FCERA June 2008 Interest Crediting FCERA Board Interest Crediting and Excess Earnings Policy Discussion Wednesday, June 18, 2008 Paul Angelo, FSA Andy Yeung, ASA The Segal Company San Francisco

Slide 2 FCERA June 2008 Interest Crediting Outline  Reserves, Interest Crediting and Excess Earnings Mechanics  FCERA Interest Crediting Policy  Prior FCERA Excess Earnings Distributions  Open Questions  Level of Contingency Reserve  Tracking and possibly restoring prior interest crediting shortfalls (Contra Account)  Priority of Undistributed Earnings distributions

Slide 3 FCERA June 2008 Interest Crediting Typical 1937 Act Reserve Structure

Slide 4 FCERA June 2008 Interest Crediting Basic Interest Crediting Process  Determine “Available Earnings” for the period  All current period earnings  Min. (1%) + Add’l (>1%) Contingency Reserve (CR)  Some or all of Undistributed (Excess) Earnings Reserve (UER)  Determine earnings needed for interest credits  If Available Earnings is enough, do the credits  Then restore Contingency Reserve  Balance to UER  Excess Earnings Policy determines use of UER

Slide 5 FCERA June 2008 Interest Crediting Mechanics: Undistributed Earnings Reserve  Two-Step process for spending Excess Earnings:  First, “siphon” Excess Earnings into a “non-valuation reserve”  Excluded from Valuation Assets  Prevents decrease in UAAL contribution rate  Later, “spend” Excess Earnings  No sudden impact on contribution rate  A form of forced budgeting!

Slide 6 FCERA June 2008 Interest Crediting Investment Income Valuation Assets Benefits Expenses County Contributions Member Contributions Undistributed Excess Earnings Ad-Hoc Benefits Drawing Not to Scale! Contingency Reserve Plumbing for Excess Earnings

Slide 7 FCERA June 2008 Interest Crediting FCERA Interest Crediting Policy  Last reviewed: October 2005  Available Earnings: Return on Actuarial Value  plus CR and UER  Credit Member Reserve at rate of retiree COLA  limited to 3%, one-half credited on 6/30 and 12/31  Credit total Valuation reserves (including Member Reserve) at valuation rate  Credit Non-Valuation Reserves at valuation rate  Supplemental COLA and Retiree Health Insurance

Slide 8 FCERA June 2008 Interest Crediting FCERA Interest Crediting Policy  If Available Earnings is insufficient: CR may become negative, but CR + UER + Non-Valuation Reserves > 1% of Market Value of Assets  Interpretation of statutory 1% CR requirement  Negative CR used to track interest credit shortfalls, but only up to Non Valuation Reserves less 1% MVA  If Available Earnings is sufficient: Restore CR to 3% level  Any remaining available earnings go to UER

Slide 9 FCERA June 2008 Interest Crediting Prior FCERA Excess Earnings Distributions  Combination of Settlement Agreement and Board discretion  Settlement Agreement  Section 6 – enhanced retirement benefits for active members retiring on or after January 1, 2001  Section 8 – enhanced retirement benefits for retired members retired before January 1, 2001  Section 9 – All retirees, $3 per month per year of service, future increase tied to UER.  Last valuation when Undistributed Earnings available: June 30, 2002

Slide 10 FCERA June 2008 Interest Crediting Prior FCERA Excess Earnings Distributions  June 30, 2002 Application of Undistributed Earnings:  Priority #1 - Current year employer and member contribution relief (NC and current UAAL cost) for:  Section 8  Section 6  Section 9  Priority #2 - Reduce unfunded liabilities (“amortized” employer contribution relief) for:  Section 8  Section 9  Section 6

Slide 11 FCERA June 2008 Interest Crediting Prior FCERA Excess Earnings Distributions  June 30, 2002 Application of Undistributed Earnings:  Priority #3 - Create new retiree health benefits under Section 9 of Settlement Agreement  Priority #4 - Other uses at Board’s discretion  Supplemental COLA and Retiree Health Insurance

Slide 12 FCERA June 2008 Interest Crediting Employer Contribution Relief  Priority #1 - Allow “dollar-for-dollar” contribution credit for settlement benefits  Full or partial contribution offset  Priority #2 - Increase in Valuation Assets for settlement benefits  Reduces Unfunded Actuarial Accrued Liability  Reduces cost on an amortized basis

Slide 13 FCERA June 2008 Interest Crediting Member Contribution Relief  Priority #1 - Allow “dollar-for-dollar” contribution credit  Full or partial member COLA contribution offset

Slide 14 FCERA June 2008 Interest Crediting Allocated in June 30, 2002 Valuation  Undistributed Earnings allocated in June 30, 2002 valuation  Priority 1 – Current year contributions:  Section 8: $1.3 million  Section 6: $19.7 million  Section 9: $1.2 million  Priority 2 – Reduce unfunded liabilities:  Section 8: $19.9 million  Section 9: $11.6 million  Section 6: $17.2 million

Slide 15 FCERA June 2008 Interest Crediting Open Questions  Level of Contingency Reserve  Tracking and possibly restoring prior interest crediting shortfalls (Contra Account)  If so, what level of priority?  Priority of Undistributed Earnings distributions  Settlement vs. other uses  Priorities among Settlement uses

Slide 16 FCERA June 2008 Interest Crediting Level of Contingency Reserve  Provide further cushion against future earnings shortfalls  A form of “smoothing ”short term earnings fluctuations  Current FCERA policy is 3% of Market Value  1% statutory plus 2% additional  Additional is consistent with equity investing  Various practices among 1937 Act Systems  Earnings are not “excess” until CR is restored

Slide 17 FCERA June 2008 Interest Crediting Tracking/restoring prior interest crediting shortfalls  Use “Contra Account” instead of “negative” Contingency Reserve to track interest credit shortfalls  Policy issue: Do we restore past shortfalls with later excess earnings before any other priorities?  If “yes”, then track shortfall in Contra Account  In future years, restore prior shortfalls by reducing Contra Account  Effect: Measures “excess” earnings on a cumulative basis  Are earnings “excess” if prior shortfalls not restored?  Legal requirement or preferred practice?  Most 1937 Act systems either do not track or do not require priority restoration.

Slide 18 FCERA June 2008 Interest Crediting Contra Account Concept  Difference comes when good year follows bad  Consider this policy thought experiment  forget about Contingency Reserve for now  Scenario X: earn zero, then 16%  Scenario Y: earn 8%, then 8%  Scenario Z: earn 16%, then zero  Should UER be any different in these scenarios?

Slide 19 FCERA June 2008 Interest Crediting Undistributed Earnings Distribution Priorities  Not in any presumed order:  Restoring prior interest shortfalls (Contra Account)  Unless required before earnings are “excess”  Allocation to settlement benefit  Priority among settlement items  Allocation to UAAL for regular benefit  Supplemental COLA, Retiree Health Insurance  Others

Slide 20 FCERA June 2008 Interest Crediting Q U E S T I O N S