Mary Ellen Angeletti's report on the STRS Board Retreat: Day Two

From Mary Ellen Angeletti, February 2, 2007
Thursday, February, 1, 2007
The second day of the STRS Retreat began at 9:30 a.m. with the introduction of Kim Nicholl, consulting actuary of Buck Consultants, who explained the actuarial principles and assumptions of the STRS pension plan. This presentation was very long and detailed.

Assumptions for STRS are redone every five years. Dr. Leone asked if it was wise to wait this long between reviews since there were so many questions about the figures used for payroll growth. There are shortfalls on payroll growth NOW. Since the five year review is due next year (2008), it was deemed appropriate by Buck Consultants to wait. The five year assumption review next year will:

1. Compare assumptions made about retirements in the past (actual) versus what actually happened (expected)
2. Update mortality info.
3. Study retirement patterns & determine trends - make judgments about the future
4. Study payroll growth which will probably change next year.

They will ask if this change can be sustained in the future. This trend would affect the funding period by lengthening it. An actuarial valuation was explained as a snapshot of the actuarial position of a pension plan at a given point in time. Like a movie, each frame is a snapshot of the present. The snapshots are of assets, liabilities and net gains or losses.

Actuaries deal with payment of money in the future that is contingent upon occurrence of future events such as salary increases, retirement, disability, and death. They also deal with risk management and the probability of future events. Assumptions are important because when and why a member leaves active service drives the amount of benefit paid. Assumptions are established by the Board based on the recommendations of the actuary.

Assumptions are long term and best estimates. Interest rates, salary increases, payroll growth and inflation all play a part in setting economic assumptions. There is a financial impact of assumption changes. Thus, if the salary scale decreases, liabilities go down. If mortality rates improve, liabilities grow. If withdrawals increase, liabilities will decline. I thought it was interesting that Kim said our STRS system compared to PERS has a better funded plan due to the fact that our turnover rate is so low and their turnover rate is high.

Smoothing was explained as investment gains and losses recognized over a specified time period, typically three to five years. STRS uses four years. Systems smooth assets to dampen volatility of market value and to stabilize employer contribution rates. In other words, by using smoothing, one does not recognize losses & gains right away. All 5 pension systems in Ohio use smoothing. CAlpers uses a 15 year smoothing period. General Motors has gone from a 5 year to 2 years and is getting out of pensions completely because they can't afford the volatility. The STRS rate of return as of July 1, 2006 was 13.5% and 11.9% in July 1, 2005. To date, it is 12%. THIS IS A GREAT MARKET VALUE OF ASSETS!

The funded ratio is the actuarial value of assets divided by the accrued liability. As of July 1, 2006, STRS had a funded ratio of 76.1%. The unfunded accrued liability is the excess of the accrued liability over the assets. As of July 1, 2006, STRS has unfunded accrued liability of $19.4 billion dollars. The funded ratio and the unfunded liability both represent the funding progress of the plan.

At the present time, it will take STRS 47 years to pay off the unfunded accrued liability. An actuarial experience gain or loss results whenever the actuarial assumptions do not accurately predict member behavior. STRS recognized an experience loss on the retirement and separation assumptions in each of the past three valuations. Preliminary analysis suggests that members with 30+ years of service are retiring at different rates than the current assumptions predict. This pattern may be generating actuarial losses.

Buck will review this info. in their review next year. Buck's projection of our funding period is that as of July 1, 2006, the system has a market value of pension assets of $62.1 billion and an actuarial asset value of $57.8 billion. The $4.3 billion difference between these figures represents investment gains that have not yet been recognized. If the market value of assets returns exactly 8% annually in the current fiscal year and beyond, the system will recognize $4.3 billion in gains in the coming three years.

The defined benefit plan still attracts 80% of new entrants with only 10% electing the defined contribution plan. Regarding payroll growth, in each of the past three years, it has fallen short of the 4.5% per year assumption. Payroll growth EXCEEDED 4.5% for each of the 5 years preceding the most recent three years. Buck Consultants does NOT recommend lowering the 4.5% per year assumption at the present time.

