Opeb and prefunding

PFM

OPEB and Pre-Funding for California
Agencies
February 25, 2011
CSMFO

PFM Asset Management LLC Presented By:
50 California Street
Suite 2300
Carlos Oblites, Senior Managing Consultant
San Francisco, CA

© 2011 PFM Asset Management LLC

Alternatives for Attacking the OPEB Issue PFM

Fund?
Not Fund?
Multi-employer trust?
Single employer trust?
VEBA?
Section 115 Trust?

© 2011 PFM Asset Management LLC 2

PFM
Typical Goals

• Ensure adequate liquidity to pay retiree benefits

• Generate sufficient return to minimize need for additional
contributions

• Maintain reasonable level of safety through diversification

• Maintain administrative ease and continuity in managing
cash flow and investments

• Achieve flexibility in adapting the investment to changing
market conditions, cash flows, and actuarial valuations


General Observations PFM

• The liability of every OPEB fund is different in its construction
– Different benefits (health, dental, life, etc.);
– Inconsistent vesting and retirement ages; and
– Employer payment structures (explicit/implicit).

• Medical inflation has far outstripped CPI

• National healthcare (as currently constructed) will not relieve employers of their
liabilities; in fact it may preclude future reductions in benefits

• Bonds have not been widely used to fund liabilities, except where taxing
authority has been expanded

• Asset management trends:
– Asset/liability management being used only minimally;
– Pension-like investing most pervasive; and
– Life insurance, viatical and other non-traditional investment being pushed.

PFM

Managing OPEB Assets:
You Have Choices


Funding Option #1: PAYGO
PFM

• Not really a funding option, but a budget strategy
• Retiree benefits are paid for as an annual budget item
• Need a coherent story for rating agencies and financial statement users about use
of this strategy
Pros Cons
• Minimizes current year expenditures • Structure creates largest possible Unfunded
throughout the life of the benefits Actuarial Accrued Liability (“UAAL”) and
Annual Required Contribution (“ARC”)
• Requires minimal outside professional • Does not address rising cost of providing
assistance retiree benefits
• Actuary every other year • No assets to invest, so no mitigation of
future liabilities
• Auditor
• For actuarial valuation and financial
• Operationally simple, requires no reporting
changes to current processes – Must use lower discount rate
– Have no assets to offset liabilities


Funding Option #2: Internal Service Fund
PFM

• Minimalist funding option, but gets the process started
• Retiree benefits may be paid from the fund or may reimburse the employer for costs
• Helps to create a “better” story for rating agencies and financial statement users

Pros Cons
• Begins to provide funding for future • Structure does not improve UAAL or ARC
benefits that begins to address over PAYGO structure due to lower discount
rate and lack of assets to offset liabilities on
intergenerational equity
balance sheet
• Earns a return on assets that can help • More expensive than PAYGO but addresses
mitigate future cost increases rising cost of providing retiree benefits in
• only a limited manner
Operationally similar to other Internal
Service Funds, requires only minimal • Typically must be invested according to
changes to current processes governmental investment statutes
• Likely requires additional outside
professional assistance of an investment
advisor and custodial bank


Funding Option #3: Irrevocable Trust
PFM

• Best of the funding options
• Retiree benefits may be paid from the Trust or may reimburse the employer for costs
• Creates the best funding story for rating agencies and financial statement users

Pros Cons
• Provides funding for future benefits in a • Significantly higher costs than PAYGO
formal, segregate manner addressing on a year to year basis to provide full
intergenerational equity funding, but may limit total future costs
• Generally, trust assets allowed to • Likely requires changes to current
invested in “prudent person” operational processes
investments which can improve
• Will require additional external
returns over the long-term helping
professional assistance
to mitigate future cost increases
• Structure improves UAAL and ARC
reporting using higher discount rate
and having Trust assets directly offset
liabilities on balance sheet


Types of Trusts
PFM

VEBA 401(h) Section 115

Voluntary adoption Separate account
Structure Governmental trust
by employers under pension trust

No IRS Approval Required   

No IRS Annual Filings   

No Contribution Caps   
Investment Earnings Non-
taxable
  

Benefits Non-taxable   


Different Trust Options
PFM

• Multi-employer options
– Ease of use

– Cost-effective

– Least amount of control

– “Cookie-cutter” approach

• Single-employer options
– More control over actuarial assumptions and process

– Customization to your needs

– More control of risk and return parameters

– Will generally require external professional assistance


PFM

Management of OPEB Trust


Differentiated OPEB Trust Components
PFM

Non-discretionary Model Discretionary Manager Model
Initial Responsibilities Initial Responsibilities
• Create Governance Charter • Can create advisory board/oversight
committee
• Create By-Laws
• Hire Discretionary
• Board Member Selection (with
Advisor/Manager(One)
substantial/majority of unaffiliated
members) Ongoing Responsibilities
• Hire Investment Managers (Two to • Periodically Review Results
Ten)
• Hire/Fire Investment Managers
Ongoing Responsibilities
• Report to Governing Body
• Periodically Review Results
• Hire/Fire Investment Managers
• Report to Governing Body


