Core Elements of a Funding Policy for Governmental Pension and OPEB Plans

Compensation packages for active workers may include pensions as well as healthcare and other similar benefits for those employees after they have completed their active service. Generically, healthcare and other benefits are described as other postemployment benefits (OPEB) to distinguish them from pensions. [1] A government’s unfunded liabilities from pensions and OPEB are considered by rating agencies when assessing their credit rating. Employers are required to recognize the cost of pension benefits as employees earn them, and the Governmental Accounting Standards Board (GASB) extends this same requirement to OPEB. [2] While pensions have long been funded on an actuarial basis in most cases, OPEB plans have typically not. The change in accounting standards has focused attention on the costs of OPEB, including concerns about rising health-care costs and an aging public-sector workforce. The real issue is not the change in accounting standards, but rather the underlying budgetary and funding challenge that those accounting standards highlight. Meeting this challenge requires governments to ensure that both pension and OPEB are sustainable over the long term - that they are affordable to stakeholders, competitive, and sufficient to meet employee needs, and that they may be reasonably expected to remain so.

1. Every government employer that offers defined benefit pensions or OPEB should obtain no less than biennially a reasonable [3] actuarially determined contribution (ADC) to serve as the basis for its contributions to those respective plans;
2. The ADC should be calculated in a manner that fully funds the long-term costs of promised benefits, while balancing the goals of 1) keeping contributions relatively stable and 2) equitably allocating the costs over the employees’ period of active service;
3. Every government employer that offers defined benefit pensions or OPEB should make a commitment to fund the full amount of the ADC each period. (For some government employers, a reasonable transition period will be necessary before this objective can be accomplished);
4. Every government employer that offers defined benefit pensions or OPEB should demonstrate accountability and transparency by communicating all of the information necessary for assessing the government’s progress toward meeting its pension funding objectives.

These principles and objectives will affect decisions related to the treatment of four core elements of a comprehensive pension funding policy:

• Actuarial cost method - The technique used to allocate the total present value of future benefits over an employee’s working career (normal cost/service cost).
• Asset smoothing method - The technique used to recognize gains or losses in pension or OPEB asset return over some period of time so as to reduce the effects of market volatility and stabilize contributions.
• Amortization policy - The length of time and the structure selected for increasing or decreasing contributions to systematically eliminate any unfunded actuarial accrued liability.
• Surplus management policy – A proactive policy that helps guide the system in the prudent management of potential “surplus,” [4] including considerations for items such as contribution levels, risk reduction opportunities, stabilization reserves and benefit levels.

To ensure consistency with the principles and objectives described above, the GFOA recommends that a pension funding policy treat each of its core elements as follows:

• Actuarial cost method. The actuarial cost method selected for funding purposes should conform to actuarial standards of practice and allocate normal costs over a period beginning no earlier than the date of employment and should not exceed the last assumed retirement age. Moreover, the selected actuarial cost method should be designed to fully fund the long-term costs of promised benefits, consistent with the objective of keeping contributions relatively stable and equitably allocating the costs over the employees’ period of active service. [5] While not the only method that would satisfy this criterion, the entry age method—level percentage of pay normal cost—is especially well suited to achieving this purpose and is consistent with GAAP requirements for public sector financial reporting.
• Asset smoothing. The method used for asset smoothing should:
  • Be unbiased relative to market. For example:
    • The same smoothing [6] period should be used for both gains and losses, and
    • Provide for smoothing to occur over fixed periods (the use of rolling periods normally should be avoided [7]), typically around five years, but not longer than ten years, and
    • Provide for a symmetrical market corridor (a range beyond which deviations are not smoothed) if smoothing is to occur over a period longer than five years.

• Amortization. Amortization of the unfunded actuarial accrued liability should:
  • Use fixed (closed) periods that:
    • Are selected so as to balance the goals of demographic matching (equitable allocation of cost among generations) and volatility management (funding at a level percentage of payroll), and
    • Never exceed 25 years, but ideally fall in the 15-20 year range, and
    • With regard to plan changes that have a temporary effect (such as early retirement incentives) use an amortization period related to the temporary period;
  • Use a layered approach for the various components to be amortized (that is, an approach that separately tracks and amortizes the different unfunded liability components as they are introduced to the plan), where costs consistently emerge as a level percentage of member compensation or as a level dollar amount.

• Surplus Management. A plan should have a policy in place so that when it enters into a surplus position, the surplus is managed prudently for the long-term health of the plan. Such a policy should:
  • Review key actuarial assumptions, to ensure that they are up-to-date and reasonable, and to evaluate the level of risk inherent in those assumptions, and
  • Evaluate possible risk reduction strategies, which could include an examination of risk and return in the asset portfolio and the plan’s other current funding policies, and
  • Consider how contributions should be affected while the plan is in a surplus position, including long, rolling amortization (recognition) of the surplus as a contribution credit [8], and possible other mechanisms such as limiting contribution reductions until other conditions have been met, such as a buffer above 100% funded, and
  • Work with the authoritative body to establish clear guard rails around acceptable conditions for possible benefit enhancements, especially permanent ones, and provide for clear illustration of their immediate costs and long-term ramifications.

Additional considerations for plans closed to new entrants. When a plan is closed to new participants, there may be cost methods other than the entry age method that could be appropriate to use. GFOA recommends discussing the appropriate cost method for a closed plan with the plan actuary.

• For closed plans with no remaining active members, the funding time horizon of the plan is generally shorter. Considerations include:
  • Special attention needs to be given to the mix of investments;
  • In comparison to open plans:
    • Asset smoothing periods should be shorter (typically no longer than three years),
    • Corridors, if used, should be narrower, and
    • Amortization periods should be shorter (typically no longer than 10 years for gains and losses).

• For closed plans that still have active members:
  • The continued use of level percent of member compensation amortization remains appropriate, but not for a long period (i.e., as the number of active members decreases); and
  • In comparison to open plans:
    • Asset smoothing periods should be shorter, and
    • For asset smoothing periods that exceed five years, a corridor (not to exceed 20 percent) should be used; and amortization periods should be shorter.

Other policy statements. As supported in the surplus management discussion above, a funding policy can also give a government an opportunity to support policies identifying the conditions under which future benefit enhancements or reductions would be evaluated. For example, a funding policy could state that future benefit enhancements would only be considered if the cost of those enhancements do not cause the plan’s funded ratio to go below 100%, or in the alternative, cause the ADC to rise above a certain level.