Chapter One

AUDITOR GENERAL’S SUMMARY

REPORT CONCLUSIONS

On June 18, 2012, Public Act 097-0694 was signed into law which directed the Auditor General to contract with or hire an actuary to serve as the State Actuary. Cheiron was selected as the State Actuary. The Public Act directed the State Actuary to:

· Review assumptions and valuations prepared by actuaries retained by the boards of trustees of the State-funded retirement systems;

· Issue preliminary reports to the boards of trustees of the State-funded retirement systems concerning proposed certifications of required State contributions submitted to the State Actuary by those boards; and

· Identify recommended changes to actuarial assumptions that the boards must consider before finalizing their certifications of the required State contributions.

Cheiron reviewed the actuarial assumptions used in each of the five systems’ actuarial valuations and concluded that they were reasonable. Consequently, Cheiron did not recommend any changes to the assumptions. Cheiron did, however, make recommendations for additional disclosures for the 2012 valuations (involving information that Cheiron reviewed but which was not presented in the valuation reports) and also recommended changes for future valuations. Recommendations included the following:

· Cheiron concluded that the interest rate assumptions for each of the five systems were reasonable at this time. However, for three of the systems (TRS, SURS, and SERS), Cheiron recommended that the Boards consider lowering the interest rate assumption in the future. Cheiron also recommended that the Boards annually review the interest rate assumption as opposed to waiting for the completion of a formal experience study.

· Cheiron recommended that the systems’ actuaries, in future valuations, consider establishing a corridor that would limit the maximum spread between the actuarial value of assets (smoothed value) and the market value of assets so that the actuarial value of assets, in any year, would be no more than 120 percent of market value or no less than 80 percent of market value. A move to this approach would have no impact on the 2012 actuarial valuation results as the actuarial value of assets for all five systems is currently within the 80 percent to 120 percent corridor.

Cheiron verified the arithmetic behind the calculations made by the systems’ actuaries to develop the required State contribution and reviewed the assumptions on which the calculations were based. Cheiron did, however, recommend that the systems’ actuaries disclose additional information in future valuation reports to enable a more comprehensive analysis of the required State contribution.

The Illinois Pension Code requires that the systems’ actuaries base the required contribution using a prescribed funding method that achieves 90 percent funding in the year 2045. In the actuarial valuation reports, the systems’ actuaries discuss the issues with this funding method. The actuaries for two of the systems (TRS and SURS) specifically recommend that the funding method should be based on 100 percent funding within 30 years. Similarly, the actuaries for the remaining three systems (SERS, JRS, and GARS) recommend reducing the projection period and increasing the 90 percent target. Cheiron concurred with the systems’ actuaries stating that the statutorily mandated funding method does not conform with the accounting parameters set forth by Governmental Accounting Standards Board Statement No. 25 or generally accepted actuarial practices. Cheiron also suggested that, due to the systematic underfunding of the systems, the Boards use the conservative end of any range of assumptions recommended by the systems’ actuaries.

INTRODUCTION AND BACKGROUND

On June 18, 2012, Public Act 097-0694 was signed into law which directed the Auditor General to contract with or hire an actuary to serve as the State Actuary. The Public Act amended the Illinois State Auditing Act as well as sections of the Illinois Pension Code for each of the five State-funded retirement systems. The five State-funded retirement systems are:

· The Teachers’ Retirement System (TRS);

· The State Universities Retirement System (SURS);

· The State Employees’ Retirement System (SERS);

· The Judges’ Retirement System (JRS); and

· The General Assembly Retirement System (GARS).

Requirements of Public Act 097-0694

Public Act 097-0694 requires the State Actuary to conduct an annual review of the valuations prepared by the actuaries of the State-funded retirement systems. Specifically the Act requires the State Actuary to:

· Review assumptions and valuations prepared by actuaries retained by the boards of trustees of the State-funded retirement systems;

· Identify recommended changes to actuarial assumptions that the boards must consider before finalizing their certifications of the required State contributions.

