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Opeb and prefunding


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Opeb and prefunding

  1. 1. PFM OPEB and Pre-Funding for California Agencies February 25, 2011 CSMFOPFM Asset Management LLC Presented By:50 California StreetSuite 2300 Carlos Oblites, Senior Managing ConsultantSan Francisco, CA© 2011 PFM Asset Management LLC
  2. 2. Alternatives for Attacking the OPEB Issue PFM Fund? Not Fund? Multi-employer trust? Single employer trust? VEBA? Section 115 Trust?© 2011 PFM Asset Management LLC 2
  3. 3. PFMTypical Goals • 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© 2011 PFM Asset Management LLC 3
  4. 4. General Observations PFM • 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.© 2011 PFM Asset Management LLC 4
  5. 5. PFM Managing OPEB Assets: You Have Choices© 2011 PFM Asset Management LLC 5
  6. 6. Funding Option #1: PAYGO PFM • 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 Pros Cons• Minimizes current year expenditures • Structure creates largest possible Unfunded throughout the life of the benefits Actuarial Accrued Liability (“UAAL”) and Annual Required Contribution (“ARC”)• Requires minimal outside professional • Does not address rising cost of providing assistance retiree benefits • Actuary every other year • No assets to invest, so no mitigation of future liabilities • Auditor • For actuarial valuation and financial• Operationally simple, requires no reporting changes to current processes – Must use lower discount rate – Have no assets to offset liabilities© 2011 PFM Asset Management LLC 6
  7. 7. Funding Option #2: Internal Service Fund PFM• 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 Pros Cons• Begins to provide funding for future • Structure does not improve UAAL or ARC benefits that begins to address over PAYGO structure due to lower discount rate and lack of assets to offset liabilities on intergenerational equity balance sheet• Earns a return on assets that can help • More expensive than PAYGO but addresses mitigate future cost increases rising cost of providing retiree benefits in• only a limited manner Operationally similar to other Internal Service Funds, requires only minimal • Typically must be invested according to changes to current processes governmental investment statutes • Likely requires additional outside professional assistance of an investment advisor and custodial bank© 2011 PFM Asset Management LLC 7
  8. 8. Funding Option #3: Irrevocable Trust PFM• 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 Pros Cons • Provides funding for future benefits in a • Significantly higher costs than PAYGO formal, segregate manner addressing on a year to year basis to provide full intergenerational equity funding, but may limit total future costs • Generally, trust assets allowed to • Likely requires changes to current invested in “prudent person” operational processes investments which can improve • Will require additional external returns over the long-term helping professional assistance 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 © 2011 PFM Asset Management LLC 8
  9. 9. Types of Trusts PFM VEBA 401(h) Section 115 Voluntary adoption Separate account Structure Governmental trust by employers under pension trust No IRS Approval Required    No IRS Annual Filings    No Contribution Caps    Investment Earnings Non- taxable    Benefits Non-taxable   © 2011 PFM Asset Management LLC 9
  10. 10. Different Trust Options PFM • 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© 2011 PFM Asset Management LLC 10
  11. 11. PFM Management of OPEB Trust© 2011 PFM Asset Management LLC 11
  12. 12. Differentiated OPEB Trust Components PFM Non-discretionary Model Discretionary Manager Model Initial Responsibilities Initial Responsibilities • Create Governance Charter • Can create advisory board/oversight committee • Create By-Laws • Hire Discretionary • Board Member Selection (with Advisor/Manager(One) substantial/majority of unaffiliated members) Ongoing Responsibilities • Hire Investment Managers (Two to • Periodically Review Results Ten) • Hire/Fire Investment Managers Ongoing Responsibilities • Report to Governing Body • Periodically Review Results • Hire/Fire Investment Managers • Report to Governing Body© 2010 PFM Asset Management LLC 12
  13. 13. Non-discreationary Model PFM • Basically directed trustee overseeing holding of assets • Fiduciary with direct responsibility for investments • Provides independent • Not typically a valuation of assets fiduciary over all aspects of investments© 2010 PFM Asset Management LLC 13
  14. 14. Discretionary Manager Model PFM • Fiduciary overseeing holding of assets • General Oversight, but no direct investment duties • Fiduciary • Provides overseeing independentinvestment functions valuation of assets© 2010 PFM Asset Management LLC 14
