London Market Monitor – 30 September 2021
September delivers some ups and downs: Equity and bond markets mostly fell, risk-free rates rose, UK inflation increased, and volatility notched upward.
One of the most important decisions made for public sector pension plans is adopting a funding policy that balances the needs of all stakeholders. In general, larger benefits require larger contributions. For a given benefit level, the purpose of a funding policy is to balance the level and volatility of contributions with the funded status of the plan. In this article, we explore, compare, and contrast various methods of amortizing liabilities and their impact on the contribution rates allocated to employers.
First, let’s discuss how pension liabilities are typically measured in the public sector. Expected benefit payments are projected using many actuarial assumptions. An actuarial present value of benefits is calculated by discounting those future benefit payments into today’s dollars. The traditional actuarial approach used in the public sector sets the discount rate equal to the expected investment rate of return.
Usually, the individual entry age actuarial cost method assigns the expected cost of benefits to the years of service for each individual covered by the pension plan. This is the only actuarial cost method permissible for financial reporting under current standards of the Governmental Accounting Standards Board (GASB). Under this method, a service cost is calculated based on the percentage of pay required to fund contributions, if all actuarial assumptions were exactly realized from hire date until retirement date. The total pension liability is the share of the actuarial present value of benefits assigned to past service based on prior service costs.
Typically, actuarially calculated contribution rates are comprised of two pieces. The first piece is equal to the service cost and the second is an amortization of the difference between the current funded status of the plan and the target funded status. The target funded status is usually 100%, the point where the net pension liability is zero, where the actuarial value of assets is equal to the total pension liability.
Plan sponsors use a variety of methods to determine the amortization amount, including “closed,” “layered” and “open/rolling” amortization methods.
Under a closed amortization method, the entire net pension liability is amortized by a specific date. Each year after the actuarial valuation, the remaining number of years over which to pay the net pension liability decreases by one year. As the period decreases, the volatility impact on the contribution increases as differences in experience and assumptions that occurred during the year are amortized over a shorter period. Once the period is short, the volatility in contribution rates may become difficult to budget on an annual basis. At that time, it might make sense to change to a layered or rolling method.
Under the layered method, an additional layer of amortization is calculated each year based on the experience or assumption changes made that year. In this article, the first layer is the current unfunded liability, also known as the net pension liability, or the difference between the actuarial value of assets and the total pension liability. In this deterministic projection, we assume that all experience exactly matches assumptions, and therefore future layers are zero. In this scenario, the layered method is no different from the closed method. Future articles in this series will explore the impact of volatility in investment markets, which will result in the creation of layers.
A potential advantage of the closed and layered methods is that they are scheduled to pay the entirety of the net pension liability by the end of the amortization period, if all assumptions are met. Layered amortizations can introduce some contribution and funding volatility when layers “drop” off after a layer has been fully amortized. It is always important to monitor the layers to ensure that the resulting total amortization payment properly amortizes the total net pension liability.
Alternatively, a system can use a “rolling” method, where the amortization is reset annually based upon the entire net pension liability. The amortization period remains constant resulting in a consistent percentage of the net pension liability paid each year. By contrast, an amortization with one closed layer or multiple layers, sees the amortization period for each layer decrease by one each year. If all assumptions are precisely met, the funded ratio will approach 100% with a rolling amortization method but will never attain it. However, assumptions are never precisely met. Future articles in this series will develop statistics for the likelihood of obtaining 100% funding under various assumptions and conditions. Under this method, there are no layers that become fully amortized, which somewhat mitigates the effect of volatility caused by fully amortized layers.
In addition to the layered and rolling amortization methods calculated in conjunction with the entry age actuarial cost method, this article considers one additional approach to funding policies. The aggregate cost method considers the entire actuarial present value of benefits. The difference between the actuarial present value of benefits and the actuarial value of assets is divided by the actuarial present value of future salaries for members as of the valuation date to calculate the contribution rate. This contribution rate is then applied to current salaries.
This methodology is less common than amortization of the net pension liability calculated under the entry age actuarial cost method. However, some systems use this method, including two of the ten largest public sector retirement systems in the United States, the Washington State Retirement Systems from the authors’ home state, as well as the New York State and Local Retirement Systems. The aggregate amortization method behaves similarly to a rolling 10 amortization method under the plan demographics, assumptions, and plan provisions modeled in this article.
The method alone does not provide much information about the funded status of the plan. For this reason, the actuarial value of assets is often compared to the total pension liability using the entry age actuarial cost method.
Setting the length of the amortization period is an important decision. It will have an impact on the level and volatility in contribution rates and the plan’s funded status. A longer amortization period will have lower initial contribution rates for an underfunded plan and less contribution volatility but will be less responsive to changes and take longer to reach 100% funded status. A shorter amortization period will pay down the unfunded liability more quickly for an underfunded plan, but there will be higher initial contributions and greater volatility. The length of either layered or rolling amortizations varies from entity to entity, but usually ranges from 10 to 30 years depending on interest and payroll growth assumptions.
