(FRS) Actuarial Valuation
STATE BOARD OF ADMINISTRATION OF FLORIDA 1801 HERMITAGE BOULEVARD TALLAHASSEE, FLORIDA 32308 (850) 488-4406 POST OFFICE BOX 13300 32317-3300
RICK SCOTT GOVERNOR AS CHAIRMAN JEFF ATWATER CHIEF FINANCIAL OFFICER AS TREASURER PAM BONDI ATTORNEY GENERAL AS SECRETARY ASH WILLIAMS EXECUTIVE DIRECTOR & CIO
To:
Honorable Mike Haridopolos, President of the Florida Senate Honorable Dean Cannon, Speaker of the Florida House of Representatives
From:
Ash Williams, Executive Director and Chief Investment Officer
Date:
May 15, 2012
Subject:
Review of 2011 Florida Retirement System (FRS) Actuarial Valuation
cc:
Honorable Rick Scott Honorable Jeff Atwater Honorable Pam Bondi
This report is submitted to the 2012 Florida Legislature in accordance with Section 121.0312, Florida Statutes, which reads as follows: Review; actuarial valuation report; contribution rate determination process. The Governor, Chief Financial Officer, and Attorney General, sitting as the Board of Trustees of the State Board of Administration, shall review the actuarial valuation report prepared in accordance with the provisions of this chapter. The Board shall review the process by which Florida Retirement System contribution rates are determined and recommend and submit any comments regarding the process to the Legislature. Background The Florida Retirement System Pension Plan (FRS-PP) was created in 1970 by combining a number of underfunded state and local pension plans.1 In light of a very low 40% funded ratio, a constitutional amendment addressing actuarial funding of the FRS-PP passed in 1977.2 The constitutional amendment represented a landmark long-term commitment to fiscal responsibility. Subsequently, the FRS-PP funding ratio was improved over many years, particularly in the 1990s. The improvement was a result of the discipline of the Legislature, SBA Trustees, 1
State employees currently comprise about 21% of the FRS membership, and a highly diverse group of school district and local government employees comprise the remainder. 2 Article 10, Section 14 of the State Constitution states: A governmental unit responsible for any retirement or pension system supported in whole or in part by public funds shall not after January 1, 1977, provide any increase in the benefits to the members or beneficiaries of such system unless such unit has made or concurrently makes provision for the funding of the increase in benefits on a sound actuarial basis.
1
Division of Retirement, and SBA staff, consistent with their respective roles, in supporting reasonable benefits, prudent investments, and responsible funding policy (Chart 1). Of note: 1. For the roughly 30 years that the FRS-PP was underfunded, all benefits were paid in full and in a timely fashion to retirees and other beneficiaries. During those years when the FRS-PP was underfunded, employer contributions included an extra portion to reduce the unfunded liability (i.e., the Unfunded Actuarial Liability or UAL contribution rate). Composite employer contribution rates in the early 1990s were over 18% of payroll. 2.
The FRS-PP became fully funded in 1998 (Chart 1). In 2000, the Legislature, in collaboration with the SBA Trustees, created a contribution rate stabilization mechanism (i.e., Section 121.031(3)(f), Florida Statutes) that allowed a conservative annual use of the surplus to reduce employer contributions over time. Employers saved a cumulative $6.59 billion through reduced contributions between FY 1999-2000 and FY 2008-2009.3
3.
The global financial crisis that began in 2008 created an unfunded actuarial liability after 11 fiscal years of actuarial surpluses. However, the SBA’s long-term investment discipline has helped the FRS-PP regain $44 billion in value since the low point of the financial crisis in March 2009, despite making net benefit payments of $14.3 billion over the last three fiscal years. With an actuarial funded ratio of roughly 88% at July 1, 2011, the FRS-PP is one of the best funded state-wide public sector pension plans (Chart 2).
4.
With Senate Bill 2100, the 2011 Legislature and Governor approved extensive benefit and funding changes to the FRS-PP. Key changes included: a. Effective July 1, 2011, requires 3% employee contribution for all FRS members. DROP participants are not required to pay employee contributions. b. For employees initially enrolled on or after July 1, 2011, the definition of "average final compensation" means the average of the 8 highest fiscal years of compensation for creditable service prior to retirement, for purposes of calculation of retirement benefits. For employees initially enrolled prior to July 1, 2011, the definition of “average final compensation” continues to be the average of the 5 highest fiscal years of compensation. c. For employees initially enrolled in the pension plan on or after July 1, 2011, such members will vest in 100% of employer contributions upon completion of 8 years of creditable service. For existing employees, vesting will remain at 6 years of creditable service. d. For employees, initially enrolled on or after July 1, 2011, increases the normal retirement age and years of service requirements, as follows: i. For Special Risk Class: Increases the age from 55 to 60 years of age; and increases the years of creditable service from 25 to 30. ii. For all other classes: Increases the age from 62 to 65 years of age; and increases the years of creditable service from 30 to 33 years.
