1. TLFFRA Educational Conference
Actuarial Matters Effect of Actuarial Assumptions on the Soundness of Your Plan
TLFFRA Educational Conference
October 2, 2017

2. Questions to Consider
What are some reasons for a range of investment return assumptions?
Why are many public pension funds using a lower investment return assumption than 10 years ago?
What are the effects of a lower investment return assumption?
How do DROPs affect our funds? 1

3. Range of Investment Return Assumptions
TLFFRA All Texas NASRA
Assumption Funds Funds Survey
8.5% 0 1 1
> 8.0 <
> 7.5 <
> 7.0 –
< 2

4. Reasons for Different Investment Return Assumptions from Fund to Fund
Different asset allocations
Different assumptions for major asset classes
Different assumptions for inflation
Different levels of investment-related expenses
Different inclinations of boards of trustees
Different actuarial conditions of fund
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5. Different Asset Allocations Have Different Expected Returns
Major categories (equities and fixed income)
60/40 vs. 65/35 vs 70/30 vs 75/25
Subcategories that can increase expected return
international equities vs. domestic equities
small and mid cap vs. large cap
emerging markets vs. developed international
real estate vs. fixed income
world bonds vs. domestic bonds
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6. Different Assumptions for Major Asset Classes
Assumed Gross Theoretical Real Rate of Return Other Investment Fixed Weighted Assumptions2 Return Set Equities Income Average1 Inflation Expenses Assumption % 3.00% 5.01% 3.00% 0.75% 7.26%
1 Assuming asset allocation of 67% equities and 33% fixed income.
2 These assumptions vary from fund to fund but were held constant for illustrating the effect of different gross real rate of return
assumptions.
3 Weighted average gross real rate of return plus inflation minus expenses. 5

7. Different Assumptions for Inflation
Most actuaries do not use the same assumption for every client but have a range of assumptions
Different actuaries have different ranges
As there has been a gradual reduction in investment return assumptions, often the inflation assumption has also been reduced
Surveys have been difficult to obtain
February 2016 TLFFRA Pension Report by the PRB showed a range of from 2.5% to 4.0%
A more reasonable current range might be 2.5% to 3.5% 6

8. Price Inflation in the USA
Years
(Dec. to Dec.)
Number
of Years
Average
Annual Increase
1951 – 2016
1956 – 2016
1961 – 2016
1966 – 2016
1971 – 2016
1976 – 2016
1981 – 2016
1986 – 2016
1991 – 2016
1996 – 2016
2001 – 2016
2006 – 2016 65 60 55 50 45 40 35 30 25 20 15 10
3.46%
3.68
3.86
4.07
4.01
3.62
2.73
2.64
2.26
2.12
2.10
1.81 7

9. Different Levels of Investment-Related Expenses
Our preferred practice is to recognize both direct and indirect expenses
Direct: paid directly by fund
Indirect: paid by reduction in net asset value
Expenses of investment managers or mutual funds are wider ranging than you might think
Selection of investment managers or mutual funds often focuses mainly on historical performance and less on expense
Generally, but not always, total investment-related expenses as a percent of assets are lower for larger funds
Range for most of the TLFFRA funds might be from as much as 1.2% down to 0.5% (no survey available) 8

10. Different Inclinations of Boards of Trustees
Board’s investment policy statement requires some consideration of risk and often includes a target asset allocation
Some boards rely on their investment consultant for recommending target asset allocation, while other boards have more influence on that policy decision
Asset allocation decision is the major determinant of expected return
Board usually gives deference to the investment return assumption recommended by the fund’s actuarial firm
Collective inclination may influence board to ask for an assumption lower than what actuary recommends
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11. Different Actuarial Conditions of Fund
The lower the pay off period for the unfunded liability, the less sensitive it is to a reduction in the investment return assumption
The higher the pay off period, the more sensitive it is
The better a fund’s actuarial condition, the easier it is to reduce the investment return assumption
Other considerations that can enhance an opportunity to reduce the investment return assumption
an increase in the total contribution rate
favorable investment experience
other favorable experience
reducing future benefit accruals
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12. Investment Return Assumptions, FY01 to FY18
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13. Investment Return Assumption Than 10 Years Ago?
Why Are Many Public Pension Funds Using a Lower
Investment Return Assumption Than 10 Years Ago?
The Great Recession of 2008 (October 2007 – March 2009)
Below average growth of the economy since 2009
Sustained period of low interest rates since 2009
Sustained period of low inflation rates since 1991
Increasing scrutiny of public employee DB plans
unfunded liability
pay off period for unfunded liability
investment return assumption
plan design
governance 12

