Employees’ Retirement System of the State of Hawaii June 30, 2016 Actuarial Valuation January 2017 Copyright © 2017 GRS – All rights reserved. AGENDA  New Assumptions  Investment Return Assumption  Life Expectancy  Actuarial Valuation Results  Impact  of 2016 Market Returns Open Group Projections  Projection  2 of Funded Status Recommendations for Higher Contribution Rates Funding a Pension Plan A Retirement System is a financing arrangement where compensation to a member for services rendered is provided in an annuity after employment  Each year there are benefit payments out, contributions in, and investment earnings on Trust assets (hopefully)  The funding goal is for the arrangement to be sustainable indefinitely with intergenerational equity  The annual valuation process measures the liability of the System, compares it to the current assets and projected contributions of the System, to determine if the arrangement is in balance or needs adjustments  3 How assumptions factor in…  Over time, the true cost of benefits will be borne out in actual experience  Cost of benefits NOT affected by actuarial assumptions  Determined by actual participant behavior (termination, retirement), plan provisions, and actual investment returns  But if wrong can lead to poor decisions, poor outcomes      If objective is to fund levelly over active career, and assumptions suggest cost is 10% per year, but true cost is 14% Losses and unfunded liabilities will develop Can’t outrun or “out-assume” the true cost Important to update regularly and re-chart your course Assumptions help us anticipate and manage what each component of the equation will be   Assumptions dictate the timing of the contributions Develop expectations for future contributions, investment returns and benefit payments  Important for decision making  4 Same can be true to the positive side, as overly conservative assumptions would pull resources to the System and away from other alternatives or force unnecessary reductions in benefits Purpose of 2016 Experience Study  Assumptions are not static; they should occasionally change to reflect  New information and changing knowledge  Mortality improvement  Changing patterns of retirements, terminations, etc.  Implementation of improved technology and processes  The analysis addresses these questions for each assumption  What was the plan’s actual experience?  How does that compare with current assumptions?  Is a change warranted? 5 Inside the Actuarial Valuation: Projecting the Liability for each Member What is the probability the member reaches retirement? Hired at age 30 How much will the benefit be? Retire at age 60 with annual benefit  Assumptions must be made to project: ► Future behavior • Voluntary or Involuntary ► Life expectancy ► Economic growth 6 How long will the benefit be paid? Receive benefit for remaining lifetime Magnitude of Individual Assumptions Impact on Determination of Funding Period Investment Return Life Expectancy Payroll Growth Individual Salary Increases Retirement Behavior Termination Behavior Funding Method Incidence of Disability/Active Mortality Other 7 Summary of Adopted Changes Main Changes   Decrease investment return assumption to 7.00% •  Previously 7.65% being phased down to 7.50% Increase life expectancy, adding an explicit assumption for continued future mortality improvement (generational approach) Other Meaningful Changes   Change the investment return assumption from net of all expenses to net of only investment expenses, add explicit charge for administrative expenses (0.35% of pay)  Decrease inflation assumption from 3.00% to 2.50%  Decrease the wage inflation (or employer budget growth) assumption from 4.00% to 3.50%  For Police and Fire, increase the real component (above inflation) of the ultimate salary scale from 2.00% to 2.50%, leaving the nominal assumption of 5% unchanged  For Police and Fire, decrease the step-rate portion of the salary scale  For Police and Fire, increase the probabilities of members becoming disabled for Dutyrelated reasons 8 Investment Return Assumption  The prior ultimate assumption was 7.50%  This is most impactful assumption  There has been a strong trend of lowering future return expectations across the industry  The Board has lowered this assumption to 7.00% 9 Investment Return Risk Comparison to Peers Public Fund Data - Investment Return Assumption 50% 45% 40% 35% % of Plans 30% 25% 20% Current ERS 15% 10% 5% 0% Below 7.00% 7.00% - 7.24% 7.25% - 7.49% 7.50% - 7.74% 2016 10 7.75% - 7.99% 8.00% - 8.24% 8.25% - 8.49% 2011 Source: Public Plans Database Systems that have recently studied this assumption (last 12 months) are more in the range between 6.75% and 7.25% 8.50% or higher Estimated Yields on Market Value of Assets 30.0% Market Returns 20.0% 10.0% 0.0% (10.0%) (20.0%) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Market Return -6.9%-5.9% 1.9% 16.5 11.1 10.8 16.9 -4.1% -18.0 11.5 20.9 -0.6% 12.3 17.8 3.9% -1.2% 6.2% average return for 5 year period ending June 30, 2016 5.3% average return