Non-discreationary Model
PFM

• Basically directed
trustee overseeing
holding of assets

• Fiduciary with
direct responsibility
for investments

• Provides
independent
• Not typically a
valuation of assets
fiduciary over all
aspects of
investments


Discretionary Manager Model
PFM

• Fiduciary
overseeing holding of
assets

• General Oversight,
but no direct
investment duties

• Fiduciary • Provides
overseeing independent
investment functions valuation of assets


Discretionary Managers Should be Independent PFM

& Conflict Free
• Independence
– When offering asset allocation advice, investment options, and
rebalancing decisions

• No conflicts of interest
No soft dollar arrangements
No directed brokerage arrangements
No financial arrangement with investment managers of any type


What Will You Need?
PFM

• Most Agencies do the following:
― Create trust
― Hire trustee/custodian bank
― Create governing/oversight board
― Discretionary versus Non-Discretionary Model
― Review asset/liability profile
― Create appropriate asset allocation
― Create investment policy statement
― Select investments
― Discretionary versus Non-Discretionary Model
― Non-discretionary: Board hires money managers
― Discretionary: Fiduciary investment advisor hires money managers
― Continued oversight and rebalancing
16

Common OPEB Trust Components
PFM

Regardless of Trust and Governance Model
• Governing Body Authorization to Create the Trust

• OPEB Trust

– Document

– Tax ID Number

– Private Letter Ruling (not required)

• Investment Policy and Asset Allocation

• Hire Custodian

– Form W-9

– Authorized Signers


OPEB Implementation process
PFM

• You should begin with the numbers:
– Perform an asset-liability analysis
– Portfolio decisions should align with the plan’s liability structure
– This protects the plan sponsor from claims of underperformance based on
“cookie cutter” solutions
• For example, why would a plan with 50% or more of its liabilities aligned
with retirees with an average expected life of 9-10 years invest 74% of its
portfolio in stocks, equities, and real estate? Would any rational
financial adviser suggest to a 65-year old that a portfolio like that is suitable
under FINRA regulations?

• Asset allocation decisions then take into account client risk
tolerances and perspectives
– Conduct portfolio planning survey process
– Develop a customized Investment Policy Statement with appropriate asset
allocation targets and ranges

Case Study: “A/L Based” Asset Allocation PFM

Vested Participant Unvested Participant
Liabilities Liabilities

$14.6 million $11.8 million
56% 44%

Multi-Asset Class Managed Fixed Income / Cash

Would you establish a 70/30 asset allocation for this plan?


Portfolio Planning Survey Identifies Needs PFM

• Customized portfolio questionnaire designed to assist staff and Committee members
in gaining consensus around investment and financial decisions
Task
• Achieve expectations for future portfolio strategy and manager decisions

1. How often are you prepared to accept the probability of a loss of greater than (-10%)? Once every?
a. Three years
b. Five years
c. Ten years
d. Other _____________________

2. Another measure of risk tolerance is the extent to which the fund’s financial decision makers are comfortable with year to
year volatility of investment returns. How concerned are you with variability in the market value of the pension fund?
a. Very concerned with variability in the fund value
b. Somewhat concerned with year-to-year variability, but more concerned with long-term growth
c. Focused on the long-term growth of the fund, unconcerned with short-term variability

3. The time frame selected to meet your return goal will affect your ability to do so. Due to the cyclical nature of the market,
the longer the time frame, the more likely you are to meet the goal. This is because market upswings and downswings will
average out. What period of time do you think is reasonable to wait to achieve your return goal?
a. Three years
b. Five years
c. Ten years
d. Market Cycle

4. Investment "risk" can be viewed in many different ways. Please circle any of the following which most closely define your
view of risk.
a. The possibility of not achieving a targeted rate of return.
b. Wide swings in the market value of your portfolio over short (1 year) periods of time.
c. Wide swings in the market value of your portfolio over long (3 years) periods of time.
d. Loss of principal


Customized Asset Allocation Analysis PFM

• Creation of customized portfolio options specific to the goals, objectives and risk
Task tolerances of each entity
• Quantify trade-off between risk and return to create efficient portfolios
Reason • Extend diversification of investment strategies and money managers
• Portfolio AND organization/headline risk management

E x p e c te d R e tu rn
20% Distribution of Projected 5 Year Returns 1 3 .0
1 2 .5

1 2 .0 S m a ll / M i d C a p D o m e s t ic E q u it y
17.8%
1 1 .5
FRONTIER BASED ON HISTORICAL ASSET CLASS RETURNS In t e r n a t i o n a l E q u i t y
1 1 .0
15%
14.9% 1 0 .5
L a r g e C a p D o m e s t ic E q u it y
1 0 .0

