COMMONWEALTH OF PENNSYLVANIA May 27, 2010

PUBLIC EMPLOYEE RETIREMENT COMMISSION

ACTUARIAL NOTE TRANSMITTAL

Bill ID: House Bill Number 2497, Printer's Number 3730

System: Public School Employees’ Retirement System and

State Employees’ Retirement System

Subject: Modification of Actuarial Funding Requirements

SYNOPSIS

House Bill Number 2497, Printer’s Number 3730, would amend both the Public School
Employees’ Retirement Code and the State Employees’ Retirement Code (Codes) to modify the
actuarial funding requirements of the Public School Employees’ Retirement System (PSERS)
and the State Employees’ Retirement System (SERS).

The bill would amend the Public School Employees’ Retirement Code to:

1) Beginning July 1, 2011, re-amortize all of the unfunded actuarial accrued

liabilities of PSERS over a 30-year period using level percentage of pay
amortization payments;

2) Beginning July 1, 2011, extend from five years to ten years the asset
smoothing period over which the fund’s investment gains and losses are
recognized;

3) Fund any increases in accrued liability enacted by legislation subsequent to

June 30, 2010, over a 10-year period using level percentage of pay
amortization payments;

4) For the fiscal year beginning July 1, 2010, establish the total employer
contribution rate as the “final contribution rate” of 5.0% of the total
compensation for all active members, plus the premium assistance
contribution rate;

5) Modify employer contribution requirements to PSERS by imposing limits,

referred to as “collars” on the rate at which employer contributions may rise
from year to year. For the fiscal years beginning July 1, 2011, July 1, 2012,
and on or after July 1, 2013, establish a temporary collared contribution
rate, that if the contribution rate is more than 3%, 3.5% and 4.5%,
respectively, of total compensation of all active members greater than the
 ACTUARIAL NOTE TRANSMITTAL
House Bill No. 2497, P. N. 3730

SYNOPSIS (CONT’D)

prior year’s final contribution rate, then the collared contribution rate shall
be applied and equal to 3%, 3.5% and 4.5%, respectively, of total
compensation for all active members; and

6) For all other fiscal years in which the actuarially required contribution rate
is less than the collared rate, establish the final contribution rate as the
actuarially required contribution rate, provided that the final contribution
rate is not less than the employer normal contribution rate.

The bill would amend the State Employees’ Retirement Code to:

1) Beginning July 1, 2010, re-amortize all of the unfunded actuarial accrued

liabilities of SERS, including previously enacted supplemental annuities,
over a 30-year period using level percentage of pay amortization payments;

2) Maintain the current five-year smoothing period over which investment

gains and losses are recognized;

3) Fund any increase in accrued liability enacted by legislation subsequent to

December 31, 2009, over a 10-year period using level percentage of pay
amortization payments;

4) For the fiscal year beginning July 1, 2010, establish the total employer
contribution rate as the “final contribution rate” of 5.0% of the total
compensation for all active members;

5) Modify employer contribution requirements to SERS by imposing limits,

referred to as “collars,” on the rate at which employer contributions may rise
from year to year. For the fiscal years beginning July 1, 2011, July 1, 2012,
and on or after July 1, 2013, establish a temporary collared contribution
rate, that if the contribution rate is more than 3%, 3.5% and 4.5%,
respectively, of total compensation of all active members greater than the
prior year’s final contribution rate, then the collared contribution rate shall
be applied and equal to 3%, 3.5% and 4.5%, respectively, of total
compensation for all active members; and

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House Bill No. 2497, P. N. 3730

SYNOPSIS (CONT’D)

6) For all other fiscal years in which the actuarially required contribution rate
is less than the collared rate, establish the final contribution rate as the
actuarially required contribution rate, provided that the final contribution
rate is not less than the employer normal contribution rate.

DISCUSSION

The Retirement Codes and Systems

The Public School Employees’ Retirement Code and the State Employees’ Retirement Code
(Codes) are governmental, cost-sharing, multiple-employer pension plans. The designated
purpose of the Public School Employees’ Retirement System (PSERS) and the State
Employees’ Retirement System (SERS) is to provide retirement allowances and other benefits,
including disability and death benefits to public school and state employees. As of June 30,
2009, there were approximately 754 participating employers, generally school districts, area
vocational-technical schools, and intermediate units in PSERS, and approximately 107
Commonwealth and other employers participating in SERS.

