PERS Financing Update

1
PERS Financing Update
February 23, 2005
2
Part 1 The Borrowing Program
3
PERS Liabilities Current Status

• In January, PERS actuary projected payroll rates
  for schools and community colleges would rise by
  approximately 11 beginning July 1, 2005.
• In response to unanticipated increase, PERS Board
  opted to phase in rate increase over two
  valuation periods.
• At February 18 meeting, Board adopted rate for
  school pool of 16.97, and 15.73 for community
  colleges beginning July 1, 2005.
• Rates for those that have made lump sum payments
  vary widely from a low of 0.59 to a high of
  12.12.
• Actuary has projected rates beginning July 1,
  2007 for school districts at approximately
  22.84, and 21.22 for community colleges.
• 2007 rates will not be finalized until late 2006,
  and will take into account actual investment
  experience as well as changes in payrolls.

4
Current Payroll Contribution Rates
School Districts
Original Payroll Rates to 7/1/07(2)
Adjusted Payroll Rates to 7/1/07(3)
Payroll Rates to 7/1/05(1)

• Normal Cost 12.75 12.64 12.64
• Health Care .64 .59
  .59
• Amortization of UAL (2.28) 7.85 3.74
• Total 12.73 21.08 16.97(4)
• Based on 2001 valuation.
• Based on 2003 valuation prior to decision to
  spread increases over 2 biennia. Does not include
  impact of lump sum payments.
• Based on 2003 valuation after decision to spread
  increases over 2 biennia. Does not include impact
  of lump sum payments.
• Expected to be set at 22.84 on July 1, 2007.

5
Current Payroll Contribution Rates
Community Colleges
Original Payroll Rates to 7/1/07(2)
Adjusted Payroll Rates to 7/1/07(3)
Payroll Rates to 7/1/05(1)

• Normal Cost 11.07 11.21 11.21
• Health Care .64 .59
  .59
• Amortization of UAL (1.47) 7.77 3.93
• Total 10.24 19.57 15.73(4)
• Based on 2001 valuation.
• Based on 2003 valuation prior to decision to
  spread increases over 2 biennia. Does not include
  impact of lump sum payments.
• Based on 2003 valuation after decision to spread
  increases over 2 biennia. Does not include impact
  of lump sum payments.
• Expected to be set at 21.22 on July 1, 2007.

6
Unfunded Actuarial Liability History

• In 1999, UAL was calculated at 900 million. By
  2002, UAL was projected to exceed 17 billion.
• Legislature made substantial changes to avoid
  catastrophic financial consequences
• 8 guarantee provided over career, not annually
• 6 employee contribution deposited in 401(k)-type
  account, not subject to money match
• Mortality tables updated
• PERS board completely revamped
• New system (OPSRP) created for employees hired
  after August 29, 2003.
• Legislative changes reduced UAL by approximately
  50
• Remaining losses have been smoothed over
  multiple valuation periods and will not be
  completely recognized until FY2008.
• Legislation has been challenged to the Oregon
  Supreme Court. Decision expected sometime this
  year.

7
Low Investment Returns in 2000-2002 Exacerbated
UAL

• Earnings for PERS funds in 2000 equaled 0.54,
  -6.96 in 2001 and -8.93 in 2002, while Tier 1
  employees were guaranteed 8.

8
What Can You Do About UAL?
Some jurisdictions have chosen to finance PERS
liability with bonds.

• Original statutory authority provided in 2001.
  Clarifying amendments in 2002 and 2003 sessions.
• PERS is currently financing the deficit at 8
  interest rate annually.
• Although bonds would have to be sold on taxable
  basis, interest rates in open market remain under
  6.00.

9
Bonding Examples
Miscellaneous other cities, counties and special
districts have sold bonds since 1999 at rates
ranging from 6.50 to 7.80
10
Long U.S. Treasury Bond Yield
October 2003 State of Oregon TIC 5.78
May 2004 Local Governments TIC 6.11
April 2003 OSBA TIC 5.73 Oregon Community
College Districts TIC 5.72
February 2004 OSBA OCCA TIC 5.49
11
What Happens to Bond Proceeds?

• Lump sum payment is made directly to PERS

• Funds held in separate side account for the
  benefit of the jurisdiction making payment.
  Invested with all other PERS funds.
• Actual earnings and losses credited to account,
  net of fixed administrative charges (2,500 for
  first 3 years, 1,000 per year thereafter).
• Employer contribution rates will be immediately
  reduced on first of month following lump sum
  payment.
• Funds in account will be amortized and applied to
  reduce payroll contribution rates through
  December 1, 2027.
• Earnings and losses in account are reconciled and
  adjusted at each biennial valuation based on
  investment performance and relative payroll
  growth rates of individual employer versus pooled
  growth rates.

12
Lump Sum Payment Made to PERS
13
Impact of Financing UAL
14
Why have Districts had such different rate
outcomes?

• Rates for school districts range from a low of
  .59 to a high of 12.21 after lump sum payments
  are taken into account.
• Rates for community colleges range from .59 to
  10.88.
• Differences in rates attributable to a number of
  factors
• Districts borrowed different proportions of total
  UALs at different times. Some borrowed
  pre-legislative reforms and now have surplus.
• Different borrowing pools have had differential
  rates of return since deposit with PERS.
• Payroll growth rates varied widely. Those with
  slower growth rates (such as Portland) have
  larger reductions than those with stronger growth
  (or less decline such as North Clackamas).

