Why Establish a Written Funding Policy?

Would you ever try to drive from Florida to Alaska without first looking at a map? What would you do if you got halfway there and realized a bridge was closed or a long stretch of the highway was under construction? Would you not get out that same map (or GPS device) and find the best alternate route? You’d probably feel pretty lost on such a long trip if you didn’t bring a road map (or a GPS device) along with you, right?

Well, in essence, many pension plans are doing just that – not bringing a road map along with them. They’re trying to get from “Florida” (their current situation) to “Alaska” (the destination – the successful funding of all current and future pension benefits as smoothly, efficiently and equitably as possible) without a road map (a formal, written funding policy).

Long-term successful funding of the costs associated with promised pension benefits is the single most important objective of pension plan trustees. It’s a long and complex process which requires careful planning and continued responsiveness to evolving circumstances and changes in the environment. A written funding policy will help tremendously by providing a road map to assist with long-term planning and enable navigation over the bumps in the road which will inevitably be encountered throughout the course of a pension plan’s lifetime.

Up until now, the Annual Required Contribution (the “ARC”), which is calculated each year by the pension plan’s actuary, has represented the de facto public-sector pension funding standard. So you might ask yourself, why should my pension plan need a written funding policy that just tells us to simply contribute the ARC each year? Well, for starters, because the ARC will soon become a thing of the past. The Governmental Accounting Standards Board (GASB) has adopted new accounting standards (effective in 2014) which separate accounting from funding standards and eliminate the ARC (note that the state of Florida funding requirements under Chapters 112, 175 and 185 will remain in place, which require a minimum contribution to be calculated which is similar to the GASB ARC). The new GASB standards will require pension plans to disclose their funding policies along with a comparison to their actual funding patterns. Therefore, the new GASB standards significantly increase the need to have a written funding policy in place, and it would be prudent to include a description of the funding policy in the annual actuarial valuation report along with a statement of whether or not it is being followed.

In addition to GASB, the Government Finance Officers Association’s (GFOA) Best Practice, “Sustainable Funding Practices of Defined Benefit Pension Plans,” states that the main objective of public employee defined benefit plans is to fund the long-term costs of promised benefits to plan participants. The GFOA recommends this be done through a systematic and disciplined process of accumulating sufficient resources (through contributions and investment earnings) to pay all promised benefits to plan members over their lifetimes. The best way to accomplish this is by establishing a funding policy.

The GFOA Best Practice’s goals for a funding policy include (1) keeping contributions relatively stable from year to year (to be consistent with the governmental budgeting process), (2) satisfaction of the principle of intergenerational equity (allocating pension costs to taxpayers on an equitable basis over time) and (3) making efforts to provide a reasonable margin for adverse experience.

What Should Be Included in a Written Funding Policy?

The primary ingredients of a sound Funding Policy include documentation of all decisions (and the reasoning behind them) regarding all items affecting the annual level of funding in a pension plan. These items include:

• The actuarial cost method to be used (Entry Age Normal, Aggregate, etc.)
• The amortization method (level dollar or level percent of pay)
• The length of the amortization periods
• Whether the same or different amortization periods will be used for various sources of changes in the unfunded liability (such as assumption changes, benefit changes and experience gains/losses)
• The asset valuation method (including the parameters of the asset smoothing method, if used)
• The discount rate and all other economic and demographic assumptions
• How often the assumptions will be reviewed and adjusted to bring them in line with actual experience
• The funding target (this should generally be 100% of the actuarial accrued liability)

The funding policy should also include provisions to manage risk and volatility and be adaptable to changing circumstances. It should not attempt to produce the lowest contribution rate possible, but should lead to the contribution rate best suited to achieving full funding as smoothly and efficiently as possible. It should address what should be done when the plan is overfunded and what to do when the plan is underfunded, and the funding policy components should be treated symmetrically regardless of whether the plan is over or underfunded. For example, amortization periods should be the same number of years regardless of the plan’s funded level.

Overfunding situations could present an opportunity to protect the pension fund from future volatility and ensure the stability of future annual funding levels. For example, when many pension plans were over 100% funded in the 1990’s, a written funding policy could have been in place that required at least the normal cost to be contributed each year. The resulting additional contributions would have created a cushion that may have helped offset some of the escalation in pension costs in recent years. The requirement to contribute at least the normal cost each year became state law in Florida under Senate Bill 1128, but it would have been sound practice historically.

The funding policy should not exist in a vacuum, but should instead be linked to the plan’s other written policies, including the plan’s investment policy, governance policy, legislative policy, benefits policy and administrative policy. For instance, the funding policy could overlap with, or be directly linked to, the plan’s investment policy by specifying that adjustments be made to the pension fund’s asset allocation if the plan becomes more than 100% funded, such as a reallocation into more conservative investments. This would require a simultaneous reduction in the plan’s assumed investment return assumption, but would increase the future stability of contribution levels by removing a portion of the fund’s future investment return volatility. The funding policy might also include provisions for purchasing annuities for retirees if the plan becomes fully funded in order to remove a portion of both the longevity and investment risk from the plan.

The actual development of the funding policy should involve the pension plan’s actuary, the Board (which is responsible for choosing the actuarial assumptions and methods), and the City (who is responsible for making the pension contributions). These three groups should cooperate and collaborate with each other to create this important document.

In summary, funding policies should be written in such a way as to satisfy a wide range of objectives, including funding the long-term costs of all promised benefits, keeping annual contributions relatively stable from year to year, allocating pension costs to taxpayers on an equitable basis over time, and managing pension risks. Once established, a funding policy should document the decisions made and the underlying reasons for each decision. It will then help decision makers understand the tradeoffs related to reaching each of the goals of the funding policy and come to a better understanding of the principles and practices that will help sustain pension benefits over the long-term.