Membership in PSERS and SERS is mandatory for most school and state employees. Certain
other employees are not required but are given the option to participate. As of June 30, 2009,
there were 279,701 active members and 177,963 annuitant members of PSERS, and as of
December 31, 2009, there were 110,107 active members and 109,639 annuitant members of
SERS. The annual retirement benefit for most members of both Systems is equivalent to the
product of 2.5 percent of the member’s high three-year average salary multiplied by the
member’s years of service.

Under the Public School Employees’ Retirement Code, superannuation or normal retirement
age is age 62 with at least one full year of service, age 60 with 30 or more years of service, or
any age with 35 years of service. Under the State Employees’ Retirement Code,
superannuation or normal retirement age for most members is age 60 with three years of
service or any age with 35 years of service, while age 50 is the normal retirement age for
members of the General Assembly and certain public safety employees.

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House Bill No. 2497, P. N. 3730

DISCUSSION (CONT’D)

Unfunded Liabilities and Amortization Periods

Generally, the overall funding objective of a public employee pension plan is to provide
reserves sufficient to fund the benefits of plan members when those benefits become due and
to fund, over time, any unfunded liability through installment payments. As the funded ratio
(ratio of assets to liabilities) of a pension plan declines below 100%, the plan’s assets represent
an increasingly smaller portion of the system’s accrued liabilities. A pension trust fund in
which the value of the actuarial accrued liabilities exceeds the actuarial value of assets is said
to have an unfunded actuarial accrued liability. This funding shortfall may occur for many
reasons, including benefit liberalizations, unfavorable investment or other actuarial
experience, changes in major economic or demographic assumptions, or underfunding of the
system by the employer. Based upon the June 30, 2009, actuarial valuations for PSERS, the
retirement system reported unfunded actuarial accrued liabilities totaling $15.7 billion,
representing a funded ratio of 79.2%. Based upon the December 31, 2009, “Valuation
Highlights” provided to the Commission by SERS (the formal actuarial valuation has not yet
been released), SERS reported unfunded actuarial accrued liabilities totaling $5.6 billion,
representing a funded ratio of 84.4%.

The unfunded actuarial accrued liability existing in a pension trust fund must be amortized
over time through installment payments. Under the Codes of both Systems, the permissible
amortization periods are either 10 years or 30 years, depending upon the source of the
liability. Subsequent to the passage of Act 40 of 2003, the amortization period for: 1) the
increased liabilities of Act 9 of 2001; 2) the outstanding balances of the net actuarial losses
incurred by PSERS in fiscal years 2000-01 and 2001-02 and by SERS in calendar year 2002;
and 3) the gains and losses experienced in all future years is 30 years rather than 10 years,
with the amortization contributions calculated as level-dollar payments. Amortization of the
remaining balance of the pre-Act 9 of 2001 unfunded actuarial accrued liability, the future
unfunded actuarial accrued liabilities attributable to benefit changes, including supplemental
annuities, and in the case of PSERS, the gains and losses attributable to the change in the
asset valuation methodology under Act 38 of 2002 continue to be amortized over 10 years on
a level-dollar basis.

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House Bill No. 2497, P. N. 3730

DISCUSSION (CONT’D)

Based on current projections, the Commonwealth will experience large increases in employer
contributions beginning in fiscal year 2012-2013, when the unfunded liability portion of the
employer contribution rate begins to sharply increase. This employer contribution “rate spike”
is the result of large unfunded liabilities generated by four major factors: 1) the two major
market down turns during the past decade, from roughly 2001-2003 and again in 2008; 2) the
benefit enhancement provided to active members of both PSERS and SERS by the passage of
Act 9 of 2001; 3) the additional unfunded liability resulting from the two-tier cost-of-living
adjustment provided to retired PSERS and SERS members by Act 38 of 2002; and 4) changes
to funding methods resulting from the enactment of Act 38 of 2002 and Act 40 of 2003.
Combined, Acts 38 and 40 had the effect of deferring the funding of liability. Of the two, Act
40 had the greatest impact by requiring PSERS and SERS to amortize certain gains and losses
over different periods of time. Under Act 40, the recognition of pre-Act 9 gains was accelerated
by amortizing these gains over a 10-year period, while the recognition of post-Act 9 losses was
delayed by amortizing these losses over 30 years. The result was, in effect, a mismatch of the
amortization of gains and losses, generating a 10-year credit that has suppressed the employer
contribution rate and masked the true costs of the Systems. This 10-year credit will be fully
amortized by fiscal year 2012-2013, which, not coincidentally, corresponds with the first year
of the projected contribution rate spike.