On or before November 1 of each year, beginning November 1, 2012, the boards of each of the systems must submit to the State Actuary a proposed certification of the amount of the required State contribution to the system for the next fiscal year, along with all of the actuarial assumptions, calculations, and data upon which that proposed certification is based.

On or before January 1, 2013, and each January 1 thereafter, the Auditor General shall submit a written report to the General Assembly and Governor documenting the initial assumptions and valuations prepared by actuaries retained by the boards of trustees of the State-funded retirement systems, any changes recommended by the State Actuary in the actuarial assumptions, and the responses of each board to the State Actuary's recommendations.

On or before January 15, 2013, and every January 15 thereafter, each Board shall certify to the Governor and the General Assembly the amount of the required State contribution for the next fiscal year. The Board's certification must note any deviations from the State Actuary's recommended changes, the reason or reasons for not following the State Actuary's recommended changes, and the fiscal impact of not following the State Actuary's recommended changes on the required State contribution.

Contracting with the State Actuary

On July 12, 2012, the Office of the Auditor General issued a Request for Proposals for the services of a State Actuary. On August 24, 2012, the contract was awarded to Cheiron. Cheiron is a full-service actuarial and consulting firm with offices in eight locations throughout the United States. Cheiron has experience working with multiple public pension plans around the country.

REVIEW OF THE ACTUARIAL ASSUMPTIONS

Cheiron did, however, make recommendations for additional disclosures for the 2012 valuations and also recommended changes for future valuations. Exhibit 1-1 summarizes the recommendations made for the various retirement systems. The recommended additional disclosures for the current 2012 valuation involved additional information that was not presented in the systems’ actuarial valuation reports. Cheiron requested and subsequently received this information from the retirement systems. However, for the actuarial valuation reports to fully comply with actuarial standards, Cheiron recommended that this information also be disclosed in the 2012 valuation reports.

Exhibit 1-1 RECOMMENDATIONS TO THE RETIREMENT SYSTEMS
Recommendations	TRS	SURS	SERS	JRS	GARS
Recommended Changes to Actuarial Assumptions used in the 2012 Actuarial Valuations:
Cheiron reviewed the actuarial assumptions and concluded that they were reasonable. Consequently, Cheiron did not have any recommended changes to assumptions this year.
Recommended Additional Disclosures for the 2012 Actuarial Valuations:
· Disclose the merit pay increase assumption by age and active employment status	X
· Disclose how the New Entrant Profile assumption was developed	X	X		X	X
· Include projections of the maximum contribution calculation without Government Obligation Bonds		X
· Offer an explanation of the loss due to retirees from active status			X
· Explore the actuarial liability loss item for salary increases of inactive members and add an actuarial assumption if necessary					X
Recommended Changes for Future Actuarial Valuations:
· Consider lowering the interest rate assumption below its current level and annually review the interest rate assumption	X	X	X
· Provide better explanation of unexplained annual liability losses	X
· Consider establishing a corridor around the market value of assets of 80% to 120% beyond which the actuarial value is limited	X	X	X	X	X
· Include a complete disability incidence table		X
· Continued examination of the recurring loss for benefit recipients and adjustment to assumptions if the loss persists		X
· Demonstrate the development of the capped pay calculation		X
· Consider increasing the 1% of salary load for disability benefits			X
· Disclose the specific data referred to in the description as to how the New Entrant Profile assumption was developed			X
· Consider using a fully generational mortality table				X	X
· Consider using actual data available rather than an assumption for determining if a member will choose a benefit option that provides a survivor annuity				X
· Consider eliminating the disability assumption				X	X
Source: OAG summary of Cheiron’s preliminary reports to the five State-funded retirement systems.

The following sections discuss some of the key assumptions and recommendations. Further details on the assumptions and recommendations, including those not discussed in this summary chapter, are contained in the State Actuary’s preliminary reports for each of the five systems, found in chapters 2 – 6 of this report.