3
Source: Department of Management Services, Division of Retirement. Additionally, in FY 1999-2000 the Legislature approved use of $5.39 billion of the surplus to fully amortize all existing unfunded actuarial liability lines for all classes.
2
e. Maintains DROP; however, employees entering DROP on or after July 1, 2011 will earn interest at a reduced accrual rate of 1.3%. For employees currently in DROP or entering before July 1, 2011, the interest rate remains 6.5%. f. Eliminates the cost-of-living adjustment (COLA) for service earned on or after July 1, 2011. Subject to the availability of funding and the Legislature enacting sufficient employer contributions specifically for the purpose of funding the reinstatement of the COLA, the new COLA formula will expire effective June 30, 2016, and the current 3% cost-of-living adjustment will be reinstated. Chart 1: Historical Perspective of FRS Pension Plan Funded Ratio Ratio o f Actuarial Assets to Actuarial Liabilities
Ratio o f Market Value o f Assets to Actuarial Liabilities
150%
100%
1 5 8 9 6 8 9 1 7 8 9 1 8 9 1 8 9 1 0 9 1 9 1 2 9 1 3 9 1 4 9 1 5 9 1 6 9 1 7 9 1 8 9 1 9 1 0 2 1 0 2 0 2 3 0 2 4 0 2 5 0 2 6 0 2 7 0 2 8 0 2 9 0 2 1 0 2 1 0 2
0%
5 % .3 4 .% 5 % .8 6 5 % .0 6 5 % .1 5 % .3 7 5 .% 9 5 % .3 4 6 % .4 9 6 % .1 3 7 % .0 7 .% 3 8 % .3 1 9 .% 6 0 1 % .4 3 1 .% 8 1 % .9 7 1 % .0 5 1 % .2 4 1 .% 2 1 .% 8 0 1 .% 7 0 1 .% 7 0 1 .% 7 0 1 % .5 8 % .6 8 % .5 7 8
b fL o % rilse a tu c A
50%
As of July 1 of Indicated Year Note: Amounts are interpolated for 1986, 1988, 1990, 1992, 1994 and 1996 because actuarial valuations were conducted biennially prior to 1997.
3
Chart 2: State Retirement System Funded Ratios
Source: Wilshire 2012 Report on State Retirement Systems: Funding Levels and Asset Allocation March 2, 2012
Review of the July 1, 2011 Actuarial Valuation Section 121.031(3), Florida Statutes provides for an annual actuarial valuation of the FRS-PP. The Department of Management Services, Division of Retirement conducts the official actuarial valuation through an independent outside actuary: Milliman, USA (Milliman). However, prior to completion of that valuation, legislative and executive branch staff meet in a Florida Retirement System Actuarial Assumption Conference, to which the SBA and Division of Retirement serve as resources. The Florida Retirement System Actuarial Assumption Conference shall develop official information with respect to the economic and noneconomic assumptions and funding methods of the Florida Retirement System necessary to perform the system actuarial study undertaken pursuant to s. 121.031(3). Such information shall include: an analysis of the actuarial assumptions and actuarial methods used in the 4
study and a determination of whether changes to the assumptions or methods need to be made due to experience changes or revised future forecasts. Section 216.136(10), Florida Statutes. The Florida Retirement System Actuarial Assumption Conference met publicly on September 27, 2011 and affirmed the assumptions and methods to be used for the 2011 actuarial valuation (i.e., measured with plan data effective July 1, 2011). Milliman provided preliminary valuation data, analysis of key assumptions (e.g., wage and workforce growth rates, expected investment returns, inflation, etc.) and projections of the future course of assets and liabilities under various favorable and unfavorable investment performance scenarios. Milliman published the final 2011 actuarial valuation in December 2011 and calculated an unfunded actuarial liability of $18 billion and a funded ratio of 87.5% (Appendix 1 has summary information from Milliman prepared March 2012). SBA staff believes that the assumptions utilized in the Milliman 2011 actuarial valuation report are consistent with those determined at the Florida Retirement System Actuarial Assumption Conference. While the SBA does not perform an independent actuarial valuation of the FRS-PP, the SBA utilizes a form of actuarial analysis, known as an asset-liability study, to establish and manage its investment policy. 1.
