SOURCE: LOCAL GOVERNMENT FINANCE – CONCEPTS & …
NOTES FOR GFOA EXAM
PENSION & BENEFITS
RISK MANAGEMENT
PROCUREMENT
June 1, 2001
Philadelphia, PA
Compiled by:
Agnes T. Walker
Revenue Officer
City of Long Beach
SOURCES: RISK MANAGEMENT
1. Local Government Finance: Concepts & Practices – Chapter 18
2. ICMA Service Report: Risk Management –
A Comprehensive Approach
3. An Elected Official’s Guide to Risk Management
SOURCES: PENSION & BENEFITS
1. An Elected Official’s Guide to Defined Benefit &
Defined Contribution Retirement Plans
2. The Legal Obligations of Public Pension Plan
Governing Boards & Administrators
3. Local Government Finance – Concepts & Practices: Chapter 19
4. Handbook of State & Local Government Finance – The Management
of State & Local Retirement Plans
5. Pension Fund Investing
6. GFOA Recommended Practices (Section on Retirement Benefits)
SOURCES: PROCUREMENT
1. Local Government Finance: Concepts & Practices – Chapter 17
2. An Elected Official’s Guide to Procurement
NOTE:
I am happy to share the notes I have taken while reading the materials for the GFOA CPFO exam on Pension & Benefits, Risk Management, and Procurement. However, I must caution you not to completely rely on these notes as they do not necessarily have all the information required in the exam.
Also, please excuse any typos and the borders on some of the bullets. I could not figure out how to remove them.
For those who are taking the Certification Program for the first time, my notes on the other examination can be found on the CSMFO website. I am not sure if they are the updated versions.
Good luck to all candidates!
RISK MANAGEMENT
SOURCE: LOCAL GOVERNMENT FINANCE – CONCEPTS & PRACTICES –
CHAPTER 18
The emergence of risk management has been fostered by the govt’s need to provide services, guard against economic loss and ensure public safety in time of uncertain legal liability and increasing litigation.
Risk management resembles a typical planning process/formal method to:
✓ Identify risks
✓ Evaluate their frequency and potential severity
✓ Decide w/c method is best for dealing w/ them
✓ Implement the chosen method(s)
Why govt should develop full-fledged risk management prog:
✓ Results in more effective use of funds
✓ Overall costs are decreased while productivity is increased
✓ Identifies exposures that can be covered by means other than insurance
✓ Helps make communities more attractive to insurance companies therefore increase insurance availability
✓ Can lower expenditures by reducing overall costs of risks
✓ Reduces uncertainties associated w/ future projects
Steps in risk management:
✓ Risk identification – outline potential exposure to loss
✓ Risk evaluation – analyze potential for loss based on historical/future/frequency/severity
✓ Risk treatment – review alternatives to deal w/ risks including control/financing
✓ Implementing the best alternative
6 types of risks:
✓ legal liability to others – injuries/prop damage/actions of employees/officials
✓ property loss – accidental loss/damage
✓ extra expenses
✓ loss of income
✓ human resources loss
✓ crime and fidelity loss
Potential financial loss is measured by frequency and degree (severity) of loss.
Review of prior loss expenses – best predictor of future losses.
Steps to evaluate severity of liability exposure:
✓ Review state laws/claims history/suits in nearby communities/recent court cases.
✓ Identify liability exposure most likely to affect organization.
✓ Estimate potential losses from all events that might occur.
Property valuation should include 2 estimates of potential total probable and maximum possible loss.
Maximum probable – worst loss occurring under average conditions
Maximum possible – worst case scenario predicting the greatest conceivable loss assuming all safety measures fail – estimates should also project indirect costs stemming from disruption of daily operations, loss of income and other expenses
Types of risks and their treatment:
✓ Low frequency/low severity – paid from operating funds or claims reserves
✓ High frequency/low severity – paid from operating funds or claims reserves
✓ Low frequency/high severity – insurance or pool coverage
✓ High frequency/high severity – insurance is often best financing
Risk control techniques/treatment:
✓ risk avoidance – most complete way to manage risk – eliminates chance of loss altho’ some public services have to be provided regardless of risk
✓ loss prevention/control – steps taken to reduce likelihood that risk will occur; e.g., fire safety training prog; smoke detectors, etc.
✓ risk transfer – (to another party, e.g., insurance) more feasible than avoidance since service is continued but protects jurisdiction
✓ insurance - commercial is most common – designed in layers – primary is first layer; excess pays beyond primary level; umbrella covers all primary liability insurance as well as self-funded retentions not covered by any insurance but does not provide complete coverage for all perils, types/amounts of losses
Types of coverage:
✓ Property – damage or loss of its ability to generate income
✓ Liability – losses related to govt responsibility (legal or contractual) not being met
✓ Fidelity bonds – embezzlement, fund misappropriation, dishonest acts by employees
✓ Workers’ comp – medical bills resulting from job related injuries/disabilities
Hold harmless agreements - a form of non-insurance transfer in w/c one party agrees to indemnify or hold another party harmless for all claims/legal exp incurred in specified situations
Risk retention – examples are paying for certain claims from a General Fund instead of purchasing insurance or carrying deductibles on automobile insurance
Govt mechanisms for own risk protection:
✓ Self-insurance – advantageous for govts w/ large budgets – determine w/c exposures will be retained - funded by operating funds; loss reserve funds; lines of credit; purchasing excess insurance for catastrophic losses….advantages: cost avoidance; cashflow; service control; enhanced awareness
✓ Intergovernmental pools –normally operate w/in state boundaries – provide 3 levels of coverages:
❑ members pay their own losses up to a specified amount
❑ pool pays for losses over the individual limit
❑ pools use membership funds to purchase insurance losses exceeding pool’s own limit
Unless risk can be avoided, govt should apply at a minimum, one risk control and one risk financing technique to each major loss exposure. While it is possible to substitute techniques of like kind, it usually not wise to substitute risk financing for risk control or vice versa.
3 criteria for risk analysis to decide which technique to use:
frequency and severity – how often losses occur and how much they may cost
effectiveness – how techniques achieve objectives
costs – costs and benefits of each technique
Risk managers must work closely w/ elected officials and dept heads to develop and disseminate comprehensive policy statements regarding their risk and insurance management objectives – policies should aim to eliminate fragmentation in managing risk across agencies. Program objectives should identify risk management function as protecting the general public and public assets against accidental loss so govt can continue to provide services even after a catastrophe.
SOURCE: ICMA SERVICE REPORT – RISK MANAGEMENT:
A COMPREHENSIVE APPROACH
Local govt’s core obligations are: health and safety; public welfare and the safeguarding of public assets – all of w/c are classified as risk management responsibilities
Risk management – process by w/c a local govt assesses and addresses its risks – historically associated w/ insurance buying, occupational safety and health, and legal management – or formal process by w/c an organization establishes its risk management goals and objectives; identifies and analyzes its risks and selects and implements measures to address its risk in an organized and coordinated fashion
Risks are not confined to insurable or accident related situations – may arise from actions of state legislature, investment management practices, climatological phenomena and even changing voter preferences
Risk imposes two types of costs on local govt:
✓ Cost of losses that occur (e.g., fires, vehicular accidents)
✓ Cost of uncertainty
Primary goal of risk management: maintenance of budget stability thru control of the costs of risk – core objective is to minimize negative impact of risks on budget and on the human psyche
Upside of risk management – potential for cost savings; service improvements; revenue enhancements such as: financial investment, training and development of employees and intergovernmental relations
Risk assessment – means identifying and analyzing risks – objective is the development of a comprehensive understanding of local govt risks – effective risk assessment involves a systematic and ongoing process for identifying and examining risks and deciding w/c risks are important
In organizing approaches to assessing risks, answers can be structured around 3 questions:
✓ Where do risks arise?
✓ What is local govt’s exposure to risk?
✓ How do local govt systematically gather information about risks?
Risks arise from seven sources: physical, economic, political, social, legal, operational and cognitive (absence of information, the influence of attitudes toward risk on decision making) environments – these environments contain hazards (characterized as features w/in an environment that elevate the probability of loss or its potential severity) – hazards in themselves do not produce losses – peril is the cause of loss
Exposure to risk – principal motivation to practice risk management – 2 types are: asset and liability
Asset exposures: physical, financial (2 primary bases of exposure: holding financial assets and issuing financial assets) and human
While a primary risk management concern will be safeguarding assets from harm, risk management decisions may also affect directly the productivity of those assets.
Liability exposures: legal (sorted into premises; contractor; product or service liability; employment liability; workers’ compensation; motor vehicle liability; professional liability; errors and omissions; and police) and moral (risk management is concerned w/ the impact of local govt decisions and actions w/in the context of its moral obligations)
Sources of information to assist in identification and assessment process: checklists, interviews, onsite inspection, incident records and reports, budget documents and other financial reports, council and committee minutes, real estate records, permits, contracts, public forums.
Categorizing risks: (risks s/b sorted, ranked, or otherwise separated to reflect the level of seriousness they represent):
Category 1 – low frequency/low severity – rare and of minor importance
Category 2 – low frequency/high severity –rare but are significant
Category 3 – high frequency/low severity –frequent but relatively modest
Category 4 – high frequency/high severity – frequent and serious
From a risk management perspective, exposures to risks have two bases of evaluation:
✓ Cost to replace those assets
✓ Contributory value of an asset (reflects asset’s value to the govt as a whole)
2 broad categories of risk treatment methods:
✓ risk control tools and techniques – include efforts to avoid, prevent, reduce or otherwise manage risk and its impact on an organization
✓ risk financing measures – involve measures taken to anticipate and pay for losses that could occur
5 basic techniques in controlling loss exposures:
✓ risk avoidance – “airtight” solution/eliminates chance of loss – (the inability to avoid many risks distinguishes public sector risk management from its private sector counterpart)
✓ loss prevention – measures seek to prevent or at least reduce the likelihood of losses (e.g., proper training/supervisory procedures)
✓ loss reduction – methods do not prevent losses from occurring but rather minimize the impact of losses that do occur (e.g., hard hats, firewalls)
✓ uncertainty reduction – primary tool is information management
✓ risk transfer – e.g., contracting w/ private or non-profit organization for services and products – service may be transferred but responsibility may not be transferred in certain cases
One way to decide whether to avoid a risk is to determine whether the benefits of the activity outweigh the costs, not only in dollars but also in social value.
Risk financing options:
✓ Risk retention – jurisdiction assumes all or part of a loss
✓ Risk transfer – organization agrees to pay for the losses of another organization in exchange for a premium
Most common risk financing mechanisms:
✓ Insurance
✓ Risk retention – 2 forms: passive or unplanned and planned retention (self-insurance – use of deductibles is a form of self-insurance)
Self-insured retention – amount that a govt chooses to retain a level of risk
The primary purpose of pools is not to lower costs but to provide consistent coverage. In other states, special enabling legislation permits pools to operate as a kind of special purpose mutual organization w/c allows most pools to escape the regulatory and tax treatment to w/c most insurance companies are subjected.
Types of insurance pools:
✓ Risk transfer pools – much like insurance companies; an indemnity agreement transfers the risk from the member entity to the pool
✓ Group insurance buying arrangements
✓ Banking pool – each member contributes to the pool to pay administrative expenses and to establish reserve funds for extraordinary losses – each member has a separate account out of w/c its losses are paid
✓ Risk management pool – the pool serves as the risk manager for its entities (most successful financing pools are evolving into a version of the risk management pool)
Other risk financing tools:
✓ Risk retention groups (private sector analogs to pools)
✓ Captive insurance companies – an insurance company that insures only one client – its parent organization
✓ Banking arrangements – e.g., lines and letters of credit
✓ Other public agencies
The idea of a cost/benefit analysis has been suggested as a means to judge the merit of a particular risk management initiative – many, if not most risk management decisions are fundamentally economic in nature.
Challenges that test the effectiveness of conventional cost benefit analyses:
✓ Extended time horizons – e.g., may take years for a safety program’s effect on persistent loss to become clear
✓ Externalities – spillover effects of a risk are not easily measurable (e.g., pollution)
✓ Data credibility – credible statistical data are often hard to come by
✓ Interdependencies – nature of one risk is strongly related to other risks
✓ Uncertainty – can lead to tentative or ineffective decision making
✓ Measurement of benefits – most often difficult to determine
The size of the risk management staff depends on the size of the local govt and the scope of services it provides. Whether there’s a risk manager or not, risk management committee and loss control committee would also be desirable. A safety and loss control committee separate from the risk management committee may be also advantageous.
