Actuarial Valuations & Unfunded Liabilities Derek Osborne, Horizonow Consultants Atlantic Connection, Miami July 11, 2012

Agenda 1. The Actuary & Actuarial Valuations 2. Are all future obligations liabilities? 3. Should all liabilities be pre-funded? 4. ALM for public sector pensions 5. Closing thoughts

Role of the Actuary  Demographic/Financial  Demographic projections  Cash flow projections  Estimate present values, surpluses/deficits  Recommend future contribution rates  Policy (only sometimes)  Assess relevance of rules  Assess level of key parameters  Assess asset-liability matching (not investment advice)  Assess operational effectiveness & efficiencies  Recommend reforms

Actuarial Valuations Public Pension Plans Private Pension Plans  Open group  Includes future new entrants  Projected cash flows & projected assets  Results seldom have effect on financials but they help drive policy  Closed group  Includes only those on hand on valuation date  Present value of future benefits & current assets  Results affect balance sheet and P&L and also drive policy

Social Security Populations General Population Labour Force Employed Population Insured Persons (Contributors & pensioners)

Contents of Actuarial Report (CAA Standard of Practice) Executive Summary Introduction Summary of Provisions Data Documentation Assumption Documentation Methodology Documentation Projection ResultsSensitivity Tests Analysis of Design, Investments, Operations Recommendations Attestation & Reliance Signature

Pension Terms – DB plans  Accrued Benefit:  benefit earned to date using past service and current salary  Projected Accrued Benefit:  benefit earned to date using past service and projected salary  Past Service or Accrued Liability:  Present value of accrued benefits (projected or unprojected)  Unfunded Liability:  Excess of accrued liabilities over assets

Primary Assumptions Country Social Security System  Demographic  Births  Deaths  Migration  Economic  GDP growth  Productivity growth  Labour force participation  Inflation  Demographic  New entrants  Leaving and re-entering  Retirement rates  Financial  Ceiling adjustments  Pension adjustments  Return on investments  Admin expense rates

Interest/Discount Rate Assumption  Interest/Discount Rate  May be prescribed  Should reflect the expected return on the current pool of assets and investment policy It is not the rate of return that the actuary says your investments should or needs to earn!

Are All Future Obligations Liabilities?

Case #1  Janet is 65 and receives a pension of $1,000 per month. What is the plan’s liability for Janet? A. $12,000 B. Present value of $1,000 per month for the rest of her life C. Present value of $1,000 per month for next 10 years

Case #2  John has been employed with ABC for 15 years and is now 50 years old. He has already earned a pension of 30% of his projected final average salary which has a present value of $90,000. If he quits now, however, he will be entitled to only $30,000. What is the plan’s liability for John? A. $30,000 B. $90,000 C. Something in between

Case #3  The government just signed an agreement with a large investor to build a resort on a remote part of the island. The government needs to build access roads over the next 10 years at an estimated cost of $1 billion. What amount should the government recognise as a liability today? A. $0 B. $1 billion C. Present value of estimated road costs (< $1 billion)

Case #4  Jane just gave birth to a baby boy, Jude. The government promises 12 years of free schooling and health care from the cradle to the grave. Regarding its future obligations for Jude the government should: A. Ignore them as these are not recognizable liabilities B. Value theses promises but do not pre-fund them C. Value these promise and reflect them in public finances

Why Estimate Future Obligations?  It’s good to know what they are  It’s required  Statutory  Regulatory  Accounting Standards  Allows for orderly pre-funding (if appropriate)  Enhances policy advice & reforms  Gives actuaries work to do

Should All Liabilities Be Pre-Funded?

Financing Future Liabilities Assets < 1 year’s payout Contribute what’s required to meet payout Pay-as- you-go Assets < Accrued Liabilities Contribution depends on law and/or funding goals Partially Funded Assets >= Accrued Liabilities Contribute enough to maintain this Fully Funded

Funding Considerations 18  Will funding change the overall cost of system?  Will funding add or reduce risk of meeting obligations?  Investment risk  Interest rate risk  Insolvency risk  Political risk  Will funding create investment opportunities for economy?

Public Sector Pensions are Different Perpetual plan 2. Guaranteed pool of tax payers & contributors  Gov’t/SSS can always raise tax/contribution rates to cover pensions expense 3. Why borrow at 9% and earn 6% on investments? 4. It all boils down to economy  Changing demographics affects both alternatives  If funded, investments must perform well  If not funded, wages need to grow faster than pensions 5. We don’t pre-fund highways, health care and education. Are pensions different?

Unfunded Liabilities  Social Security  PV Future Benefits – Assets – PV Future Contributions  Employer Pension Plans  PV Accrued Projected Benefits - Assets

ALM For Public Pension Funds  Different from ALM for private pension funds  PV of Accrued Benefits doesn’t matter  There’s guaranteed money coming in every year (contributions)  Asset maturities should be matched with income- expenditure shortfalls, not benefit payouts  Need projected net cash flows on open group basis

Closing Thoughts  Public liabilities and private liabilities are different  Not all future obligations need to be recognised as liabilities  Not all liabilities need to be pre-funded  Regardless of how liabilities are recognised or funded, sustainable systems require: a) Strong economy b) Good design c) Efficient & effective administration d) Honest & responsible government