Historically, every three to five years, the SBA conducts extensive asset-liability studies so that FRS-PP assets are invested sufficient for the plan to be maintained in a manner that ensures the timely payment of promised benefits to current and future retirees, and keeps plan cost at a reasonable level. The study assesses investment policy in light of projected benefit payments (i.e., future liabilities) and expected investment performance over a 15-year period.
2.
The last major asset-liability study was conducted in 2010 and resulted in significant changes to the FRS-PP asset allocation policy (e.g., expanded the utilization of alternative investments) and structure of individual asset classes.
3.
Each year since 2002, the SBA has also updated the asset-liability study based on Milliman’s annual actuarial valuation as well as developments in the capital markets, and presented the results to the Investment Advisory Council at its Spring meeting. The purpose of the annual update is to monitor progress toward the attainment of the FRSPP’s long-term objectives with a specific focus on the implications for investment policy, and identify issues so that they can be addressed in a timely and proactive fashion.
Using the final 2011 actuarial valuation, Hewitt EnnisKnupp (HEK) presented its annual assetliability update to the Investment Advisory Council on March 19, 2012, and on the following day made a summary presentation to the Trustees (Appendix 3). Also, on March 20, the Trustees received a presentation from Milliman on the 2011 actuarial valuation and contribution rates (Appendix 1 contains excerpt of presentation).
5
Notable findings in the HEK analysis were: 1. Updated capital market assumptions indicate a 50% probability of meeting or exceeding
the actuarial investment return assumption of 7.75% under the current asset allocation policy (i.e., “expanded authority”) over a 15-year horizon. The analysis does not reject modestly lowering the investment return assumption. 2. Even if all actuarial assumptions are accurate, the funded ratio of the FRS-PP will
gradually decline over the next 20 years due to the actuarial method used to recognize the contribution rate cost savings from the Senate Bill 2100 benefit changes (Appendix 2 has an operative excerpt from page A-2 of Milliman’s Florida Retirement System Actuarial Valuation as of July 1, 2011). 3. Several years of not making the full unfunded actuarial liability contributions (UAL
contributions) are further exacerbating the trend toward lower funded status (Appendix 1 Table 2 illustrates the underfunding relative to the actuarially recommended rates for the regular class and special risk class).4 4. There are some conflicting indicators as to how much investment risk the asset allocation
policy of the FRS-PP should target: a. The risk-reward curve based on long-term economic cost suggests a possible
increase in the target risk—driven by a higher equity risk premium, i.e., the difference between the expected return on stocks and bonds.5 b. Unlike in previous studies, there are reasons to avoid more short-term risk
exposure, because a significant funded ratio shortfall in the near term can be difficult to recover from; i.e., materially adverse investment performance compounds the factors described in #2 and #3 above.6 5. In light of the above interplay between investment policy and funding policy, HEK and
SBA staff identified several opportunities to improve the asset allocation for the FRS-PP: a. Increased allocations to real estate and/or strategic investments could enhance
diversification and mitigate downside risk. b. Improved liquidity for benefit payments could be obtained with a higher cash
allocation (i.e., foregoing returns), or with more complex fixed income allocations (i.e. liquidity barbell).
4
See also page I-4 of 2011 Valuation: “The contribution rates legislated for plan year 2011-2012 are significantly less than the sum of the Normal Cost only rates and UAL Cost rates determined by the July 1, 2010 valuation, after reflecting the impact of Senate Bill 2100. Thus, the contribution being made to fund the UAL in plan year 20112012 is lower than the actuarially determined contribution. Therefore, the contribution lag will result in an increase in the unfunded actuarial liability as of July 1, 2012 assuming no further gains or losses.” 5 However, low fixed income yields are likely to revert to more normal levels during the planning horizon and would lower the equity risk premium. 6 HEK’s analysis indicates a nearly 18% probability that the ratio of market value to actuarial accrued liabilities could be less than 60% at the end of 5 years. In roughly 90% of those scenarios, the FRS-PP actuarial funded ratio does not recover to at least 85% (i.e., a healthy level) by the end of the 15-year planning horizon.
