“Undistributed Earnings” and Interest Crediting Presentation to the FCERA Board of Retirement June 18, 2008 Harvey L. Leiderman Jeffrey R. Rieger Reed Smith, LLP

2 Purpose Of Today’s Discussion  Education for Board, Members, Employers and Public  Board Observations, Questions and Direction

3 Agenda For Discussion 1.What are "undistributed earnings" under the Settlement Agreement and how does the Board determine how much, if any, exist? (a) Must the Board use all the same procedures that were in place at the time of the Settlement Agreement? (b) How much discretion does the Board have on actuarial issues that may impact the amount of “undistributed earnings”? 2.Use of “undistributed earnings” (a) Must the Board use them for settlement benefits before using them for anything else that the law otherwise allows? (b) What is the priority for using them under the Settlement Agreement?

4 What Are “Undistributed Earnings”? Settlement Agreement  States that the settlement benefits will be funded with “undistributed earnings”  Does not define “undistributed earnings”  Does not require the Board to use any particular actuarial assumptions or methodologies  If intent does not appear in the text of the agreement, it may not be supplied from other sources  “All parties agree that this [] Agreement is clear and unambiguous … [and] no parol or other evidence outside this agreement may be offered to explain, construe, contradict or clarify the terms of the [] agreement, the intent of the Parties or their counsel, or the circumstances under which the [] agreement was made or executed.”

5 What Are “Undistributed Earnings”? CERL  Phrase “undistributed earnings” does not appear in CERL  CERL does discuss “excess” earnings:  Section 31592: “Earnings of the retirement fund during any year in excess of the total interest credited to contributions and reserves during such year shall remain in the fund as a reserve against deficiencies in interest earnings in other years, losses on investments and other contingencies.”  Section and other statutes provide the Board with discretion to use funds (“may transfer”) for certain purposes “when such surplus [described in section 31592] exceeds 1 percent of the total assets of the retirement system …”

6 What Are “Undistributed Earnings”? Board Discretion  Cal. Const., art. XVI, § 17(e): “The retirement board … shall have the sole and exclusive power to provide for actuarial services in order to assure the competency of the assets of the public pension or retirement system.”  Civil Code § 1441: “A condition in a contract, the fulfillment of which is impossible or unlawful … or which is repugnant to the nature of the interest created by the contract, is void.”  Civil Code § 1643: “A contract must receive such an interpretation as will make it lawful, operative, definite, reasonable, and capable of being carried into effect, if it can be done without violating the intention of the parties.”

7 What Are “Undistributed Earnings”? Board Discretion, cont.  Case law limits a governmental entity’s ability to contract away its discretionary authority. See Trancas Property Owners v. City of Malibu (2006) (settlement agreement “illegal” because zoning authority could not contract away its powers)  But, see 108 Holdings, Ltd. v. City of Rohnert Park (2006) (city could not contract away its powers, but it could promise to interpret existing law and policy in a particular manner)

8 What Are “Undistributed Earnings”? Board Discretion, cont.  In re Retirement Cases (2003): “When a statute imposes upon an administrative body discretion to act under certain circumstances, mandate will not lie to compel the exercise of such discretion in a particular manner”  Can a settlement agreement “compel the exercise of discretion in a particular manner” if a court cannot?  A “legislative” board may not divest itself or future boards of power to enact “legislation” within its competence; many of the Board’s discretionary acts are “legislative” in nature

9 What Are “Undistributed Earnings”? Other Considerations  Board must make many actuarial decisions in the ordinary course of administering the system, which could impact the existence and amount of “undistributed earnings”  Example: Board used 8.42% assumed rate of return at the time of the settlement. It has since changed it twice and it now stands at 8.00%  System’s funded status was much higher at the time of the settlement agreement. Could that have impacted the parties’ agreement on the use of “undistributed earnings”?  “Course of performance” may help determine the meaning of ambiguous terms in a contract (e.g., Board’s actions in 2003)

10 What Are “Undistributed Earnings”? Preliminary Conclusions (1)We do not believe the Settlement Agreement constrains the Board’s constitutional and statutory discretion over actuarial assumptions and methodologies (2)The Board should exercise its discretion and work with its actuary to establish assumptions and methodologies that are in the best interests of the system as a whole (3)The Board may consider the impact its actuarial assumptions and methodologies will have on whether and how much “undistributed earnings” exist

11 Using “Undistributed Earnings” Must Settlement Benefits Come First?  The most reasonable interpretation of the Settlement Agreement is that “undistributed earnings” must be used to pay for settlement benefits before they are used for other statutory purposes  Use of the word “shall” in paragraphs 6, 9 and 14  Paragraph 9 benefits “tied to the amount of future undistributed earnings” But ….

12 Using “Undistributed Earnings” Must Settlement Benefits Come First?, cont.  See earlier discussion about Board discretion  Was Board contracting away its discretionary powers, or just agreeing interpret law and policy in a particular way?  Whatever may be legally required, the Board can exercise its discretion to act consistent with the terms of the Settlement Agreement, as it construes those terms

13 Using “Undistributed Earnings” Priority Under the Settlement Agreement  No clear answer on the face of the Agreement  A court would most likely give substantial deference to any determination the Board makes as to priorities  Looking at only the language of the Agreement, without considering anything else, we believe the most reasonable interpretation is: (1)If there are unfunded liabilities for any of the settlement benefits, those unfunded liabilities have first priority (2)If there are more than $25 million in “undistributed earnings,” after step one, then retiree benefits should be determined according to the table in paragraph 9 (3)After steps one and two, the employer and employee normal cost of benefits under paragraph 6 may be paid with “undistributed earnings”

14 Using “Undistributed Earnings” Alternatives  Alternative No. 1: Determine priorities under the Settlement Agreement at the conclusion of this process based on input from staff, consultants, members of the system, participating employers  Advantage: Policy establishes guidance before “undistributed earnings” exist  Disadvantage: Will not have the benefit of all relevant facts under prevailing circumstances when “undistributed earnings” exist  Alternative No. 2: Wait until “undistributed earnings” exist and then revisit the question of how to use them under the then prevailing circumstances  Advantage/Disadvantage – Flip side of the above