Economic Assumptions

Cheiron reviewed the economic assumptions utilized in the actuarial valuations for each of the five State-funded retirement systems. The following sections discuss two of those assumptions – the interest rate assumption and the inflation assumption.

Interest Rate Assumption

The interest rate assumption (also called the investment return or discount rate) is the most impactful assumption affecting the required State contribution amount. This assumption is used to value liabilities for funding purposes. The retirement systems use varying interest rate assumptions. Exhibit 1-2 shows the interest rate assumptions for each of the five State-funded retirement systems. As can be seen in the exhibit, each of the systems recently lowered its interest rate assumption.

Exhibit 1-2 INTEREST RATE ASSUMPTIONS FOR THE FIVE STATE-FUNDED RETIREMENT SYSTEMS
System	Interest Rate	Notes
Teachers’ Retirement System	8.00%	Lowered from 8.50% for the June 30, 2012 actuarial valuation
State Universities Retirement System	7.75%	Lowered from 8.50% for the June 30, 2010 actuarial valuation
State Employees’ Retirement System	7.75%	Lowered from 8.50% for the June 30, 2010 actuarial valuation
Judges’ Retirement System	7.00%	Lowered from 8.00% for the June 30, 2010 actuarial valuation
General Assembly Retirement System	7.00%	Lowered from 8.00% for the June 30, 2011 actuarial valuation
Source: Retirement system actuarial reports and experience studies.

After reviewing all of the materials made available, Cheiron concluded that the interest rate assumptions for each of the five systems were reasonable at this time. However, for three of the systems (TRS, SURS, and SERS), Cheiron recommended that the Boards consider lowering the interest rate in the future and annually reviewing the interest rate assumption as opposed to waiting for the completion of a formal experience study. As shown in Exhibit 1-2, all three systems have recently lowered their interest rate assumption:

· TRS – The TRS actuary, Buck Consultants, issued a five-year experience study in August 2012 where they recommended that the Board change the interest rate assumption to a figure in the range of 7.75 percent to 8.25 percent. The Board adopted a rate of 8.0 percent at its September 21, 2012 Board meeting.

· SURS – SURS changed its interest rate assumption to 7.75 percent from 8.5 percent for the June 30, 2010 actuarial valuation.

· SERS – SERS changed its interest rate assumption to 7.75 percent from 8.5 percent for the June 30, 2010 actuarial valuation in partial response to a 2010 five-year experience study.

For each of the three systems, Cheiron cited specific rationale for concurring with the system’s interest rate assumption. For example, for TRS, Cheiron noted the following:

· The TRS actuary, Buck Consultants, complied with Actuarial Standard of Practice No. 27 in developing the interest rate assumption;

· Buck’s expectation for expected future earnings over the next 30 years was 8.42 percent; and

· TRS’ long history of actual returns exceeding 8.0 percent.

While concurring with the current interest rate assumptions, Cheiron offered several different rationales for considering lowering the interest rate in future valuations. These included:

· Under Actuarial Standard of Practice (ASOP) No. 27 Selection of Economic Assumptions for Measuring Pension Obligations, Section 3.6.3 Measurement Specific Factors refers to other factors to consider in the selection of the investment assumption. Cheiron believes the statutory funding requirement under the Illinois Pension Code is one such factor to consider in the selection of the investment assumption. Given that the actuarial value of assets are projected to grow at the interest assumption rate, if the market value of assets is less than the actuarial value there is an implied expectation of contribution rate increases. Also if the interest rate assumption is less than the median expected average future return there is also an implied expectation of contribution rate increases. To mitigate these factors a lower long term interest rate assumption should be considered.

· Industry pressure may lead to mandated lower discount rates. In recent years, there has been increased and controversial movement in the actuarial community that actuaries must move away from its traditional theory, and instead employ theories espoused by financial economists. Under this theory, the discount rate used to value pension plan liabilities should be based on near risk free rates of return, because pension liabilities (or benefit payments) are considered more akin to bonds, and that using the higher expected earnings rates hides the risks of achieving that return.

