1. Actuarial Assumptions and Methods: What is Reasonable?
LAPERS Seminar 2015
Actuarial Assumptions and Methods:
What is Reasonable?
John Garrett, ASA, MAAA, FCA
Principal and Consulting Actuary
Cavanaugh Macdonald Consulting, LLC

2. Perception of the Actuarial Valuation
Population
Data
Actuary
Contribution
Rates
Plan
Provisions
Financial
Reporting
This is unfortunately the case in many instances. Hopefully by the end of the morning you will have a better idea of what goes on in the black box.
Assumptions &
Methods

3. Basic Funding Equation: C + I = B + E
INFLOW:
Employee Contributions +
Employer Contributions
Investment Income
OUTFLOW:
Benefit Payments
Expenses

4. Purpose of Valuations Benefits payments are defined by plan
Employee contributions are typically defined by plan
Investment Income (net of expenses) is “assumed”
Employer contributions usually the dependent variable
Requires an actuarial valuation to determine the employer contribution necessary to solve the funding equation over the long term future.
Most employer’s desire stability in the rate
Based on the actuarial assumptions and methods recommended by the actuary and adopted by the Board.

5. Actuarial Assumptions
Assumptions are utilized to estimate unknown future events in order to calculate the actuarial present value of future plan benefits
Demographic Assumptions
Retirement Rates
Disability
Turnover/Withdrawal
Mortality
Promotional/Step Pay Increases
Miscellaneous
Economic Assumptions
Price Inflation
May also be the COLA assumption
Wage Inflation
Real Rate of Wage Increase
Investment Return
Real Rate of Investment Return
Payroll Growth Rate
Here’s how NOT to measure experience...

6. Things That Happen to People
KNOWN at valuation date:
Age
Salary
Gender
Service to date
Occupation
Date of
Hire
(Age 30)
Valuation
Date
(Age 45)
Retirement
(Age 60)
Death
(Age 85)
15 Years
25 Years
30 Years
An Individual’s Valuation Timeline

7. Calculation of Expected Future Benefits

8. Impact of Assumptions
The timing of future benefit payments is impacted by demographic assumptions such as rates of retirement, withdrawal, disability and death.
The size of future plan payments to actives is impacted by salary increase assumptions, the size of future payments to both actives and retirees is impacted by mortality, COLA assumptions.
The present value of every future payment is impacted by the assumed rate of investment return.

9. Assumptions are Precisely Wrong
Many demographic assumptions use probabilities
Rates of deaths, retirements, disabilities…etc.
Reality is binary – 0 or 1, yes or no, did or did not
This results in assumptions which are not realistic for the individual
But….
The goal is that demographic assumptions applied to large populations accurately reflect the experience of that population
Law of Large Numbers

10. What Are The Right Assumptions?
Assumptions ideally are the best estimate of future experience
Based on sufficient experience or related experience of similar populations
Example: Mortality Assumptions of Small Public Plans
Not too heavily based on recent experience and reflects future expectations
Example: Investment Returns
Assumption should be unbiased – not overly pessimistic or optimistic
“Reflects Actuary’s professional judgment”
“Common Sense” based on statistical analysis

11. How Do We Know We Have Good Assumptions?
Actuarial valuations should report the actuarial gains and losses due to material assumptions
Investment return, salary increases, post-retirement mortality, rates of retirement and other material assumptions
Well performing assumptions should result in offsetting gains and losses overtime
Lower impact to unfunded accrued liabilities
Lower resulting contribution volatility
Smaller plans have less opportunity for offsetting experience
Periodic review of assumptions (Experience Studies) to make adjustments as necessary
Never meant to be forever

12. Example of Actuarial Gains and Losses by Source

13. Actuarial Methods
Actuarial Methods are the various techniques employed by actuaries to allocate program costs to specific periods
Three primary types of methods used in public pension valuations
Actuarial Cost Method
Actuarial Asset Smoothing Method
UAAL Amortization Method
Usually defined in the plan’s funding policy

14. Actuarial Cost Methods
Allocate cost of pension benefit accruing over a career
Accrued liability – value of benefits allocated to past service
Normal cost – cost of this year’s benefit accrual (actual or average)
Examples
Entry Age Normal
Normal cost is the average annual rate over career
Accrued liability is the accumulation of past normal cost
Projected Unit Credit
Accrued Liability is the present value of accrued benefit
Normal cost is the expected accrual earned in upcoming year

15. Actuarial Asset Smoothing
Why smooth investment experience?
Range of Return Expectation
22.00%
1 Std Dev Above Mean
8.00%
Long-term Expected Return
1 Std Dev Below Mean
(6.00)%
Years

16. Actuarial Asset Smoothing
Typically 3 to 5 year smoothing
Spreads “unexpected” returns
Unexpected market return
Unexpected actuarial return
Difference between market and actuarial values

17. UAAL Amortization Methods
Amortization Payment Amount Attributes
Level as a dollar amount
Similar to most loan financing (home mortgage, car loans, etc.)
Level as a percentage of payroll
Increasing dollar amounts
Requires payroll growth assumption
Amortization Payment Period Attributes
Closed amortization period
Similar to most loan financing
Open amortization period
Annual refinancing of loan

18. UAAL Amortization Methods

19. UAAL Amortization Methods

20. UAAL Amortization Methods

21. Who’s Methods Are These?
Methods utilized in valuations should best fit the funding objectives of the Board
Balance of cost stability and desired funding progress
Methods utilized should make sense
Level percent of pay amortization for a plan closed to new entrants?
Does an open amortization period make sense?
As with assumptions - actuary recommends but Board selects

22. What Is Going On With Actuaries?
American Academy of Actuaries (actuary.org)
Issue Brief on “Objectives and Principles for Funding Public Sector Pension Plans”
Society of Actuaries (soa.org)
“Report of the Blue Ribbon Panel on Public Pension Plan Funding”
Actuarial Standards Board (actuarialstandardsboard.org)
Currently considering whether Actuarial Standards of Practice (ASOPs) specific to public pension plan funding are necessary
Conference of Consulting Actuaries (ccactuaries.org)
White Paper - “Actuarial Funding Policies and Practices for Public Pension Plans”
Provides “Model”, “Recommended”, “Acceptable”, “Acceptable with Conditions”, “Non- recommended” and “Unacceptable” practices for each of the three common methods.