TO:	Honorable Jane Nelson, Chair, Senate Committee on Finance
FROM:	Jerry McGinty, Director, Legislative Budget Board
IN RE:	SB321 by Huffman (relating to contributions to, benefits from, and the administration of the Employees Retirement System of Texas.), Committee Report 1st House, Substituted

COST ESTIMATE

Projected as of  August 31, 2021 Actuarial Valuation

Employees Retirement System	Current	Proposed	Difference
Employer Contribution (% of payroll)	10.00%	10.00%	0.00%
Employee Contribution (% of payroll)	9.50%	9.50%	0.00%
Total Contribution (% of payroll)	19.50%	19.50%	0.00%
Annual Level Dollar Contribution (millions)	$0.00	$350.00	$350.00
Unfunded Actuarial Accrued Liability (millions)	$15,119.80	$15,119.80	$0.00
Amortization Period (years)	Infinite	54	N/A

Projected as of August 31, 2021 Actuarial Valuation

Law Enforcement & Custodial Officers Supplemental Retirement Fund	Current	Proposed	Difference
Employer Contribution (% of payroll)	0.50%	0.50%	0.00%
Employee Contribution (% of payroll)	0.50%	0.50%	0.00%
Total Contribution (% of payroll)	1.00%	1.00%	0.00%
Level Dollar Contribution (court fees in millions)	$17.10	$17.10	$0.00
Unfunded Actuarial Accrued Liability (millions)	$1,663.00	$1,663.00	$0.00
Amortization Period (years)	Infinite	Infinite	N/A

 
ACTUARIAL EFFECTS
Employees Retirement System of Texas (ERS)

The bill would amend the Government Code to require the state to make additional contributions of $350 million in annual payments to ERS and restructure the retirement benefit program into a cash balance plan for new members hired on or after September 1, 2022. 

Given that the benefit changes are prospective, and only apply to new members beginning September 1, 2022, there is no immediate impact on the unfunded actuarial accrued liability (UAAL), funded ratio, expected normal cost, or the employee contributions for ERS or Law Enforcement and Custodial Officers Supplemental Retirement Fund (LECOS). According to ERS' actuarial analysis, the additional payments to the UAAL would be the largest contributor to moving the plan from an infinite funding period to a 54-year funding period. The new benefit tier would not decrease the employer cost significantly, but according to the actuarial analysis, the risk sharing design of the proposed cash balance plan would significantly diminish the creation of future unfunded liabilities in the case of investment under performance. To achieve a 31-year funding period, the state would need to contribute $183.5 million in addition to the $350 million, for a total of $533.5 million per fiscal year.

The actuarial review states that under the current Pension Review Board (PRB) Pension Funding Guidelines, funding should be sufficient to cover the normal cost and to amortize the UAAL over as brief a period as possible, but not to exceed 30 years, with 10 - 25 years being the preferable target range. ERS statute defines actuarial soundness, for purposes of making modifications to benefit and contribution levels, as no more than 31years. ERS is currently actuarially unsound, with an infinite amortization period. The projected funding period would decrease to 54 years with the passage of the bill.

LECOS

According to the analysis, the bill would not provide additional payments to LECOS, therefore, its unfunded liability is still expected to never be paid off, and the fund is still projected to have a depletion date of 2048. The actuarial analysis notes that the value provided by the cash balance provisions is largely comparable to the current defined benefit provisions, with a slight increase in the expected employer cost. Additionally, the analysis notes that an increase to the employer contribution of 2.51 percent of pay, or an annual level dollar payment of $58.3 million, would be required to amortize the LECOS UAAL within 31 years.

SYNOPSIS OF PROVISIONS
 
The bill would amend several chapters of the Government Code and add Chapter 820, Cash Balance Benefit.  The bill would establish a new benefit tier (Group 4) in both ERS and LECOS for new members hired on or after September 1, 2022. The new benefit tier would be structured as a cash balance benefit with a minimum guaranteed interest credit plus the opportunity for gain sharing when the average return over the previous five years exceeds four percent. Additionally, the bill would require the state to make additional payments to pay off the system's UAAL.
 
New Benefit Tier
ERS

An employee of the new tier would contribute six percent of their compensation into their individual accounts. At retirement, the system would convert the member's total account balance, equal to the member's accumulated account balance plus a 150 percent employer match, to a lifetime annuity. Members of the employee class would be vested after five years of service and could retire with a minimum of five years of service at age 65, or if they met the rule of 80 (the sum of years of service and the member's age equals or exceeds 80). There are no changes to the retirement eligibility for members of the elected class.

LECOS

Law enforcement and custodial officers would contribute an additional two percent of compensation into LECOS. At retirement, the system would convert the member's total account balance, equal to the member's accumulated account balance, including interest, for contributions paid into LECOS plus a 300 percent employer match, to a lifetime annuity. While the bill language is not clear on whether the 300 percent match also applies to the six percent of contributions made by law enforcement or custodial officers to ERS, it is the PRB's understanding that the bill author intended for this match to only apply to the two percent additional contribution made to LECOS. There are no changes to retirement eligibility for LECOS members.