6
After reviewing the results of the HEK analysis, the consensus view of SBA staff, HEK, and the Investment Advisory Council was: 1. The SBA should continue with its multi-year plan to methodically implement the asset
allocation changes approved following the 2010 and 2011 asset-liability studies, facilitated by the expanded statutory authority to utilize alternative investments. 2. The actuarial assumptions, funding methodology, and contribution rate setting policy for
the FRS-PP should be re-evaluated before considering new incremental asset allocation policy changes. The Florida Retirement System Actuarial Assumption Conference should consider the following: 1. Revisiting the funding cost methodology. A goal might be to provide more funding
support if investment return targets are not met, and mitigate the risk of persistent and potentially unrecoverable low funded ratios if returns fall below target levels. a. Evaluate changes in the amortization method (either shorter period and/or level
dollar amounts, instead of level percent of payroll method). b. Evaluate changes in the actuarial cost method (switch to “traditional” Entry Age,
from the current “ultimate” Entry Age method). 2. Revisiting the actuarial assumptions used for cost calculations. For example, lowering the
return assumption from 7.75% to 7.25% and lowering the wage increase assumption from 4% to 3%. The combination of these assumption changes could result in an increase in employer cost (~2% of payroll) and decrease in reported funded status (~ 7% to 8%). Note: HEK estimates that the probability of meeting or exceeding a new 7.25% investment return assumption over 15 years is about 55%, versus the 50% probability for the current 7.75% assumption. 3. Evaluating approaches to more fully address the recommended unfunded actuarial
liability contributions (UAL). Under 2012 legislation, deferred funding of the UAL may amount to about a $1 billion lower contribution for FY 2013-2014; to be amortized over 30 years and added to future cost rates. Alternative approaches could be to contribute the actuarially calculated cost each year to amortize the UAL or develop a multi-year plan targeting a 100% funding ratio. 4. Reviewing any other issues that should be part of an integrated review of the funding
policy for the Florida Retirement System programs. Possible areas might include: a. The method of funding the DROP feature b. The manner in which FRS-PP costs are allocated amongst/between the
participating employers, membership classes, and members. c. On March 6, 2012, the Circuit Court of the Second Judicial Circuit found that the
portions of Chapter 2011-68, Laws of Florida, imposing a 3% employee contribution to the Florida Retirement System and eliminating the cost-of-living 7
adjustment for future service to be unconstitutional as applied to individuals who were members of the FRS prior to July 1, 2011 and ordered the defendants to be permanently enjoined from implementing these provisions and to reimburse (with interest) the funds deducted or withheld. The trial court’s decision has been appealed to the Florida Supreme Court, which results in a continued stay of the trial court’s order. In the event the Florida Supreme Court ultimately affirms the trial court’s order, however, the underfunded status of the FRS-PP will be exacerbated unless corresponding action is taken by the Legislature.
The SBA appreciates the opportunity to review the FRS-PP actuarial valuation report and contribution rate determination process. Please do not hesitate to contact me if you have any questions regarding our comments.
Attachments
8
Appendix 1
Table 1:
9
Table 2
10
Appendix 2: Excerpt from Page A-2 of Milliman’s Florida Retirement System Actuarial Valuation as of July 1, 2011 The benefit changes legislated by Senate Bill 2100 reduced the Normal Cost, Present Value of Future Normal Cost (PVFNC) and the Present Value of Benefits (PVB) for current and future active members. The actuarial accrued liability is defined as PVB less PVFNC. For some membership classes the percentage decrease in the PVFNC was larger than the percentage decrease in the PVB, resulting in an increase in an actuarial liability. For the remaining membership classes, the percentage decrease in the PVFNC was smaller than the percentage decrease in the PVB, resulting in a decrease in the actuarial liability. The variation is due to the different demographics, benefit multipliers and unique interrelation of the modified benefit provisions of each membership class. The PVB will decrease in future valuations as current active members are replaced by new members impacted by the change in benefits. All current members will continue to earn benefits at levels greater than those annually earned by members initially enrolled on or after July 1, 2011. When this impact is combined with amortizing the change in the unfunded liability due to this proposal over 30 years, the funding of current member’s actual normal costs will extend beyond working lifetime into retirement. Under the percent of pay amortization method used in the valuation, payment of the actual excess normal costs will effectively not occur until the last 10 years of the 30 year amortization period. Under a level percent of pay amortization, initial payments are less than interest on the unfunded liability, resulting in the unfunded liability increase over time. After approximately 20 years, the unfunded liability will be approximately at the same level as the initial amount. By deferring to the later years of the 30-year amortization period, the funded ratio of the plan is expected to gradually decline for the next 20 years, which could compound the impact of any future adverse experience. This result is somewhat mitigated by the decrease in the accrued liability due to the elimination of the COLA for future service for all members.