The bill would restructure the amortization periods of both PSERS and SERS for the fiscal
years beginning July 1, 2011, and July 1, 2010, respectively. The bill would require the
Systems to re-amortize all of the unfunded actuarial accrued liabilities of their pension trust
funds over a 30-year period. This “fresh start” of the amortization bases would have the effect
of extending the amortization of the Systems’ current pension liabilities, resulting in a
reduction in the Systems’ annual amortization contribution requirements.

The bill would also require the use of a level-percentage of pay amortization method, rather
than the level-dollar method currently used by both PSERS and SERS. Compared to the level-
dollar amortization method, which results in level installment payments throughout the
course of the amortization period, the level-percentage of pay method will produce
amortization payments that are generally lower than would be the case under the level-dollar
method in the early years of the amortization period, but steadily rise by a level percentage
of pay using each System’s assumed annual payroll increase assumption (4.0% for PSERS and
3.3% for SERS). Although the level-percentage of pay amortization method has the advantage
of helping reduce annual employer contribution requirements in the early years, this method
will result in steadily escalating contribution requirements and ultimately greater total costs.

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House Bill No. 2497, P. N. 3730

DISCUSSION (CONT’D)

Additionally, increases in accrued liability caused by legislation enacted subsequent to June

30, 2010, for PSERS, and subsequent to December 31, 2009, for SERS, would continue to be
amortized over a 10-year period, but would use level percentage of pay amortization payments
instead of level-dollar payments as currently required by the Codes of both Systems.

Asset Smoothing

In public pension systems, asset “smoothing” involves the gradual recognition of investment
gains and losses over time and is part of the method used to determine the actuarial value of
assets in a pension trust fund. One purpose of the various smoothing methods is to avoid large
year-to-year fluctuations in employer contribution requirements that may otherwise result
from volatility in the investment markets.

Both PSERS and SERS currently apply a 5-year smoothing period to recognize investment
gains and losses. The bill would preserve the 5-year smoothing period for SERS, but for
PSERS, the bill would extend from 5 years to 10 years the smoothing period applicable to
investment gains and losses. The Actuarial Standards Board (ASB) is an entity within the
American Academy of Actuaries (AAA) that establishes standards of practice for the actuarial
profession in the United States. Actuarial Standards of Practice No. 44, Selection and Use of
Asset Valuation Methods for Pension Valuations, requires that asset smoothing methods must
recognize “the differences from the market value of assets in a sufficiently short period.” It is
the professional opinion of the Commission’s consulting actuary that ten years is too long a
time period over which to recognize investment gains and losses because such an extended
smoothing period has the potential to produce actuarial values of assets that deviate greatly
from market values of assets. While the extended smoothing period would have the effect of
delaying the recognition of unfavorable investment experience, it would also have the
consequence of delaying recognition of favorable investment experience in future years. In the
short-term, the extended smoothing period would serve to mitigate the negative effects of the
unprecedented investment losses suffered by PSERS in 2008 by extending the period over
which those investment losses are recognized.

Modification of Employer Contribution Requirements

PSERS and SERS are funded through: 1) employer contributions, 2) employee contributions,
and 3) returns on investments. The employer normal contribution rate represents the
employer portion of the value or cost (normal cost) of the benefits earned during a given year,
based upon the Systems’ actuarial funding methods.

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House Bill No. 2497, P. N. 3730

DISCUSSION (CONT’D)

Like most large defined benefit public employee retirement systems throughout the United
States, PSERS and SERS both utilize variations of the entry age normal actuarial cost
method. The entry age normal cost method allocates the annual cost of all future benefits to
be paid by the plan by spreading those costs over the entire period of a member’s service from
the date of entry to the member’s anticipated date of retirement. These costs are expressed
both as a dollar amount and as a percentage of actual or projected payroll. This method
results in the calculation of two costs: 1) the annual contributions required to establish
sufficient reserves to support future retirement benefits when made from entry age to normal
retirement age is the normal cost; and 2) the aggregate normal cost of all members of the plan
for prior years of service is the actuarial accrued liability. If assets of the plan are less than
the accrued liability, then a deficit exists. This deficit is known as an unfunded actuarial
accrued liability. Because this liability has not been accounted for or funded, it must be
amortized through annual payments over a specified number of years, and the required annual
payments are reflected in the total determination of employer annual cost.

