8 th Atlantic Connection Public Pensions Assumed Rate of Return & Pension Deficits: New Ideas, New Solutions Jeanna M. Cullins, Partner

What Happened to Create the Pension Deficit? The current funded status of many plans is due primarily to the financial market decline of 2008 – in which many public funds lost up to 1/3 of their assets. External factors include: – rising unemployment, – economic decline and falling housing values, and – falling state and local revenues. Internal factors include: – the late 1990’s benefit increases, – investment risks, and – plan sponsors not contributing the ARC. 2

What’s Been the Response? Between 2009 and now – over 45 states have instituted pension plan modifications Categories of the modifications – COLA reductions – Increasing employee contributions – Higher age and service requirements – Replacing DB plan with another plan Defined contribution plan Hybrid plan Cash balance plan 3

What’s Been the Response? Benefit decreases are being enacted, usually for new hires, typically starting with COLAs – COLAs are a target because they are an expensive benefit and because they may not have the same legal protections as the benefit formula under the applicable state laws. Post-employment COLAs have been revised in a dozen states – In most states, future COLAs were reduced – In several states, the COLA change affected current recipients; this resulted in litigation 4

Examples Oklahoma did away with automatic COLAs. The funding source for a COLA now must be specifically identified before it can be enacted In Wyoming, the Plan has to be 120% funded in order to grant a COLA Connecticut reduced their automatic COLA from 2.5% to 2.0% Hawaii reduced their automatic COLA from 2.5% to 1.5% Some states are pushing out the time before a retiree first becomes eligible for a COLA as a way of saving money 5

Examples Rhode Island has also tied the granting of COLAs to a funded ratio of at least 80%, but allows for intermittent COLAs before the 80% target is reached. The COLA is equal to the difference between the five-year smoothed investment return and 5.5%, but not less than zero and not greater than 4%. In Rhode Island, the COLA applies only to the first $25,000 of a member’s benefit. The limit is indexed to inflation. Arizona has implemented a two-prong risk sharing approach for granting COLAs: (1) investment earning must be at a specific level, in excess of 10.5%, and (2) the funded ratio must be at least 60%. Assuming the investment earnings requirement is met, then the amount of the COLA grows incrementally from 2% (if the plan is at least 60% funded) to 4% (if the funded ratio is at least 80%). If the earnings above 10.5% are not sufficient to fully fund the intended COLA, the COLA increase is limited to the amount that can be funded with the excess earnings. Any excess is not carried over to future years. 6

Are pension modifications permissible? Legal protections that apply to state employees pension benefits are a matter of state law – So the questions of whether changes are permissible is not a simple one Does the change impair existing and contractual obligations? Does the change have to be collectively bargained? 7

Are pension modifications permissible? In some states although the changes caused substantial contractual impairment, it was allowed because the courts found that the action was necessary to serve a significant public purpose 8

9 What is the appropriate role of a Pension Board in Pension Reform Question – Settlor vs. Fiduciary Actions – What is a fiduciary act is a functional test – The settlor is the entity that decides to adopt a plan in the first place and determines what benefits will be provided – An individual is not a fiduciary when performing settlor functions – Examples of settlor functions Choosing the type of plan, or options in the plan Amending a plan, including changing or eliminating plan options Requiring employee contributions or changing the level of employee contributions Terminating a plan, or part of a plan, including terminating or amending as part of a bankruptcy process

10 Settlor vs. Fiduciary Actions Examples of fiduciary functions – Managing the plan – Control over plan assets The implementation of a settlor decision may involve a fiduciary function An individual may have two roles, as a board member and a officer or employee of the plan sponsor Awareness of which role you are performing is critical Under ERISA and many state laws A fiduciary with respect to a retirement system or pension fund established under this Code shall discharge his or her duties with respect to the retirement system or pension fund solely in the interest of the participants and beneficiaries ….for the exclusive purpose of…defraying reasonable expenses of administering the retirement system or pension fund You should not use trust assets for settlor functions

“Neutral Administrator” follow the statutory parameters as established “Advisor” or “Educator” give costs and implications of benefit changes, but offer no recommendations “Protector” act on legislative amendments only when the actuarial stability of the System is threatened “Advocate” or “Activist” lobby for changes in state laws to sustain the System; lobby against illegal or ill-advised proposed changes “Innovator” design and recommend changes to benefits and funding sources  What role has the Board had?  What role is needed going forward?  Identify what changes in policies, staffing, and budget are needed to assume a different role. 11 What is the Appropriate Role of the System?