11
Appendix 3: March 20, 2012 Hewitt EnnisKnupp Presentation to SBA Trustees
12
RICK SCOTT GOVERNOR AS CHAIRMAN JEFF ATWATER CHIEF FINANCIAL OFFICER AS TREASURER PAM BONDI ATTORNEY GENERAL AS SECRETARY ASH WILLIAMS EXECUTIVE DIRECTOR & CIO
To:
Honorable Mike Haridopolos, President of the Florida Senate Honorable Dean Cannon, Speaker of the Florida House of Representatives
From:
Ash Williams, Executive Director and Chief Investment Officer
Date:
May 15, 2012
Subject:
Review of 2011 Florida Retirement System (FRS) Actuarial Valuation
cc:
Honorable Rick Scott Honorable Jeff Atwater Honorable Pam Bondi
This report is submitted to the 2012 Florida Legislature in accordance with Section 121.0312, Florida Statutes, which reads as follows: Review; actuarial valuation report; contribution rate determination process. The Governor, Chief Financial Officer, and Attorney General, sitting as the Board of Trustees of the State Board of Administration, shall review the actuarial valuation report prepared in accordance with the provisions of this chapter. The Board shall review the process by which Florida Retirement System contribution rates are determined and recommend and submit any comments regarding the process to the Legislature. Background The Florida Retirement System Pension Plan (FRS-PP) was created in 1970 by combining a number of underfunded state and local pension plans.1 In light of a very low 40% funded ratio, a constitutional amendment addressing actuarial funding of the FRS-PP passed in 1977.2 The constitutional amendment represented a landmark long-term commitment to fiscal responsibility. Subsequently, the FRS-PP funding ratio was improved over many years, particularly in the 1990s. The improvement was a result of the discipline of the Legislature, SBA Trustees, 1
State employees currently comprise about 21% of the FRS membership, and a highly diverse group of school district and local government employees comprise the remainder. 2 Article 10, Section 14 of the State Constitution states: A governmental unit responsible for any retirement or pension system supported in whole or in part by public funds shall not after January 1, 1977, provide any increase in the benefits to the members or beneficiaries of such system unless such unit has made or concurrently makes provision for the funding of the increase in benefits on a sound actuarial basis.
1
Division of Retirement, and SBA staff, consistent with their respective roles, in supporting reasonable benefits, prudent investments, and responsible funding policy (Chart 1). Of note: 1. For the roughly 30 years that the FRS-PP was underfunded, all benefits were paid in full and in a timely fashion to retirees and other beneficiaries. During those years when the FRS-PP was underfunded, employer contributions included an extra portion to reduce the unfunded liability (i.e., the Unfunded Actuarial Liability or UAL contribution rate). Composite employer contribution rates in the early 1990s were over 18% of payroll. 2.
The FRS-PP became fully funded in 1998 (Chart 1). In 2000, the Legislature, in collaboration with the SBA Trustees, created a contribution rate stabilization mechanism (i.e., Section 121.031(3)(f), Florida Statutes) that allowed a conservative annual use of the surplus to reduce employer contributions over time. Employers saved a cumulative $6.59 billion through reduced contributions between FY 1999-2000 and FY 2008-2009.3
3.
The global financial crisis that began in 2008 created an unfunded actuarial liability after 11 fiscal years of actuarial surpluses. However, the SBA’s long-term investment discipline has helped the FRS-PP regain $44 billion in value since the low point of the financial crisis in March 2009, despite making net benefit payments of $14.3 billion over the last three fiscal years. With an actuarial funded ratio of roughly 88% at July 1, 2011, the FRS-PP is one of the best funded state-wide public sector pension plans (Chart 2).
4.
With Senate Bill 2100, the 2011 Legislature and Governor approved extensive benefit and funding changes to the FRS-PP. Key changes included: a. Effective July 1, 2011, requires 3% employee contribution for all FRS members. DROP participants are not required to pay employee contributions. b. For employees initially enrolled on or after July 1, 2011, the definition of "average final compensation" means the average of the 8 highest fiscal years of compensation for creditable service prior to retirement, for purposes of calculation of retirement benefits. For employees initially enrolled prior to July 1, 2011, the definition of “average final compensation” continues to be the average of the 5 highest fiscal years of compensation. c. For employees initially enrolled in the pension plan on or after July 1, 2011, such members will vest in 100% of employer contributions upon completion of 8 years of creditable service. For existing employees, vesting will remain at 6 years of creditable service. d. For employees, initially enrolled on or after July 1, 2011, increases the normal retirement age and years of service requirements, as follows: i. For Special Risk Class: Increases the age from 55 to 60 years of age; and increases the years of creditable service from 25 to 30. ii. For all other classes: Increases the age from 62 to 65 years of age; and increases the years of creditable service from 30 to 33 years.
