Considerations for investing OPEB trust assets under GASB 45.

1. OPEB Investments:
The DANGER in Playing it Safe
January 17, 2013
Tony Jacobs Mark D. Meyer, JD, FSA Mary Fedorak Donn Hanson
Treasurer, LCWM School Board Van Iwaarden Associates MACM Regional Product Specialist Director
607 Knights Lane 840 Lumber Exchange 222 North LaSalle 800 Nicollet Mall
Lake Crystal, MN 56055 10 South Fifth Street Suite 910 Suite 2710
(507)726-2323 Minneapolis, MN 55402 Chicago, IL 60601 Minneapolis, MN 55402
(888) 596-5960 (312) 523-2438 (612) 371-3720
markm@vaniwaarden.com fedorakm@pfm.com hansond@pfm.com
www.vaniwaarden.com www.pfm.com www.pfm.com

2. Presentation Overview
• OPEB Basics
• Actuarial Implications
• Investment Implications
• Board Implications
• Questions and Answers
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3. GASB Accounting for OPEB
Other
Post-Employment
Benefits
3

4. Background of GASB Statements
OPEB in the Media
“School districts struggle to pay retirees' health benefits”
“The next retirement time bomb”
“Officials continue to grapple with liability issue”
“District is stretching out OPEB burden”
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5. What is an OPEB?
• Form of deferred compensation
• Promise to provide retiree benefits must now be accrued
during the working years of employees
• Post-retirement benefit other than pension
– Including:
• Retiree medical, life, vision, dental
• Implicit retiree medical subsidy
– Not Including:
• Early retirement incentives, severance based on unused sick pay,
vacation and compensated absences
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6. Implicit Rate Subsidies for Retirees
• In health insurance plans where a government’s retirees
and current employees are insured together as a group
• The premiums paid by the retirees are lower than they
would have been if the retirees were insured separately
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7. The Actuarial Model for OPEB Liability
Data Assumptions Methods Plan Provisions
Actuarial Model
(Present Value of Benefits)
Liabilities Accounting Results
• Accrued liability • Balance sheet liability Projected Payments
• Normal cost • Accounting expense
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8. Important Actuarial Assumptions
Factors that affect liability
Economic Demographic
 Discount rate  Participation rates
– Employee
 Pay increase rates (severance)
– Spouse
 Healthcare trend rates – Pre/post Medicare
 Amortization method  Retirement/turnover rates
 Plan election
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9. Distinction Between Accounting and Funding
• Accounting is required by GASB
– Measure liabilities
– Allocate expense to current year
– Report
• Funding is a management choice
– Balance assets and liabilities
– Match contributions and expense
– OPEB bonds now require a referendum
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10. Two Methods of Funding
Pay-as-you-go Actuarial Method
Paying an amount each Paying to an OPEB
year equal to the plan an amount that is
benefits distributed or expected to be
claimed in that year sufficient to pay for the
benefits of employees
after they are no longer
working
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11. Health Care Costs Are Age Related
Age Monthly Cost Index to 45
25 $245 55%
30 284 64%
35 329 74%
40 382 86%
45 442 100%
50 513 116%
55 594 134%
60 689 156%
65 287 65%
70 333 75%
75 387 88%
Difference between actual cost and premium is Implicit Subsidy
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12. Implicit Healthcare Subsidy
Insured Medical Plan Costs
Monthly premium $400
Retiree monthly contribution $200
Net employer cost $200
GASB 43/45 Interpretation
Retiree age-specific cost $520
Retiree monthly contribution $200
Net employer OPEB cost $320
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13. GASB Actuarial Valuation Required
• 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)
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14. Annual OPEB Cost Definitions
• 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
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15. OPEB Funding Rules
• GASB’s requirements for a funded plan
– Employer contributions irrevocable
– Assets dedicated to providing retiree benefits (establishing a Trust)
– Assets protected from creditors
• Trust funding vehicles
– 501(c)(9) trust, aka VEBA
– Section 115 Trust
– Insurance Contract
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16. Implications of Funding
• Potential higher discount rate
• Greater flexibility in investments
• Smaller ARC and Net OPEB Obligation
• Better credit rating
* Note that pre‐funding is not required
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17. Authorized Investment Considerations
• Permitted ‘NON’ OPEB Trust considerations
– Short term horizon
– Uncertain cash flow
– 1st priority…protect investment principal
– Limited by M.S. 118A
• Bank Deposits and Certificates of Deposit
• Local Government Investment Pools
• Municipal Notes
• Commercial Paper, etc.
– Local investment policy guides investment strategy
• MSBA model policy
• Often written with no consideration of OPEB Trusts
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18. Authorized Investment Considerations (cont.)
• OPEB Trust considerations
– Long term horizon
– Predictable cash flow needs
– 1st priority…achieve long term growth
– Limited by M.S. 356A
• All provisions of 118A permitted
• Equity exposure permitted
– Local investment policy guides investment strategy
• Identify asset allocation targets
• Clarify liquidity needs
• Portfolio limitations
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19. Long-term Equity and Bond Returns Have Outpaced Inflation
Annualized 5 Year Rolling Equity & Bond Returns
Return Values
30.0%
28.0%
26.0%
24.0%
22.0%
20.0%
DOMESTIC EQUITY
DOMESTIC EQUITY
18.0% Geometric Mean: 10.67%
Geometric Mean: 10.67%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0% AGGREGATE
AGGREGATE
-2.0% FIXED INCOME
U.S. INFLATION FIXED INCOME
U.S. INFLATION Geometric Mean: 5.60%
-4.0% Geometric Mean: 5.60%
Geometric Mean: 3.86%
Geometric Mean: 3.86%
-6.0%
-8.0%
-10.0%
Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2012
Interval: 60
S&P 500 TR Barclays Aggregate Bond (1976-2011) and 50% Intermediate Corporate; 25% Int. Govt; and 25% US Long-term Govt (1950-1976)
_____ Consumer Price Index Source: Morningstar En Corr/ Ibbotson Associates
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20. Pre-Funding Advantage
• 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
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21. Discount Rate Advantage
• 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
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22. Discount Rate Advantage Example
6% Return 4% Return Increase
Retiree liability - for
$478,311 $499,169 4%
payments before age 65
Active liability $594,320 $686,001 15%
Total liability $1,072,631 $1,185,170 10%
The higher the investment return the smaller the liability and
the less assets needed to pay for the promised benefits.
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23. Predictable Long Term Cash Flow
Why invest for the short term when the cash flows are long term?
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24. How Long Will the Assets Last?
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25. Properly Structured Portfolios are Key
Source: Bloomberg
25