· The federal government, which promulgates minimum funding standards for corporate pension plans, already requires corporate pension plans to utilize discount assumptions that are based on short-term and mid-term bond rates, which are very low.

Cheiron also discussed the nationwide movement among pension plans to lower interest rates. The National Association of State Retirement Administrators (NASRA) conducts the Public Fund Survey which is an online compendium of key characteristics of 99 of the nation’s largest public retirement systems covering 126 public pension plans. Exhibit 1-3 shows the change in the interest rate assumptions, since the inception of the Public Fund Survey in 2001, for 126 public pension plans.

(Please see full report for Exhibit 1-3.) The exhibit shows the shift to lower interest rate assumptions. In 2001, 104 of the 126 plans (83%) used an interest rate assumption of 8.0 percent or higher. The most recent data shows that this number has dropped to only 56 of 126 plans (44%) that use an interest rate of 8.0 percent or higher. The median assumption has fallen below 8.0 percent for the first time. Also for the first time, two plans have adopted a rate below 7.0 percent.

Inflation Assumption

The inflation assumption primarily impacts the salary increase assumption. The five State-funded retirement systems use inflation assumptions ranging from 2.75 percent to 3.25 percent. Exhibit 1-4 shows the inflation assumptions for each of the five systems.

Exhibit 1-4 INFLATION ASSUMPTIONS FOR THE FIVE STATE-FUNDED RETIREMENT SYSTEMS
System	Inflation Rate	Notes
Teachers’ Retirement System	3.25%	Lowered from 3.50% for the June 30, 2012 actuarial valuation
State Universities Retirement System	2.75%	Lowered from 3.75% for the June 30, 2011 actuarial valuation
State Employees’ Retirement System	3.00%	Lowered from 3.50% for the June 30, 2002 actuarial valuation
Judges’ Retirement System	3.00%	Lowered from 4.00% for the June 30, 2011 actuarial valuation
General Assembly Retirement System	3.00%	Lowered from 4.00% for the June 30, 2011 actuarial valuation
Source: Retirement system actuarial reports and experience studies.

Cheiron concluded that the inflation assumptions used by the five State-funded retirement systems were within a reasonable range. Cheiron’s rationale for concurring with the inflation assumptions included:

· The 2012 Old-Age, Survivors, and Disability Insurance Trustees Report projects that over the long-term (next 75 years) inflation will average somewhere between 1.8 percent and 3.8 percent.

· Cheiron’s comparison of other public sector retirement systems’ inflation assumptions as shown by surveys published by the National Association of State Retirement Administrators (NASRA) and Boston College's Center of Public Research (CPR) show that most public sector pension plans utilize an inflation assumption in the range of 2.75 percent to 3.75 percent.

Demographic Assumptions

The retirement systems utilize a number of demographic assumptions such as mortality rates, disability rates, and termination rates. Cheiron reviewed the demographic assumptions and concluded that they were reasonable. Cheiron did, however, make a number of recommendations for additional disclosures for the 2012 valuations and also recommended changes for future valuations concerning various demographic assumptions. As shown previously, Exhibit 1-1 summarizes the recommendations made for the various retirement systems. Additional details on the demographic assumptions examined can be found in the chapters for each of the five State-funded retirement systems.

PROPOSED CERTIFICATION OF REQUIRED STATE CONTRIBUTION

As required by Public Act 097-0694, each of the five State-funded retirement systems submitted to the State Actuary a proposed certification of the amount of the required State contribution for that system. Cheiron verified the arithmetic behind the calculations made by the systems’ actuaries to develop the required State contribution and reviewed the assumptions on which the calculations were based. Exhibit 1-5 shows the amounts of proposed State contributions submitted by the systems.

