OPEB Investments: The DANGER in Playing it Safe Mary Fedorak MACM Regional Product Specialist 222 North LaSalle Suite 910 Chicago, IL 60601 (312) 523-2438 [email protected]www.pfm.com Donn Hanson Director 800 Nicollet Mall Suite 2710 Minneapolis, MN 55402 (612) 371-3720 [email protected]www.pfm.com January 17, 2013 Mark D. Meyer, JD, FSA Van Iwaarden Associates 840 Lumber Exchange 10 South Fifth Street Minneapolis, MN 55402 (888) 596-5960 [email protected]www.vaniwaarden.com Tony Jacobs Treasurer, LCWM School Board 607 Knights Lane Lake Crystal, MN 56055 (507)726-2323
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• Groups over 200 total membership – every 2 years
• Groups under 200 – every 3rd year
• Groups under 100 – “alternative measurement method”permitted (intended to make it possible to do calculations without using an actuary)
GASB Actuarial Valuation Required
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• Annual Required Contribution (ARC) – Normal cost + amortization of unfunded actuarial accrued liability over
maximum 30 year period
• Net OPEB Obligation (NOO)– The cumulative difference since implementation between the annual
OPEB cost and the employer’s contributions
• If Net OPEB Obligation exists…– Annual OPEB Cost=ARC + one year’s interest on NOO + adjustment to
ARC•ARC adjustment is the discounted value of the balance of the net OPEB obligation
Annual OPEB Cost Definitions
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• GASB’s requirements for a funded plan– Employer contributions irrevocable– Assets dedicated to providing retiree benefits (establishing a Trust)– Assets protected from creditors
Long-term Equity and Bond Returns Have Outpaced Inflation
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_____ Consumer Price Index
S&P 500 TR Barclays Aggregate Bond (1976-2011) and 50% Intermediate Corporate; 25% Int. Govt; and 25% US Long-term Govt (1950-1976)
Source: Morningstar En Corr/ Ibbotson Associates
• Best practices in managing OPEB liabilities include funding– Pay-as-you-go funding basis is unsecured borrowing
against future revenues– Fund OPEB at the same time as other compensation
• Major advantages to having an OPEB trust:– Improved credit rating– Uses current tax dollars to pay for current compensation– Prudent long term investments reduces the cost
Pre-Funding Advantage
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• Discount rate is based on expected rate of return• OPEB Trust assets will earn a higher rate of return
– Higher rate of return means higher discount rates– Higher discount rate means lower liabilities– Lower liabilities produces a stronger balance sheet
• Unfunded OPEB liabilities come from general assets – Internal School District assets are severely restricted to the
safest and lowest return investments– Lower discount rate means higher liabilities
Discount Rate Advantage
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6% Return 4% Return Increase
Retiree liability - for payments before age 65
$478,311 $499,169 4%
Active liability $594,320 $686,001 15%
Total liability $1,072,631 $1,185,170 10%
Discount Rate Advantage Example
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The higher the investment return the smaller the liability and the less assets needed to pay for the promised benefits.
Predictable Long Term Cash Flow
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Why invest for the short term when the cash flows are long term?
How Long Will the Assets Last?
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Properly Structured Portfolios are Key
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Source: Bloomberg
Short term strategy for long term obligation
Source: Bloomberg
2‐Year U.S. Treasury Note Yield
An investment strategy based upon M.S. 118A restrictions will likely deplete OPEB Trust prematurely!
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Projected Total OPEB Liability
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2.5% Return Depletes the Trust Rapidly!
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Asset Allocation and Diversification are Critical
S&P 500 Has Generated Inconsistent Historical Returns
Only 5 out of 87 calendar year periods has the S&P 500 return been between 8%‐12%
Frequency of S&P 500 Calendar Year Returns since 1926
Diversification: There is no substitute
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Great Opportunities Exist Outside The U.S.
World Market Capitalization
2012 Total Market Capitalization: $29.5 Trillion 21) Data from BlackRock, Inc. which includes developed only2) Data from MSCI: includes total U.S. ($13.4 Trillion), ACWI ex US ($16 Trillion)3) Projection from Goldman Sachs
1970 1970 11 2012 2012 22
20302030 33
• Fiduciary Responsibility– Know the Investment Policy– Monitor the Investment Performance– Rely on the Experts
• Investment Expertise– No requirement to be an expert– Hire expertise
• Administration Expertise– Experts at school administration are probably not experts on OPEB
investments
Board Member Implications
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DANGER in Playing it Safe
• Safe does not automatically mean prudent– Fiduciary duty to be prudent
• Bond proceeds may be depleted prior to final bond payment • Investment earnings may be lower than bond interest• Disappointed constituents• Less money for school operations• Lost opportunity cost• Headline risk
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School Board Action Plan
• Estimate the projected life of the OPEB Trust• Review investment policy and its handling of OPEB• Amend policy and investment strategy appropriately
A detailed actuarial report is the start of the process
• Retiree medical cash flows are less predictable than retirement benefits
• Changes in federal health care laws and benefits materially affect the projected benefits
• Changes in investment policy materially affect investment return expectations and the discount rate
• Health care cost inflation is higher and more variable than general consumer price inflation
Actuarial Caveats
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Any investment advice in this document is provided solely by PFM Asset Management LLC. PFM Asset Management LLC (“PFMAM”) is an investment advisor registered under the Investment Advisers Act of 1940. PFM Advisors is a division of PFM Asset Management LLC. Public Financial Management Inc. is not providing and is not responsible for any investment advice herein.
This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.