The employer contribution requirements for both PSERS and SERS are determined using the
employer portion of the employer normal cost, plus any amortization contribution
requirements necessary to amortize the unfunded liabilities of the System over the statutorily
specified amortization time periods as modified by the experience adjustment factor. The
experience adjustment factor is a reference to the experience of the pension funds, most
importantly, the investment experience of those funds. If gains from positive plan experience
are greater than expected, employer contributions may be reduced. Conversely, losses from
negative plan experience require additional employer contributions to compensate for those
losses.

The bill would modify the methods currently used to determine the employer contribution
requirements for both PSERS and SERS by imposing limits, referred to as “collars” on the rate
at which employer contributions may rise from year-to-year. For the fiscal year beginning July
1, 2010, the total employer contribution rate for each System, referred to in the bill as the
“final contribution rate,” would be equivalent to 5.0% of the total compensation of all active
members, plus in the case of PSERS, the premium assistance contribution rate, and in the
case of SERS, the benefit completion plan contribution rate. For the fiscal years beginning
July 1, 2011, July 1, 2012, and on or after July 1, 2013, the bill would establish temporary
collared contribution rates, equal to 3%, 3.5% and 4.5%, for each year respectively. The collars
would apply only if the calculation of the employer contribution rate results in an actuarially
required contribution rate that is greater than the collared rate. The effect would be to limit
the year-to-year increase in the employer contribution rate by the percentage amounts

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House Bill No. 2497, P. N. 3730

DISCUSSION (CONT’D)

specified for each year. Beginning with the July 1, 2013, fiscal year, and for each year
thereafter, the bill would limit the annual increase in employer contributions to no more than
4.5%, until such time as the actuarially required contribution rate calculated by the Systems’
actuaries results in an increase in the employer rate that is less than the collared rate of 4.5%.
At this point, the collared contribution limits would expire and a new employer contribution
floor rate equal to each System’s employer normal cost rate would be established.

As described previously, the fiscal challenges facing employers and the Commonwealth
resulting from the much publicized pension “rate spike” are significant. However, it should
be noted that the employer contribution collars proposed in the bill represent a departure from
the norms of actuarial funding practice. The effect of the bill would be to suppress the
employer contributions to both PSERS and SERS resulting in significant underfunding of both
retirement systems. In turn, this underfunding will permit the continued growth of the
Systems’ unfunded liabilities resulting in a steady decline in the funded ratios of both PSERS
and SERS.

Establishment of Employer Normal Cost Rate as Minimum Employer Contribution Floor

Act 38 of 2002 first established a 1% minimum employer contribution rate for both PSERS and
SERS. In 2003, the mandated rate was increased through the enactment of Act 40 of 2003 for
both Systems. For PSERS, the minimum employer contribution rate was increased effective
July 1, 2004, from 1% to 4% plus the premium assistance contribution rate. For SERS, the
rate was increased from 1% to: 1) 2% beginning July 1, 2004; 2) 3% beginning July 1, 2005;
and 3) 4% beginning July 1, 2006. Act 8 of 2007 extended and made permanent the 4%
employer floor rate for SERS.

The bill would establish the employer normal cost rate as the new employer contribution floor
rate for all future years following expiration of the temporary collared contribution rates. By
mandating payment of the employer normal contribution rate as the minimum or floor rate
for all future years following expiration of the collared contribution rate, the bill would ensure
that employer contributions in future years will be adequate to fund the costs of benefits
earned in that year. The bill would not impact the cost of benefits already earned (accrued
liability), nor would it directly affect the unfunded liabilities of the Systems.