Exhibit 1-5 AMOUNTS OF STATUTORILY REQUIRED STATE CONTRIBUTIONS
System	State Contribution (for Fiscal Year 2014)
Teachers’ Retirement System	$ 3,438,578,000
State Universities Retirement System	1,551,766,000
State Employees’ Retirement System	1,743,865,000
Judges’ Retirement System	126,808,000
General Assembly Retirement System	13,856,000
Total	$6,874,873,000
Source: 2012 retirement system actuarial valuation reports.

Cheiron did, however, recommend that the systems’ actuaries disclose additional information in future valuation reports to enable a more comprehensive analysis of the required State contribution. To calculate the required State contribution, the systems’ actuaries must make an assumption regarding the new hires that replace existing members over the projection period. This assumption is commonly referred to as the new entrant profile. The new entrant profile is a critical assumption as the required projection of 90 percent funding in 2045 means that the majority of active members at that time will be new hires after the current June 30, 2012 valuation.

Cheiron recommended that the systems’ actuaries disclose additional information as to how the new entrant profile was developed and include all relevant information in their valuation reports to better comply with Actuarial Standard of Practice No. 41 Actuarial Communications.

ACTUARIAL METHODS

Actuarial methods consist of three components: (1) the funding method, which is the attribution of total costs to past, current, and future years; (2) the method of calculating the actuarial value of assets (i.e. asset smoothing); and (3) the amortization basis of the Unfunded Actuarial Liability (UAL). The amortization basis is discussed under the State Mandated Funding Method in the next section.

Funding Method

All of the five State-funded retirement systems use the Projected Unit Credit (PUC) cost method to assign costs to years of service. This method is required under the Illinois Pension Code. Cheiron had no objection to using the PUC cost method as it is an acceptable method that is used by other public sector pension funds. However, Cheiron would prefer the Entry Age Normal (EAN) funding method as it is more consistent with the Pension Code’s requirement for level percent of pay funding.

Under the PUC method, which is used by some public sector pension funds, the benefits of active participants are calculated based on their compensation projected with assumed annual increases to ages at which they are assumed to leave the active workforce by any of these causes: retirement, disability, turnover, or death. Only past service (through the valuation date but not beyond) is taken into account in calculating these benefits. The cost of providing benefits based on past service and future compensation is the actuarial accrued liability for a given active participant. Under the PUC cost method, the value of an active participant’s benefits tends to increase more sharply over their later years of service than over their earlier ones.

As a result of this pattern of benefit value increasing, while the PUC method is not an unreasonable method, more plans use the EAN funding method to mitigate this affect. The NASRA Public Fund Survey indicates that only 15 of the 126 public pension plans (12%) use the PUC cost method.

Asset Smoothing Method

The actuarial value of assets for the systems is a smoothed market value. Unanticipated changes in market value are recognized over five years in the actuarial value of assets. The primary purpose for smoothing out gains and losses over multiple years is that the fluctuations in the actuarial value of assets will be less volatile over time than fluctuations in the market value of assets. Cheiron concurred with the use of the asset smoothing method noting that smoothing the market gains and losses over a period of five years to determine the actuarial value of assets is a generally accepted approach in determining actuarial cost.

Another aspect of asset smoothing methods is whether or not to limit the maximum spread between the actuarial value of assets (smoothed value) and the market value of assets. Many public sector pension plans limit the actuarial value of assets to, in any year, no more than 120 percent of market value or no less than 80 percent of market value. According to Actuarial Standard of Practice No. 44 Selection and Use of Asset Valuation Methods for Pension Valuations 3.3(b)(1) the actuarial value of assets should "...fall within a reasonable range around the corresponding market value." Therefore, Cheiron recommended that the Boards consider moving to this approach in future valuations. Cheiron also noted that a move to this approach would have no impact on the 2012 actuarial valuation results as the actuarial value of assets for all five systems is currently within the 80 percent to 120 percent corridor.

OTHER ISSUES

Cheiron raised two other issues in its reports to the retirement systems. The first issue related to the State mandated funding method and the second issue related to the State mandated projection method.

