 . 0 % 2 0 . 0 % 1 8 . 0 % 1 6 . 0 % 1 4 . 0 % 1 2 . 0 % 1 0 . 0 % 8 . 0 % 6 . 0 % 4 . 0 % 2 . 0 % 0 . 0 % - 2 . 0 % - 4 . 0 % - 6 . 0 % - 8 . 0 % - 1 0 . 0 % D e c 1 9 5 0 D e c 2 0 1 2 Geometric Mean: 3.86% D e c 1 9 5 5 D e c 1 9 6 0 D e c 1 9 6 5 D e c 1 9 7 0 D e c 1 9 7 5 D e c 1 9 8 0 D e c 1 9 8 5 D e c 1 9 9 0 AGGREGATE FIXED INCOME D e c 1 9 9 5 D e c 2 0 0 0 D e c 2 0 0 5 DOMESTIC EQUITY Geometric Mean: 10.67% AGGREGATE FIXED INCOME Geometric Mean: 5.60% Geometric Mean: 3.86% 19 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
    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 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% 22 The higher the investment return the smaller the liability and the less assets needed to pay for the promised benefits.
    23. 23. Predictable Long Term Cash Flow 23 Why invest for the short term when the cash flows are long term?
    24. 24. How Long Will the Assets Last? 24
    25. 25. Properly Structured Portfolios are Key 25 Source: Bloomberg
    26. 26. Short term strategy for long term obligation Source: Bloomberg An investment strategy based upon M.S. 118A restrictions will likely deplete OPEB Trust prematurely! 2-Year U.S. Treasury Note Yield 26
    27. 27. 27 Projected Total OPEB Liability
    28. 28. 28 2.5% Return Depletes the Trust Rapidly!
    29. 29. 29 Asset Allocation and Diversification are Critical
    30. 30. S&P 500 Has Generated Inconsistent Historical Returns 7 6 5 4 3 2 1 0 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% Source: Morningstar EnCorr/ Ibbotson Associates 30 I A S B B I S & P 5 0 0 T R U S D : D e c e m b e r 1 9 2 6 - D e c e m b e r 2 0 1 2 R e t u r n N u m b e r - 4 4 . 0 % - 3 8 . 0 % - 3 2 . 0 % - 2 6 . 0 % - 2 0 . 0 % - 1 4 . 0 % - 8 . 0 % - 2 . 0 % 4 . 0 % 1 0 . 0 % 1 6 . 0 % 2 2 . 0 % 2 8 . 0 % 3 4 . 0 % 4 0 . 0 % 4 6 . 0 % 5 4 . 0 %
    31. 31. Diversification: There is no substitute 31
    32. 32. 32 Great Opportunities Exist Outside The U.S. World Market Capitalization 11997700 11 22001122 22 22003300 33 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
    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. 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 appropriately A detailed actuarial report is the start of the process
    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. Disclaimers 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. 37

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