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House Bill No. 2497, P. N. 3730

SUMMARY OF ACTUARIAL COST IMPACT

The Commission’s consulting actuary has reviewed the bill and the actuarial cost estimates
provided to the Commission by the consulting actuaries for both PSERS and SERS and found
these estimates to be reasonable. The result of these analyses is summarized in the following
three tables. Table I shows the employer contribution rate and the employer contribution
amount for PSERS for Fiscal Year 2011 to Fiscal Year 2042 under current law and under the
bill. Table II shows the same information for SERS. Table III shows a comparison of the
expected funded ratio using the actuarial value of assets for 2009 to 2040 for both PSERS and
SERS under current law and under the bill. As shown in Tables I and II, the anticipated spike
in the employer contribution rate in 2013 under current law would be delayed if the bill is
enacted. For both Systems, the actuarially required contribution rate would be reached in
2016 and the collared contribution rates would then expire. The estimates show that the
employer contribution rate for PSERS increases to 23% by 2016 and then gradually increases
to approximately 29% beginning in 2029 through 2041 before decreasing to 18.9% in 2042. The
employer contribution rate for SERS increases to about 25% beginning in 2016 through 2040
before decreasing to 19.6% in the year 2041. It should also be noted that the gradual increase
in the employer contribution rate for PSERS is due to the appropriation payroll increasing at
less than the assumed payroll growth of 4.0% per year. The projected appropriation payroll
for SERS increases at the assumed payroll growth of 3.3% per year.

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House Bill No. 2497, P. N. 3730

SUMMARY OF ACTUARIAL COST IMPACT (CONT’D)

Table I

Public School Employees' Retirement System

Projected Em ployer Contribution Rates
Fiscal Year 2011 to 2042

($ amounts in millions)

Current Law House Bill 2497 Increase / (Decrease)

Fiscal
Year
Ending Appropriation Employer Contribution Employer Contribution Employer Contribution
June 30 Payroll Rate Amount Rate Amount Rate Amount

2011 $13,510.0 8.22% $1,110.5 5.64% $762.0 -2.58% $(348.5)

2012 13,920.9 10.59% 1,474.2 8.72% 1,213.9 -1.87% (260.3)
2013 14,345.3 29.22% 4,191.7 12.22% 1,753.0 -17.00% (2,438.7)
2014 14,797.7 32.09% 4,748.6 16.71% 2,472.7 -15.38% (2,275.9)
2015 15,280.1 33.60% 5,134.1 21.20% 3,239.4 -12.40% (1,894.7)
2016 15,794.5 33.27% 5,254.8 23.31% 3,681.7 -9.96% (1,573.1)
2017 16,341.3 32.74% 5,350.1 24.32% 3,974.2 -8.42% (1,375.9)
2018 16,926.7 32.06% 5,426.7 25.29% 4,280.8 -6.77% (1,145.9)
2019 17,557.7 31.27% 5,490.3 26.36% 4,628.2 -4.91% (862.1)
2020 18,232.1 30.42% 5,546.2 27.25% 4,968.2 -3.17% (578.0)
2021 18,948.0 29.56% 5,601.0 27.53% 5,216.4 -2.03% (384.6)
2022 19,703.2 28.75% 5,664.7 27.77% 5,471.6 -0.98% (193.1)
2023 20,493.7 27.95% 5,728.0 27.96% 5,730.0 0.01% 2.0
2024 21,321.5 27.18% 5,795.2 28.12% 5,995.6 0.94% 200.4
2025 22,185.0 26.44% 5,865.7 28.24% 6,265.0 1.80% 399.3
2026 23,081.8 25.74% 5,941.3 28.34% 6,541.4 2.60% 600.1
2027 24,006.8 25.05% 6,013.7 28.40% 6,817.9 3.35% 804.2
2028 24,958.6 24.40% 6,089.9 28.46% 7,103.2 4.06% 1,013.3
2029 25,937.5 23.78% 6,167.9 28.51% 7,394.8 4.73% 1,226.9
2030 26,944.0 23.19% 6,248.3 28.55% 7,692.5 5.36% 1,444.2
2031 27,978.1 22.63% 6,331.4 28.60% 8,001.7 5.97% 1,670.3
2032 29,041.5 22.10% 6,418.2 28.65% 8,320.4 6.55% 1,902.2
2033 30,136.5 19.46% 5,864.6 28.70% 8,649.2 9.24% 2,784.6
2034 31,268.4 18.16% 5,678.3 28.75% 8,989.7 10.59% 3,311.4
2035 32,446.3 16.82% 5,457.5 28.79% 9,341.3 11.97% 3,883.8
2036 33,675.8 15.65% 5,270.3 28.81% 9,702.0 13.16% 4,431.7
2037 34,956.6 14.33% 5,009.3 28.85% 10,085.0 14.52% 5,075.7
2038 36,292.1 13.88% 5,037.3 28.88% 10,481.2 15.00% 5,443.9
2039 37,690.6 14.64% 5,517.9 28.89% 10,888.8 14.25% 5,370.9
2040 39,153.0 14.47% 5,665.4 28.91% 11,319.1 14.44% 5,653.7
2041 40,680.0 13.15% 5,349.4 28.91% 11,760.6 15.76% 6,411.2
2042 42,266.6 12.18% 5,148.1 18.87% 7,975.7 6.69% 2,827.6