3
Source: Department of Management Services, Division of Retirement. Additionally, in FY 1999-2000 the Legislature approved use of $5.39 billion of the surplus to fully amortize all existing unfunded actuarial liability lines for all classes.
2
e. Maintains DROP; however, employees entering DROP on or after July 1, 2011 will earn interest at a reduced accrual rate of 1.3%. For employees currently in DROP or entering before July 1, 2011, the interest rate remains 6.5%. f. Eliminates the cost-of-living adjustment (COLA) for service earned on or after July 1, 2011. Subject to the availability of funding and the Legislature enacting sufficient employer contributions specifically for the purpose of funding the reinstatement of the COLA, the new COLA formula will expire effective June 30, 2016, and the current 3% cost-of-living adjustment will be reinstated. Chart 1: Historical Perspective of FRS Pension Plan Funded Ratio Ratio o f Actuarial Assets to Actuarial Liabilities
Ratio o f Market Value o f Assets to Actuarial Liabilities
150%
100%
1 5 8 9 6 8 9 1 7 8 9 1 8 9 1 8 9 1 0 9 1 9 1 2 9 1 3 9 1 4 9 1 5 9 1 6 9 1 7 9 1 8 9 1 9 1 0 2 1 0 2 0 2 3 0 2 4 0 2 5 0 2 6 0 2 7 0 2 8 0 2 9 0 2 1 0 2 1 0 2
0%
5 % .3 4 .% 5 % .8 6 5 % .0 6 5 % .1 5 % .3 7 5 .% 9 5 % .3 4 6 % .4 9 6 % .1 3 7 % .0 7 .% 3 8 % .3 1 9 .% 6 0 1 % .4 3 1 .% 8 1 % .9 7 1 % .0 5 1 % .2 4 1 .% 2 1 .% 8 0 1 .% 7 0 1 .% 7 0 1 .% 7 0 1 % .5 8 % .6 8 % .5 7 8
b fL o % rilse a tu c A
50%
As of July 1 of Indicated Year Note: Amounts are interpolated for 1986, 1988, 1990, 1992, 1994 and 1996 because actuarial valuations were conducted biennially prior to 1997.
3
Chart 2: State Retirement System Funded Ratios
Source: Wilshire 2012 Report on State Retirement Systems: Funding Levels and Asset Allocation March 2, 2012
Review of the July 1, 2011 Actuarial Valuation Section 121.031(3), Florida Statutes provides for an annual actuarial valuation of the FRS-PP. The Department of Management Services, Division of Retirement conducts the official actuarial valuation through an independent outside actuary: Milliman, USA (Milliman). However, prior to completion of that valuation, legislative and executive branch staff meet in a Florida Retirement System Actuarial Assumption Conference, to which the SBA and Division of Retirement serve as resources. The Florida Retirement System Actuarial Assumption Conference shall develop official information with respect to the economic and noneconomic assumptions and funding methods of the Florida Retirement System necessary to perform the system actuarial study undertaken pursuant to s. 121.031(3). Such information shall include: an analysis of the actuarial assumptions and actuarial methods used in the 4
study and a determination of whether changes to the assumptions or methods need to be made due to experience changes or revised future forecasts. Section 216.136(10), Florida Statutes. The Florida Retirement System Actuarial Assumption Conference met publicly on September 27, 2011 and affirmed the assumptions and methods to be used for the 2011 actuarial valuation (i.e., measured with plan data effective July 1, 2011). Milliman provided preliminary valuation data, analysis of key assumptions (e.g., wage and workforce growth rates, expected investment returns, inflation, etc.) and projections of the future course of assets and liabilities under various favorable and unfavorable investment performance scenarios. Milliman published the final 2011 actuarial valuation in December 2011 and calculated an unfunded actuarial liability of $18 billion and a funded ratio of 87.5% (Appendix 1 has summary information from Milliman prepared March 2012). SBA staff believes that the assumptions utilized in the Milliman 2011 actuarial valuation report are consistent with those determined at the Florida Retirement System Actuarial Assumption Conference. While the SBA does not perform an independent actuarial valuation of the FRS-PP, the SBA utilizes a form of actuarial analysis, known as an asset-liability study, to establish and manage its investment policy. 1.