Risk management policy statement
✓ emphasizes the importance of risk management and commits govt to managing risks
✓ strengthens the authority of the person or committee assigned to risk management responsibilities
✓ shows insurance companies that govt is committed to managing risks
✓ useful in litigation to show that govt had a formal policy dictating certain procedures
✓ does not describe specific actions but presents guidelines for making decisions about controlling and financing risks
✓ should contain: risk management objectives; description of the authority and responsibilities of the person or committee overseeing the risk management effort; description of the responsibilities of supervisors, managers and other employees.
Risk management manual: - outlines and describes the policies that a dept or local govt should follow – should include:
✓ Criteria for making insurance decisions
✓ Guidance on whether to join a pool or a risk retention group
✓ Types of risks to be insured
✓ How to select insurers, agents, brokers
✓ Use of co-insurance/deductibles
✓ Establishment/operation of a claims reserve fund
✓ Guidance for deciding whether to use insurance or risk management consultants
✓ Description of procedures (e.g., accident reporting/investigation)
✓ Guidelines for risk transfer
✓ Description of insurance cost allocation among various depts.
✓ Type of decisions that must be approved by specified officials
✓ Training and employee orientation processes
✓ Policy on the role of citizens to risk management
Accident records are useful for filing insurance claims but documenting safety efforts and results can help reduce insurance premiums – moreover, documentation of all preventive actions and actions taken after a claim can be valuable for defense in case of litigation.
One of the most important functions of an accident investigation is to determine why an accident occurred and how it can be prevented in the future.
Risk management program evaluation: results standards (measured in dollars, percentages, ratios or number of losses or claims) and activity standards (measure efforts to achieve goals)
If performance meets standards, it may be that no action is necessary or may be the standard needs to be raised – if performance exceeds standards, the standard may be simply too low.
Insurance method – simple, non quantitative method for evaluating individual projects and for looking at a risk management program as a whole – involves 4 basic steps:
✓ Risk identification
✓ Insurance coverage identification
✓ Risk and insurance coverage prioritization (categorized as mandatory – treatment is required; important – correspond w/ serious or catastrophic outcomes; useful – correspond w/ moderate or noncatastrophic outcomes; unimportant – neither important nor useful)
✓ Consideration of alternatives and supplements – results in a listing of the control and financing solutions that will be used by the local govt
Insurance method accomplishes the ff not ordinarily seen in organization management:
✓ Forces managers to systematically identify and think about risks
✓ Forces managers to understand where coverages exist and where they do not
✓ Compels managers to consider w/c are key problem areas/moderate importance/unimportant
✓ Motivates managers to consider what other measures might be undertaken to help the risk management effort to succeed
A critical step for the development of a risk management function is the creation of a document that provides guidance and structure to the organizational practices that constitute risk management – the principal means of communicating for the purposes of this function is a risk management manual (possible blueprint or contents would be as follows):
✓ Risk management policies and procedures
✓ Risk assessment policy and practice
✓ Risk control policy and practice
✓ Risk financing policy and practice
✓ Statement on risk management program audit and review programs/procedures
✓ Appendices
SOURCE: AN ELECTED OFFICIAL’S GUIDE TO RISK MANAGEMENT
Govt exposes itself to ff forms of risks:
✓ Lost of damaged property
✓ Employee injury
✓ Loss of public confidence
Risk – can be defined as the chance of a loss – in govt associated w/ delivery of public services – classified into operational risk or pure risk (no upside) or speculative risk (has upside and downside)
Goals of risk management:
✓ Create safe workplace
✓ Prevent catastrophic financial losses
✓ Provide budgetary stability
Benefits of a comprehensive risk management program:
✓ Allows for a more effective use of govt funds (effective prog can save funds)
✓ Increases work productivity (prevent worksite accident, etc)
✓ Reduces uncertainties (including budget) associated w/ future projects – effective prog highlights better ways to prevent/pay for accidental losses w/c eliminates consequences associated w/ govt’s future projects
Fundamental risk management activities:
✓ Risk identification – where exposure lies
✓ Risk evaluation – frequency/severity
✓ Risk treatment – tools and techniques
✓ Implementation – financing/ongoing monitoring prog’s results
Why govt face more unique risks compared to private sector:
✓ Public sector services inherently high risk
✓ Scope of public sector is enormous
✓ Govt typically lacks total control over its physical environemtn
Risk manager – plans/organizes/leads risk management activities such as purchasing insurance; loss control; administering claims; monitoring litigation
A govt that self insures retains the financial obligations of any losses rather than transferring them to an insurance company.
Recent trends in risk management: new risks; costlier litigation; evolving role of intergovt risk pools; technology; better data on losses
Standardization of data on claims help to:
✓ Simplify analysis of cause, frequency/severity of claims
✓ Identify patterns and trends
✓ Benchmark risks against other govt
✓ Evaluate risk management program
Govt face 3 types of risks that have become more prominent: law enforcement; workplace; technology (privacy, e-commerce)
Alternative market – creation of risk pools and the incidence of govts choosing to go it alone and self insurance
Enterprise risk management: marries both operation (traditionally the focus) and financial risk (used to be managed separately by: separate policies for short term and long term investment portfolios; diversification strategies; procedures for custody of assets)
Organization’s internal control structure for tracking assets provides an underlying strategy for managing financial risk.
Sources of risks:
✓ Physical environment – snowstorms, earthquakes, etc
✓ Legal environment – laws and legal precedents
✓ Political environment – legislative activity, elections
✓ Social environment – cultural composition of community/attitudes/preferences
✓ Economic environment– market trends, interest rates
✓ Cognitive environment – absence of information
The erosion of sovereign immunity has made it easier to sue and win awards from state and local govt.
Tort reform – legislation that aims to curb the growing number of civil lawsuits and their attendant costs – attempt by govt and private businesses to make the legal environment more favorable to them – puts caps or limits on jury awards
Six types of risks that can result in economic loss:
✓ Legal liability to others
✓ Property loss
✓ Extra expenses (e.g., replace equipment)
✓ Loss of income
✓ Human resources loss
✓ Crime and fidelity loss
Exposure – refers to the vulnerability of a govt’s physical assets, legal liability or moral responsibility w/in a certain environment.
Factors increasing risk of loss:
✓ Environmental
✓ Hazard – risk factor that creates conditions called perils
✓ Perils – immediate cause of loss
✓ Outcome
Matching cause of loss to incident difficult in practice b/c:
✓ Multiple immediate factors can cause a loss
✓ Persons preparing periodic risk management tracking reports may confuse cause w/ effect
Risk management reports may help determine:
✓ Level of future pool contributions (if govt is participant)
✓ Strategies for risk finance
✓ Future loss control efforts
Selecting risk finance alternatives:
Frequency
Severity low high
Low self insure self insure
High insurance insurance
self insure self insure
risk pool risk pool
Moral hazard – any change in behavior due to the purchase of insurance
Four basic risk management methods used to prevent/minimize risk of loss:
✓ Loss prevention and control – before the fact strategy; loss prevention reduces probability; control measures mitigate severity
✓ Risk transfer – shift financial burden
✓ Risk retention – risk financing in house
✓ Risk avoidance – do not provide service altogether – strictest sense, most complete way to manage risk
Risk transfer:
✓ Financial risk transfer – to insurance company; risk pool
✓ Contractual risk transfer – to contractor
Hold harmless provision – govt transfers risks under the terms of a contract (non-insurance risk transfer or contractual risk transfer) – one party agrees to indemnify and hold the other party harmless
3 basic types of insurance coverage (in addition, fidelity/faithful performance bonds):
✓ property – against damage or loss – protects govt from direct loss
✓ liability – govt negligence in performance of operations – indirect loss
✓ workers’ compensation – on the job injuries – indirect loss
Supplemental coverage maybe needed depending on:
✓ One time projects exposures – e.g., RDA
✓ Geography based exposures– e.g., California, earthquake insurance
✓ Unique exposures – e.g., employees handling cash
Errors & omissions policy – may be required for wrongful acts by public official
Criteria for procuring insurance:
✓ Quality of service
✓ Scope of service – a la carte or integrated
✓ Lines or breath of coverage – whether govt selects a single insurance carrier for liability, workers’ comp and property insurance or select different companies; and, whether coverage from one carrier for a given line of coverage will be as complete as another carrier’s standard or will it have important gaps/exclusions.
✓ Financial stability – use ratings by Weiss Ratings or A.M. Best
✓ Cost
Role of risk retention in managing risk: can lower govt’s premiums and align its incentives w/ insurance company to create safer environment – often, the unintentional result of a govt being unaware of its exposures and simply failing to insure for certain risks
Classifications of risk pool by:
✓ Type of services offered
✓ Lines of insurance coverages
✓ Types of local govt members
✓ Packaged services versus “a la carte” options
✓ Degree of state regulation
✓ Financial resources available to the pool
✓ Extent of risk transference
✓ Primary versus excess coverage
When pools self insure – rely only on its own resources and those of its members
When pools self fund – pass part of their collective risk to a reinsurer or insurance co
✓ 3 choices govt have in financing cost of risk (each makes sense depending on severity/frequency of each risk):
✓ purchasing insurance
✓ member of risk pool
✓ self insurance
(ATTACH PAGE 41 – TABLE ON RISK FINANCE ALTERNATIVES)
Organizational challenges when implementing risk management program:
✓ Making top level officials aware of risk management issues
✓ Gaining their political support
Establishing safety committee – primary way to obtain both top-down and bottom-up support in making risk management a priority throughout the organization
Purpose of risk management policy: create framework allowing supervisors, managers and other employees to implement the risk management objectives in their departments – s/b brief and to the point –clarifies the value an organization places on risk management – may resolve dispute over authority w/in organization and encourage interdepartmental cooperation – may help demonstrate to risk pools of govt’s commitment to managing risks - should include:
✓ Statement of organization’s goals and objectives
✓ Identify officials charged w/ carrying out risk related functions
✓ Contain overarching guidelines for making decisions about fundamental activities
Principal players in public sector risk management marketplace:
Insurance brokers
✓ Insurance companies
✓ Risk pools
✓ Third party claims administrators
✓ Actuaries
Risk management activities to be included in budget (govt that self insure should also include costs of making claim payments):
✓ Premiums
✓ Deductibles
✓ Loss prevention activities
✓ Loss control measures
✓ Claims administration
✓ Legal review/litigation management
Most of the cost of a general risk management program is for risk finance – paying premium or claims
Top three expenditures for risk exposure:
✓ Workers’ comp – often expressed as % of payroll – average in 1998 1.3%
✓ General liability
✓ Property coverage
Most risk management expenditures appear as an Internal Service Fund in govt budget. If govt chose to account directly in the General Fund, for financial reporting purposes, charges or premiums paid to the General Fund by other funds must be treated as a reduction of risk-related expenditures rather than as revenues (i.e., reimbursement accounting).
Success of risk management program determined by: workload, efficiency and effectiveness. Challenge in benchmarking lies in obtaining reliable data and using relevant benchmarks so that meaningful comparisons can be made over time.