If the teaching force declines, it will have the biggest impact on the unfunded liability. The history of STRS health care program and its funding goals was reviewed. It was explained that there are two ways to look at the health care funding issue:

1. Full reserve actuarial funding (how much is needed to fully fund health care for current and future retirees )

2. Fund solvency period (how many years will the health care fund last). Due to GASB (Government Accounting Standards Board) 43, STRS will have to disclose full reserve contribution effective with the July 1st, 2006 fiscal year.

The meeting continued through a working lunch with a discussion of the Public Speaks policy. Tai Hayden said that the 3 minute rule is degrading for a member who drives a long distance when there are only a couple of speakers signed up. Dr. Leone also spoke to this concern asking for flexibility of time limits when so few speakers were signed up. However after much discussion, it was decided that in the interest of time constraints the three minute limit for speeches would be maintained but that flexibility would be permitted. Dr. Asbury will try to signal the speaker when one minute remains. It was mentioned by Board members that the distribution of hard copies of the speeches is especially appreciated.

Contingency Planning was next on the agenda, led by Executive Director, Damon Asbury, Steve Mitchell, Director of Investments, and John Osborn, Consultant with Russell Investment Group. Dr. Asbury began with a discussion of the results of a Contingency Plan Survey completed by the STRS Board members. The survey (which was not passed out to visitors) apparently included triggering events, the impact on STRS benefits, changes to asset allocations, operational factors to consider in the event of a terrorist attack, a worldwide epidemic, high inflation, a net loss or some other disaster.

Some of the changes which the Bd. members felt should be part of contingency planning were:

1. Only offering services essential to the pension fund

2. Eliminating all out-of-state travel

3. Freezing salaries

4. Bd. approval of any new hires

5. Grandfathering cuts

6. Dropping health care

7. Changing the age for eligibility for health care

8. Reducing the 35 year benefit.

It was generally agreed in the discussion that the impact on pension benefits would be the last result. Dr. Leone wanted to know how to avoid another $12 billion drop. Mr. Osborn then said that in 1987, the market declined 25% in two days. He said the only way to avoid risks is to put funds into bonds which have low earning power. The only way to address market downturns is diversification he said.

Mr. Mitchell then began his portion of the Contingency Planning presentation with a series of case studies. The first case study showed that the market decline was NOT the result of 9/11. The economy was actually declining prior to 9/11 and the U.S. economic recovery started in the 4th quarter of 2001, the quarter AFTER 9/11. The stock market peaked in March 2000 and had already declined 29% by 9/11. The market value of STRS investment assets was approximately $49 billion on 9/11. The assets declined to $47.5 billion on 06/30/02 and remained essentially the same at $47.3 billion on 06/30/03. (We did have a 12 billion dollar loss though)

Another case study showed that positioning the assets of STRS for a potential negative event can be very costly. Alan Greenspan indicated in late 1996 that the stock market exhibited "irrational exuberance". STRS assets were only $37.9 billion at the time. The stock market continued to rise for the next 3 and a half years. STRS assets increased to $57.5 billion (06/30/00) before declining. In the quarter starting just 19 days after 9/11, the return on STRS total fund was an outstanding +7.7%. In addition, the next quarter (March 2002) also had a positive return of +1.3%.

More than two years ago, when STRS assets were $50 billion, several members urged STRS to eliminate all equities due to potential worldwide turmoil, a potential second terrorist attack, and a rising stock market. Had STRS done so, assets today would be $55 billion, not the actual $72 billion STRS achieved. Dr.Buser was concerned about the high stock market in the spring of 2005. The stock market has risen
+24% since then.

Still another case study showed that STRS' diversified assets provide the best long-term contingency plan for difficult short-term periods. While the stock market suffered a substantial decline of more than 50%, STRS loss was much less:

...RETURNS ........S&P 500...STRS TOTAL FUND

...FISCAL 2001.... -14.8%......- 6.3%

...FISCAL 2002.....-18.0%......- 8.1%

...FISCAL 2003.....+ 0.3%......+ 2.3%

The ten year annual compounded return from fiscal 1997 to fiscal 2006 for the STRS total fund is +8.3% per year. This includes the difficult three year period of fiscal 2001 to fiscal 2003 when the 3 year annual compounded return was -4.2% per year. If the STRS total fund had been invested (during this same time) in long term FIXED, the return would have been +5 and one half % instead of +8.3%.