Historically, every three to five years, the SBA conducts extensive asset-liability studies so that FRS-PP assets are invested sufficient for the plan to be maintained in a manner that ensures the timely payment of promised benefits to current and future retirees, and keeps plan cost at a reasonable level. The study assesses investment policy in light of projected benefit payments (i.e., future liabilities) and expected investment performance over a 15-year period.
2.
The last major asset-liability study was conducted in 2010 and resulted in significant changes to the FRS-PP asset allocation policy (e.g., expanded the utilization of alternative investments) and structure of individual asset classes.
3.
Each year since 2002, the SBA has also updated the asset-liability study based on Milliman’s annual actuarial valuation as well as developments in the capital markets, and presented the results to the Investment Advisory Council at its Spring meeting. The purpose of the annual update is to monitor progress toward the attainment of the FRSPP’s long-term objectives with a specific focus on the implications for investment policy, and identify issues so that they can be addressed in a timely and proactive fashion.
Using the final 2011 actuarial valuation, Hewitt EnnisKnupp (HEK) presented its annual assetliability update to the Investment Advisory Council on March 19, 2012, and on the following day made a summary presentation to the Trustees (Appendix 3). Also, on March 20, the Trustees received a presentation from Milliman on the 2011 actuarial valuation and contribution rates (Appendix 1 contains excerpt of presentation).
5
Notable findings in the HEK analysis were: 1. Updated capital market assumptions indicate a 50% probability of meeting or exceeding
the actuarial investment return assumption of 7.75% under the current asset allocation policy (i.e., “expanded authority”) over a 15-year horizon. The analysis does not reject modestly lowering the investment return assumption. 2. Even if all actuarial assumptions are accurate, the funded ratio of the FRS-PP will
gradually decline over the next 20 years due to the actuarial method used to recognize the contribution rate cost savings from the Senate Bill 2100 benefit changes (Appendix 2 has an operative excerpt from page A-2 of Milliman’s Florida Retirement System Actuarial Valuation as of July 1, 2011). 3. Several years of not making the full unfunded actuarial liability contributions (UAL
contributions) are further exacerbating the trend toward lower funded status (Appendix 1 Table 2 illustrates the underfunding relative to the actuarially recommended rates for the regular class and special risk class).4 4. There are some conflicting indicators as to how much investment risk the asset allocation
policy of the FRS-PP should target: a. The risk-reward curve based on long-term economic cost suggests a possible
increase in the target risk—driven by a higher equity risk premium, i.e., the difference between the expected return on stocks and bonds.5 b. Unlike in previous studies, there are reasons to avoid more short-term risk
exposure, because a significant funded ratio shortfall in the near term can be difficult to recover from; i.e., materially adverse investment performance compounds the factors described in #2 and #3 above.6 5. In light of the above interplay between investment policy and funding policy, HEK and
SBA staff identified several opportunities to improve the asset allocation for the FRS-PP: a. Increased allocations to real estate and/or strategic investments could enhance
diversification and mitigate downside risk. b. Improved liquidity for benefit payments could be obtained with a higher cash
allocation (i.e., foregoing returns), or with more complex fixed income allocations (i.e. liquidity barbell).
4
See also page I-4 of 2011 Valuation: “The contribution rates legislated for plan year 2011-2012 are significantly less than the sum of the Normal Cost only rates and UAL Cost rates determined by the July 1, 2010 valuation, after reflecting the impact of Senate Bill 2100. Thus, the contribution being made to fund the UAL in plan year 20112012 is lower than the actuarially determined contribution. Therefore, the contribution lag will result in an increase in the unfunded actuarial liability as of July 1, 2012 assuming no further gains or losses.” 5 However, low fixed income yields are likely to revert to more normal levels during the planning horizon and would lower the equity risk premium. 6 HEK’s analysis indicates a nearly 18% probability that the ratio of market value to actuarial accrued liabilities could be less than 60% at the end of 5 years. In roughly 90% of those scenarios, the FRS-PP actuarial funded ratio does not recover to at least 85% (i.e., a healthy level) by the end of the 15-year planning horizon.