PENSION & BENEFITS
SOURCE: AN ELECTED OFFICIAL’S GUIDE TO DEFINED BENEFIT & DEFINED CONTRIBUTION RETIREMENT PLAN
2 types of retirement plans:
✓ defined benefit – target benefit is fixed; contributions must be adjusted over time to meet that target – size of pension is fixed prior to retirement
✓ defined contribution – contribution is fixed and consequently benefits vary depending on investment returns – the actual amounts are not known until retirement and are not guaranteed – can be lump sum or annuity
Objectives of managing retirement assets:
✓ Provide income security during retirement
✓ Compensate workers for services rendered
Formula for basic types of retirement plans:
C+I=B (contribution + investment income = benefit)
Types of DC plans:
✓ 401(k) – private sector
✓ 403(b) – tax sheltered annuity – non profit sector
✓ 401(a) – govt sector
✓ Keogh plan – small businesses
✓ 457 govt sector - supplemental
Similarities of DB & DC plan (but diff task re education – also, timely payments to employee’s retirement account):
✓ same objectives
✓ similar legal standards – e.g., prudent person standard
✓ can be administered by same org
Legal obligations of pension board and administrators come from:
✓ Constitutional law
✓ Statutes
✓ Regulations
✓ Contract law (collective bargaining)
✓ Common law
ERISA – Employee Retirement Income Security Act (1974) – mainly applies to private sector
Labor Dept regulation 404(a) – holds administrators responsible for selecting & monitoring investments and service providers
Qualifying for pension benefits is a function of: employment status & vesting schedules
Types of vesting: step (gradual) or cliff (after waiting period)
Thrift Savings Plan: (1987 Federal converted from DB to DC plan) which has:
✓ Several investment options
✓ Employee control over investment options
✓ Joint contribution
✓ Enhanced portability
Trend towards DC plan b/c:
✓ Job growth by small businesses using DC plan
✓ DB plans more costly regulations
✓ Greater employee acceptance
✓ Thru DC conversion, businesses capture assets of over funded DB plans
✓ Changes in worker preferences
From employee perspective, pros & cons of DB & DC plans:
✓ DB offers greater employee reward for long service
✓ DB shields employee from investment risk/inflation risk
✓ DB allows employee retiring at young age to have two sources of income (second job)
✓ DC participants have greater portability & investment control – participate in bull market – tailor their investments according to their risk/return preferences – but retirement amount is not fixed – can be rolled over to IRA
From employer perspective, pros & cons of DB & DC plans:
✓ DB plans cost is not transparent – set aside funding now for future retirement costs
✓ DB plans – upredictable budget b/c of actuarial uncertainties (returns on investments; worker demographics; salary decisions; policy decisions imposed by state legislature)
✓ DB plans have higher operating expenses for actuarial/investment management but lower education costs
✓ DB plans help retain long-term employees b/c of vesting schedules (benefits accruals escalate)
✓ DB plans can be used to accelerate early retirements – replace high old salaried workers with less expensive new hires
✓ DB plans may assist in recruiting certain categories (e.g., police)
✓ DC plan costs predictable/transparent
✓ DC plan investment risk shifted from employer to employee
✓ DC plan not an effective tool for retaining long term employees
Portability is attractive to employees w/ less perceived or real job security; exit job market for some reason (e.g., caregivers).
Types of risk for both DB & DC plans (in either plan, employees face an additional risk of failing to preserve their retirement benefits):
✓ DB – plan sponsor assumes risk – if investments fall short, employer makes up difference
✓ DC – employee taking risk may not provide sufficient income due to volatile returns; not keep w/ inflation due to excessive conservative investments
Strategies for managing DB risks:
✓ Establish investment policy and adhere to it
✓ Develop asset allocation plan that diversifies risks
✓ Monitor asset allocation targets and other performance benchmarks
Strategies for managing DC risks:
✓ Establish retirement goals
✓ Self assess risk tolerance
✓ Define time period for retirement investments
✓ Establish asset allocation plan to diversify risks
✓ Monitor asset allocation targets and other performance benchmarks
✓ Preclude certain investments
✓ Employers help staff manage risk by offering certain retirement payout choices
Ancillary benefits of retirement plans: Disability benefits; survivor benefits
Unfunded actuarial accrued liability: cost of outstanding pension obligations made by the employers in past years (in DC plan, elected officials cannot build unfunded liability)
Normal cost – new obligations expected to be paid in the current year
Costs of DB/DC plans (in DB employers usually incur costs; in DC employees):
✓ Custodial services
✓ Record-keeping
✓ Investment management
✓ Employee education
Retirement income compared to 3-legged stool: social security, employer retirement plan and personal savings
IRS does not tax both plans differently as long as both are IRS qualified plans – by being a qualified plan, taxes that would apply to investment earnings are deferred until retirement
3 options for converting DB to DC plans: immediate, gradual and new employees only
DB pension board may have a limited role in overseeing a DC plan.
SOURCE: THE LEGAL OBLIGATIONS OF PUBLIC PENSION PLAN
GOVERNING BOARDS & ADMINISTRATORS
I. Sources of Legal Obligations for Public Pension Plan Board & Administrators:
A. Federal & State Constitutional Law
✓ In general – United States Constitution/Constitution of a State
✓ Federal Constitutional Law – directly or indirectly impact employee pension plans – for fed govt pension plans, all applicable provisions of the Fed Const.; for state and local govt, the 14th Amendment on its face (applies whenever state action in involved and requires that the state action reflect due process and represent equal protection) and Bill of Rights (first 10 amendments) – due process means pension plan must observe various procedural steps w/ care when an identifiable property right is involved – equal protection means pension plans must be interpreted and applied in a manner that results in comparable treatment of similar circumstances based on rational classifications.
✓ State Constitutional Law – will most commonly provide generalized requirements and limitations of govt action applicable to pension plan
B. Federal, State & Local Statutory Law
Primary federal legislative enactments affecting public pension plans:
✓ ERISA - mainly for private sector – provides minimum participation standards/vesting requirements; limitations on benefit accrual differentials; maximum benefit amounts; minimum/maximum funding; minimum fiduciary responsibility standards; minimum reporting/disclosure requirements; and mandatory federal plan termination insurance.
✓ Internal Revenue Code – includes 1986 Tax Reform Act
✓ Age Discrimination in Employment Act
✓ Equal Employment Opportunity Legislation
✓ Social Security Act
✓ Comprehensive Omnibus Budget Reconciliation Act
State Statutory Law – primary source for most public pension plans; can be specifically oriented and applicable to the individual pension plan – can be direct
Local Government Enactments – supplement state statutory law – can be form of charter amendment, ordinance or resolution
C. Administrative Rules & Similar Regulation
Administrative Agency Regulation – typically has the force of law (IRS is the chief agency applicable to public pension plan) – others are SSA, EEOC, SEC and DOL
Internal Plan Regulation – e.g., articles of incorporation if plan is a corporation
Collective Bargaining Agreements – chiefly apply to benefit plan/benefit provisions
Administrative Hearings – may be required, e.g. disallowance of a disability claim
Prior Administrative Practice – will influence and impact current administrative practice
D. Common Law
Common Law – differs from other sources b/c it encompasses a group of adaptable general principles rather than a specifically binding code of enactments – predates constitutional, statutory and administrative law – foundation of the Anglo-American legal system – fashioned by the judiciary in the context of resolving specific legal controversies – approaches regulation in a manner directly opposite that of constitutional, statutory and administrative law
Common Law Relating to Trusts – a trust is a relationship between two or more persons in which at least one person holds legal title or formal ownership to property for the benefit of another person – can be implied by law or by the court – can also be created by an organization to underlie a program or benefit structure – in its clearest application to pension plan, applies to areas of asset investment and authorized disbursements
Common Law Relating to Torts – a tort is any civil or non-criminal injury to another resulting from a person’s action or inaction when there was a duty to act – can be intentional or negligent; intentional (injuries or consequences are readily foreseeable); negligent (act in less haphazard fashion)
Common Law Relating to Contracts – a contract functions as a private law created by an individual process and binding on the parties (obligation akin to the legal burden imposed from statutory or related law) – this applies to pension plans b/c the relationship between the pension plan and the plan participant may clearly be a formal contract/founds to be a contract/treated as though it were a contract – places considerable emphasis on the quality of free consent in the relationship, the mutuality of its obligations and the lack of undue influence or duress in the process, the adequacy of consideration and the legal form of the agreement
II. The Legal Nature & Structure of Public Pension Plans, Funds and Administrative Systems or Structure
A. Differentiation
Public employee pension plan – collection of benefit provisions under w/c a public employee becomes entitled to an immediate or eventual retirement annuity or benefit under w/c the employee or employer or both are obligated to pay specified amounts of contribution and undertake certain reporting and related duties.
Public employee retirement fund – the accounting and investment vehicle for the deposit of any periodic public employee member deductions or contributions and employer contributions for the segregation of those monies from other monies and for separate investment of those assets and crediting of any investment income from those assets – this fund is necessary if the pension plan is to be funded on an actuarial basis or any manner beyond a current disbursements (pay as you go) basis
Public employee pension system – the administrative entity that is entrusted with the duties of operating a public employee pension plan/retirement fund
The distinction between public and non-public pensions plans typically will be a function of the character of the plan membership and the source of all or a portion of the pension fund’s contributions or revenues, nature of the plan organizing document or the character of the sponsoring employing unit(s).
One potential measure differentiating public employee pension plans is the presence or absence of insurance w/ third party carriers for the liability for retirement benefits. The most immediate legal implication for the pension plan and the plan administrator of the presence or absence of insurance is the extent of the insurance coverage and the pre-conditions for gaining payment from the carrier.
Another differentiation is the plan’s formulation, either as a defined contribution or defined benefit plan – the chief difference from a legal standpoint is a function of what is being promised (either level of ongoing funding or specific level of benefits).
A pension plan in its broadest senses is made up of 2 components or potential variables: benefits (provided as % of a specified final/average compensation) and funding.
Percentage is the benefit accrual rate.
Normal retirement age – age for the payment of full benefits
The immediate legal implication as a defined contribution/benefit plan – nature of the potential rights that are obtained and enforceable by active, deferred or retired plan members.
In a defined contribution plan, the rights obtained and enforceable related chiefly to the amount and timeliness of the contribution to the plan; extent of participation allowed in the investment of plan assets; handling of administrative expenses; crediting of accrued investment income; and the manner in w/c the accumulated individual member account balance is translated into a monthly retirement annuity for life.
In a defined benefit plan – relate to amount of the promised level of benefits and the age at w/c those benefits are first payable and are payable w/o reduction for early retirement.
Difference of single employer or multiple employer plan – raises legal implications from the extent of the financial and governance responsibility a participating employing unit has over the pension plan and the extent of the agency relationship between the plan and the participating employing units.
Single employer public pension plan – active membership from one participating employing unit w/c has the sole responsibility for any non-member contribution portion of the funding requirements of the pension except to the extent of any state pension aid provided in the case of a local pension plan (pure extension of employing units personnel system).
Multiple employer public pension plan – active membership from two or more participating employing units – tends to be insulated, either formally or practically, from a variety of financial and legal liability factors – typically lacks practical and legal identification w/ any particular employing unit and its personnel and plan administrative determinations/actions will largely be outside the context of any employing unit’s discretion/judgment.
Further distinctions in multiple employer pension plans by govt accounting profession (w/c looks to the basis for determining employing unit funding requirements):
✓ Agent public employee pension plan – if the plan has no risk or liability pooling or limits risk or liability pooling to retired lives only and has separate determination of funding requirements from a separate actuarial valuation for each employing unit
✓ Cost sharing public employee pension plan – if the plan pools all risks and liabilities, determines the funding requirements of the plan overall and allocates those funding requirements proportionately – the liability for the payment of pension benefits and meeting any annual funding requirements are only enforceable against the current assets and accruing revenue of the public employee pension plan.
✓ Agent multiple employer public employee pension plan –the liability for the payment of pension benefits and meeting any annual funding requirements are potentially attributable to particular employing units.
B. Legal Status of Plan, Fund and System
As a practical matter, the legal status affects the number of parties potentially affected by any litigation and potentially responsible for any imposed liability. If the plan is a separate legal entity, the parties to the litigation will likely be limited to public pension plan officials. If the plan is a particular legal entity, such as a nonprofit corp, the parties to litigation and potential liability will be determined in the context of that body of develop law. If the plan is not a separate legal entity, the parties to the litigation will likely include the appropriate officials from the applicable govt unit.
III. Specific Responsibilities and Liabilities of Public Pension Plan Governing Boards and Administrators
4 broad areas of responsibilities and liabilities: pension benefit; pension plan funding; plan fund investment; and plan administration
a) under pension benefit - payments solely to qualified individuals – setting benefit level; determination of qualified recipients and amounts; timeliness of payments
In applying fiduciary principles derived from ERISA pension benefit levels s/b established:
✓ Solely in the interest of the plan participants and beneficiaries
✓ As an exercise of the exclusive purpose of providing benefit to participants and beneficiaries and of defraying reasonable plan administration expenses (must be conscious of equal protection concerns to make distinctions and a rational basis exists for the classifications on w/c those distinctions are to be made)
✓ W/ the degree of care, skill, prudence and diligence under the prevailing circumstances that a prudent person (expert) acting in a similar capacity (compliance may be more problematic since the criteria for judging conduct is applied after the fact)
✓ In a manner consistent w/ the plan’s governing law and documents
Elements of a notice and review procedure that likely will meet any minimum due process scrutiny by the court (in considering pension amount, timing and duration):
✓ Notice – in writing, clearly specify the adverse determination or action based on facts/statutes
✓ Appeal of review opportunity
✓ Answer – in writing
✓ Open accessible record
✓ Hearing – have appropriate legal or other counsel present
✓ Judicial review
b) under pension funding: if DC plan, benefit is a function primarily of the aggregate periodic funding of the plan; if DB plan, based on mathematical formula that is unrelated to the level of pension funding the must be determined separately and functions largely as a budgeting tool (can be pay-as-you-go where no appreciable amount of assets is accumulated relative to accrued liabilities – e.g. social security) – choice of funding alternatives is not made by governing board or administrators (their responsibility is to implement the established funding procedures)
In a DC plan, the responsibility of governing board/administrator in determining funding requirements is limited to ascertaining the correct salary of each participant and assessing correct contribution amount based on specified percentage.
