Graham Schmidt, ASA
Vice President, EFI Actuaries
2/6/2007
1

Fundamental Differences
◦
◦
◦
◦

Purposes
Revenue
Budget obligations
Longevity
Actuarial Differences
◦ Private sector requirements (FASB / PBGC / IRS)
◦ Governmental approaches (level cost, transfers,
funding rules)
◦ Public vs. private
2/6/2007
2
“Why Governmental
Accounting and Financial
Reporting is – and should be –
different” – GASB White Paper
2/6/2007
3

Purpose
◦ For-Profit Business Enterprise: Generate a financial
return on investment
◦ Government: “Focus on providing services and
goods to constituents in an efficient, effective,
economical and sustainable manner.”

Revenue
◦ For Taxpayer, amount of taxes paid does NOT bear
direct relationship to services received

Budget Obligations
2/6/2007
4

Longevity
◦ Number of municipal bankruptcy filings 0.02% of
business filings
◦ Long-term outlook leads to focus on “trends in
operations, rather than on short-term fluctuations,
such as in fair values of certain assets and
liabilities.”
 Short-term fluctuations result in less “decision-useful”
measurements
 For businesses, short-term more important because of
current value of equity
2/6/2007
5
Methods, Measurements and
Other Issues
2/6/2007
6

Accounting
◦ Governed by FASB (FAS 87, 106, 132 & 158)
◦ Measure Projected Benefit Obligation (PBO)
 Based on Projected Unit Credit actuarial funding
method
 Prescribed to improve comparability, but mismatch
between accounting/funding
◦ Rate used to discount liabilities based on
“settlement rates”
 based on annuity rates or high-quality fixed income
 average ~ 5.5–6.0% in FY 05
 can be quite variable from year-to-year
2/6/2007
7

Accounting Continued
◦ Use different rate for “expected return on assets”
 used to calculate reported pension expense
 average ~ 8.0-8.5% in FY 05
 may change due to future FASB projects
◦ Amortization / Smoothing
 Most elements amortized over average remaining
service of current actives
 Only have to amortize portion of g/l
 Max smoothing period for assets is 5 years
2/6/2007
8

Funding
◦ Basis
 Companies offer “qualified” plans to obtain tax
advantages
 IRS makes rules to ensure funding status (protect PBGC
and participants) and ensure “fairness” (nondiscrimination, etc)
 Rules define minimum / maximum contributions
 Pension Protection Act (PPA) changed rules
significantly
2/6/2007
9

Funding (new rules)
◦ PPA defines “Funding Target” – 100% of PV of
accrued benefits (was 90%) [using Unit Credit
method]
◦ Unfunded liability must be amortized over 7 years
◦ Discounting based on yield curve (different rates for
different payment durations)
◦ Mortality rates dictated by IRS (very large plans can
use own experience)
2/6/2007
10

Funding
◦ Max asset smoothing is 24 months, with 10%
corridor
◦ Plans with low funding levels (“At-Risk Plans”)
subject to additional restrictions / requirements:
 Contributions
 Benefit improvements / changes
 Forms of payment (no lump sums)
◦ PPA also increased maximum contribution limits
◦ Changes to multi-employer rules not as significant
2/6/2007
11

Not one-size-fits-all
◦ Governmental plans not subject to most of ERISA
rules
◦ More difficult for IRS to enforce through tax policy
◦ No Federal restrictions on funding (occurs at State
or Local level)
◦ GASB defines accounting standards (GASB 25, 27,
43, 45) - contain more flexibility than FASB
(funding methods, amortization, etc)
2/6/2007
12

General Actuarial Characteristics
◦ Funding Methods
 Most pre-fund
 Cost methods split cost into past costs (accrued liability),
current year’s cost (normal/service cost), future normal
costs
 Most common method is Entry Age Normal
 Goal is to determine level normal cost needed to fund
each individual’s benefit
 GASB allows 6 methods
 Proposed GASB change: if use Aggregate method, must
show funding ratio using EAN
2/6/2007
13

General Actuarial Characteristics
◦ Amortization / Smoothing
 Most amortize unfunded accrued liability (UAL)
 Again, no federal rules, but GASB has some restrictions
 Max period 30 years, level $ or % of pay, open or closed
period
 With long period and level % of pay, current payment may
be less than interest on UAL
 Assets generally smoothed
 Most common to use 3-5 years (CalPERS using 15)
◦ Discount Rate
 Generally use expected return on assets
 Most common: 8.0% in ‘05 (NASRA survey)
2/6/2007
14

Private sector moving towards discounting
liabilities at market rates (yield curve)
◦ Influenced by “Financial Economics”
 Price of liability is asset consisting of matching
cashflows (use yield curve)
 “Mark-to-Market” liabilities
 $1 of bond = $1 of stock: why would value of liabilities
be different?
 Discounting of liabilities at 8% anticipates “risk
premium” -> transfers risk to future generations
 Existence of PBGC has introduced moral hazard –
encouraging investment in overly-risky portfolios
2/6/2007
15

Why important for Private Sector?
◦ Value of equity/debt important (companies bought
& sold)
◦ Earnings and contributions (accounting and
funding) directly impacted by fluctuations in
interest rates because of FASB / IRS rules
 Large penalties for missing earning targets
◦ Liability-Driven Investing (LDI) attempts to reduce
volatility due to interest rate risk by taking into
account payment structure of liabilities
◦ Generally results in increased allocation to longduration bonds
2/6/2007
16

Why could be different for governments?
◦ GASB: “Information on fair values of capital assets is
of limited value” (less likelihood of bankruptcy /
termination)
◦ In current practice (accounting & funding),
fluctuations in interest rates do NOT impact
government plans
 Do you measure it?
 Does measurement matter?
◦ Assuming plans invest in “risky” assets, current
practice does better job determining level
contributions
2/6/2007
17

Issues with current practice for governments
◦ Discounting at expected rate of return (8%) does
not reflect risk of investing
◦ Could measure/contribute using risk-free rate and
invest in “matching” portfolio
 However, certainty has cost!
 Remember purpose: “providing services and goods to
constituents in an efficient, effective, economical and sustainable
manner”
◦ Alternatively, could project future asset returns /
cashflows (including impact of uncertain inflation)
using simulation or other methods
 Shifts emphasis from liabilities to range of future costs
2/6/2007
18

Smoothing / Amortization
◦ Financial Economics approach says smoothing
disguises volatility:
 “When followed by a corporate bankruptcy, this policy of ignoring
economic reality and failing to make needed contributions can lead to
devastating losses of retirement income for long-serving employees” –
Bradley Belt
◦ With reduced likelihood of bankruptcy / termination
in public sector, does argument against still hold?
 May cause some shifts in cost between generations,
but overall contribution level does not change and is
more stable
2/6/2007
19

Likelihood of Change?
◦ If government plans forced to measure interest rate
volatility (and measurement matters), then changes
to investments may result
◦ Important users of financial statements (bondrating agencies) are not currently demanding
changes
 Ability to meet cashflow future requirements more
important than consideration of “economic” value of plan
◦ Series of high-profile municipal bankruptcies could
prompt demand for funding rules (PBGC-type
entity?)
2/6/2007
20