The fundamental financial objective of government employers that offer defined benefit (DB) pensions and other postemployment benefits (OPEB) to their employees is to fund the long-term cost of the benefits promised to participants. It is widely acknowledged that the appropriate way to attain reasonable assurance that benefits will remain sustainable is for a government to accumulate resources for future benefit payments in a systematic and disciplined manner during the active service life of the benefitting employees.
Long-term funding is accomplished through contributions from the employer and employee, and from investment earnings, which typically provide the largest component of funding. Contributions often are expressed as a percentage of active member payroll, which should remain approximately level from one year to the next. A funding policy for benefits offered codifies the government’s commitment to fund benefit promises based on regular actuarial valuations. Creating a funding policy that embodies this funding principle is a prudent governance practice and helps achieve intergenerational equity among those who are called on to financially support the benefits, thereby avoiding the transfer of costs into the future.
GFOA recommends that government officials ensure that the costs of DB pensions and OPEB are properly measured and reported. Sustainability requires governments that sponsor or participate in DB pension plans, or that offer OPEB, to contribute the full amount of their actuarially determined contribution (ADC) each year. Failing to fund the ADC during recessionary periods impairs investment returns by providing inadequate funds to invest when stock prices are low. As a result, long-term investment performance will suffer and ultimately require higher contributions.
Public officials and associated trustees should, at a minimum, adhere to the following best practices for sustaining DB pension plans and OPEB, as applicable:
- Adopt a funding policy with a target funded ratio of 100 percent or more (full funding). The funding policy should provide for a stable amortization period over time,1 with parameters provided for making changes based on specific circumstances. The amortization period for the unfunded actuarial accrued liability should be consistent with the funding policy.
- Discuss the funding and amortization methods with the government’s actuary and select the one most closely aligned with the government’s funding policy. The actuarial funding method selected is a key component of the funding policy for the offered benefits.2 Some funding methods may result in greater variation in the ADC (the portion of the present value of projected benefits that is attributable to the current period) than others. Governments should take measures to reduce the volatility in the ADC in order to create a more predictable operating budget and enhance their ability to meet their funding obligations.
- The funding policy should stipulate that employer and employee contributions are to be made at regular intervals, with the contribution amount determined by the results of a recent actuarial valuation of the system. To ensure that this objective can be achieved, the funding policy should be integrated with investment and asset allocation policies. Reductions or postponements in collecting the ADC would typically be inconsistent with the assumptions made in computing the ADC. When contributions fall below the ADC, the board of trustees should prepare a report that analyzes the effect of the underfunding and distribute that report to all stakeholders.
- Have a qualified actuary prepare an actuarial valuation3 at least biennially, in accordance with generally accepted actuarial principles. Each valuation should include a gain/loss analysis that identifies the magnitude of actuarial gains and losses, based on variations between actual and assumed experience for each major assumption.
- Have an actuarial experience study4 performed at least once every five years and update actuarial assumptions as needed. Assumptions that should be carefully reviewed include the long-term return on assets, salary growth, inflation, mortality tables, age eligibility, and any anticipated changes in the covered population of plan participants. As part of this review, assess the overall risk of the assumptions to ensure that what may have been determined to be an acceptable level of risk in any one area has not been compounded.
- Have an independent actuary perform a comprehensive actuarial audit of the actuarial valuations5 at least once every five to eight years. The purpose of such a review is to provide an independent assessment of the reasonableness of the actuarial methods and assumptions in use and the validity of the resulting actuarially computed contributions and liabilities. Actuarial assumptions should be carefully reviewed, discussed with outside experts (including investment advisors), and explicitly approved by the governing body.
- Communicate plan status and activities by preparing and widely distributing a comprehensive annual financial report (CAFR) covering the retirement system, and distribute summary information to all plan participants. The CAFR should be prepared following GFOA’s guidance for the preparation of a public-employee retirement system CAFR.