In a DB plan, will be same as DC plan if funding requirements are set as a percentage of payroll or set as a particular rate w/o any direct automatic tie to periodic actuarial work but if funding requirements are a function of the periodic actuarial work, responsibility is substantial w/ duty to have periodic actuarial performed on a timely basis and prepared accdg. to all applicable standards and translate this into a contribution rate/amount.
If there is discretion in the preparation of periodic actuarial work, that discretion will generate a corresponding legal responsibility and possible liability for the board/admin.
The obligation to provide benefit increase cost estimates is related to plan funding b/c benefits can’t be separated from funding and b/c actuarial cost estimate will or may become the basis for setting the funding requirements and contribution amounts.
In establishing the eligibility of potential benefit recipients, s/b be checks for age, service credit for vesting purposes, disablement for disability coverage and survivorship for death benefit coverage.
First and foremost, administrative expenses must be necessary and reasonable – should not exceed the customary marketplace price range for the type, quantity and quality of services.
c) under pension fund investment: inherent in a pension plan fiduciary responsibility and liability are the benefits of its dual functions: as a guide and legal recourse (legal recourse is essentially retrospective) – area of pension plan activities traditionally subject to fiduciary concern is investment of pension fund assets
fiduciary – a person who has legal responsibility for the conservation and management of property in w/c another person has a beneficial interest – historically, the primary aspect of characteristic that differentiates between pension plan fiduciaries and individuals performing purely ministerial duties in connection w/ a pension plan is the question of the presence or absence of discretion
Fiduciary standards:
✓ per se sound or unsound practice – basic principle is that specific investments are deemed to be on their face either sound or unsound for purchase as investments by a trust fund – investment w/b per se sound if it involved public funds; unsound if not public funds – the per se sound or unsound applies only to investments and no potential application to other fiduciary activity
✓ prudent person rule – flexible standard for judging conduct similar to negligence standards in torts situations – elements include standard of care by w/c investment decisions are judged; standard applied to specific factual situation as understood by trustee at time of making critical investment decisions; compares actions of trust w/ those of hypothetical universal rational investor; requires knowledgeable and cautious investments; emphasizes long-term investment perspective and does not permit speculation; emphasizes joint aims of protecting principal and maximizing income derived – (in practice courts emphasize preservation of principal over generation of investment income)
✓ prudent expert rule – similar to prudent person; difference is the basis for comparison: prudent person compares actions of a particular fiduciary w/ those actions of a hypothetical universal rational investor managing his own affairs; whereas prudent expert compares w/ those that would have been taken by others in a like capacity in conducting an enterprise of like character and w/ like aims, e.g., investment expert (ERISA prudent expert rule focus to the entire investment portfolio and to total portfolio objectives)
There are a number of other specific fiduciary duties applicable to private or public pension plans or both. Also included are the obligations of co-fiduciary responsibilities to monitor the actions of another fiduciary, etc.
The most commonly found public pension plan investment regulation beyond the traditional fiduciary regulation is the authorized investment security legal list w/c reflects the concern on the part of policy makers about the extent of discretion given to pension investment officials and the manner in w/c those officials would exercise that discretion – the list typically imposes certain quality requirements and quantity restrictions. The question of whether the legal list augments or supplants the general standard of care depends on whether or not there must be compliance w/ both or primary w/ the legal list.
d) under plan administration: pension fund investment is typically viewed as the primary area of plan administration – in its broadest sense, involves the timely provision of money into the investment process, selection of appropriate investment vehicle and appropriate timing of liquidation of investment securities; other plan administration includes: record keeping; communications, reporting and disclosure; accounting, audit and actuarial activities; benefit information/counseling activities/payments and processing; plan interpretation; status determinations; social security coverage; data privacy; board elections and vacancies; administrative organization, staffing and employment; pension plan rulemaking; budget setting; legal activities; legislative representation and advocacy; taxation question; disaster planning; and interrelationships w/ other programs and activities.
Remedies and enforcement in the event of failure to conform to non-investment plan administration are categorized as follows:
✓ Compulsion of performance (generally in the form of mandamus action w/c is a court order to an official requiring that person to complete a ministerial duty or be held in contempt of court – key is character of the duty for it if is discretionary w/ the official, the official cannot be compelled to undertake that action)
✓ Imposition of monetary award
✓ Transfer of functions to another administrative entity
✓ Removal of plan official
IV. Protection from Liability or Enforcement of Remedies Regarding Public Pension Plan Action
Prevention of liability or other remedies: identification of responsibilities and obligations; continuing education; clear allocations and delegations of duties in writing (proper delegation will also allow plan officials who deal in specialized pension areas to be insulated from other liabilities); use of appropriate expertise in the decision making process; use of written communications for all major plan activities; coordination w/ benefit plan document (reconcile all written communication); ascertain the appropriate level of plan personnel activities; always act in good faith
Liability insurance and indemnification: indemnification of a public pension plan official can be provided by the pension or by one or more sponsoring employing units – means that any liability of a plan official for money damages will be assumed by the plan or employing unit – however, indemnification increases the risk that plan officials will be more careless in performing their duties b/c of the absence of personal liability. Liability insurance can also be obtained but coverage for public pension plan officials may have limitations and gaps – unlike indemnification, liability insurance does not raise the question of conflicting incentives.
Defenses against liability and other remedies:
✓ Sovereign immunity – broadly, it holds that govt cannot be bound to answer for its actions in a private lawsuit – frequently limited to purely govt’l acts and not to propriety actions
✓ Public officer’s immunity – similar to sovereign immunity – may apply only to small scale errors – govt official may be required to prove good faith actions
✓ Plaintiff’s lack of standing (to assert a claim)
✓ Statute of limitations (may toll for a variety or reasons; e.g., mental incapacity, absence from the state) – undiscovered fraud appears to be the only generally application tolling event for public pension plan litigation
✓ Failure to notify govt entity – applies to alleged torts – w/o waiver granted by the court where good cause exists for the failure, a failure to comply w/ the statutory notice provision will bar the action
✓ Failure to exhaust administrative remedies – plan should have appeals process altho’ failure to use will not necessarily be a permanent bar to subsequent litigation
✓ Assertion of counterclaims
Conclusion: Public pension governing board and administrators have numerous legal obligations, duties and responsibilities – performance is manageable if prudence and care are exercised and consequent litigation can hence be avoided. The amount of litigation relating to public pension plan activities is historically small. Pension plan officials can meet expectations by keeping reasonably well informed about applicable pension and related developments; by paying strict attention to the benefit plan document and other relevant laws; by observing consistent operating practices; and by acting in good faith.
SOURCE: LOCAL GOVERNMENT FINANCE: CONCEPTS & PRACTICES –
CHAPTER 19
Public Employee Retirement Systems (PERS) and Benefits
PERS – categorized by type of employees (e.g., general employees, teachers, etc) and by their scope of operations (e.g., statewide or single-employer plans)
Nature of retirement benefits – pension originated as gifts provided by sovereigns as acts of grace to faithful servants – 2 types of pension benefits plan:
✓ DB – offer employees specific (defined) benefit when they retire usually based on length of service and final average salary
✓ DC – employer sets aside specific (defined) contribution into the employee’s account on a periodic basis – this amount plus employee’s contributions and interest accrued is given to the employee at retirement – shifts the risk of financing future retirement benefits from employer to employee since obligation ends when employer has made contribution – more portable
Types of benefits formula:
✓ DC – product of employee’s salary times the employer’s contribution rate)
✓ DB – two types; flat benefit formula (based on some flat percentage of compensation) and unit benefit formula (majority plans use this – has 2 basic variations – “single rate” and “step rate”) promise to pay retirement benefits equal to the unit benefits that have accumulated over the employee’s years of service times the employee’s final average salary. Under the single rate unit benefit formula, the benefit rate is fixed over the service life of the employee; under a step rate unit benefit formula, the benefit rate applicable to the first years of an employee’s service is different from the rate applicable during the remaining years. Most PERS use the single rate formula for ease but step rate formula offers more flexibility to the employer.
Determination of final average salary – can be average salary during last 3 or 5 years of service or during the 3 or 5 years of service when employee received highest level of pay – being closest to the last years of employment
2 basic approaches to SS integration among PERS:
✓ offset approach – recipient’s pension benefits from the plan are reduced by a set % of the recipient’s SS benefit
✓ step rate approach – higher benefit accrual rate is applied to compensation above the integration level (usually the maximum taxable wage base for SS) and a lower rate is applied to compensation below that level
PERS generally come into being thru legislative enactment (mostly from State statutes; also from governing bodies of home-rule cities, counties, special districts, and other political subdivisions).
The overall management of the system is the responsibility of the system’s board of trustees – responsibility includes making policy decisions w/in the framework of system’s enabling statutes; employing administrator to carry day to day operations and consultants; approves procedures and policies that ensure the proper performance of system operation such as adopting interest rate and mortality tables, approving methods for system control and reporting, and setting investment policy.
The system administrator (director) responsible for day to day operations.
Technical consultants include legal counsel, actuary, auditor, investment adviser and fund custodians.
Approaches to benefit obligations/actuarial valuation:
✓ Pay as you go – monies required to pay retirement are appropriated by the employer when the benefits come due – no attempt is made to accumulate monies or to make long term investments
✓ Reserve funding – offers a number of advantages – will result in lower contributions since investment income can be substituted for contributions – also increases security of pension benefits by accumulating assets in a systematic manner and provides equitable treatment to different generations of employees and taxpayers
Actuarial valuation – procedure for measuring the expected value of a plan’s future benefit payments and assigning portions of this value to past, current and future years – main purpose is to adequately fund the retirement plan over a period of time.
Actuarial present value(APV) of total projected benefits – technically, the expected value of a plan’s future benefits payments – in two parts are actuarial present value (the value on the actuarial valuation date of the total projected benefits w/c is the amount that would have been invested as of actuarial valuation date so that the amount invested plus the investment earnings would provide money to pay the total projected benefits) and total projected benefits (sum of all benefits payable to retirees, beneficiaries, terminated employees, current covered employees entitled b/c of past service and current covered employees entitled b/c of expected future service)
Normal cost – the portion of APV of total projected benefits attributable to a given year
Actuarial accrued liability – sum of the costs assigned to years before the valuation date plus the interest accrued on those costs
Unfunded actuarial accrued liability – difference between the actuarial accrued liability and the total assets that have been accumulated in the plan
Actuarial funding method – method used to determine the contribution amount or rate to provide for current funding of the normal cost and the methods used for unfunded actuarial liability include the following:
✓ Unit credit actuarial method – 2 basic forms
❑ accumulated benefit method (credits benefits using employee’s service and salary history as of valuation date) -actuarial accrued liability at a given time is a function of the current salary and the number of years of the employee’s credited past service up to that point in time, known as the accumulated benefit obligation - costs can increase sharply as employees approach retirement
❑ credited projected benefit method (credits benefits using employee’s service history as of valuation date and the projected salary on w/c benefits will be based) - similar to ”above” but modified to take into account the effect of projected salary increases – results in actuarial accrued liability called pension benefit obligation
✓ Entry age normal actuarial method – does not focus on the benefits earned by employees as result of service thru valuation date – computes the total cost of funding projected benefits including benefits from expected future service and allocates the total cost to the years of past credited service and expected future service – designed to allocate total cost on a level basis to all years of service
✓ Aggregate actuarial cost method – difference bet the APV of projected benefits for the group (rather than individual) and the actuarial value of assets allocated on a level basis over the period between the valuation date and the projected exit date – benefits not covered by current assets are amortized over the remaining working career of the covered group – consequently there is no unfunded actuarial liability under this method
Actuarial assumptions – play an important role in determining amount of employer’s contribution – by controlling this, one can influence the level and timing of employer contributions – fundamental tenet is that all assumptions s/b conservative in nature
3 methods of actuarial valuation of assets:
✓ cost method (generally used by public plans)– investment return is the sum of ordinary income plus capital gains and losses that result from sales of investments during the period (variant is amortized cost method w/c allows the original premium or discount on fixed income securities to be amortized over the investment period)
✓ market method – value of investment is its market price on actuarial valuation date
✓ moving average method – value of investment is calculated by a formula that smoothes short term market fluctuations in the manner that better reflects the long term values of investmentsThe long-term investment objective of a pension fund s/b to obtain a good return on investment consistent w/ the risk tolerances of the plan sponsors, the trustees, and the fund itself. In order to specify the fund’s investment policy properly, administrators and trustees s/b knowledgeable about the effects of asset allocation, the tradeoffs between risk and return and the legal and fiduciary constraints that pertain to PERS investments.
