* Evaluation of 11-14-2012 draft of MOFD Long Range Financial Forecast

On November 14, 2012 MOFD released its first 15 year (previous forecasts have been limited to 5 years) Long Range Financial Forecast (LRFF).  The focus of the forecast was to address the issue of funding long term liabilities while continuing to provide service to the community.  The Task Force commends MOFD for focusing on long term liabilities and extending the term of its forecast.

MOFD's LRFF does not vary significantly from the Task Force's revised long range forecast (Table IV-4b in the September 2012 Task Force report) on the revenue side.  However, the Task Force believes that MOFD underestimates its long term liabilities and is too aggressive in basing its long term plans on a 7.75% earning rate for its pension assets.

MOFD identified the three main long term liabilities as:

  1. A Pension Obligation Bond:  This is a fixed rate bond with a current balance of $24 million, an interest rate of about 5.25%, and fixed payments increasing from $2.4 million this year to $3.8 million in 2022 after which this loan will be paid off.
  2. A post retirement medical benefit liability (termed OPEB standing for Other Post-Employment Benefits):  To date these benefits, provided to all retirees, have been unfunded; paid for out of current revenues.  The last actuarial report on this liability showed that these future benefits, when discounted back to the present at a 4.25% discount rate, would equate to $26 million and when discounted at 7.75% would discount to $17 million.  The  LRFF states that it believes MOFD can, through negotiations with its employees and accounting maneuvers, reduce this liability to $12 million.
  3. Underfunded (called UAAL standing for Unfunded Actuarial Accrued Liability) pension liabilities: Currently MOFD's UAAL is about $24 million.

The LRFF then treats each of these liabilities as loans with stated or assumed interest rates and projects payments for 15 years (through fiscal year 2027/28) that will reduce each of these outstanding liabilities to zero.  While the Task Force approves of the District's desire and commitment to deal with its outstanding liabilities, the Task Force believes that viewing the three classes of liabilities as debt is only applicable to the first one, the Pension Bond, which truly is a loan.  Viewing the other two as "relatively small" loans hides the true nature and magnitude of these liabilities, opening the district and the community up to continuing economic hardship and putting the provision of appropriate emergency services at risk.  These liabilities need to be explicitly displayed in the LRFF so that the funding of them can be rationally dealt with.

The OPEB and pension liabilities are structurally the same, they just differ in magnitude.  The other difference is that the OPEB liabilities are completely unfunded while the pension liabilities are partially funded.  This does not make a difference in how these liabilities are treated in a financial sense but it does make a difference in an accounting sense.  The LRFF should focus on finances, not accounting.

What are MOFD's liabilities (and assets)?

For the Pension Obligation Bond, the liabilities are fixed.  $32 million of total payments due over 11 years with a current balance of $24 million (which may or may not be pre-payable; not that MOFD has the ability or desire to prepay it).  So the total liability is $32 million with a discounted present value of $24 million.

For OPEB the liabilities are projections.  The Task Force asked MOFD as recently as August 2012 what these projections, year-by-year, were and was told that MOFD did not know.  Only their actuary knew.  The numbers are in a "black box" and all the actuary would say (in its latest report dated August 27, 2010) was that their discounted present value, using a 4.25% discount rate, was $26 million and using a 7.75% discount rate was $17 million.  Now MOFD is saying the "black box" might be manipulated to produce a value of $12 million.  The Task Force says the black box should be opened to the light of day.  The actual projected liabilities, stretching out 30 to 60 years, should be shown and then, and only then, can a funding plan be put into place.

For the pension plan the liabilities are also projections; they are also hidden in a black box; and only CCCERA's actuary knows the actual values (again, MOFD confirmed they did not know the year-by-year values as recently as August 2012).  However, given CCCERA's report of a discounted present value of $144 million using a 7.75% discount rate, the Task Force estimated the total undiscounted liabilities to be about $600 million, stretching out for 60 years.  These liabilities are partially offset by assets which CCCERA manages for MOFD.  These assets currently have a market value of $112 million.  But the value used in determining the UAAL (an accounting concept) is not the current market value of the assets but what is called the "actuarial" value ($120 million).  Thus, MOFD's $24 million pension UAAL is the result of subtracting the $120 million actuarial value of the assets from the $144 million discounted present value of the liabilities.

The UAAL is not a loan.  Its magnitude can fluctuate dramatically as it is the difference between the discounted present value of $600 million in liabilities and the value of $112 million of assets.  Even if everything goes according to "plan" (appropriate contributions are made to fund newly vested liabilities and the assets earn at the projected 7.75% interest rate), over the next several years the accounting value of the assets will be decreased so that it approaches the market value and the UAAL will increase by $8 million.  MOFD's LRFF does not take this into account.  It also does not take into account the possibility that CCCERA might decrease its assumed asset earning rate as other pension plans have which would increase the discounted present value of the liabilities and thus the UAAL (a one half percent increase would increase discounted liability and UAAL by $10 million).  And the assets may not earn at the 7.75% rate CCCERA, and the MOFD LRFF, assumes.  Over the past ten years they have earned less than 5%.  What happens if they do not earn at this rate?  Is it better to plan for the best or plan for the worst and hope for the best?

What the analysis needs to include

First of all it needs to start with MOFD's true OPEB and pension liabilities.  The OPEB liabilities can be obtained from MOFD's own actuary.  The pension liabilities need to be obtained from CCCERA's actuary.  However, considering the magnitude of the pension liabilities (estimated at $600 million), it would be prudent for MOFD to make a "shadow" or verification analysis on its own of these pension liabilities.  If MOFD can really constrain, or even reverse, its salary growth rate (pension benefits are dependent on an employee's final year salary level), total liabilities might actually be reduced.