12.4% 9 .5
12.2%
9 .0
10% 10.6%
8 .5
P o r t fo lio 3
9.2% 8 .0 R e a l E s ta te
%R

P o r t fo lio 2
n
tu
e

8.7%
)
(
r

7.9% 7 .5
P o r t fo lio 1
7.0% 7 .0
C o m m o d it ie s
6 .5
5% 5.3% 5.4% FRONTIER BASED ON PFM ADVISORS’ LONG-TERM PROJECTIONS
4.9% 6 .0

5 .5

5 .0
2.0% A g g r e g a t e F ix e d In c o m e
1.5% 4 .5
0% 0.5% 5 .0 6 .0 7 .0 8 .0 9 .0 1 0 .0 1 1 .0 1 2 .0 1 3 .0 1 4 .0 1 5 .0 1 6 .0 1 7 .0 1 8 .0 1 9 .0 2 0 .0 2 1 .0 2 2 .0
S t a n d a r d D e v ia t i o n ( R is k )
Conservative Balanced Aggressive


Case Study: Proposed Portfolios
PFM

Conservative Balanced
Comparative Comparative
Liability-Driven Liability-Driven
Portfolio C Portfolio D
Portfolio A Portfolio B
Multi-Asset Class 44% 44% 44% 44%
Domestic Equity 28% 33% 42% 55%
International Equity 17% 21% 26% 35%
Other Equity 5% 6% 7% 10%
Fixed Income 50% 40% 25% 0%

Managed Fixed Income 56% 56% 56% 56%
1-3 Year 100% 100% 100% 100%
Cash TBD TBD TBD TBD

Combined Portfolio 100% 100% 100% 100%
Equity 22% 26% 33% 44%
Fixed Income 78% 74% 67% 56%
Cash TBD TBD TBD TBD

Domestic Equity International Equity Other Equity Domestic Equity
Aggregate Fixed Income Short Term Fixed Income / Other Equity
International Equity Cash Aggregate Fixed Income
Domestic Equity Short Term Fixed Income / Other Equity
International Equity Cash Aggregate Fixed Income
Domestic Equity Short Term Fixed Income / Cash Equity
International Equity Other Aggregate Fixed Income Short Term Fixed Income / C

Domestic Equity International Equity Other Equity Aggregate Fixed Income Short Term Fixed Income / Cash


Manager Selection: PFM

Structuring an Efficient Multi-Asset Class Portfolio

• Managers for each asset type Manager Sourcing: 1,500 Managers;
must be selected 5,500 Separate Accounts; and 14,000 Mutual Funds

• For most trusts, investments
Universe Creation: 200+ Managers
will be in the form of mutual
funds
Quantitative Analysis
• Recommendations: 10-20 Managers

• Select best-in-class
Qualitative Review
• Institutional shares 5-6 Managers

• Consider active/passive Diversification
Analysis
strategy 3 Managers
• Review performance and risk
parameters Finalists for inclusion
In Portfolio


Sample Money Managers PFM

Domestic Equity Real Estate & Inflation Hedged
Active Management  Vanguard REIT Index (VGRSX)
 Davis NY Venture (DNVYX)  PIMCO Commodity Real Return (PCRIX)
 American Fundamental Investors (RFNFX)
 FMI Common Stock (FMIMX) Domestic Fixed Income
 Columbia Acorn (ACRNX)
Active Management
Passive Management  PIMCO Total Return (PTTRX)
 Vanguard Total Stock Market Index (VTSSX)  Metropolitan West Total Return (MWTIX)
 Touchstone Core Plus (TCPNX)
 Artio Global High Income (JHYIX)
International Equity
Active Management Passive Management
 Dodge & Cox International Stock (DODFX)  Vanguard Total Bond Market Index (VBTSX)
 American EuroPacific Growth (RERFX)  Vanguard Short-Term Bond Index (VBSSX)
 Oppenheimer

Passive Management
 Vanguard Total International Index (VGTSX)


Final Thoughts
PFM

• When setting up an OPEB Trust
– Ensure that the trust and governance documents are appropriate for you
– Clearly separate the trust and asset management from the employer to protect
assets from creditors
– Create an investment policy that takes your specific liability profile into account
– Use a third-party custodian/trustee to provide a good governance structure
(asset manager/advisor should not also be your custodian)

• When managing an OPEB Trust
– If you are using a discretionary manager/advisor, make sure they are a fiduciary
investment advisor to help mitigate your potential liabilities
– Make sure the fiduciary investment advisor/consultant is independent
– Make sure your advisor/consultant is migrating the asset allocation to match the
liability profile over time
– Monitor your advisor/consultant for compliance with your investment policy

Opeb and prefunding

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