Asset allocation – refers to the distribution of assets among the traditional asset classes; e.g, stocks, bonds, real estate, cash, etc.
Investment risk is measured by the volatility of investment returns for the different classes of investments – a statistical measure of the size and frequency of deviations from the average return - managed thru diversification (reduces portfolio’s overall volatility by managing the number and types of investments)
2 forms of risks:
✓ systematic risk – associated w/ owning an entire class of securities (e.g., stocks, bonds) – not reduced by increasing the number of individual securities held – reduced instead by allocating assets among different unrelated classes of securities – ideally, investments that have good long term potential for returns move opposite each other in the short term
✓ unsystematic risk – potential for loss associated w/ an individual security (e.g., specific stock) – reduced by holding a large number of different securities
2 basic fiduciary responsibilities:
✓ loyalty – requires fiduciaries do not place their own interests above the interests of the plan members
✓ reasonable care – requires that investments be made by informed individuals, acting prudently, to meet the retirement needs of their members
Indirectly, the federal govt regulates most PERS thru:
✓ IRC – sets for provisions that pension funds and institutional investors must meet in order to qualify for tax exempt status – investments must be made for the exclusive benefit of system members (might prohibit investment for economic development, whether or not investments were prudent) – however, Revenue Ruling 69-495, 1969-2 CB interprets exclusive as “primary” therefore PERS may retain tax exempt status while making investments that benefit members and other parties provided:
❑ The cost of the investment does not exceed their fair market value
❑ The investment offer a rate commensurate w/ that offered in the market
❑ Prudent investor and diversification requirements are met
✓ ERISA – sets forth prudent investor and diversification requirements – prudence requires fiduciaries to:
❑ Exercise the care, skill, and diligence of a prudent individual
❑ Select investments solely in the interests of the plan participants
❑ Diversify investments unless it would be imprudent to do so
3 different methods of GAAP for PERS financial statements:
✓ NCGA Statement 1 – Governmental Accounting and Financial Reporting Principles – follows NCGA 6 in asset valuation; allows pension obligation to be calculated using any one of several acceptable actuarial cost methods
✓ FASB Statement 35 – Accounting and Reporting by Defined Benefit Pension Plans – requires assets to be valued at market value; does not allow salary to be considered in determining benefit obligation
✓ NCGA Statement 6 – Pension Accounting and Financial Reporting: PERS and State & local government employers – also provides that assets s/b valued at cost of amortized cost; requires inclusion of salary in the calculation of the benefit obligation
Regardless of the above options, all PERS are required to provide a common set of disclosures prescribed by GASB 5/Disclosure of Pension Information by PERS and State & Local Government Employers – e.g., description of plan, summary of significant accounting policies, info on funding status and progress and info on contributions required and contributions made.
Unlike CAFRs/CUFRs, PERS reports also contain a separate actuarial section w/ ff. info: actuarial certification letter; schedule of active member valuation data/retirants and beneficiaries added or removed; recommended versus actual contributions; summary of accrued and unfunded accrued liabilities; solvency test; analysis of financial experience; and the financial section also contains: schedule of administrative expenses; investment summary; summary schedule of cash receipts and disbursements/compensation of administrative officials and commissions and payments to brokers/consultants.
SOURCE: THE MANAGEMENT OF STATE & LOCAL RETIREMENT PLANS
PERS – requires wide range of legal, actuarial and investment expertise
Progress in last 3 decades re PERS:
✓ Trustee/administrators – more sophisticated in the performance of their duties
✓ Oversight officials – have begun to recognize the power of pension assets
✓ Standard setting bodies – have undertaken the Herculean task of creating a set of unified and consistent standards
There is no typical pension system – can be broadly categorized into dimensions: number of participants; geographic region; type of participants covered; single-multiple employer plans and administrating jurisdiction: local and state level.
Retirement plans accomplish two objectives:
✓ Compensate employees in exchange for the performance of work
✓ Ensure employees (plan members) and their beneficiaries have a secure retirement
3 basic plan design:
✓ defined benefit – best known and most common – offers employees fixed benefit
✓ defined contribution - employer pays specific contribution – this plus employee’s contribution and investment income earned on account is paid to employee at retirement either as annuity or lump sum
✓ hybrid – employee entitled to higher of the formula DB or “money purchase” DC benefit - the money purchase benefit is based on the actuarial equivalent of two times employee contributions and accumulated investment earnings – reflects the returns of long-term bull markets while protecting retirees against long-term bear market
Basic difference is DB offers fixed income whereas DC provides fixed contribution – additional differences:
✓ budget predictability – DC easier to budget – DB requires actuarial analysis
✓ portability – DC more portable
✓ investment control and risk – in DC employee takes risks
In situations where employees transfer from DB to DC plan, the amount transferred is typically calculated as the present value of the accrued benefit (PVAB) – i.e., the discounted value of the benefit an employee would receive at retirement based on accrued service at time of transfer.
Some keys to successful conversion:
✓ Availability of info to employees
✓ Individualized projections of retirement benefits
✓ Conducting employee opinion poll to gauge sentiment
✓ Over funding of the old DB plan provide resources for more generous conversion terms
GFOA policy: states and localities should have a policy statement to guide plan design decisions w/c takes into service delivery, employment policies and the views of jurisdictions that are part of the pension plan – this policy along w/ potential cost implications/savings to employer s/b the guiding factor in designing/redesigning a retirement program.
Responsibilities for administration of retirement benefits:
✓ Board of trustees – overall management – make policy decisions; employ administrator/consultants; approve procedures and policies to ensure proper performance:
❑ Approve methods for system control and reporting
❑ Set investment policy – trustees act as fiduciaries
❑ Adopt interest rate and mortality tables for actuarial calculation
✓ Policymakers – state and local legislators – determine how much discretion administrators will have in day to day operations
✓ System administrator – in charge of day to day operation
✓ Technical consultants – legal, actuary, investment advisor, auditor, fund custodians
Types of benefit formula in DB plan:
✓ Flat benefit – provide a retirement benefit based on a set % of compensation
✓ Unit benefit – mostly used; promise to pay retirement benefits equal to the unit benefits that have accumulated over the employee’s years of services times employee’s final average salary – has two basic variations:
❑ Single rate – benefit rate is fixed over the service life of the employee – single benefit multiplier is applied to all years of service – easier to communicate to employees and administer
❑ Step rate – benefit rate applicable to the first years of an employee’s service is different from the rate applicable during the remaining years – offers more flexibility to employer and can be tailored to attract new workers
FAS – employee’s average salary during employee’s last 3-5 years of service or during the 3 or 5 years when employee receive highest level of pay.
Before 1951 state and local govt employees were not covered by OASDI or SS.
COLA – provided to mitigate the effect of inflation on retirement income
Calculation of pension costs:
✓ Pay as you go – monies required to pay retirement benefits are appropriated by the employer when benefits come due and no attempt is made to accumulate monies or make long term investments (e.g., SS)
✓ Reserve funding approach – periodic contributions are made in excess of the amounts necessary to pay benefits to current retirees during early years of the plan – offers a number of advantages – as assets accumulate, investment income can be used to defray portion of the required contributions – results in more stable funding pattern – results in lower contribution b/c of investment income – increases security of pension benefits by accumulating assets in a systematic manner and provides equitable treatment of different generations of employees and taxpayers
Actuarial valuation – procedure for measuring expected value of a plan’s future benefit payments and assigning portions of this value to past/current and future years – main purpose is to determine contribution necessary to adequately fund the retirement over a period of time – actuary uses demographics of covered employees, assumptions about rates of investment returns, pay increases, withdrawals from employment and mortality
Actuarial present value – expected value of a plan’s future benefit payments – value as of actuarial valuation date, of the total projected benefits, discounted to reflect the time value of money and the probability of payment – amount that would have to be invested so that the amount invested plus investment earnings would provide funds to pay total projected benefits when due - can be best understood in 2 parts: actuarial present value and total projected benefits
Total projected benefits – sum of all benefits payable to retirees, beneficiaries, terminated employees entitled to benefits, current covered employees entitled to benefits for past service and current covered employees entitled to benefits for future service
Actuarial accrued liability – sum of the costs assigned to years before the valuation date plus interest accrued on those costs
Normal cost – portion of the APV of total projected benefits attributable to a give year
Unfunded actuarial liability – difference between the actuarial accrued liability and the total assets that have accumulated in the plan
Actuarial funding method – method used to determine the contribution amount – few of the methods used by PERS (all of these methods when applied consistently result in sufficient assets being available to meet benefit payments over the long run – but different actuarial methods will result in different patterns of contributions over time):
✓ Unit credit (or unit benefit) actuarial method – includes projected unit credit – two methods: accumulated benefit (credits benefit using the employee’s service and salary history as of the valuation date – the actuarial accrued liability at a given time is a function of current salary and the number of years of employee’s credited past service up that point in time – costs can increase sharply as employees approach retirement); and projected unit credit benefit – similar to accumulated benefit but is modified to take into account the effect of projected salary increase – credits benefits using employee’s service history as of valuation date and the projected salary on w/c the benefits will be based – this approach produces the pension benefit obligation – liability may increase more gradually
✓ Entry age normal actuarial method – does not focus on benefits earned by employees as result of service thru valuation date – instead, computes total cost of funding projected benefits (including from future service) and allocates total cost to the years of past credited service and expected future service – this approach is designed to allocate total cost on a level basis to all years of service
✓ Aggregate actuarial cost method – difference between the APV of projected benefits for the group (rather than individual) and actuarial value of assets is allocated on a level basis over the period between the valuation date and projected exit date – benefits not covered by current assets are amortized over the remaining working career of covered group and actuarial accrued liability is set equal to actuarial value of assets – there is no unfunded actuarial liability under this approach
By controlling the actuarial assumptions, one can influence the level and timing of employer contributions.
As a formal practice, the Actuarial Standards Board requires the actuary to consider the reasonableness of each actuarial assumption independently on the basis of its merits, its consistency w/ other assumptions and the combined impact of all assumptions.
3 methods to determine actuarial value of plan assets:
✓ cost method – investment return is the sum of ordinary income plus the capital gains and losses that result from the sales of investments during the period – a variant is the amortized cost method w/c allows the original premium or discount on fixed income securities to be amortized over the investment period
✓ market method – value of an investment is its market price on the date of the actuarial valuation
✓ moving average method - value of an investment is calculated by a formula that smoothes short term market fluctuations in a manner that better reflects the long term values of investment (mostly used by plans)
funding sources for retirement plans: employer and employee contributions
criteria for developing an investment program:
✓ fiduciary duties – cornerstone of investment program – entrusted to invest funds on behalf of plan participants – loyalty (requires that fiduciaries do not place their own interests above the interests of plan members) and reasonable care (requires that investment be made by informed individuals acting prudently) are the two basic fiduciary duties
✓ federal policy – indirectly regulates PERS thru IRC (section 401a - pensions funds must meet in order to qualify for tax exempt status – must be for exclusive benefit of its members) and ERISA
✓ state policy – mostly determines policies for PERS to adhere to
✓ asset allocation – single most important component determining overall portfolio performance – mix of assets invested
Revenue Ruling 69-495, 1969-2C.B. – IRS chose to interpret exclusive to mean primary – therefore, PERS may retain tax exempt status while making investments that benefit members and other parties provided:
✓ Cost of investments does not exceed their fair market value
✓ Investments offer rate commensurate w/ that offered in the market
✓ Prudent investor and diversification requirements are met
To comply w/ standard of prudence:
✓ Exercise the care, skill and diligence of a prudent individual
✓ Select investments solely in the interests of plan participants
✓ Diversify investments unless it would be imprudent to do so
Checklist of activities for establishing comprehensive investment program:
✓ Adopt investment policy
✓ Ensure competent investment expertise
✓ Provide investment training to trustees and staff
✓ Develop plan for retaining competent investment advisers
✓ Develop and review asset allocation plan
✓ Regularly review role of indexed investments
✓ Review practices that could be called into questions
✓ Establish high standards for impartiality
✓ Establish formal benchmarks for each portfolio
✓ Communicate investment results to plan sponsors, participants and others
Investment risk is measured by the volatility (statistical measure of size and frequency of deviations from an average return) of investment returns for different classes of investments and managed by technique called diversification .