GFOA recommends the following options to reduce ADC volatility:
- Smoothing returns on assets. Smoothing investment returns over several years recognizes that investment portfolio performance fluctuates, and only by coincidence will it exactly equal the assumed actuarial rate of return for any given year. This approach reduces the volatility within the calculation of the ADC. A smoothing period is used to balance the need for a longer-term investment horizon with the short-term market fluctuations in the value of assets. While the smoothing period is typically about five years, it can be longer, if controls are in place to assure that any variation between the market value and actuarial value of assets does not become too large. A common approach is to establish corridors around the market value of assets that stipulate the maximum percentage by which the actuarially smoothed value will be allowed to deviate from actual market value. Once a smoothing method is established, the governing board should adhere to it and avoid making arbitrary changes to the methodology.
- Diversifying the investment portfolio to reduce volatility in investment returns. Diversifying assets across and within asset classes is a fundamental risk management tool that also has the effect of reducing the fluctuations in ADC volatility. Although annual changes in the ADC are affected by numerous factors, the most significant is usually investment return. Retirement systems should periodically conduct asset-liability studies for use in reviewing their asset allocation policies. The risk of investment strategies should also be assessed as well as an evaluation of any management fees associated with investment strategies utilized. (See GFOA’s Best Practice, “Asset Allocation for Defined Benefit Plans,” 2009).
- Managing investment returns long term. Because the investment return assumption is an average long-term expected rate of return, excess earnings in any one year will likely be offset by lower-than-expected rates of return in a future year. Thus, any program that is derived from an excess-earnings concept is detrimental to the funded status of the plan.
- Managing growth in liabilities. All benefit increases for members and beneficiaries should be carefully considered, appropriately approved, and consistent with applicable Internal Revenue Service requirements. Whether cost of living adjustments (COLAs), benefit formula enhancements, or postretirement benefit increases, a clear strategy should be developed that integrates benefit enhancements with the funding policy. Further, all benefit enhancements and COLAs should be actuarially valued and presented to the appropriate governing bodies before they are adopted so the effect of the benefit enhancements on the fund’s actuarial accrued liability, funded ratio, and contribution rates is fully understood. This step will help ensure that the goals of fully funding member benefits and financial sustainability are achieved. If a benefit enhancement is being considered, a source of funding should be identified that can support the enhancement over the long term.
To further ensure sustainable funding practices, design the plan to prevent calculation abuses of retirement benefit enhancements such as salary spiking, and any other ethical violations. These violations can create negative public perceptions that are harmful to all participants and can adversely affect the sustainability of the system. Policies to safeguard against ethical violations and benefit calculation abuses should be considered.
- GFOA recommends that a pension funding policy use a fixed (closed) amortization method so that the entire liability would be fully amortized at the end of a set duration, e.g., 25 years. See GFOA Best Practice, “Core Elements of a Funding Policy,” 2013.
- The use of projected unit credit method typically would not be consistent with the goal of level funding.
- The purpose of an actuarial valuation is 1) to determine the amount of actuarially determined contributions (i.e., an amount that, if contributed consistently and combined with investment earnings, would be sufficient to pay promised benefits in full over the long-term) and 2) to measure the plan’s funding progress.
- An actuarial experience study reviews the differences between a plan’s assumed and actual experience over multiple years (typically 3 to 5), with the goal of examining the trends related to actual experience and recommending changes to assumptions, if needed.
- Because the reliability of an actuarial valuation depends on the use of reasonable methods and assumptions, a comprehensive audit of the actuarial valuations is conducted to review the appropriateness of the actuarial methods, assumptions, and their application.
- Financing Retirement System Benefits, Richard G. Roeder, GFOA, 1987.
- Pension Accounting and Reporting, Second Edition, William R. Schwartz, GFOA, 1995.
- Guidelines for the Preparation of a Public Employee Retirement System Comprehensive Annual Financial Report, Stephen Gauthier, GFOA, 1996.
- An Elected Officials Guide to Public Retirement Plans, Cathie G. Eitelberg, GFOA, 1997.
- A Guide for Selecting Pension Actuarial Consultants: Writing RFPs and Evaluating Proposals, Robert Pam, GFOA, 1999.
- Public Pension Systems – Operational Risks of Defined Benefit and Related Plans and Controls Investment Policy Checklist for Pension Fund Assets, GFOA, May 2003.
- GFOA Best Practice, “Asset Allocation for Defined Benefit Plans,” 2009.