State Mandated Funding Method

In the TRS June 30, 2012 Actuarial Valuation Report, TRS’s actuary, Buck Consultants, notes the following:

· “Public Act 94-0004 has resulted in contributions to the System much less than those that would be contributed under generally accepted actuarial standards. Under such standards, a funded ratio of 100% would be achieved within 30 years as opposed to the 90% funded ratio achieved by 2045 under Public Act 94-0004.”

· “The continued use of Public Act 94-0004 in its current form will continue the history of an inadequate funded ratio of less than 100%. In addition, the Net Pension Obligation clearly exhibits the shortfall of the Public Act 94-0004 contributions when compared to the GASB 25/27 ARC [Annual Required Contribution], which is generally recognized as a reasonable contribution under generally accepted actuarial standards.”

Similarly, in the SURS June 30, 2012 Actuarial Valuation Report, SURS’s actuary, Gabriel Roeder Smith, notes the following:

· “The calculations in this report were prepared based on the methods required by the Statutory funding policy…In light of the current funded status of this Retirement System, we do not endorse this funding policy because the Statutory funding policy defers funding for these benefits into the future….”

Cheiron concurred that, under generally accepted actuarial standards, the funding method should be based as a minimum on achieving 100 percent funding within 30 years. Cheiron also suggested that, due to the systematic underfunding of the systems, the Boards use the conservative end of any range of assumptions recommended by the systems’ actuaries.

State Mandated Projection Method

Cheiron noted that under the Pension Code, the actuarial methodologies utilized in performing the 2045 projection of the systems’ funded status assume that the future earnings rate is applied to the actuarial value of assets (smoothed value) rather than the market value of assets. If the actuarial value of assets (smoothed value) is higher than the market value of assets, as it has been for each of the systems, the assets of the system would have to earn a much higher rate of return than what was projected. Cheiron recommended that consideration be given to requiring that the projected future earnings of the systems be based on the starting market value of assets rather than the smoothed value of assets.

RESPONSES TO THE RECOMMENDATIONS

Each of the five State-funded retirement systems provided responses to Cheiron’s recommendations contained in the preliminary reports. The systems generally agreed with Cheiron’s recommendations. The complete responses are in Appendix C. Cheiron offered additional comments regarding the response from TRS.

Response from Teachers’ Retirement System

In its response to Cheiron’s preliminary report, TRS agreed with the majority of recommendations and findings of Cheiron. However, TRS disagreed with Cheiron’s recommendation that TRS annually review the interest rate assumption rather than wait for the completion of the next formal experience study. TRS stated in its response that “…one year is not long enough to consider changing such a key assumption, and actually making the change would add more volatility to the state contribution.”

Cheiron disagreed with TRS. In asking for TRS to review the assumption annually, Cheiron was not suggesting that the review be based on one year’s return, which they agree is too short. Cheiron’s recommendation for an annual review was to start with the conclusions arrived in Buck’s July 1, 2006- June 30, 2011 Experience Study, and annually consider whether the factors reached in that study have changed materially enough (e.g. new market expectation, major economic movements, etc.) to warrant further change. In Cheiron’s opinion, there is no benefit to be gained to wait for a formal study for the interest rate assumption.

Cheiron also recommended additional disclosures, including disclosures on the historical development of TRS assets without the pension obligation bonds. In its response, TRS stated that they will give careful consideration to how they could present such items. However, they noted: “Other recommended schedules may make the report even more informative to an actuary, but we are concerned that they may not add the same value for lay users.” Cheiron notes that the recommendation was not just to be more informative but was based on adherence to Actuarial Standard of Practice No. 41 Section 3.2 which states that the actuarial report should present data “…with sufficient clarity that another actuary qualified in the same practice area could make an objective appraisal of the reasonableness of the actuary’s work as presented in the actuarial report.” The value to the lay user is in the knowledge that the inclusion of the additional information makes the report more transparent to the methods used in calculating the State contributions.