6
After reviewing the results of the HEK analysis, the consensus view of SBA staff, HEK, and the Investment Advisory Council was: 1. The SBA should continue with its multi-year plan to methodically implement the asset
allocation changes approved following the 2010 and 2011 asset-liability studies, facilitated by the expanded statutory authority to utilize alternative investments. 2. The actuarial assumptions, funding methodology, and contribution rate setting policy for
the FRS-PP should be re-evaluated before considering new incremental asset allocation policy changes. The Florida Retirement System Actuarial Assumption Conference should consider the following: 1. Revisiting the funding cost methodology. A goal might be to provide more funding
support if investment return targets are not met, and mitigate the risk of persistent and potentially unrecoverable low funded ratios if returns fall below target levels. a. Evaluate changes in the amortization method (either shorter period and/or level
dollar amounts, instead of level percent of payroll method). b. Evaluate changes in the actuarial cost method (switch to “traditional” Entry Age,
from the current “ultimate” Entry Age method). 2. Revisiting the actuarial assumptions used for cost calculations. For example, lowering the
return assumption from 7.75% to 7.25% and lowering the wage increase assumption from 4% to 3%. The combination of these assumption changes could result in an increase in employer cost (~2% of payroll) and decrease in reported funded status (~ 7% to 8%). Note: HEK estimates that the probability of meeting or exceeding a new 7.25% investment return assumption over 15 years is about 55%, versus the 50% probability for the current 7.75% assumption. 3. Evaluating approaches to more fully address the recommended unfunded actuarial
liability contributions (UAL). Under 2012 legislation, deferred funding of the UAL may amount to about a $1 billion lower contribution for FY 2013-2014; to be amortized over 30 years and added to future cost rates. Alternative approaches could be to contribute the actuarially calculated cost each year to amortize the UAL or develop a multi-year plan targeting a 100% funding ratio. 4. Reviewing any other issues that should be part of an integrated review of the funding
policy for the Florida Retirement System programs. Possible areas might include: a. The method of funding the DROP feature b. The manner in which FRS-PP costs are allocated amongst/between the
participating employers, membership classes, and members. c. On March 6, 2012, the Circuit Court of the Second Judicial Circuit found that the
portions of Chapter 2011-68, Laws of Florida, imposing a 3% employee contribution to the Florida Retirement System and eliminating the cost-of-living 7
adjustment for future service to be unconstitutional as applied to individuals who were members of the FRS prior to July 1, 2011 and ordered the defendants to be permanently enjoined from implementing these provisions and to reimburse (with interest) the funds deducted or withheld. The trial court’s decision has been appealed to the Florida Supreme Court, which results in a continued stay of the trial court’s order. In the event the Florida Supreme Court ultimately affirms the trial court’s order, however, the underfunded status of the FRS-PP will be exacerbated unless corresponding action is taken by the Legislature.
The SBA appreciates the opportunity to review the FRS-PP actuarial valuation report and contribution rate determination process. Please do not hesitate to contact me if you have any questions regarding our comments.
Attachments
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Appendix 1
Table 1:
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Table 2
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Appendix 2: Excerpt from Page A-2 of Milliman’s Florida Retirement System Actuarial Valuation as of July 1, 2011 The benefit changes legislated by Senate Bill 2100 reduced the Normal Cost, Present Value of Future Normal Cost (PVFNC) and the Present Value of Benefits (PVB) for current and future active members. The actuarial accrued liability is defined as PVB less PVFNC. For some membership classes the percentage decrease in the PVFNC was larger than the percentage decrease in the PVB, resulting in an increase in an actuarial liability. For the remaining membership classes, the percentage decrease in the PVFNC was smaller than the percentage decrease in the PVB, resulting in a decrease in the actuarial liability. The variation is due to the different demographics, benefit multipliers and unique interrelation of the modified benefit provisions of each membership class. The PVB will decrease in future valuations as current active members are replaced by new members impacted by the change in benefits. All current members will continue to earn benefits at levels greater than those annually earned by members initially enrolled on or after July 1, 2011. When this impact is combined with amortizing the change in the unfunded liability due to this proposal over 30 years, the funding of current member’s actual normal costs will extend beyond working lifetime into retirement. Under the percent of pay amortization method used in the valuation, payment of the actual excess normal costs will effectively not occur until the last 10 years of the 30 year amortization period. Under a level percent of pay amortization, initial payments are less than interest on the unfunded liability, resulting in the unfunded liability increase over time. After approximately 20 years, the unfunded liability will be approximately at the same level as the initial amount. By deferring to the later years of the 30-year amortization period, the funded ratio of the plan is expected to gradually decline for the next 20 years, which could compound the impact of any future adverse experience. This result is somewhat mitigated by the decrease in the accrued liability due to the elimination of the COLA for future service for all members.
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Appendix 3: March 20, 2012 Hewitt EnnisKnupp Presentation to SBA Trustees
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