PFM OPEB and PreFunding for California Agencies February
PFM OPEB and Pre-Funding for California Agencies February 25, 2011 CSMFO PFM Asset Management LLC 50 California Street Suite 2300 San Francisco, CA © 2011 PFM Asset Management LLC Presented By: Carlos Oblites, Senior Managing Consultant
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 1
Typical Goals PFM • 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 © 2011 PFM Asset Management LLC 2
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. © 2011 PFM Asset Management LLC 3
PFM Managing OPEB Assets: You Have Choices © 2011 PFM Asset Management LLC 4
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 • Minimizes current year expenditures throughout the life of the benefits • Requires minimal outside professional assistance • Actuary every other year Cons • Structure creates largest possible Unfunded Actuarial Accrued Liability (“UAAL”) and Annual Required Contribution (“ARC”) • Does not address rising cost of providing retiree benefits • No assets to invest, so no mitigation of future liabilities • For actuarial valuation and financial reporting • Auditor • Operationally simple, requires no changes to current processes – Must use lower discount rate – Have no assets to offset liabilities © 2011 PFM Asset Management LLC 5
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 • Structure does not improve UAAL or ARC over PAYGO structure due to lower discount rate and lack of assets to offset liabilities on balance sheet Earns a return on assets that can help mitigate future cost increases • Operationally similar to other Internal Service Funds, requires only minimal changes to current processes More expensive than PAYGO but addresses rising cost of providing retiree benefits in only a limited manner • Typically must be invested according to governmental investment statutes • Likely requires additional outside professional assistance of an investment advisor and custodial bank • Begins to provide funding for future benefits that begins to address intergenerational equity • • © 2011 PFM Asset Management LLC 6
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 formal, segregate manner addressing intergenerational equity • Significantly higher costs than PAYGO on a year to year basis to provide full funding, but may limit total future costs • Generally, trust assets allowed to invested in “prudent person” investments which can improve returns over the long-term helping to mitigate future cost increases • Likely requires changes to current operational processes • Will require additional external professional assistance • Structure improves UAAL and ARC reporting using higher discount rate and having Trust assets directly offset liabilities on balance sheet © 2011 PFM Asset Management LLC 7
Types of Trusts PFM VEBA 401(h) Section 115 Voluntary adoption by employers Separate account under pension trust Governmental trust No IRS Approval Required No IRS Annual Filings No Contribution Caps Investment Earnings Nontaxable Benefits Non-taxable Structure © 2011 PFM Asset Management LLC 8
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 © 2011 PFM Asset Management LLC 9
PFM Management of OPEB Trust © 2011 PFM Asset Management LLC 10
Differentiated OPEB Trust Components Non-discretionary Model Initial Responsibilities • Create Governance Charter • Create By-Laws • Board Member Selection (with substantial/majority of unaffiliated members) • Hire Investment Managers (Two to Ten) Ongoing Responsibilities PFM Discretionary Manager Model Initial Responsibilities • Can create advisory board/oversight committee • Hire Discretionary Advisor/Manager(One) Ongoing Responsibilities • Periodically Review Results • Hire/Fire Investment Managers • Report to Governing Body © 2010 PFM Asset Management LLC 11
Non-discreationary Model • Basically directed trustee overseeing holding of assets Custodian Trust Board (Fiduciaries) • Not typically a fiduciary over all aspects of investments © 2010 PFM Asset Management LLC Investment Managers PFM • Fiduciary with direct responsibility for investments Actuary • Provides independent valuation of assets 12
Discretionary Manager Model • Fiduciary overseeing holding of assets PFM Bank Trustee (Custodian) Oversight Committee • Fiduciary overseeing investment functions © 2010 PFM Asset Management LLC Investment Advisor • General Oversight, but no direct investment duties Actuary • Provides independent valuation of assets 13
Discretionary Managers Should be Independent & Conflict Free PFM • Independence – When offering asset allocation advice, investment options, and rebalancing decisions • No conflicts of interest üNo soft dollar arrangements üNo directed brokerage arrangements üNo financial arrangement with investment managers of any type © 2011 PFM Asset Management LLC 14
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 15
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 © 2011 PFM Asset Management LLC 16
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 © 2011 PFM Asset Management LLC 17
Case Study: “A/L Based” Asset Allocation Vested Participant Liabilities $14. 6 million 56% PFM Unvested Participant Liabilities $11. 8 million 44% Would you establish a 70/30 asset allocation for this plan? © 2011 PFM Asset Management LLC 18
Portfolio Planning Survey Identifies Needs Task PFM • Customized portfolio questionnaire designed to assist staff and Committee members in gaining consensus around investment and financial decisions • Achieve expectations for future portfolio strategy and manager decisions © 2011 PFM Asset Management LLC 19
Customized Asset Allocation Analysis Task • Creation of customized portfolio options specific to the goals, objectives and risk tolerances of each entity Reason • Quantify trade-off between risk and return to create efficient portfolios • Extend diversification of investment strategies and money managers • Portfolio AND organization/headline risk management PFM Distribution of Projected 5 Year Returns © 2011 PFM Asset Management LLC 20
Case Study: Proposed Portfolios PFM Conservative Liability-Driven Portfolio A Balanced Liability-Driven Portfolio B Comparative Portfolio C Comparative Portfolio D Multi-Asset Class Domestic Equity International Equity Other Equity Fixed Income 44% 28% 17% 5% 50% 44% 33% 21% 6% 40% 44% 42% 26% 7% 25% 44% 55% 35% 10% 0% Managed Fixed Income 1 -3 Year Cash 56% 100% TBD Combined Portfolio Equity Fixed Income Cash 100% 22% 78% TBD 100% 26% 74% TBD 100% 33% 67% TBD 100% 44% 56% TBD © 2011 PFM Asset Management LLC 21
Manager Selection: Structuring an Efficient Multi-Asset Class Portfolio • Managers for each asset type must be selected • For most trusts, investments will be in the form of mutual funds • Recommendations: PFM Manager Sourcing: 1, 500 Managers; 5, 500 Separate Accounts; and 14, 000 Mutual Funds Universe Creation: 200+ Managers Quantitative Analysis 10 -20 Managers • Select best-in-class • Institutional shares Qualitative Review 5 -6 Managers • Consider active/passive strategy • Review performance and risk parameters © 2011 PFM Asset Management LLC Diversification Analysis 3 Managers Finalists for inclusion In Portfolio 22
Sample Money Managers Domestic Equity Active Management § Davis NY Venture (DNVYX) § American Fundamental Investors (RFNFX) § FMI Common Stock (FMIMX) § Columbia Acorn (ACRNX) Passive Management § Vanguard Total Stock Market Index (VTSSX) International Equity Active Management PFM Real Estate & Inflation Hedged § Vanguard REIT Index (VGRSX) § PIMCO Commodity Real Return (PCRIX) Domestic Fixed Income Active Management § PIMCO Total Return (PTTRX) § Metropolitan West Total Return (MWTIX) § Touchstone Core Plus (TCPNX) § Artio Global High Income (JHYIX) Passive Management § Dodge & Cox International Stock (DODFX) § Vanguard Total Bond Market Index (VBTSX) § American Euro. Pacific Growth (RERFX) § Vanguard Short-Term Bond Index (VBSSX) § Oppenheimer Passive Management § Vanguard Total International Index (VGTSX) © 2011 PFM Asset Management LLC 23
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 © 2011 PFM Asset Management LLC 24
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