2 forms of risk:
systemic – associated w/ owning an entire class of securities – risk not reduced by increasing number of individual securities – instead reduced by allocating assets among different unrelated classes of securities
unsystemic – associated w/ an individual security – reduced by holding a large number of different securities
GFOA urges state and local financial managers to assure that promised retirement benefits are properly measured in accordance w/ ASB and GASB.
GASB 25 – Financial Reporting for DB Pension Plans: establishes single approved method of accounting and financial reporting – extends to all DB plans except healthcare benefits – requires 2 basic financial statements:
✓ Statement of Plan Net Assets – reported by major asset category – investment reported at fair value – liability is plan’s accounting liability, including refunds due and payable to plan members/beneficiaries; accrued investment/ administrative expenses
✓ Statement of Changes in Plan Net Assets – shows how additions (grouped into contributions) and deductions (grouped into benefits and refunds) from the plan have affected its financial status over the year – present actuarial value of assets, accrued liability, unfunded actuarial liability and annual covered payroll for past 6 consecutive years
statements supported by:
✓ schedule of funding progress – shows actuarial value of assets and accrued liability – shows long term actuarial status of the plan
✓ schedule of employer contributions – shows contributions required to fund the plan
Further, GASB 25 places certain limitations on actuarial calculations – only of 6 actuarial methods may be used: entry age, frozen entry age, attained age, frozen attained age, projected unit credit or aggregate – also, amortization period for unfunded actuarial liability may not exceed 30 yrs after an initial 10 yrs transition period.
Other info on PERS reports:
✓ Actuarial certification letter
✓ Schedule of active member valuation data
✓ Schedule of retirants and beneficiaries
✓ Summary of accrued and unfunded accrued liabilities
✓ Solvency test
✓ Schedule of recommended versus actual contributions
✓ Analysis of financial experience
Other specialized schedules:
✓ Schedule of administrative expenses
✓ Investment summary
✓ Summary schedule of cash receipts/disbursements
✓ Summary schedules of compensation of administrative officials and commissions and payments to brokers and consultants
Challenges in managing future demographics and economic trends:
✓ Large increase in number of births after WWII
✓ Decrease in mortality rates
✓ Federal govt cost shifting
SOURCE: PENSION FUND INVESTING
Trustees’ program structure re pension fund investment:
✓ Retain professional expertise – admin staff, attorneys (legal counsel help determine trustees’ fiduciary responsibilities), actuaries, auditors, investment advisers, etc.
✓ Develop financial profile – assets; obligations for retirees and beneficiaries, etc., expected future contributions
✓ Adopt investment policies – return objectives, risk constraints, diversification requirements
✓ Formalize investment program – investment committee, asset allocation plan, portfolio management strategies, monitoring/evaluation/control
Types of money managers (who buy and sell securities according to investment strategies and market conditions):
✓ Bank trust dept – offer balanced funds and pooled funds (e.g., fixed income or stock or even mutual funds)
✓ Money management firms (SEC registered advisers) – invest directly on clients’ behalf – may also do same as bank trust depts.
✓ Specialty managers – real estate, international securities, etc.
✓ Index funds managers – portfolio consists entirely of stocks or bonds held in amounts proportionate to the representation in a market index
Before an investment program can be designed, trustees must first understand the financial structure of their retirement system.
Formal investment policies typically involve 3 sections:
✓ Rate of return target or objective is set forth
✓ Risk constraint statement – identify system’s tolerance for risk – can be expressed in relation to overall market or in absolute terms
✓ Diversification (cannot eliminate risk) statement – to ensure individual losses don’t undermine the entire portfolio
Formalized investment program typically involves 7 related activities:
✓ Big picture portfolio analysis – s/b studied in the context of its objectives and funding requirements; primary components; recent performance compared w/ general market indices
✓ Asset allocation
✓ Money manager selection
✓ Strategic decision making
✓ Monitoring and controlling performance
✓ Evaluation and adjustments
✓ Reporting
Asset classes include cash equivalents (short-term investments usually considered risk free); bonds and other fixed income securities; stocks; real estate, venture capital, etc.
Cash serves two purposes: provides reserve buying power so that bargains can be bought as they are discovered; purchase other assets when the time is right – portfolio trustees should have their assets in cash when they believe other vehicles are overpriced.
Bonds contain higher degree of risk than cash equivalent securities b/c market prices usually decline if interest rates rise – biggest risk is the loss of purchasing power if inflation returns to double digit levels.
Trustees must be familiar w/ the legal restrictions that typically include state statutes or local laws that govern:
✓ Composition and operations of the board of trustees
✓ Fiduciary responsibilities (keep minutes, inappropriate decisions, limitations on behavior)
✓ Specific investments of pension plans
3 general forms of authorization for legal authority for investments:
✓ specific legal list – identifies instruments that may be allowed
✓ insurance company clause – restricts pension fund’s investments to instruments otherwise allowed by regulated insurance companies w/in the state
✓ prudent investment clause
The long term investment objective of a pension fund is to obtain a good return on investment consistent w/ the risk tolerances of the plan sponsors, trustees and the fund itself.
Diermeier’s 1985 studies of long-term investment returns are attributed to: 86% asset allocation (by far the most important reason that an investment portfolio will do well or poorly); 7% timing of transaction and 7% securities selection.
In a market economy, the production of goods and services depends upon two factors of production: labor and capital.
Equity (form or ownership) – the investor assumes the risks and reaps the rewards of ownership of the enterprise
Investment professionals measure risk in a different quantitative way thru measurement of volatility (statistical measure of the frequency and size of deviation from an average return). Volatility is measured thru use of term called standard of deviation (premised on probability theory) – w/c defines a probable range w/in w/c prices would be likely to fluctuate.
Risk diminishes w/ time: the longer the time periods for w/c investment returns are measured, the less fluctuation from the average is likely to occur.
Unsystematic risk – risk attributable to only a specific stock or bond
Systematic risk (most impt for portfolios w/c are already diversified)– risk of owning the entire class of securities
The only way for pension fund trustees to minimize the risk to their portfolio of an entire market sector collapsing is thru the allocation of assets into unrelated investments – to do this, investor must fund instruments that have good long term return prospects but are likely to perform differently in the short run. The ideal investments would be those w/c produce good long term returns but move in opposite directions in the short run thereby canceling each other’s short term volatility.
Correlation – degree to w/c one asset goes up in value when another also goes up in value. Perfectly correlated assets increase in identical proportions and would have correlation coefficients of +1.0 – on the other hand, if an asset goes up in value and another declines in value, they are inversely correlated and would have a negative correlation coefficient. The lower the correlations, the more likely that it is possible to improve returns w/o adding risks or to diminish the risk of a given level of return.
Ways to approach the process of a normal asset allocation plan:
✓ Naïve investment approach – attempts to replicate a normal universe – e.g., naïve global approach w/c simply mirrors the world portfolio or naïve public universe investing w/c attempts to duplicate the asset allocation used by other public funds
✓ Liability sensitive approach – tries to tailor the portfolio to the fund’s liability profiles (the projected future payments to beneficiaries)
The typical result of a strategic asset allocation policy will be a target level for asset percentages.
If a policy shift is desired in response to changing capital markets, it is most likely to fall into the category of tactical (involves opportunities to acquire undervalued assets for potential appreciation or extraordinary income) asset allocation or asset timing.
Underweight stocks – means to hold stocks less than their normal or strategic % of the portfolio.
In asset timing, the most popular techniques involve financial models that examine economic fundamentals.
The selection of portfolio managers s/b driven by the asset allocation process, and not the reverse. This means the role of a given manager s/b pre-determined by the board of trustees or the investment committee on the basis of a portfolio master plan.
Portfolio manager selection process includes:
✓ Establishing criteria
✓ Selecting potential candidates
✓ Gathering information
✓ Analyzing data
✓ Choosing candidates to interview
✓ Interviewing finalists
✓ Negotiating contract
✓ Distributing assets
The final stage of the pension investment program is the reporting (to the constituents) function: aside from accounting reports in the notes to financial statements; should include: asset allocation; comparison between target or asset allocation plan and the current one; narrative description of any special asset allocation studies/major developments in the capital market and changes in financial managers.
SOURCE: GFOA RECOMMENDED PRACTICES – RETIREMENT &
BENEFITS ADMINISTRATION
PERS investments:
Subject to applicable federal, state and local laws and judicial decisions, governance of PERS investment programs is provided thru the investment policy objectives and constraints established by a plan’s fiduciaries.
GFOA affirms that fiduciaries of PERS must invest plan assets for the exclusive benefit of plan participants.
1) GFOA recommends that when fiduciaries invest and manage assets of the systems, they may only do so in investments that provide collateral benefits if it is determined that the investment providing those collateral benefits would be prudent even w/o the collateral benefits. To be prudent, GFOA recommends the ff basic tests:
✓ Investments designed w/ below market rates of return or other concessionary terms are not acceptable – they compromise a plan’s risk return standard and conflict w/ trustee responsibilities – investments must yield a rate of return commensurate w/ the recognized level of risk of security.
✓ Investments must meet the diversification and credit standards.
✓ Asset strategies should anticipate cash needs.
To adopt comprehensive investment program, board should:
✓ Adopt formal investment policies
✓ Assure board governance processes controlling the selection process of trustees, staff, etc. are designed to assure sufficient and competent investment expertise and fiduciary behavior
✓ Assure systematically appropriate investment training for trustees
✓ Establish organizational plan for and retain competent investment expertise – s/b competitive selection process
✓ Develop and regularly review asset allocation strategy
✓ Evaluate formally and regularly role or potential role of passive/indexed investment strategies – minimize costs of transactions, etc.
✓ Review carefully investment related policies – e.g., soft dollar services, etc.
✓ Establish high standards for impartiality.
✓ Establish formal benchmarks for portfolio and managed account performance
✓ Provide/facilitate regular communications on investment results
Funding of PERS:
The fundamental financial objective of a state or local govt employee retirement system is to establish and receive contributions w/c expressed as a % of active member payroll, will remain approximately level from generation to generation based on the plan’s existing benefit package. Embodied in this objective are the principles of accrual accounting.
2) GFOA recommends that benefits promised are properly measured and then reported in accordance w/ standards established by GASB:
✓ Have an actuarial valuation at least biennially
✓ Establish amortization period of unfunded actuarial accrued liabilities
✓ Assure that actuarially required contributions are collected on a timely basis
✓ Have an actuarial experience study at least once every 5 years
✓ Have a review of plan’s actuarial valuation by an independent actuary at least once every 10 years
✓ Prepare and widely distribute CAFR – should follow GFOA guidance for PERS CAFR
Employee involvement in health plan changes:
Participants for health plan – include active employees and retirees as well as employers in a multiple employer setting
3) GFOA recommends health plan sponsors to consider participants’ opinions and preferences to develop/maintain effective health plan for all participants:
✓ Involve employees in health care plan decisions
✓ Participant involvement s/b part of original adoption of health care plan
✓ Participants’ opinions/preferences can be expressed thru focus groups, surveys, etc. – could be initiated by a short survey
✓ Develop guidelines concerning make up of reviewers/selection-term, etc.