Account Balance Interest Adjustment

The bill would set a minimum interest credit at four percent and a maximum credit at seven percent. Each fiscal year, the retirement system would credit the employee or retiree's accumulated account balance with a four percent interest credit plus a gain sharing interest credit if applicable. The gain sharing interest adjustment would be 50 percent of the average return on the system's investments over the preceding five years greater than four percent and less than 10 percent, for a maximum of a three percent gain sharing interest adjustment. For example, if the average rate of return over the preceding five years were seven percent, the total interest credited to the employee's account would be 5.5 percent, consisting of the four percent minimum interest credit and 1.5 percent of gain sharing interest credit.

The bill would also amend the current statute by requiring the state to make an additional payment of $350 million to the retirement system each fiscal year to pay off the UAAL.
 
FINDINGS AND CONCLUSIONS
According to the actuarial review, while the cash balance benefit does not impact the expected long-term employer cost, it does lower the long-term employee cost, reducing employee contributions from 9.5 percent to 6 percent of pay and significantly reduces certain risks to the state. Specifically, the gain sharing feature ensures both the member and the employer share some of the investment risk, and the likelihood of future increases in the unfunded liability due to investment under performance is significantly lowered.

The actuarial review notes that while the overall structure of the benefit changes is described in the bill language, the ERS board would also be authorized to adopt rules as necessary to implement the bill. The actuarial review refers to two primary areas associated with the gain sharing interest adjustment that warrant consideration, either for clarification in the bill or for the ERS board to consider when developing rules.

Average Return Calculation
The current bill language indicates the gain sharing interest rate is a function of the average return during the preceding five fiscal years while not specially detailing how the average return is to be calculated. It is important to recognize that the methodology used to determine an average return over multiple periods should be prescribed clearly.

Retiree Gain Sharing Interest Adjustment
The current language in the bill provides for a gain sharing adjustment for a retiree that is based on the retiree's accumulated account balance.  However, the actuarial analysis states that retirees can participate in gain sharing interest credit after retirement by having their annuity adjusted.  Any post-retirement gain sharing should account for actual distributions made to the retiree.
 
The PRB actuarial review further states that the bill significantly improves the funding of the plan, eliminating the depletion date on a funding basis. Therefore, it is likely the bill could eliminate the depletion date on an accounting basis, resulting in a significant reduction in the reported net pension liability.
 
METHODOLOGY AND STANDARDS

The ERS and LECOS analysis relies on the participant data, financial information, benefit structure and actuarial assumptions, and methods used in the ERS and LECOS actuarial valuation updates for February 28, 2021. According to the PRB actuaries, the actuarial assumptions, methods and procedures are reasonable for the purpose of this analysis. All actuarial projections have a degree of uncertainty because they are based on the probability of occurrence of future contingent events. Accordingly, actual results will be different from the results contained in the analysis to the extent actual future experience varies from the experience implied by the assumptions. This analysis assumes that no other legislative changes affecting the funding or benefits of both ERS and LECOSRF will be adopted. It should be noted that when several proposals are adopted, the effect of each may be compounded, resulting in a cost that is greater (or less) than the sum of each proposal considered independently.
 
SOURCES
Actuarial Analysis by R. Ryan Falls, FSA, EA, MAAA,and Joseph P. Newton, FSA, EA, MAAA, Gabriel, Roeder, Smith & Company April 20, 2021.
Actuarial Review by Marcia Dush, FSA, EA, MAAA, Board Actuary, and Kenneth J. Herbold, ASA, EA, MAAA, Staff Actuary, Pension Review Board, April 21, 2021.
 
GLOSSARY
Actuarial Accrued Liability(AAL) - The current value of benefits attributed to past years.
Actuarial Value of Assets (AVA) - The value of assets used for the actuarial valuation. The AVA can be either the market value (MVA) or a smoothed value of assets.
Amortization Payments - The portion of the total contribution used to reduce the unfunded actuarial accrued liability (UAAL).
Amortization Period - The specified length of time used when calculating the amortization payment portion of an actuarially determined contribution, or as the time it would theoretically take to fully fund the UAAL or fully recognize a surplus. The State Pension Review Board recommends that funding should be sufficient to cover the normal cost and to amortize the UAAL over as brief a period as possible, but not to exceed 30 years, with 10-25 years being the preferable target range.
Actuarial Cost Method - An actuarial cost method is a way to allocate pieces of a participant's total expected benefit to each year of their working career. In other words, it is a technique to determine how much of the present value of future benefits (PVFB) to assign to past service (AAL) vs. future service (present value of future normal costs, or PVFNC).
Funded Ratio (FR) - The ratio of actuarial assets to the actuarial accrued liabilities.
Market Value of Assets (MVA) - The fair market value of the system's assets.
Normal Cost (NC) - Computed differently under different actuarial cost methods, the normal cost generally represents the current value of benefits attributed to the present year. The employer normal cost equals the total normal cost of the plan reduced by employee contributions.
Present Value of Future Benefits (PVFB) - The current value of all benefits expected to be paid from the plan to current plan participants.
Present Value of Future Normal Costs (PVFNC) - The current value of benefits attributed to the present year and all future years (includes the normal cost as the first year).
Unfunded Actuarial Accrued Liability (UAAL) - The difference between the actuarial accrued liability and the actuarial value of assets; therefore, the UAAL is the amount that is still owed to the fund for past obligations.