Beginning in the 1970s, public pension plan sponsors began to increasingly prefund their plans, rather than paying benefits as they were due. This resulted in the need for pension plan funding policies. A funding policy states how to determine the amount that must be contributed to the pension each year to systematically fund the long-term cost of the promised benefits.

Since the mid-1990s, the annual required contribution (ARC) - as defined by the Governmental Account Standards Board (GASB) pension disclosure standards - has stood as a de facto funding standard. GASB has recently made significant changes to these standards. Plan accounting is now separated from funding, which has resulted in a vacuum for guidance on funding policies which a number of organizations have taken steps to address. This article provides an overview of funding policies, the considerations and components of establishing a policy, and recently issued and pending guidance. A more detailed treatment of this topic is available in our Client Advisory on this topic.

In order to meet the primary objective of a pension plan - paying promised benefits to members when due - it is vital that the plan has sufficient assets. In developing a funding policy, several objectives should be considered in addition to this fundamental objective, including:

• Considering intergenerational equity (i.e., ensuring taxpayers bear a burden commensurate with the services they receive);
• Sustainability and stability of contribution levels;
• Long-term feasibility of funding strategy; and
• Enforceability of the funding policy

Three primary components of a funding policy are typically identified: actuarial cost method, asset valuation method, and amortization methods. The actuarial cost method defines the procedures used to allocate the pension cost over the working life of an employee. The asset valuation methodology defines the method used to recognize pension asset gains and losses over a period of time, rather than in a single year, to reduce market volatility effects. The amortization methods define the length of time and structure of the payments (or credits) necessary to bring the level of assets to the level of the funding target, generally by paying down any unfunded accrued liability or gradual recognition of a surplus.

ALTERNATIVE TECHNIQUES

Not all funding methods are designed based solely on a framework defined by actuarial cost methods, asset smoothing methods, and amortization methods. Some components of alternative financing strategies include direct smoothing of contribution rates, fixed-contribution rate methods, asset-liability based strategies, and even the use of stochastic or simulation-based methods. Although much of the recently-issued guidance does not address the development and evaluation of these alternative techniques, they may be considered in the development of a funding policy, with the advice of an actuary.

Two groups have issued guidance for funding policies as of this writing: the "Big 7" and the California Actuarial Advisory Panel (CAAP). Other groups considering proposing guidelines include the Conference of Consulting Actuaries and the American Academy of Actuaries.

A pension funding task force developed by the "Big 7" state and local government associations recently developed and released funding policy guidance¹. They identified a number of key policy objectives for funding policies:

1. They should be based around an ADC;
2. Discipline should be included within the policy to assure payment;
3. They should strive to maintain intergenerational equity;
4. They should strive for stable employer contribution costs as a percentage of payroll; and
5. They should require clear reporting of how and when they will be funded.

Their report identified actuarial cost method, asset smoothing method, and amortization policy as the three most important parts of a funding policy. A final aspect of this report was emphasizing the need for audits and reviews of the funding policy.

GUIDANCE FROM CAAP

The second group which has already issued guidance is the CAAP. The CAAP recently published "Actuarial Funding Policies and Practices for Public Pension and OPEB Plans and Level Cost Allocation Model"². This document is advisory in nature and identifies elements and parameters of actuarial funding policy while also developing a Level Cost Allocation Model (LCAM), an internally consistent mathematical model to develop level costs that is suggested as a valid option for a funding policy. The CAAP document considers possible practices in each of the policy elements and classifies them according to their acceptability for use.

CAAP's advisory guidance also identified a set of goals for funding policies:

• Ensure that future contributions plus current assets will be sufficient to pay for all benefits expected to be paid to members and beneficiaries,
• Reasonably allocate benefit cost and required funding to years of service,
• Manage contribution volatility,
• Support accountability and transparency, by being clear both in intent and effect and providing for assessment mechanisms, and
• Provide tools to deal with the nature of plan governance, including agency risk issues.

Similar to the "Big 7" taskforce findings, the CAAP has noted that surplus should be considered separately from unfunded liabilities. In fact, the guidance says that amortization of UAAL and surplus should not be symmetrical. The CAAP guidance also generally favors fixed amortization layers over approaches which include rolling periods.

PROVIDING GUIDANCE AND TRANSPARENCY

A written, well thought out and developed funding policy will result in many positive outcomes. In addition to providing guidance to decision-makers - thus making prudent decisions more likely - it should create enhanced transparency to all stakeholders. This transparency results in increased confidence by the members in their benefit security, less risk to the taxpayers of unexpected costs, and more positive evaluations of the sponsors by the financial market participants.

The importance of developing and making an actuarially determined contribution for public pension funds cannot be overstated. Most examples of serious funding problems in public plans are not the result of market events or unreasonable benefit changes, but a result of the sponsor not making the required contributions.

Cheiron is an actuarial consulting firm that provides actuarial and consulting advice. However, we are neither attorneys nor accountants. Therefore, we do not provide legal services or tax advice.

¹www.nga.org/files/live/sites/NGA/files/pdf/2013/1303PensionFundingGuideBrief.pdf.