Total: $169,590.6 $210,717.2 $41,126.6

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House Bill No. 2497, P. N. 3730

SUMMARY OF ACTUARIAL COST IMPACT (CONT’D)

Table II

State Employees' Retirement System

Projected Em ployer Contribution Rates
Fiscal Year 2011 to 2042
($ amounts in m illions)

Fiscal Current Law House Bill 2497 Increase / (Decrease)

Year Appropriation Employer Contribution Employer Contribution Employer Contribution

June 30 Payroll Rate Amount Rate Amount Rate Amount

2011 $5,936.0 5.64% $335.0 5.00% $296.8 -0.64% $(38.2)

2012 6,131.9 7.98% 489.0 8.00% 490.6 0.02% 1.6
2013 6,334.2 26.66% 1,688.4 11.50% 728.4 -15.16% (960.0)
2014 6,543.3 29.22% 1,911.7 16.00% 1,046.9 -13.22% (864.8)
2015 6,759.2 27.72% 1,873.5 20.50% 1,385.6 -7.22% (487.9)
2016 6,982.2 27.46% 1,917.0 24.53% 1,712.9 -2.93% (204.1)
2017 7,212.7 27.09% 1,953.9 24.79% 1,788.1 -2.30% (165.8)
2018 7,450.7 26.64% 1,985.2 24.87% 1,853.3 -1.77% (131.9)
2019 7,696.5 26.16% 2,013.4 24.92% 1,917.9 -1.24% (95.5)
2020 7,950.5 25.69% 2,042.1 24.96% 1,984.4 -0.73% (57.7)
2021 8,212.9 25.22% 2,071.2 24.99% 2,052.8 -0.23% (18.4)
2022 8,483.9 24.76% 2,100.9 25.03% 2,123.3 0.27% 22.4
2023 8,763.9 24.32% 2,131.5 25.06% 2,196.2 0.74% 64.7
2024 9,053.1 23.89% 2,163.0 25.09% 2,271.5 1.20% 108.5
2025 9,351.8 23.48% 2,195.5 25.12% 2,349.4 1.64% 153.9
2026 9,660.5 23.07% 2,229.1 25.15% 2,430.0 2.08% 200.9
2027 9,979.3 22.69% 2,263.9 25.18% 2,513.3 2.49% 249.4
2028 10,308.6 22.31% 2,299.7 25.22% 2,599.4 2.91% 299.7
2029 10,648.8 21.94% 2,336.7 25.25% 2,688.5 3.31% 351.8
2030 11,000.2 21.59% 2,375.0 25.28% 2,780.6 3.69% 405.6
2031 11,363.2 21.25% 2,414.5 25.31% 2,875.9 4.06% 461.4
2032 11,738.2 20.92% 2,455.3 25.34% 2,974.5 4.42% 519.2
2033 12,125.5 18.83% 2,283.7 25.37% 3,076.4 6.54% 792.7
2034 12,525.7 17.83% 2,233.3 25.40% 3,181.8 7.57% 948.5
2035 12,939.0 17.37% 2,247.8 25.43% 3,290.8 8.06% 1,043.0
2036 13,366.0 15.87% 2,121.2 25.46% 3,403.6 9.59% 1,282.4
2037 13,807.1 15.39% 2,125.1 25.50% 3,520.2 10.11% 1,395.1
2038 14,262.7 15.46% 2,205.1 25.53% 3,640.8 10.07% 1,435.7
2039 14,733.4 16.43% 2,420.5 25.56% 3,765.5 9.13% 1,345.0
2040 15,219.6 14.92% 2,270.8 25.59% 3,894.5 10.67% 1,623.7
2041 15,721.8 14.14% 2,223.0 19.61% 3,083.1 5.47% 860.1
2042 16,240.6 13.21% 2,144.7 17.73% 2,879.0 4.52% 734.3