Recently, there has been a downward trend in the length of amortization periods. According to the Public Plans Database1, approximately 40% of nearly 200 plans used a 30-year amortization, or higher, for fiscal year 2012. As of fiscal year 2019, the percentage had declined to 24%. The median amortization period of these systems declined from 27 years to 22 years from 2012 to 2019.
The changes in financial reporting requirements between GASB 27, the pension accounting standard in place in 2012, and the current GASB 68 standard may have had a role in the shift away from 30-year amortizations. While funding did not need to conform to GASB’s standards, thirty-year rolling amortization did result in the lowest permissible contribution level to avoid a balance sheet liability under the old standards, and it became the de facto funding standard for some plans. By eliminating the connection between funding and accounting, many systems renewed their focus on their funding policies potentially resulting in lower amortization periods.
For purposes of this article, we modeled a “typical” public plan as of January 1, 2021. We use a 7.0% expected return on assets, which is a common assumption among public pension plans, an entry age normal actuarial cost method and a fresh start for the amortization of the unfunded liabilities. We then explored multiple amortization methodologies. We set assets equal to 79% of liabilities, which is the aggregated funding level as of January 1, 2021 in the Milliman Public Pension Funding Index (PPFI). Additional key methods, assumptions and plan provisions are listed in our appendix.
In our projections, we assume that all assumptions are met and that there are no gains or losses. In a future article, we will explore the impact of asset variance on both funding levels and employer contributions under the myriad of amortization methods.
Under a layered amortization, a “cliff” is created where the employer contributions drop once the initial amortization layer is fully amortized. This “cliff” does not exist on the rolling amortization method as the unfunded liability is never paid off, unless future actuarial gains occur.
Employer contributions under the layered and rolling methods with the same amortization period begin at the same place. Methods with shorter amortization periods start with higher contributions, and methods with longer amortization periods start with lower contributions. The Rolling 10 Method starts at 19.5% of pay, while the Layered 30 Method and Rolling 30 Method start at 11.9%.
The contributions under the layered methods remain relatively steady, (they increase slightly due to generational mortality), until the initial unfunded liability has been paid off, at which point there is a sharp, one-year decrease in contributions. The shorter the period the larger the decrease. After the drop, the contributions are nearly the same for all layered methods, and continue to increase slowly over time, ending the projection period around 6.6% of pay.
The contributions under rolling methods decrease over time, with greater annual reductions in contributions for methods with shorter amortization periods. Shorter amortization methods fund more aggressively earlier, which leads to a higher funded status and lower amortizations of the underfunding in subsequent years compared to longer amortization methods. Therefore, shorter amortization methods start off with higher contributions compared to longer amortization methods in our deterministic projection. Shorter amortization methods eventually have lower contributions. As shown in the graph above, this crossover is between 10 to 16 years.
Contributions under rolling methods are smoother than contributions under layered methods. They start out at the same place, but quickly become notably lower under rolling methods. Once the amortization of the initial layer has passed, contributions under layered methods are lower than under rolling methods since the unfunded liability has been paid off. Assuming no gains or losses, under the layered method, once the initial unfunded is amortized, the contributions only need to fund the ongoing service cost.
In this article, the funded status of the modeled starts out at 79% under all amortization methods.
Layered amortization methods eliminate the entire unfunded liability by the end of the amortization period assuming no gains or losses. Therefore, the plan will reach 100% funded as of the end of the amortization period. Once 100% funded the employer contribution only needs to fund the ongoing service cost.
The funded status under rolling methods never reaches 100% under our deterministic projection, although methods with shorter amortization periods begin to approach 100%. At the end of the 40-year projection period, the funded status under the Aggregate Method reaches 98%, while the funded status under the Rolling 30 Method only improves from 79% to 89%. Note that while the funded status on a percentage basis grows modestly over the decades, the net pension liability actually grows on a dollar basis every year when assumptions are met. This is because the amortization payment is insufficient to pay the interest on the net pension liability when amortized over 30 years based on a level percentage of a growing payroll.
Our discussion so far examines how various amortization methods handle the initial underfunding if all assumptions are met. However, actuarial assumptions are not always met. When actual experience differs from assumed then an actuarial gain (improved funded status) or actuarial loss (deteriorated funded status) occurs. Under layered amortization methods, a new amortization layer is set up equal to the gain or loss and then amortized over the designated number of years. Under rolling methods, the gain or loss is included in the amortization of the unfunded amount. For this article, we assumed no gains or losses in our projections. In future articles, we intend to examine the impact of volatile asset returns.