✓ Health plan sponsor and staff should determine type/scope of plan changes that trigger participant involvement
Preparing an effective summary plan description:
Summary plan description (SPD) – primary means of communicating pension plan benefits info – GFOA recommends that PERS prepare SPD that completely, accurately and clearly describes the significant components of the plan for participants – developing SPD should include ff: (SPD contains extensive info)
✓ Assessment of info needs of participants, their interests/general reading level
✓ Thorough analysis of the terms of pension plan/administration/application
✓ Preparation of initial draft should involve many individuals
✓ PERS attorney to review
✓ Consideration of level of detail
✓ Inclusion of charts/tables/graphs
Encouraging financial and retirement planning:
4) GFOA recommends PERS provide suitable access to and encourage the use of retirement planning services for their employees – examples of recommended financial/ retirement planning practices:
✓ introduction to importance of retirement savings in early years of one’s employment
✓ periodic financial education/retirement planning sessions
✓ encouragement of supplemental tax sheltered annuities
✓ unbiased educational programs for employees given optional benefit plans
✓ access to qualified financial planning services
✓ employee instruction how to confirm SS info (recommended regularly every 3 years and at retirement)
✓ retirement planning sessions that include info on other issues employees face at retirement
Directed brokerage programs:
In order to obtain benefits for its participants w/o raising commission costs, PERS may establish a directed brokerage program whereby broker credits a portion of the commission directly back to the plan – this can be done in form of commission recapture of “soft dollars” – recapture began when DOL issued technical bulletin in May 1986:
✓ Commissions s/b considered an asset of a plan; therefore sponsors have fiduciary responsibility to monitor/control these commissions.
✓ Commission recapture is consistent w/ plan’s sponsor’s fiduciary responsibility if the commissions are used exclusively for the benefit of the participants/ beneficiaries and managers continue to achieve “best execution” for plan transactions.
Hard dollar recapture – process whereby plan typically receives cash refund resulting from transactions incurred by fund’s investment managers
Commission – are from equity trades
Spreads – are from fixed income trades
Soft dollar program – means by w/c brokers get paid for providing research and other services to investment managers
There are concerns about participation in directed brokerage programs b/c:
✓ A manager may place directed trades after nondirected trades causing market impact costs to the plan
✓ Certain trades are difficult (involve high % of security’s average daily volume) – may not be able to provide best execution
✓ Soft dollar may give a manager opportunity to effectively charge expenses that its own fee income should support thereby increasing plan’s cost
✓ Off budget income may tempt some administrators to misuse funds or hide them
5) GFOA recommends PERS require comprehensive annual disclosure of all soft dollar benefits and services received by all vendors and all RFP’s for services to the plan and its trustees provide comparison of soft dollar services against hard dollar costs if the plan were to instead direct that commissions be recaptured to the fund. Carefully review credentials, procedures, controls of brokerage firms offering commission recapture and/or soft dollar services and evaluate the ff:
✓ experience in direct brokerage programs – references/relationships/etc
✓ ease of implementation – acceptance/full documentation
✓ institutional trading – product options/exchange memberships/financial solvency/etc
✓ full disclosure – all aspects of relationship/SEC compliance/accurate accounting/etc
✓ manager reporting – trade costs per transaction/authorized broker dealers (why)/soft $ gains
Public pension plan design consideration:
State and local policymakers must view pension benefits w/in the broad context of service delivery and employment policy. Pension benefit is provided to:
✓ Assist employees in preparing for retirement
✓ Compensate individuals for their many years of public service
✓ Assist employer in recruitment and retention of public employees
DB plans – w/ very few exceptions, provide pension benefit calculated using a formula based upon a plan participant’s age, tenure and salary. Employer bears all investment-related risks. DB plans represent 90% of the plans in public sector. Advantages:
✓ Suited for large employers/attract-retain employees for full careers/want tool to manage workforce levels
✓ Allow for definite retirement planning – employer bear all investment risks/ provide easily determine lifetime benefits
✓ Optional COLA may be provided to retirees
DC plans – provide benefits solely based on the assets available in an employee’s individual account – employees direct investment and fully bear investment risk – dollar accumulated will vary depending upon amount contributed/investment performance. Advantages:
✓ Portable benefits
✓ Employer liability obligations fulfilled annually – no unfounded liab
✓ Benefits are fairly easy for participants to understand
Hybrid plans – incorporate features of both DB and DC plans – actual costs to plan sponsors and participants are determined by the number and amount of benefits actually paid to recipients and the source and amount of plan contributions and net income.
6. GFOA recommends PERS have a policy statement that will guide their plan design decisions – should take into account service delivery and employment policies and s/b developed in conjunction w/ all participating jurisdictions.
Assuming potential plan design change is consistent w/ retirement policy, employer and pension system should consider impact of any plan changes on many factors such as:
✓ Benefits for employees w/ different salaries/tenure
✓ Employer contributions
✓ Employee educational efforts
✓ Pre-retirement distribution disability/survivors’ benefits
✓ Early retirement
✓ Distribution of plan benefits
Asset allocation – guidance for DB plans:
Asset allocation – process of determining w/c types of investments are included and the % that they comprise in an overall investment portfolio – single most important component determining overall portfolio performance is how portfolio is allocated among different types of investments. Purpose is to provide an optimal mix of investments that has the potential to produce the desired returns w/ the least amount of fluctuation in the overall value.
Most asset classes fall into 3 broad categories:
✓ Equities – growth, value, large or mid-small cap, domestic, international
✓ Fixed income – short term (less than 5 yrs); intermediate (5-10); long term (30 yrs) bonds – treasuries or agencies, mortgage-backed or corporate securities
✓ Cash equivalents
DBP asset allocations come in 2 forms:
✓ Strategic asset allocation (long-term decisions) – generally concerned w/ allocation of assets into broad classes of equities, fixed income or cash equivalents
✓ Style (dynamic) allocation (intermediate-term decisions) – decisions are made relative to a strategic plan but are implemented in order to take advantage of opportunities or conditions in subasset classes of the capital markets over an intermediate term (-10 yrs) horizon
7. GFOA recommends/encourages PERS to establish w/in their investment guidelines, the ff asset allocation policies and practices (investment decisions must be made w/in the framework of legal restrictions set forth in the state/local statutes as well as the investment policy objectives).
✓ Thoroughly review and evaluate: legal framework/fiduciary standards; actuarial return/risk expectations; need for growth of principal/income/liquidity; tolerance for risk; investment time horizons/other constraints/considerations.
✓ Determine relative impact of the various asset classes on the investment process over different time horizons.
✓ Work closely w/ plan actuaries/consultants to determine expected rate of return
✓ Review/match term structure of assets/liabilities.
✓ Develop long term strategic asset allocation plan.
✓ Develop/review investment plan
✓ Investment goals/objectives should guide level of diversification.
✓ Rebalance plan assets at least annually, if market conditions are favorable.
✓ Establish investment policy to preclude market timing as an acceptable strategy.
Asset allocation – guidance for DC plans:
8. GFOA recommends PERS assure adequate investment education and asset allocation information be provided to participating employees – ff guidelines are recommended/ suggested:
✓ trustees should provide complete comprehensive/coherent spectrum of investment alternatives
✓ investment program should include asset allocation tools
✓ inform participants that there’s trade off between probability/high returns/risks of loss
✓ inform participants about risk exposure/historical market returns of each choice
✓ send account statements on a periodic basis
✓ remind participants systematically about their potential need to change their asset allocation as they age or experience various life events
✓ provide all participants specific info re importance of asset allocation/diversification
To avoid potential liabilities, govt should refrain from making recommendations on specific investment options.
Alternative investments policy for PERS:
2 major types:
✓ those b/c of how they are traded or not traded (based on investment methods)
✓ those b/c of what is traded (assets are nontraditional)
Alternative methods usually involve securities that are not publicly traded and subject to less disclosure and regulations – refer to investment w/ unusual return and volatility expectations of those for w/c the base economic assumptions are different from the more traditional investments. Examples are derivatives; oil/gas, timber, farmland/real estate.
Risk factors – illiquidity – lack of ready trading markets – info weaknesses create additional risk
9. GFOA recommends PERS exercise extreme prudence and care in the use of alternative investments in PERS portfolios – use s/b limited to fulfilling a measurable objective found necessary or desirable by plan trustees and fiduciaries – s/b be carried out as part of strategy based on:
✓ Sound investment policies/objectives
✓ Clear articulation of investment’s economic rationale
✓ Plan’s organizational resources – staffing/culture/discipline/ability to measure and monitor performance, risks/costs
✓ Expanded due diligence efforts by trustees, etc
✓ Development of appropriate benchmarks
✓ Review of plan’s liquidity needs
PROCUREMENT
SOURCE: LOCAL GOVERNMENT FINANCE – CONCEPTS & PRACTICES
Purchasing - encompasses total process of supplying goods and services to user agencies and disposing of surplus property
3 major phases of purchasing cycle:
✓ planning and scheduling
✓ vendor selection
✓ contract administration
No matter who is authorized to make purchases, however, the ultimate authority and responsibility for ensuring that the function is administered competently within legal requirements should be assigned by law to a single person.
Responsibilities of Purchasing:
✓ Assist dept to select most appropriate purchasing method
✓ Compile/maintain list of potential suppliers
✓ Participate in decisions whether to make or buy services (in house or contract)
✓ Secure/evaluate bids, proposals
✓ Award contracts in behalf of dept
✓ Maintain continuity of supply thru coordinated planning, etc.
✓ Seek to assure quality of goods and services (standardize, inspect, etc.)
✓ Advise management/dept on market conditions, product improvements, etc
Procurement cycle: determine need for a product or service – includes variety of tasks, functions and responsibilities
Govt can improve their planning & scheduling thru consolidation of requirements (result in better pricing and increased responsiveness); inventory management (goal is to ensure certain items are immediately available and keep at a minimum govt’s investments in inventories items and overhead costs); market research, value analysis (analytical technique for studying function to determine lowest total cost for performing that function consistent w/ requirements for performance, reliability, quality and maintainability) and scheduling acquisitions.
Questions for value analysis:
✓ What is the function that must be performed?
✓ How is it being performed now and at what cost?
✓ What are the alternative means of accomplishing required function (cost each)?
✓ Which approach s/b taken considering cost of current vs alternative
Value analysis is used to:
✓ Exclude inferior quality merchandise – include performance standards
✓ Facilitate purchase of higher quality and sometimes higher priced goods or services
✓ Reward vendor that pollute less than competitive offerings
✓ Determine if service s/b in-house or contract
✓ Decide if equip s/b leased or purchased
To ensure only live and interested vendors are solicited and pricing is competitive:
✓ Use a proven commodity coding systems to organize bidders
✓ Require or encourage bidders to sign up only for items they wish to bid on
✓ Establish and implement purging vendors that don’t respond to solicitation
✓ Seek out continuously additional firms
An effective system for soliciting offers emphasizes and facilitates the use of the most appropriate source-selection method and most appropriate type of contract. Purchasing’s effectiveness will depend in large degree on the amount and quality of competition its solicitation documents can generate.
Fundamental methods in competitive purchasing of products/services: competitive sealed bidding; multi-step competitive sealed bidding; and competitive sealed proposals.
Types of contract:
✓ Are fixed price or the cost reimbursement type – almost all contracts by local govt fall into this category b/c most products and services required are commercially available – include firm, fixed w/ readjustments and w/ a performance incentive
✓ Call for definite or an indefinite quantity
✓ Involve performance incentive for the vendor
✓ Are one-time requirement (spot purchase) or span of period of time (term)
✓ Are for purchase, lease purchase or true lease
The evaluation of bids and proposals brings together 2 of the most fundamental objectives in govt’l purchasing: economy and fairness.
A contract based on competitive sealed bidding – should be awarded to the responsible bidder whose offer is responsive to the solicitation and lowest in price; on a competitive sealed proposals – s/b awarded to the offeror whose proposal is deemed to represent the best combination of offeror responsibility and responsiveness; a responsive offer is one that at a minimum, conforms in all material respects to the invitation for bids.
Factors for prospective contractor to meet standard of responsibility: has available appropriate financial, material, equipment, facility and personnel resources and expertise or the ability to obtain them; satisfactory record of performance/integrity; legally qualified to contract w/ local govt; supplies all necessary info.
Tips for contract administration to protect govt’s financial interests and ensure quality of services:
✓ Ensure all necessary contractual requirements are spelled out clearly, correctly and concisely in the PO/contract.
✓ Ensure that govt and vendor staff understand their responsibilities
✓ Flush out and resolve as many potential problems before PO/contract is in effect
✓ Check if vendor provides goods or services in accordance w/ PO/contract
✓ Document problems and take appropriate action
✓ Take the lessons that are learned and utilize them for future improvements
Several practices that can be (not necessarily) evidence of ethical violations:
✓ Circumventing competitive bidding requirements (split purchases; making emergency purchase when there’s not true emergency; make “sole source” purchase when competition is available)
✓ Denying one or more vendors the opportunity to bid or propose on a particular contract – (use unnecessary restrictive specification; prequalify bidders on a discriminatory basis; remove companies from bidders lists w/o just cause; require unnecessary high bonding)
✓ Giving favored vendors an unfair advantage (provide info regarding competitors’ offers before bid opening; make info available to favored vendors but not to others; give unfavored vendors inaccurate and misleading info)
Managers can promote adherence to standards of conduct or code of ethics thru: employee training, code enforcement and personal example.