for 10 year period ending June 30, 2016 5.7% average return for 15 year period ending June 30, 2016 11 7.0% 5.3% Capital Market Assumptions – Investment Consultants  Projected real returns were developed using ERS target investment allocation and 2016 capital market return assumptions developed by the following investment consulting firms:         12 BNY Mellon JP Morgan RVK Mercer HEK Wilshire NEPC PCA Distribution of Expected Returns Investment Consultant 13 Distribution of 20-Year Average Geometric Net Nominal Return 40th 50th 60th Probability Probability of of exceeding exceeding 7.50% 7.00% (1) (2) (3) (4) (5) (5) 1 5.42% 6.19% 6.96% 33.4% 39.5% 2 5.99% 6.72% 7.45% 39.3% 46.1% 3 5.95% 6.70% 7.47% 39.6% 46.1% 4 6.30% 7.00% 7.70% 42.8% 50.0% 5 6.41% 7.08% 7.76% 43.8% 51.2% 6 6.35% 7.13% 7.92% 45.3% 51.7% 7 6.71% 7.43% 8.16% 49.1% 56.0% 8 6.73% 7.53% 8.33% 50.3% 56.6% Average 6.23% 6.97% 7.72% 43.0% 49.7% Target Asset Allocation as of June 30, 2016 Risked Based Policy Framework 7% 5% 0% 12% Broad Growth Principle Protection Real Estate Real Return Other 76% 14 Estimates of what investors needed to earn 7.5% 1995 2005 2015 12% 52% 33% 100% 8% Bonds 203333?? 7.5% 7.5% 7.5% Standa'd 6.0% 8.9% 17.2% deviation" amount by which returns could vary Source: Callan Associates 15 THE WALL STREET JOURNAL. Bonds U.S. Large Cap U.S. Small Cap Equity Real Estate Private Equity Illustration of Return Expectations GRS Post-retirement mortality      16 Consistent with trends across the country, beneficiaries of ERS continue to experience improvements in life expectancy This assumption was materially changed in the 2006 experience study to reflect the long life expectancies for the Hawaii population The assumption was updated again in the 2011 experience study However, actual experience has caught up to the current assumption and there is no longer room to allow for further improvement We have discussed the likely change to the mortality assumption in each of the last two valuation presentations Life Expectancy for the General US Population - from Age 65 25.0 20.0 16.2 17.0 18.0 18.3 18.6 18.9 15.0 10.0 0.15 year since 2005 Increase 0.05 per year 1975-2005 12.8 13.1 13.7 14.1 14.6 15.1 18.9 19.2 19.5 20.3 16.8 17.7 15.6 16.3 0.16 year since 2005 Increase 0.10 per year 1975-2005 5.0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Male Female Since 2010, life expectancies continue to increase. The latest published rates (2014) are 20.5 years for females and 18.0 years for males, both from age 65. 17 Source: National Vital Statistics Reports Life Expectancy by State (measured in years from birth) 82 81 80 79 78 77 76 75 74 73 72 71 18 Hawaii (81.3) Mortality Improvement 30.0 1.4 Improvements in Life Expectancy (Males) 1.8 25.0 2.3 Life Expectancy (Years) 1.4 1.6 2.1 20.0 1.3 1.5 1.9 15.0 10.0 5.0 0.0 60 65 Current Age (Years) Teachers General Employees Police and Fire 70 Improvement The solid bar is the life expectancy of a member at the given age from 2000-2005. The shaded area on top is the improvement when compared to the period 2010-2015 19 Post-retirement Mortality – New Assumptions  Created a base mortality table developed using the ERS’ experience    2016 Public Retirees of Hawaii mortality table (2016 PRH) Separate tables for males and females Apply multipliers to fit to various employee groups and genders • Teachers > General Employees > Police and Fire  For the projected improvement assumption, we will use Scale BB (medium)  We will use a fully generational approach to project future mortality improvement   20 With this fully generational projection approach, a gradual and consistent improvement over time would be in the valuation process Greatly diminishes the risk of having to have another large update in a future experience study 2016 PRH Mortality Tables Future Life Expectancy 35.0 30.0 25.0 Males Actual 20.0 Males 2016 PRH 15.0 Females Actual 10.0 Females 2016 PRH 5.0 60 65 70 Ages 75 80 Generational Projection: Illustrated from Another Client Life Expectancy from Age 65 Compared to if we added in more margin using historical methods Project approximately 0.09 growth per year going forward Growth already recognized in valuation Estimated 0.09 growth per year 1995-2013 Today’s 65 year old will have a different life expectancy than a 65 year old in 2025 If historical methodologies are used, there will likely be other adjustments to the assumption in future years 22 ACTUARIAL VALUATION – KEY CHANGES AND ISSUES  New assumptions adopted by Board    Funding period of 66 based on current (new) assumptions, benefits, and contribution policy    7.00% investment return assumption Updated mortality assumption, including provision for further improvement in the future 26 last year Would have been 27 based on previous assumptions 2016 investment performance below expectations    23 -1.2% return on market value of assets • 3.9% return on market value of assets last year Expected 7.65% Wiped out all of previous deferred gains, now in a net deferred loss position ACTUARIAL VALUATION – KEY CHANGES AND ISSUES  2011 Legislature created new benefit tier for employees hired after June 30, 2012    Very small impact on current liabilities (only 4 years of new members in this valuation) Significant impact on future liabilities and funding period calculation 2011 Legislature created schedule of increasing Employer Contributions over fiscal years 2013 – 2016, now at the peak of 25% for Police and Fire and 17% for All Other Employees 24 Sources of Impact  Investments underperformed 7.65% assumption on market basis and a smoothed basis (Negative)   Liabilities grew faster than expected due to salary increases larger than current expectations (Negative)   Also new assumption set expects lower investment returns in the future (7.00%) Also new assumption set expects members to live longer in the future Contributions in dollars are expected to be slightly larger than prior projections  25 Current contribution levels are lower than those required by Hawaii Revised Statutes §88-122(e)(1). However, since new contribution rates have not been approved, we have not incorporated any changes into our valuation results. Market and Actuarial Values of Assets (Smoothed) $ Billions $16 $11 $6 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Market Value $9.9 $11.4 $10.8 $8.8 $9.8 $11.6 $11.3 $12.4 $14.1 $14.4 $14.1 Actuarial Value $9.5 $10.6 $11.4 $11.4 $11.3 $11.9 $12.2 $12.7 $13.6 $14.4 $15.0 AVA is 106.6% of MVA at 2016, compared to 100.3% at 2015 AVA is deferring estimated $929 million in investment losses compared with $49 million gain last year 26 2016 Valuation Results 2014 2016 based on Old Assumptions 2015 Valuation Year 2016 based on New Assumptions Based on Smoothed Asset Value UAAL ($ Billions) $8.58 $8.77 $9.52 $12.44 Actuarial Funded Ratio 61.4% 62.2% 61.2% 54.7% 26 26 27 66 Funding Period in years* Based on Market Value Actuarial Funded Ratio Funding Period in years* 63.9% 62.3% 57.4% 51.3% 24 26 30 85 *Based on open group projection, recognizing new benefits for members hired after June 30, 2012 27 Contribution Recommendations Police and Fire Employees All Other Employees Total UAAL ($ Billions) $2.09 $10.35 $12.44 Funded Ratio 58.2% 53.9% 54.7% Infinite 59 66 Funding Period in years Employer Contribution Rates 25 Year Funding Period from June 30, 2017 based on smoothed assets – ER Rate for FY2018* 39.75% 23.50% 25 Year Funding Period from June 30, 2017 based on market assets** – ER Rate for FY2018* 42.50% 24.75% * ER Rate for all future years assumed to be the same as FY 2018 rate **Board recommended contribution rates 28 Impact of Contribution Rate Increases  Increases in contribution rates increase the dollars that the employers are expected to contribute   Assuming the size of the workforce does not change Expected pensionable payroll for fiscal year 2018  All Other Employees – $3.855 billion  Police & Fire Employees – $493 million  All Employees combined – $4.348 billion  1% increase in contribution rate is expected to increase the FY 2018 contribution dollars as follows:  All Other Employees – $38.6 million  Police & Fire Employees – $4.9 million  All Employees combined – $43.5 million 29 Non-Police/Fire Counts by group and by age 30,000 25,000 20,000 Ret 15,000 Inactive Vested Previous Plans 10,000 Hybrid Pre-2012 5,000 Post 2012 Hires 0 Age 30 Non-Police/Fire Liability by group and by age $9,000 $8,000 $7,000 In Millions $6,000 $5,000 Ret $4,000 Inactive Vested $3,000 Previous Plans $2,000 Hybrid Pre-2012 Post 2012 Hires $1,000 $0 31 Age Funded Ratio 80% 60% 65.0% 67.5% 68.8% 64.6% 61.4% 59.4% 61.4% 62.2% 59.2% 60.0% 54.7% 40% 20% 0% 2006 32 2007 2008 2009 2010 2011 2012 2013 Funded Ratio is Actuarial Value of Assets divided by Actuarial Accrued Liabilities 2014 2015 2016 Projection of UAAL (Assumes current contribution policy continues) Based on 6/30/2016 Valuation 90,000 80,000 70,000 $ in Millions 60,000 50,000 40,000 30,000 20,000 10,000 0 2016 2021 2026 2031 2036 2041 2046 2051 2056 2061 2066 Based on 6/30/2016 Valuation 33 Assumes all assumptions are met, including 7.0% return on market value of assets 2071 2076 2081 2086 2091 Projection of UAAL (With 25 year contribution policy) 90,000 80,000 70,000 $ in Millions 60,000 50,000 40,000 30,000 While increased employer contributions have higher short term costs, saves $225 billion over the full amortization cycle 20,000 10,000 0 2016 2021 2026 2031 2036 Based on 6/30/2016 Valuation 34 2041 2046 2051 2056 2061 2066 2071 2076 2081 2086 2091 Based on 6/30/2016 Valuation with 25 Year Employer Contribution Rates Assumes all assumptions are met, including 7.0% return on market value of assets Summary Recent return environment, compounded with new actuarial assumptions, have materially changed the outlook for ERS  The current employer contribution rates are not   35 adequate to meet the requirements of Hawaii Revised Statutes §88-122(e)(1) We recommend increases in the employer contribution rates in order to lower the funding period to a more appropriate range, with a recommended target of 25 years