Total: $65,520.7 $76,796.0 $11,275.3

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House Bill No. 2497, P. N. 3730

SUMMARY OF ACTUARIAL COST IMPACT (CONT’D)

Table III

Projected Impact on PSERS and SERS Funded Ratios

PSERS' Funded Ratio SERS' Funded Ratio

Valuation Current House Increase/ Current House Increase/
Year Law Bill 2497 (Decrease) Law Bill 2497 (Decrease)

2009 79.2% 79.2% 0.0% 84.4% 84.4% 0.0%

2010 73.4% 73.9% 0.5% 79.0% 79.7% 0.7%
2011 66.8% 69.9% 3.1% 72.3% 73.4% 1.1%
2012 58.3% 66.2% 7.9% 66.4% 66.1% -0.3%
2013 54.2% 62.8% 8.6% 68.0% 65.8% -2.2%
2014 55.1% 60.0% 4.9% 68.8% 65.3% -3.5%
2015 56.7% 57.8% 1.1% 69.8% 65.4% -4.4%
2016 58.5% 55.7% -2.8% 70.9% 65.8% -5.1%
2017 60.5% 53.5% -7.0% 72.0% 66.3% -5.7%
2018 62.6% 51.8% -10.8% 73.2% 66.9% -6.3%
2019 64.7% 51.9% -12.8% 74.3% 67.5% -6.8%
2020 66.8% 52.2% -14.6% 75.5% 68.1% -7.4%
2021 68.9% 52.8% -16.1% 76.6% 68.8% -7.8%
2022 71.0% 53.6% -17.4% 77.8% 69.5% -8.3%
2023 73.0% 54.6% -18.4% 79.0% 70.4% -8.6%
2024 75.0% 55.8% -19.2% 80.2% 71.2% -9.0%
2025 77.0% 57.1% -19.9% 81.4% 72.2% -9.2%
2026 79.0% 58.6% -20.4% 82.7% 73.3% -9.4%
2027 80.9% 60.2% -20.7% 84.0% 74.4% -9.6%
2028 82.8% 61.9% -20.9% 85.3% 75.6% -9.7%
2029 84.6% 63.7% -20.9% 86.6% 76.9% -9.7%
2030 86.5% 65.6% -20.9% 88.0% 78.2% -9.8%
2031 88.2% 67.5% -20.7% 89.5% 79.7% -9.8%
2032 90.0% 69.6% -20.4% 90.6% 81.3% -9.3%
2033 91.4% 71.7% -19.7% 91.6% 82.9% -8.7%
2034 92.7% 73.9% -18.8% 92.6% 84.7% -7.9%
2035 93.8% 76.2% -17.6% 93.4% 86.5% -6.9%
2036 94.7% 78.6% -16.1% 94.1% 88.5% -5.6%
2037 95.5% 81.0% -14.5% 94.9% 90.5% -4.4%
2038 96.2% 83.6% -12.6% 95.9% 92.7% -3.2%
2039 97.1% 86.3% -10.8% 96.7% 94.9% -1.8%
2040 97.9% 89.0% -8.9% 97.4% 96.3% -1.1%

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 ACTUARIAL NOTE TRANSMITTAL
House Bill No. 2497, P. N. 3730

POLICY CONSIDERATIONS

In reviewing the bill, the Commission identified the following policy considerations.

Appropriateness of Departure from Actuarial Funding Standards. ( ) The bill would

reduce the actuarially required contribution rate to both PSERS and SERS for several
years, effectively delaying the anticipated spike in employer contribution rates
projected to begin in 2013. The Commission is well aware of the fiscal challenges
facing the Commonwealth resulting from the anticipated pension contribution spike.
However, it must be noted that the temporary collared contribution rates proposed in
the bill do not follow generally accepted actuarial standards of practice. The short-
term effect of the bill would be to defer the payment of actuarially required
contributions to both PSERS and SERS, resulting in the underfunding of both
retirement systems. This underfunding will permit the continued growth of the
Systems’ unfunded liabilities resulting in a steady decline in the funded ratios of both
PSERS and SERS. The bill appears to be intended to delay the anticipated
contribution increases, spread those increases over many future years, but to
determine contribution rates in an actuarially sound manner in the long term. The
Commonwealth’s policymakers must determine whether the temporary departure from
actuarial funding proposed by the bill is consistent with the Commonwealth’s pension
plan funding and fiscal management goals.