26. Short term strategy for long term obligation
An investment strategy based upon M.S.
118A restrictions will likely deplete OPEB
Trust prematurely!
2‐Year U.S. Treasury Note Yield
Source: Bloomberg
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27. Projected Total OPEB Liability
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28. 2.5% Return Depletes the Trust Rapidly!
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29. Asset Allocation and Diversification are Critical
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30. S&P 500 Has Generated Inconsistent Historical Returns
Frequency of S&P 500 Calendar Year Returns since 1926
Only 5 out of 87 calendar year periods has the S&P 500 return been between 8%‐12%
Number
7
6
5
4
3
2
1
0
-44.0% -38.0% -32.0% -26.0% -20.0% -14.0% -8.0% -2.0% 4.0% 10.0% 16.0% 22.0% 28.0% 34.0% 40.0% 46.0% 54.0%
Return
Source: Morningstar EnCorr/ Ibbotson Associates
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31. Diversification: There is no substitute
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32. Great Opportunities Exist Outside The U.S.
World Market Capitalization
1970 1 2012 2
2030 3
2012 Total Market Capitalization: $29.5 Trillion 2
1) Data from BlackRock, Inc. which includes developed only
2) Data from MSCI: includes total U.S. ($13.4 Trillion), ACWI ex US ($16 Trillion)
3) Projection from Goldman Sachs
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33. Board Member Implications
• 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
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34. 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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35. 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
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36. Actuarial Caveats
• 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
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37. Disclaimers
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.
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