Mr. Osborn of the Russell Group then discussed risk management elements and the importance of diversification, active management, tactical asset allocation, and time horizon (long-term focus allows system to weather short-term events & medium-term cycles). He mentioned that after dropping $5 billion, STRS then dropped another $9 billion. He said if we had shifted to bonds after the $5 billion drop, STRS would have had less of a drop. BUT in history, the same shift of funds to bonds would have produced even more of a drop. Historically the stock market has come back.

Dr. Leone was critical of the past STRS Executive Director, Herb Dyer, who actually hired 144 more employees for STRS at the time of this drop. Dr. Asbury countered that Dr. Dyer had also let a large number of employees go at this time too.

Craig Rider, the Facilitator, asked "What didn't STRS do that they could have done?" to which Mr. Osborn replied that if we have declines like Enron again, STRS should/would reassess asset allocation immediately. He said that it was an investment fact that any market trigger will be unreliable and that unfortunately this is a fact of life in investing. He said that alternative risk reducing strategies such as conservative asset allocation (less equities) and hedging strategies using options or other derivative strategies are okay over the short term but they are costly over the long term. Using them would immediately worsen returns.

Dr. Puckett said that he has lived through this down period in STRS' history but suggested that we need to explain to our membership that Board members are not just sitting on their hands. Communication with membership should be improved during down periods he said.

Dr. Leone said that we must have a procedure in place in the event that STRS has a heavy loss of returns. Mr. Rider suggested that perhaps STRS could develop a set of actions or procedures to follow in order to review all investments. Dr. Leone asked, "At what point will the pension system be threatened?" He said the STRS Board members should begin now to look at equity factors which may affect the pension solvency on down the road. Chair, Conni Ramser, agreed with Dr. Leone. This plan will be pursued.

Marla Bump, STRS Government Relations, then introduced Aristotle Hutras, Director of the Ohio Retirement Study Council, who spoke informally to the STRS Board members & visitors regarding a review of the political landscape of Ohio and across the country. He reviewed that the ORSC was formed in1968 by the Ohio legislature for the purpose of providing information about the five pension plans and measure them. The council includes 3 Ohio House members, 3 Ohio Senate members and 3 appointed members, and is funded by a percentage of all five retirement systems.

Hutras has worked as Director for the past 17 years. He reminded us that STRS predates Social Security and had the foresight to offer the defined benefit plan. In reviewing the current status in the Statehouse, he said that Blasdel's 700 bill will probably be reworked. He mentioned that GASB 43 (mentioned at the end of the first paragraph above) will put angles on pension funds and that health care liabilities will be huge. He suspects that an attempt will be made to get rid of the defined benefit plan. Senate President Harris allowed the ORSC to do a study on this.

Dr. Leone asked Mr. Hutras if he has explained to Representative Wachtmann that bill 700 would threaten our STRS pension. Hutras expressed concern that language from bill 700 might go into bill 272. The 700 bill has to be introduced first. However, he is optimistic. He says that the legislature will follow the path of least resistance, so he doesn't see any problems. If things do go bad for pensions, it will become Hutras and the ORSC's problem.

Mary Ann Cervantes asked if he suspected resistance to our STRS legislation for health care. She asked what STRS could do. He said to keep doing what we are already doing. He did say that Wachtmann said the legislation was dead on arrival so Hutras said it will be difficult. If the legislation is passed, then SERS will want an increase for health care too. PERS' rate is going up to 13.35%.

He talked about how term limits has hindered rather than helped at the Statehouse. Camaraderie and trust used to be much better among legislators than it is now. They used to have evening meetings and work out problems. He predicts that the current term limits of 8 years will NOT be changed to 12. He also predicts that mandatory Social Security is not on the radar now for teachers. However he did say that the push to eliminate the GPO-WEP just causes renewal of consideration of mandatory Social Security.

Craig Rider, the Retreat Facilitator, had nothing additional to offer so the Retreat was adjourned around 3:30 p.m.