Re-amortization of Pension Liabilities. ( ) The bill would require PSERS and SERS
to re-amortize all of the unfunded actuarial accrued liabilities of their pension trust
funds over a 30-year period. The re-amortization of pension plan liabilities is a
legitimate actuarial technique. Under the level percentage of pay amortization method
proposed in the bill, the unfunded accrued liability of both PSERS and SERS is
expected to increase for the first 18 to 20 years, because the amortization payments
will be insufficient to pay the interest accruing on the outstanding balance of the
unfunded liabilities of the Systems. Contributions in the later years of the
amortization period will therefore be much higher to compensate for the years that
payments made were less than the interest on the outstanding balance. Therefore, the
fresh start re-amortization of liabilities combined with the use of level percent of pay
amortization payments will have the advantage of reducing annual employer
contribution requirements in the short term, but long term will result in much higher
contributions in later years and ultimately in greater total costs to the Commonwealth
and other employers.

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 ACTUARIAL NOTE TRANSMITTAL
House Bill No. 2497, P. N. 3730

POLICY CONSIDERATIONS (CONT’D)

Extended Smoothing Period. ( ) For PSERS, the bill would extend from five years to
ten years the smoothing period applicable to the investment gains and losses of the
System. The Actuarial Standards Board (ASB) is an entity within the American
Academy of Actuaries (AAA) that establishes standards of practice for the actuarial
profession in the United States. Actuarial Standards of Practice No. 44, Selection and
Use of Asset Valuation Methods for Pension Valuations, requires that asset smoothing
methods must recognize “the differences from the market value of assets in a sufficiently
short period.” It is the professional opinion of the Commission’s consulting actuary that
ten years is too long a time period over which to recognize investment gains and losses
because such an extended smoothing period has the potential to produce actuarial
values of assets that deviate greatly from market values of assets. While the extended
smoothing period would have the advantage of delaying the recognition of unfavorable
investment experience, it would also have the consequence of delaying recognition of
favorable investment experience in future years. In the short-term, the extended
smoothing period would serve to mitigate the negative effects of the unprecedented
investment losses suffered by PSERS in 2008 by extending the period over which those
investment losses are recognized.

New Employer Contribution Floor. (+ ) The bill would establish the employer normal
cost rate as the new employer contribution floor rate for all future years following
expiration of the temporary collared contribution rates. Normal cost equates to the
value or “cost” of benefits accrued by active members in a given year. By mandating
payment of the employer portion of the normal cost rate as the minimum contribution
rate for all future years following expiration of the collared contribution rate, the bill
would ensure that employer contributions in future years will be adequate to fund the
costs of benefits earned in that year. The bill would not impact the cost of benefits
already earned (accrued liability), nor would it affect the unfunded liabilities of the
Systems.

Technical Drafting Consideration. ( ) The bill would amend section 5508(f)(1) of the
SERS Code, pertaining to the “experience adjustment factor,” to state that one of the
permissible causes for an increase or decrease in the unfunded accrued liability of the
System may be “changes in contributions caused by the final contribution rate being
different from the actuarially required contribution rate.” The bill does not make a
corresponding amendment relating to the experience adjustment factor in the PSERS
Code. The bill sponsor may wish to consider an amendment to section 8328(e)(1) of the
PSERS Code to provide specificity similar to that for the SERS Code.

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 ACTUARIAL NOTE TRANSMITTAL
House Bill No. 2497, P. N. 3730

COMMISSION RECOMMENDATION

The Commission voted to attach the actuarial note to the bill, recommending that the General
Assembly and the Governor consider the policy issues identified above.

ATTACHMENTS

Actuarial Note provided by Katherine A. Warren and Timothy J. Nugent of Milliman, Inc.

Actuarial cost estimate provided by Buck Consultants, consulting actuary for the Public School
Employees Retirement System.

Actuarial cost estimate provided by the Hay Group, consulting actuary for the State
Employees Retirement System.

House Bill Number 2497, Printer's Number 3730.

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