1. FCERA June 2008 Interest Crediting 4049213 FCERA Board Interest Crediting and Excess Earnings Policy Discussion Wednesday, June 18, 2008 Paul Angelo, FSA Andy Yeung, ASA The Segal Company San Francisco

2. 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

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

4. 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

5. 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!

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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.

18. 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?

19. 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

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