Ways for cooperative procurement: intergovt’l cooperative purchasing; joint administrative/use of facilities; interchange of personnel, info and technical services
2 most common methods:
✓ Piggybacking – large purchaser of an item(s) invites bids, enters into a contract and arranges, as a part of the contract, for other govt’t units to purchase same under basically same terms and conditions
✓ Joint-bid – two or more govt entities agree on specifications and contract terms and conditions for an item of common usage and combine their requirements for this item in a single invitation for bids
SOURCE: ELECTED OFFICIALS’ GUIDE TO PROCUREMENT
Procurement – process thru w/c a govt acquires goods and services for its own use.
The integrity and efficiency of a govt’s procurement system is a crucial component of its credibility.
Procurement stands to benefit significantly from improvements thru automation.
Objectives of procurement: integrity – achieved thru compliance w/ all applicable legal provisions; efficiency and lowest overall cost
Stages of procurement:
✓ Planning and scheduling – meet program and budgetary objectives – planning is necessary to consolidate purchases and achieve economies of scale; scheduling takes advantage of market cycles by anticipating the best time to buy
✓ Source selection – solicitations are issued, ads, vendors selected, goods/services received – program and procurement staff work together to define what is to be bought
✓ Contract administration – terms of purchase agreement are enforced and bills are paid – lead responsibility falls on program personnel
Effective procurement program – team effort w/ customer service orientation in w/c using program is viewed as the customer
Fundamental objective of procurement: provide dept w/ needed goods/services in w/ right quality/quantity on a timely basis as efficiently as possible and at lowest overall cost – to achieve this, procurement function seeks to foster as much competition as possible – adopt a goal of fairness in doing it.
Govt procurement laws provide legal and procedural framework that generally emphasizes price rather than total cost and value and openness, control and accountability rather than efficiency.
Procurement actions – result in legal contracts – governed by common law, Uniform Commercial Code, govt procurement laws and ordinances and by case laws.
The individual who signs a procurement document must have the authority to do so (program officials typically do not have procurement authority).
Essential elements of procurement:
✓ Purchasing structure, policy and authority
✓ Competitive processes
✓ Planning and scheduling
✓ Specifications, bid evaluation and award
✓ Provision for and restrictions on processes that limit competition
✓ Quality assurance, safeguards, materials management
✓ Cooperative purchasing
✓ Professional development, environmental concerns
✓ Clear written procedures available to the public
Common threads flowing thru the above elements: authority; competition;
documentation; compliance
Procurement documents: solicitations; offers; contracts; amendments
Types of agreements:
✓ Agreements to provide care to individuals (regulated by govt like Medicare)
✓ Franchise agreements – govt divests itself of the responsibility for providing a service to the public but continues to regulate the provision of service
✓ Grants-in aid – govt’s objective is to support or simulate a public purpose
✓ Joint ventures – govt and private entity become partners in achieving a public purpose
Distinction between a grants and contracts: grants and cooperative agreement are used when the principal purpose is to provide support or stimulate activities w/c have a public purpose; contracts are used when the principal purpose is the acquisition of property or services for the direct use of govt.
Examples of abuses by govt employees in procurement activities:
✓ Persons external to the process attempting to influence vendor selection
✓ Circumventing competitive bidding requirements
✓ Splitting purchase order to remain w/in small purchase limits
✓ Using emergency procedures in the absence of an emergency
✓ Using sole source when competition is available
✓ Denying one or more vendors the opportunity to bid or propose
✓ Using unnecessarily restrictive specifications
✓ Removing companies from bidders lists
✓ Requiring unnecessarily high bonding
✓ Making info available to some but not to all vendors
Examples of abusive practices by the private sector:
✓ Collusion or price fixing
✓ Providing kickbacks or offering bribes
✓ Low-balling to win contract followed by change orders
✓ Substitution of lower quality goods than specified
✓ Falsifying certifications
To safeguard procurement function: employ qualified and trained personnel; establish procedures w/c effectively insulate procurement activity from political influence; effective contract administration
Suspension – vendor is prohibited from receiving govt contracts temporarily pending an investigation of activities likely to result in debarment
Debarment – vendor is not eligible to receive any govt contract for a specified period of time
Relationship of procurement to other financial functions:
✓ Budgeting – budget development depends on good estimates of the costs and timing for the purchase of goods and services – goes hand in hand w/ planning and scheduling
✓ Accounting – encumbrances, payments
✓ Material management – likelihood of good coordination is enhanced if purchasing, warehousing, inventory and surplus disposition are all under the purview of the chief procurement officer
Centralized procurement office’s primary responsibility is management rather than ordering.
The degree of decentralization varies accdg to local statutes, availability of trained staff, adequacy of procurement info systems; and attitude of central officials.
Delegation should always be in writing.
Key objectives of procurement performance evaluation: (primary measure is customer satisfaction):
✓ Efficiency – depends on the economy of the administrative process of procuring and on the ability of the procurement to buy goods and services at the least cost
✓ Effectiveness – extent to w/c the goods and services acquired are of the desired quality and available for the use of the govt programs when they are needed
Objective performance measures include:
✓ Average length of time to complete a solicitation/number of bidders, solicitation amendments, change orders
✓ Ratio of bid/proposal protests to solicitation issued
✓ Percentage of protests sustained/procurement employees receiving training/contract monitoring reports filed on time/early payment discounts taken
Requirements for competition are specified in the procurement laws or ordinance, regulation and policy. Competitive sealed bidding thru invitation to/for bid (ITBs or IFBs) is the preferred method of announcing a govt’s desire to purchase.
Solicitation – process of announcing the govt’s desire to receive bids or offers from org willing to sell an item or service to it
Bidders or vendors’ lists – maintained by jurisdictions to let vendors know of their interests in selling goods or services to the govt
Specifications – description of the item or service (scope of work) sought – categorized into: design – method for production of goods/services; performance – goal measurable to be achieved thru delivery of goods/services. Specifications must be precise; scope of work for negotiated contract can be less precise – important b/c they serve as the basis for determining whether the supplier provided what the govt believes it procured – best when prepared in a simple standard format – as much as possible, should reflect what is commercially available in the marketplace
Pre-bid or pre-proposal conference – useful technique to uncover confusion in the way specifications are written
When purchasing a particular brand of a commodity, the specification can be defined as “brand name or approved equal”.
Scopes of work for negotiated contract can be less precise but should reflect service objectives, rather than how those services are to be provided.
Standardization of specifications reduces the variety of items purchase
A high incidence of non-competitive procedures is usually indicative of: poor procurement planning; an unresponsive procurement function; and intentional diversion of purchases to preferred sources.
Source selection – process thru w/c govt suppliers are chosen
3 primary methods of competitive source selection:
✓ Competitive sealed bids – preferred method for purchases larger than the small purchase threshold – bids are take it or leave it propositions
✓ Competitive sealed proposals – used for goods and services above the small purchase threshold where specifications cannot be developed so that they are sufficiently precise to make a selection solely based on price
✓ Requests for quotation - vendors are requested to submit a quote w/c may be verbal – faster and less formal than ITB or RFQ
Allowed limitations on competitive methods:
✓ Emergency procedures – practicable given legitimate time constraints
✓ Sole source – when deemed to be the only practicably available and advertising is pointless
✓ Proprietary source – competition can be obtained as a practical matter, only on the basis of a specification of a good or service produced or marketed by one having exclusive legal right
✓ Unsolicited proposals – offer made w/o govt seeking offers – should trigger a competitive process
The focus of procurement is on achieving the best overall value for the govt’s dollar.
Bids are strictly evaluated on price – award is made to the responsive and responsible bidder whose price is the lowest.
Proposals are evaluated partly on price and partly on other factors.
A responsive bidder or offeror is one who responds to all of the significant requirements outlined in the specifications.
A responsible bidder or offeror is one who is deemed to be capable of supplying the goods or services requested in the solicitation – various factors are considered in determining if an organization is responsible; e.g., current on tax payments? – have license, experience, received satisfactory performance, adequate acctg system; etc.
Priority order of sources before new solicitation may be issued:
✓ Existing inventories
✓ Terms or requirement contracts already in place
✓ Items available from sheltered workshops/correctional industries/pooled or cooperative purchasing arrangements
Differences between goods and services:
Goods – tangible items: commodities (articles of trade); non commodities (complex, novel or customized goods)
Services – personal (labor and skill); professional (consulting, expert); client (provided directly to individuals on behalf of govt); construction (roads, buildings); and technology
Real estate acquisition and disposal is, strictly speaking, neither a good nor a service – not suited for procurement.
How to determine w/c method to use when buying goods or services:
✓ Competitive sealed bidding – used when specifications can be written precisely enough for the price to be the only evaluation criteria
✓ Competitive sealed proposals – when specifications cannot be written precisely enough for the price to be the only evaluation criteria
✓ Emergency method – when there is insufficient time to use CSB or CSP
✓ Sole source – when only one source for the item
National Institute of Governmental Purchasing commodity code system – standard for state and local govt – assigns a code or identifier to every type of item a govt is likely to purchase
Commodity codes – used to categorize goods and services – method for organizing data – used in conjunction w/ a suitable automated system w/c allows a procurement office to reduce postage and mailing costs, increase number of responses to a solicitation and collect, analyze and report info that can improve services to dept customers
Service contracting – govt contracts w/ private entity to provide or manage service for w/c govt is legally responsible – govt retains ultimate control and accountability for the services
Privatization – process of transferring to a non-govt entity the responsibility for delivering services previously delivered by the govt – govt may or may not remain accountable for service delivery – covers a range of modes of alternative service delivery
✓ Divestiture – govt gets out of business
✓ Service contracting – contracting out but govt retains control, responsibility and accountability
✓ Franchising – govt gives right to private entity to provide service and runs its own business – govt continues to regulate the service monopoly to ensure adequate customer satisfaction
To justify a decision to privatize, a careful cost savings or cost benefit analysis is normally prepared – may be difficult if govt does not have an effective cost accounting system.
Some of the parties involved when govt is contracting out service:
✓ Procurement authority
✓ Program department
✓ Legal counsel
✓ Personnel authority
✓ Labor relations office
✓ Budget office
✓ Department responsible for regulation of the services
Contract administration – final phase of the procurement cycle – objective is to ensure the vendor and govt comply w/ contract – 2 aspects of administration: quality assurance,
and contract management. – consists of ff activities:
✓ preparing and filing reports on vendor performance
✓ submitting requests to the purchasing authority for changes
✓ developing checklist/schedule of all actions to be performed/ensure completion
Contracts can be terminated for non performance or for the convenience of the govt to cover unforeseen circumstances where goods or services are no longer needed as result of budgetary constraints.
Contract types vary accdg to form and distribution of risk and responsibility between the contractor and the govt – can be categorized accdg to price arrangements and risk (govt’s commitment to purchase)
Procurement laws generally prohibit the use of a cost plus percentage of cost arrangement since it provides no incentive to the vendor to hold costs down.
Contract – legal document that spells out the responsibilities of the supplier and the govt – clarity is essential – terms and conditions are listed that identify the requirements placed by the govt on its contractors – components include: period covered; deliverables; schedule for delivery; price agreement; payment process; process for amending; signatures by authorized parties; order of precedence and severability clauses.
A change to the standard terms and conditions in an invitation to bid is considered an alteration to the request and may render the bid or quote non responsive. While language in the major components of the contract may be negotiable in a request for proposal process, the language in the standard terms and conditions section is considered mandatory – changes s/b be approved by legal counsel.
Cooperative purchasing (pooling) – used when two or more govt combine their purchasing requirements and enter into a contract w/c meets the needs of everyone in the group – an effective tool for smaller govt units. Types include:
✓ Localities may be allowed to buy off state contracts
✓ Federal govt moving to allow states and localities to buy off large federal contracts
✓ Councils of govt
✓ Local govt may act as purchasing agent to meet needs of one or more neighboring jurisdictions
Pooling can reduce administrative costs of procurement and can result in lower costs due to the economies of scale when placing large orders.
Electronic purchasing – posts solicitations electronically on bulletin boards or electronic libraries – use credit card
EDI – (electronic date interchange) – govt to business exchange of data in standard electronic format
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