Then a financial plan needs to be put into place to fully fund both the OPEB and pension liabilities.  While CCCERA is assuming its assets will earn at 7.75%, maybe the MOFD community does not want to make that same bet.  CCCERA may have earned 7.75% over the past 20 years but they have earned slightly below 5% over the past ten years.  This means CCCERA must have earned an average of almost 11% per year for the first ten years of that 20-year period.  Is this performance repeatable?  Are we willing to bet on it, risking the public safety of the next generation if we are wrong?  What will happen if we bet that the 7.75% will be repeated but only 5% is achieved?  What will happen if we bet that 5% will be repeated and 7.75% is achieved?   Shouldn't we have a financial model which can test these possibilities?  The current LRFF does not.

Impact of a Revised Analysis

The Task Force has produced a revised analysis of just the OPEB and pension liabilities.  The attached tables show the impact of this analysis using three assumed asset earning rates:

  • The 7.75% asset earning rate CCCERA currently assumes and the draft MOFD LRFF adopts.
  • The 7.25% asset earning rate which CalPERS's actuary recommended CalPERS revert to (however, Calpers only dropped its rate to 7.50%).
  • A 6.00% asset earning rate which some economists believe is a more reasonable rate to assume.  Even this exceeds CCCERA's average return over the past ten years by a full percent.

The results from these three different assumptions are:

  • Assuming that MOFD assets earn 7.75% and the additional UAAL funding suggested by MOFD in the 11/14/2012 draft LRFF is provided, current funding will be depleted by 2040, leaving almost $300 million of remaining unfunded liabilities.  It would take an additional $20 million asset infusion today to fund this or $1.8 million per year, on top of the LRFF recommended funding, for the next 25 years to prevent this underfunding.

    The reasons the Task Force analysis, even assuming a 7.75% asset earning rate, indicates that the LRFF plan falls far short of removing all unfunded liabilities within 15 years are (1) the LRFF plan ignores the $8 million difference between the accounting value of the pension assets and their market value and (2) the Task Force continues to use the OPEB liabilities specified in District's 2010 report from its actuary until the assumption that these liabilities can be reduced by a significant amount is better understood and agreed upon.

  • Assuming that MOFD assets earn a more conservative 7.25%, they will be depleted three years earlier, by 2037; the total remaining unfunded liabilities will be almost $330 million; and it would take an additional $30 million asset infusion today to fund this or $2.6 million per year for the next 25 years to prevent this underfunding.

  • Assuming MOFD makes the conservative assumption that its assets will only earn 6.0%, the current assets (including the additional funding assumed by the draft LRFF) would be depleted by 2034; total remaining liabilities of almost $400 million would be left unfunded; and it would take an additional $60 million asset infusion today to fund this or $4.8 million per year for the next 25 years to prevent this underfunding.

Where will this $1.8 to $4.8 million of additional funds come from?  Since 85% of MOFD's total expenses are personnel expenses, there is only one place.  As the Contra Costa Grand Jury report recently concluded, "fire agencies should conduct evaluations of alternative service models."  It appears that past promises are impacting the ability to do business the same way we have been.  Maybe there is a better way.

Further Notes

            CCCERA demands to cure underfunding:  CCCERA "bills" its "clients" for the underfunding of their accounts.  It amortizes the underfunded amount (the UAAL) over 18 years including interest at the assumed asset earning rate (7.75%).  The current $24 million UAAL will cause CCCERA to "bill" MOFD $2.5 million (on top of the cost of funding newly vested benefits each year).  This is much greater than the $1.6 million LRFF projects for next year.  Within a few years, as the "actuarial" value of the assets moves toward the market value of the assets the UAAL will increase to $32 million and the "bill" will increase to $3.3 million.

In addition, CCCERA might follow CalPERS and lower its assumed earning rate.  If it lowered the assumed earning rate by only one half of a percent it to 7.25%, MOFD's net liability would increase by $10 million to $42 million and the payment required by CCCERA to amortize this over 18 years would increase to over $4 million per year; not the $1.8 million anticipated by MOFD in its LRFF.  Will CCCERA allow MOFD to pay "interest only" on its unfunded liabilities for ten years as the LRFF assumes or will it demand an principal and interest amortization?

            GASB (Governmental Accounting Standards Board) changes:  Starting at the end of 2014 (fiscal year ending 6/30/2015 for MOFD), the definition of MOFD's UAAL and its placement in the balance sheet will change. (A) instead of discounting all MOFD pension liabilities at the assumed CCCERA asset earning rate of 7.75%, only those liabilities that can be paid off by current assets can be discounted at that rate.  Liabilities beyond those covered by current assets must be discounted at the 20 year municipal bond rate.  Currently that rate is slightly above 3%.  In addition, the asset value to be used to net against the discounted liability will be the current market value of the assets, not the actuarial value.  Finally, the net value (currently a net liability) will be put on the balance sheet and not "hidden" in the footnotes.

How will this impact MOFD?  Assuming a 7.75% asset earning rate and a 3% municipal bond rate, the attached table shows that these changes in GASB accounting rules will increase MOFD's total pension liability from $144 million to $244 million; increase net liabilities (UAAL) from $24 million to $131 million; and move this liability from a footnote to the audited balance sheet into the balance sheet itself.  With another adjustment to the balance sheet (removing a prepaid item currently accounted for as an asset which is already accounted for as a pension plan asset), this will cause MOFD's balance sheet to go from showing $10 million in net assets to $160 million in net liabilities.

The open question is what CCCERA will do when its balance sheet also shows MOFD's UAAL increasing from $24 million to $131 million.  Will it demand a further increase in funding to pay down the restated UAAL or continue using the same formula as before?

Click here for a print version of this evaluation

Click here for a copy of the evaluation spreadsheet

Click here for a copy of the GASB UAAL analysis spreadsheet