  15. 15. Discretionary Managers Should be Independent PFM & Conflict Free • 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© 2011 PFM Asset Management LLC 15
  16. 16. What Will You Need? PFM• 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
  17. 17. Common OPEB Trust Components PFM Regardless 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© 2011 PFM Asset Management LLC 17
  18. 18. OPEB Implementation process PFM • 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© 2011 PFM Asset Management LLC 18
  19. 19. Case Study: “A/L Based” Asset Allocation PFM Vested Participant Unvested Participant Liabilities Liabilities $14.6 million $11.8 million 56% 44% Multi-Asset Class Managed Fixed Income / Cash Would you establish a 70/30 asset allocation for this plan?© 2011 PFM Asset Management LLC 19
  20. 20. Portfolio Planning Survey Identifies Needs PFM • Customized portfolio questionnaire designed to assist staff and Committee members in gaining consensus around investment and financial decisions Task • Achieve expectations for future portfolio strategy and manager decisions 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© 2011 PFM Asset Management LLC 20
  21. 21. Customized Asset Allocation Analysis PFM • Creation of customized portfolio options specific to the goals, objectives and risk Task tolerances of each entity • Quantify trade-off between risk and return to create efficient portfolios Reason • Extend diversification of investment strategies and money managers • Portfolio AND organization/headline risk management E x p e c te d R e tu rn 20% Distribution of Projected 5 Year Returns 1 3 .0 1 2 .5 1 2 .0 S m a ll / M i d C a p D o m e s t ic E q u it y 17.8% 1 1 .5 FRONTIER BASED ON HISTORICAL ASSET CLASS RETURNS In t e r n a t i o n a l E q u i t y 1 1 .0 15% 14.9% 1 0 .5 L a r g e C a p D o m e s t ic E q u it y 1 0 .0 12.4% 9 .5 12.2% 9 .0 10% 10.6% 8 .5 P o r t fo lio 3 9.2% 8 .0 R e a l E s ta te %R P o r t fo lio 2 n tu e 8.7% ) ( r 7.9% 7 .5 P o r t fo lio 1 7.0% 7 .0 C o m m o d it ie s 6 .5 5% 5.3% 5.4% FRONTIER BASED ON PFM ADVISORS’ LONG-TERM PROJECTIONS 4.9% 6 .0 5 .5 5 .0 2.0% A g g r e g a t e F ix e d In c o m e 1.5% 4 .5 0% 0.5% 5 .0 6 .0 7 .0 8 .0 9 .0 1 0 .0 1 1 .0 1 2 .0 1 3 .0 1 4 .0 1 5 .0 1 6 .0 1 7 .0 1 8 .0 1 9 .0 2 0 .0 2 1 .0 2 2 .0 S t a n d a r d D e v ia t i o n ( R is k ) Conservative Balanced Aggressive© 2011 PFM Asset Management LLC 21
  22. 22. Case Study: Proposed Portfolios PFM Conservative Balanced Comparative Comparative Liability-Driven Liability-Driven Portfolio C Portfolio D Portfolio A Portfolio B 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 Domestic Equity International Equity Other Equity Domestic Equity Aggregate Fixed Income Short Term Fixed Income / Other Equity International Equity Cash Aggregate Fixed Income Domestic Equity Short Term Fixed Income / Other Equity International Equity Cash Aggregate Fixed Income Domestic Equity Short Term Fixed Income / Cash Equity International Equity Other Aggregate Fixed Income Short Term Fixed Income / C Domestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / Cash© 2011 PFM Asset Management LLC 22
  23. 23. Manager Selection: PFMStructuring an Efficient Multi-Asset Class Portfolio • Managers for each asset type Manager Sourcing: 1,500 Managers; must be selected 5,500 Separate Accounts; and 14,000 Mutual Funds • For most trusts, investments Universe Creation: 200+ Managers will be in the form of mutual funds Quantitative Analysis • Recommendations: 10-20 Managers • Select best-in-class Qualitative Review • Institutional shares 5-6 Managers • Consider active/passive Diversification Analysis strategy 3 Managers • Review performance and risk parameters Finalists for inclusion In Portfolio© 2011 PFM Asset Management LLC 23
  24. 24. Sample Money Managers PFMDomestic Equity Real Estate & Inflation Hedged Active Management  Vanguard REIT Index (VGRSX)  Davis NY Venture (DNVYX)  PIMCO Commodity Real Return (PCRIX)  American Fundamental Investors (RFNFX)  FMI Common Stock (FMIMX) Domestic Fixed Income  Columbia Acorn (ACRNX) Active Management Passive Management  PIMCO Total Return (PTTRX)  Vanguard Total Stock Market Index (VTSSX)  Metropolitan West Total Return (MWTIX)  Touchstone Core Plus (TCPNX)  Artio Global High Income (JHYIX)International Equity Active Management Passive Management  Dodge & Cox International Stock (DODFX)  Vanguard Total Bond Market Index (VBTSX)  American EuroPacific Growth (RERFX)  Vanguard Short-Term Bond Index (VBSSX)  Oppenheimer Passive Management  Vanguard Total International Index (VGTSX)© 2011 PFM Asset Management LLC 24
  25. 25. Final Thoughts PFM • 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© 2011 PFM Asset Management LLC 25