As the initial unfunded liability is paid down, the funded status of the plan increases. In general, methods that require greater contributions earlier on, tend to require lower contributions in the long-term as measured by the average percent of payroll contributed each year.
|YEARS 1-15||YEARS 16-30||YEARS 1-30|
|Average Employer Contributions*||End of Period Funded Percent||Average Employer Contributions*||Average Employer Contributions*||End of Period Funded Percent|
*As a percent of payroll
Under the Layered 15 amortization method, contributions during the first 15 years average 16.0%, the highest average contributions under all methods studied. The advantages to this method are that it is the only method to reach 100% funded at the end of 15 years, and the average contribution during the next 15-year period is the lowest of all methods studied.
In comparison, under the Rolling 30 amortization method, average contributions are only 11.5% during the first 15 years and 10.7% for the next 15 years. However, at the end of 30 years, the funded status has only improved to 88%. Average contributions over the entire 30-year period are 11.1% of pay, the same average contribution level as that under the Layered 15 method, yet the Layered 15 method reached and maintained 100% for the final 15 years of the projection.
There are different ways to contribute 11% of pay on average over a 30-year period, and these can result in significantly different funded statuses at the end of the period, even when there are no experience gains or losses.
There is another consideration when setting an amortization policy. Under GASB 67/68, there is a specific methodology for determining a “depletion date.” If it is determined using GASB’s methodology that the assets are projected to be inadequate to pay benefits at some point in the future, a blended discount rate is used for purposes of financial reporting of the actuarial liabilities. The blended discount rate could be significantly lower than the expected return on assets used for financial reporting purposes.
There are two potentially negative consequences of having a depletion date. One is that the plan will need to disclose that a depletion date exists. The other concern is that the lower discount rate will result in a higher net pension liability than there would be if using the long-term rate of future investment return. This means that two otherwise identical plans could have differing net pension liabilities depending on the funding policy.
Due to GASB’s methodology, rolling amortizations are more likely to result in depletion dates than layered amortizations. A future article in this series will provide more detail about this calculation, including examples, and some ideas to avoid having a depletion date.
In this article, we developed a framework to help plan sponsors understand the funding policy implications of their choice of amortization method. We introduced our model pension plan. We explored how various amortization methodologies work and the resulting contribution rates and funded status. This inclusion of projected funding status considerations in conjunction with the contribution rate analysis may be a reason that the 30-year rolling methodology has recently fallen out of favor.
Throughout this article, we have assumed that all assumptions are perfectly met. However, actual investment returns will not be precisely 7.0% for each year. For that reason, future articles in this series will focus on how the various amortization methodologies react to the volatility in investment markets. We will do this by applying stochastic modeling to forecast various outcomes using a random variable. We will look at multiple metrics for contribution volatility and measure the likelihood of crossing various thresholds for contribution rates and funded status. We will explore what happens when a plan’s investment rate of return assumption is higher than the expected median geometric investment return.
Assets: Assets are valued based on their fair value, with a five-year smoothing of all fair value gains and losses. The expected return is determined for each year based on the beginning of year fair value and actual cash flows during the year. Any difference between the expected fair value return and the actual fair value return is recognized evenly over a period of five years.
Initial asset values are such that the funded status of the plan at the beginning of the projection period is 79%.
Investment earnings: Deterministic projections are based on a 7.0% annual investment return.
Actuarial cost method: Liabilities are valued using the entry age actuarial cost method.
Data: The population is made up of 50% active members, 15% terminated vested members, and 35% retired, and in-pay members. Within each status group, males and females are equally weighted by count.
The population is not assumed to grow or decline. Future members are assumed to have the same ages at entry and distribution by sex of the present members that they replace.
Plan provisions: Normal retirement benefits are equal to 2% of the highest consecutive three-years of pay per year of service, up to 30 years. Normal retirement benefits are payable at age 65. Upon retirement, benefits increase annually at 2%.
Early retirement benefits and optional forms of benefits are actuarially equivalent to the normal form of payment.
Member contributions: Employees contributions are 6% of pay annually, regardless of the funded status of the plan.
Employer contributions: Service cost plus amortization of Net Pension Liability (NPL) minus employee contributions, but not less than zero. Note that for the aggregate actuarial cost method, the service cost is defined under that actuarial cost method, and there is no component for the amortization of the NPL.
Mortality: PubG-2010 General Amount-Weighted Mortality Rates Projected with MP-2019.
Termination: Service-based rates starting at 20% in the first year of service and grading to 1.5% at 22 or more years of service.
Retirement: Rates vary by age and service based on retirement eligibility up to 100% at ages 70 or older.
Disability: Age-based rates starting at 0% and grading to 0.1% at retirement eligibility.
Discount rate: Based on a 7.0% annual investment return.
Projected payroll increases: Total plan payroll increases by 3.0% per year. Individual members receive increases due to promotion and longevity.
1Sourced from https://publicplansdata.org/.
Public pension plan funding policy: Effectiveness of amortization methods under deterministic projections
Public pension funding policies have implications, so we present plan sponsors with a framework to understand their choice of amortization method.