COLA UAAL and the Correction Process

Presentation to the FCERA Board of Retirement

August 15, 2007

Harvey L. LeidermanJeffrey R. RiegerReed Smith, LLP

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Agenda for Discussion1. Event #1 – COLA UAAL Error from FY 03-04 through

FY 06-072. Event # 2 -- “Phase In” of Member Contributions from

FY 04-05 through FY 06-073. Event # 3 -- General Member “Basic” Rate Error in FY

03-04

4. Correction Process

5. Board’s Remaining Decisions

6. Our Recommendations

7. Perspective

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Event # 1 – COLA UAAL PPP’s June 30, 2002 valuation recommended

employee rates for FY 03-04 that included half of the UAAL attributable to COLA benefits

Board adopted PPP’s recommended employee rates, including a COLA UAAL component, for FYs 03-04, 04-05, 05-06 and most of 06-07

Board acted in December, 2006 to stop the practice based on Segal Company’s audit of PPP’s valuations and Reed Smith’s legal analysis, which is now a public document

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Event # 2 – “Phase In” of Employee Contribution

Increases Employee contribution rates were set to dramatically increase

from FY 03-04 to FY 04-05 in large part due to: Ventura Settlement increased benefits No excess earnings to pay for settlement benefit contributions Assumption changes Half of COLA UAAL being charged to employees

Board looked for a way to lessen impact; PPP presented various alternatives in Spring, 2004

Board chose to “phase-in” increases, deferring a portion of contributions and spreading them out over time Contribution relief so long as no employee liabilities would

be shifted to employers

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Event # 2 –“Phase In” of Employee Contributions,

cont’d.In hindsight, we now know: In FY 04-05, the “phase in” resulted in General

Tier 1 members paying less than the “normal cost” they would have otherwise paid

In FY 05-06 and 06-07 (until March 2007), the “phase in” resulted in General Tier 1 members paying their full “normal cost” and part, but not all, of the COLA UAAL amortization

In all three fiscal years, Safety and General Tier 2 Members paid their full normal cost and part, but not all, of the COLA UAAL amortization

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Event # 3 – General Member “Basic” Rate Error in FY 03-04

Segal has now determined that PPP made another error in calculating General Tier 1 employee rates in FY 03-04

Understatement of “basic” contribution rate Effect was that General Tier 1 members underpaid

their “basic” contributions by app. $2.6 million (after interest is applied)

This underpayment was not related to the “phase in”

Board has not yet decided what to do about this newly discovered error

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Event # 3 – General Member “Basic” Rate Error in FY 03-04,

cont’d.Complicating factors:

At the same time General Tier 1 employees were underpaying “basic” contributions by app. $2.6 million (after interest is applied), they were overpaying COLA UAAL by app. $1.2 million (after interest is applied)

Excess earnings were available to potentially reduce employee contributions in FY 03-04. The Board used some, but not all, excess earnings to reduce employee contributions. If one or both of the errors in FY 03-04 had not occurred, Board may have exercised its discretion with excess earnings differently

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Correction Process On December 6, 2006, Board voted to cease COLA UAAL

practice as soon as practicable On January 10, 2007, Board voted to:

Reverse past employee payments towards COLA UAAL in a lawful, fair and practicable way

Offset amounts underpaid for “deferred normal cost” under the phase-in against amounts overpaid for COLA UAAL, to return members as near as possible to where they would have been had these events not occurred

Implement rate changes to eliminate COLA UAAL in July, 2007 In January, 2007, PPP projected total net overpayments of

approximately $3.5 million for General and $4.0 million for Safety

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Correction Process, cont’d. On January 24, 2007, Board voted to eliminate

COLA UAAL as soon as possible, rather than waiting until July, 2007

On February 7, 2007, Board terminated PPP and hired Segal Company

On February 21, 2007, the Board voted to make refunds for COLA UAAL on an individual basis, if possible

Segal to review PPP’s adjusted rates Programming assistance from Watson Wyatt

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Correction Process, cont’d. On March 7, 2007, Board voted to correct for

PPP’s Safety member salary assumption error In March 2007, all employee rates were reduced to

reflect the elimination of the COLA UAAL component; Safety rates also were reduced to correct salary assumption error

From March to July 18, Segal reviewed PPP’s adjusted rates for all affected fiscal years

Found General “basic” error in FY 03-04 PPP delayed process by failing to provide

necessary information in a timely fashion

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Correction Process, cont’d.

July 18, 2007 – Segal presented adjusted rates to Board:

Refunds due to Safety and General Tier 2 members

Net “underpayments” from most General Tier 1 members

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Correction Process, cont’d.

Reasons that everyone’s expectations for General Tier 1 were not met – PPP’s January projections were wrong: Fewer payments towards COLA UAAL than originally

projected because COLA UAAL practice stopped earlier, in March, 2007, instead of July, 2007

Newly discovered “basic” rate error in FY 03-04 resulted in $2.6 million “underpayment” for that year

PPP had understated the COLA “normal cost” in its January adjusted rates for FY 03-04, creating the appearance that a larger amount had been paid towards COLA UAAL that year than had actually been paid

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Correction Process, cont’d. July 18, 2007 continued

Board voted to proceed with refunds for Safety members and General Tier 2 members as originally planned

Board asked Segal and Reed Smith for further input on General Tier 1 members, given newly-discovered errors

That takes us up to today

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Board’s Remaining Decisions

1. Should the Board make adjustments for General Tier 1 “basic” contribution rate error in FY 03-04?

2. Should the Board reconsider its prior decision to offset “deferred normal cost” underpayments that resulted from the “phase in” against COLA UAAL overpayments?

3. For General Tier 1 members, who on balance have underpaid their contributions because of all these events, what should the Board do?

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Our Recommendations1. Make no adjustments (either for COLA UAAL or for the

“basic” error) for FY 03-04 General Tier 1 rates Occurred over three years ago and “basic” error would not have

been discovered, but for the COLA UAAL correction process Board’s discretionary use of some, but not all, excess earnings to

reduce employee contributions cannot be reversed; therefore, the Board cannot put members back where they would have been had the errors not occurred

It is reasonable not to refund COLA UAAL “overpayments” in FY 03-04 when we know that, in total, less than full normal cost contributions were paid in that year

Will result in net “overpayment” by General Tier 1 members of app. $630,000, with most members receiving a refund

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Our Recommendations2. Do not reconsider prior decision to offset “deferred

normal cost” underpayments resulting from the phase in against COLA UAAL overpayments

Failing to offset would transfer employee liabilities to employers, unless “deferred normal cost” is charged back to employees through adjustments to rates in future years

If employee rates are adjusted in future years (a) member-to-member equity issues arise, and (b) Board cannot put this process behind it for at least another two years

Prudent to deal with as many issues as possible all at once and move forward without further distractions, costs and further impact to future years

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Our Recommendations3. Do not collect any net underpayments on a member-by-

member basis, but consider recouping total underpayments through FY 08-09 General Tier 1 employee rates

Individual collection would be inconsistent with phase in policy, burdensome and inefficient

Recouping through rate adjustments would be consistent with phase in policy and ensure that no additional liability is charged to the employer as a result of the phase in

Given unique and complicated circumstances, and relatively small amount involved, Board may consider moving forward without making adjustments for “underpayments” Uncertainty regarding FY 03-04 rates Discretion under CA law not to collect “arrears contributions” Board may wish to defer decision until receiving final numbers

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Perspective Unique circumstances with no single “right” answer

Board has options in addition to our recommendations

Goal should be fairness, equity and sound funding

Correction process is important, but only one small part of the recent COLA UAAL reversal