Sharon Winslow Erickson Amanda Noble PUBLIC PENSIONS: PERFORMANCE AUDITING AND THE NEW ACCOUNTING RULES

Learning Objectives Understand the context of current pension reforms Consider how changes in pension accounting rules could affect your jurisdiction Consider the role of local government performance auditors in pension reforms 2

A Widening Gap in Cities: Shortfalls in Funding for Pensions and Retiree Health Care (Pew Charitible Trusts, 2013) 3

Underfunding: Why It Matters Budget stress posed by increasing pension costs Ratio annual recommended contribution compared to covered payroll: 10% of payroll in Charlotte, Seattle, Memphis, San Francisco, Wichita 30% of payroll in Chicago, Omaha, Portland, Wilmington 50% of payroll in Charleston Cut to city services or tax increases Reductions to benefits Loss of investment opportunities Source: A Widening Gap in Cities, 4

What Caused the Problem? 1. Fiscal discipline Chronic underpayments Borrowing to shore up pension funds 2. Accuracy of assumptions Investment returns Demographic and economic assumptions 3. Decisions about workers’ benefits Unfunded benefit increases Pension spiking Source: A Widening Gap in Cities, 5

Moving Forward: Reforms Changes to plans for new employees are most common Reforms include: Plan design – defined benefit vs defined contribution plans; health care package redesign Funding – raising taxes; increasing employee contributions; increasing city contributions Benefits – limiting cost-of-living increases; increasing retirement ages; addressing pension spiking; reducing or eliminating retiree health benefits Organization and management – pension board makeup; transparency and oversight Source: A Widening Gap in Cities, 6

What’s Next? 7 Lack of consensus about the urgency and need for reform “While Pew acknowledges the factors behind the underfunded pension systems, to suggest modifications that punish public employees is irresponsible and uncalled for.” National Public Pension Coalition, January 2013 Half-truths and myths “The pension mess was caused by greedy people, not us… There’s no crisis. The stock market will recover and then there is no problem… Experts consider 80 percent to be a healthy pension funding ratio… The average public pension is $23,000… The $100,000 pension club…” Girard Miller, January 2012

Update on Changes to Pension Accounting Standards Effective for employer fiscal years beginning after June 15, 2014 Change in focus of financial reporting for pensions Measurement and recognition of net pension liability Discount rate Timing and frequency of actuarial valuations Cost-sharing plans 8

Change in Focus of Financial Reporting for Pensions Pensions are a form of compensation, like salaries, which governments provide to their employees in return for work. Consequently, like salaries, the costs and obligations associated with pensions should be recorded as they are earned by the employees, rather than when contributions are made by the government to a pension plan or when benefit payments are made to retirees. New standard separates accounting and financial reporting from funding determination. 9

Measurement and Recognition of Net Pension Liability Net pension liability = Present value of projected benefit payments to current active and inactive employees attributable to past periods of service Less The amount of the pension plan’s fiduciary net position 10

Discount Rate The discount rate should be a single rate that produces a present value of total projected benefit payments equivalent to that obtained by discounting projected benefits payments using (1) the long-term expected rate of return on plan investments to the extent that current and expected future plan net position available for pension benefits are projected to be sufficient to make benefit payments and to continue investing using the investment strategy selected for the long term and (2) a high-quality municipal bond index rate for those payments that are projected to be made beyond that point. 11

Timing and Frequency of Actuarial Valuations Perform actuarial valuations of the total pension liability at least every two years For valuations not current “as of the measurement date,” roll forward amounts from an earlier actuarial valuation performed no more than 30 months and 1 day prior to the employer’s most recent year end. Intended to accommodate concerns of agent multiple employer plans 12

Cost-Sharing Plans Net pension liability = Proportionate share of plan’s net pension liability 13

Implications of Reporting a Large “New” Liability on the Balance Sheet 14

Role of Government Performance Auditors? How can we prepare decision makers in our jurisdictions for what will probably be sticker shock? Clarify reasons for the reporting change Analyze the extent to which different factors contributed to the gap Evaluate overall compensation strategy Assess the impact of proposed changes Evaluate sustainability Review governance structure Assess actuarial assumptions Audit transactions 15

Analyzing Factors That Contributed to Pension Gap Source: Review of the FY 2008 General Fund Budget, City Auditor’s Office, Atlanta GA 16

Audit of Pension Sustainability Rising pension costs threaten the city’s ability to maintain service levels – alternatives for a sustainable future Did costs really skyrocket? Yes. Benefit payments grew; city and employee contributions grew; unfunded liability $4 billion, or about 9 times annual covered payroll. How does that happen? Investment returns not achieved; investment losses in ; retroactive benefit enhancements; longer lives; declining ratio of employees to retirees. What’s the impact of the cost increases? Significant reductions to city services. San Jose City Auditor’s Office (September 2010) 17

Audit of Pensionable Earnings and Time Reporting Errors resulted in higher pensions Time reporting codes were unclear and duplicative Some pensioners benefited from the city’s definition of earnable income and highest salary San Jose City Auditor’s Office (December 2009) 18

Audit of Disability Retirement: A Program in Need of Reform Rate of disability retirements among San Jose’s sworn employees is unacceptably high Some disabled retirees have already been compensated for their work-related injuries San Jose City Auditor’s Office (April 2011) 19

Audit of San Jose’s Deferred Compensation Program 20 The city can improve controls to ensure employee contributions and credits are accurate The city can provide savings to participants through administrative efficiencies and reduced fees San Jose City Auditor’s Office (February 2013)

Auditors’ Role in Pension Reform 21 Pension reform ballot measures in San Diego and San Jose passed by wide margins in June 2012 San Jose – previously issued audit recommendations were incorporated into reform package San Diego – auditor conducted analysis of potential savings attributed to pension reform package

Questions raised on pension funding in Monticello The News-Gazette, Tue, 03/12/ :14pm 22 MONTICELLO — The topic of pension funding came before the city council this week when a resident accused the city of underfunding police and city Illinois Municipal Retirement Fund pension accounts. Maureen Holtz said the city's 2012 auditor's report showed the underfunded actuarial accrued liability for city employees is over $500,000, while the police pensions are only 28 percent funded and $1.8 million short. Mayor Chris Corrie said after the meeting that the issue dates back several years ago when there was a switch to state IMRF plans and that auditors told him the city is on a 30-year path to fully fund local pensions. But to Holtz, the long-term plan is jargon for "put it on a tab for future generations to deal with." Corrie said city auditors will be on hand at the March 26 meeting to answer questions on the pension funds. "He (the auditor) says communities statewide are behind on their pension funds, and a lot of was due to the changeover they made from different agencies to the IMRF," said Corrie. Holtz countered that employees still have to pay 100 percent of their contribution to local pensions each year, and felt the city should consider doing the same.

Other Jurisdictions 23 Oakland City Auditor: Review of Pension Funding Options (October 2010) Berkeley: Employee Benefits – Tough Decisions Ahead (November 2010) Sacramento: Audit of Employee Health and Pension Benefits (April 2011) Portland: Fire and Police Disability and Retirement – Improvements results from 2006 Charter reforms, but significant fiscal challenges remain (June 2011) Jacksonville: Retirement System Audit (March 2013)

CONCLUSION 24 Context of current pension reforms Outlook for local government pension and retiree healthcare liabilities Changes in pension accounting rules as they affect your jurisdiction Role of local government performance auditors and topics for future audits Questions?