14. What Are the Effects of a Lower Investment Return Assumption on a TLFFRA Fund?
It will vary from fund to fund
Bigger increase in unfunded liability pay off period
the higher the current pay off period
the higher the current funded ratio
the higher the current ratio of the normal contribution rate to the total contribution rate
the inflation assumption is not lowered 13

15. Example 1 – Dramatic Increase in Pay Off Period
Investment Return Assumption
Base % %
Valuation Lower Lower
Pay Off Period 19.2 yrs yrs yrs.
Funded Ratio 83.2% 80.8% 78.5%
NCR / TOTCR 73.9% 78.0% 82.2%
Inflation base no change no change 14

16. Example 2 – Modest Increase in Pay Off Period
Investment Return Assumption Base 0.25% 0.50% Valuation Lower Lower Pay Off Period 24.6 yrs yrs yrs. Funded Ratio 53.5% 52.0% 50.5% NCR / TOTCR 55.6% 58.4% 61.4% Inflation base no change no change 15

17. Example 3 – Modest Increase in Pay Off Period with Change in Inflation
Investment Return Assumption Base 0.25% 0.50% Valuation Lower Lower Pay Off Period 24.6 yrs yrs yrs. Funded Ratio 53.5% 52.1% 50.7% NCR / TOTCR 55.6% 57.0% 58.6% Inflation base 0.25% lower 0.50% lower 16

18. How Do DROPs Affect our Funds?
Isn’t DROP cost neutral?
Why does our actuary say it would increase our pay off period
to increase the DROP period?
to lower the age at which we can get the maximum DROP lump sum?
to credit interest on our monthly benefit during the DROP period?
to add the city’s contributions to the DROP lump sum? 17

19. Is DROP Actuarially Equivalent to the Regular Benefit?
Electing DROP provides a lump sum and a lower monthly benefit compared to regular benefit
Electing regular benefit provides no lump sum and a higher monthly benefit compared to DROP benefit
Actuarial equivalence is based on present values (PV) at retirement date
PV of lump sum and DROP monthly annuity compared to PV of higher regular monthly annuity
Time value of money makes lump sum up front more valuable than PV of excess of higher regular monthly benefit over lower DROP monthly benefit
Generally the PV of DROP is greater than the PV of regular benefit
Why does our actuary say it would increase our pay off period
to increase the DROP period?
To lower the age at which we can get the maximum DROP lump sum?
To credit interest on our monthly benefit during the DROP period
To add the city’s contributions to the DROP lump sum? 18

20. Benefit Example DROP not Elected DROP is Elected
Monthly Benefit $ 4,600 Monthly Benefit $ 4,000
Value of Future Value of Future
Monthly Benefits $ 644, Monthly Benefits $ 560,000
Lump Sum $ 130,000
Total Value of Benefits $ 690,000 19

21. But Somebody Said DROP is Cost Neutral
Your fund’s original DROP design may have included
minimum age and service for earliest DROP benefit calculation date beyond the average retirement age
maximum period for accumulating DROP lump sum
Such design was to encourage some firefighters to work to somewhat higher age than they otherwise might
A somewhat longer career ending at a higher age slightly reduces the net cost from the interaction of these components
increased benefit
longer work career for paying for the benefit
shorter expected pay out period
So DROP could have been approximately cost neutral in the aggregate when it was added 20

22. So If DROP Was Approximately Cost Neutral When Added, Why Does It Cost to Improve It?
Increased DROP period usually increases the disparity in the PV of a DROP benefit and the PV of a regular benefit without enough of an offsetting increase in retirement age
Reducing the age at which you can get the maximum DROP lump sum reduces the work career for paying for the benefit and lengthens the expected pay out period
Crediting interest or adding the city’s contributions to the DROP lump sum increases the PV of benefits 21