15
Issues to Consider

• Refinancing PERS UAL is not risk-free. Choosing
  to finance liability involves certain risks not
  choosing to financing does as well.
• Main benefit is in short and long term reductions
  in costs, but cost savings are estimates, not
  guarantees.
• Interest rates remain at historic lows.
  Borrowing rates are currently under 6. If
  interest rates rise, opportunities to reduce
  costs may disappear.

16
The Arbitrage Issue

• This is not like refinancing your mortgage

• Success from borrowing depends on the market
  returning more than the cost of the bond.
• If returns equal 8 over 23 year period (as
  assumed by PERS) over the life of the bonds,
  costs will be reduced as estimated.
• If returns are greater than 8, cost reductions
  will be greater than projected.
• If returns are less than 8 cost reductions will
  be less than projected.
• If returns are less than the bond yield,
  borrowers will be worse off than those who do not
  borrow.

17
Investment of Lump Sum Payments

• Oregon Investment Council is responsible for
  PERS investment.

• Common stock acquisitions limited to 50.
• PERS has long history of strong investment
  performance.
• 10-year average 12.38
• 15-year average 12.69
• 56-year average 10.84
• July 2003 study by Russell Investment Group
  (Frank Russell Company) estimated expected annual
  total return on PERS would be 8.8 over 20 years.
• State Treasury regression analysis conducted in
  July 2003 projected probability of positive
  arbitrage in PERS refinancing at nearly 90.

18
Recent Returns Lump Sum Accounts
Oregon School Boards Association Pension
Obligations Series 2002
19
Recent Returns Lump Sum Accounts
OSBA Oregon CC Pension Obligations Series 2003
20
Recent Returns - Lump Sum Accounts
OSBA Oregon CC Pension Obligations Series 2004
21
Recent Returns Lump Sum Accounts
Oregon Local Governments Pension Obligations
Series 2004
22
What happens if the UAL changes after you borrow?
If subsequent judicial, legislative or
investment activity causes changes to UAL

• Reductions Lump sum payment would put
  jurisdiction in surplus, which is set up in side
  account. All earnings/losses net of fixed
  administrative expenses go to benefit of account.
  Funds would be used to reduce payroll rates
  further.
• Increases Lump sum payment would defray total
  deficit. UAL would not be as high as would
  otherwise be the case.

In either case, arbitrage issue remains the same.
23
Other Issues to Consider

• Adjustments to payroll rates will vary going
  forward to track payroll growth rates relative to
  pool.
• Every borrowers rate adjustment will be
  different in each valuation, so that decision to
  borrow does not create new winners and losers.
• Bonds are not likely to be subject to early
  redemption.

24
PERS Pooled Financing How does it work?

• Individual districts issue pension bonds that are
  pooled by Trustee.
• Trustee certificates bonds in pool, enabling
  obligations to be sold to wide number of
  investors.
• Bond proceeds are delivered directly to PERS,
  which makes immediate adjustments to payroll
  rates.
• Debt service on bonds is responsibility of each
  district however intercept agreement requires
  State to actually make payment by deducting funds
  out of appropriation.

25
Intercept Agreement

• Intercept agreement enable all districts to be
  treated as equivalent credits by rating agencies,
  insurance companies and investors, regardless of
  size or individual financial condition.
• Debt service payments are diverted from state
  appropriations to Trustee who holds funds on
  behalf of bond holders.
• If state funding timing changes, intercept shifts
  to match new schedule.
• If State cannot intercept sufficient funds,
  districts ultimately responsible for debt
  payments, likely on monthly basis.

26
Potential Timeline for Refinancing Program
27
Next Steps

• If you are interested
• Notify OSBA, OCCA, SNW and Preston Gates Ellis
  as soon as possible.
• Approve Authorizing Resolutions by April 14 and
  submit copies to SNW.
• Send Required PERS documentation Payoff Request,
  Intergovernmental Agreement and check for amount
  to be determined to SNW for submission to PERS by
  April 15.
• Submit Disclosure information to SNW for
  preliminary official statement.
• Final date to opt out of financing is seven days
  prior to pricing date.

28
Part 2 Interest Rate Swaps as they relate to
PERS borrowings
29
What is an interest rate swap?

• For an issuer with fixed rate debt, fixed rates
  on their bonds are changed (in concept) into
  floating rates through a separate agreement.
• The issuers underlying obligation is unchanged.
• A separate agreement with a Swap Provider calls
  for the issuer to pay a variable interest rate to
  the Swap Provider in exchange for a fixed
  interest rate.
• The variable rate is based on a published index.
  The fixed rate is agreed upon at the beginning of
  the agreement.
• Interest is based on the principal amount of an
  outstanding bond issue. No principal is actually
  paid just the cash flow based on the interest
  calculation.
• Historically, fixed rates on swaps have been
  higher than the variable rate indexes.
• The net result is that an issuer may potentially
  save money by doing a swap.

30
Example PERS Bonds for a Sample Municipality
This obligation is unchanged.

• The variable rate index used as the benchmark
  for payments by the Swap Provider to the Issuer
  can be either the BMA Index or some percentage of
  1- month LIBOR.

31
A swap could be done using the municipalitys
current interest bonds. (Capital appreciation
bonds are not suitable for a swap.)
Current Interest Bonds
32
Hypothetical savings with swap of 50 of PERS
current interest bond maturities

• The chart assumes a 12-year swap at a rate of
  4.00 , average variable rate of 2.50, and a
  notional amount of 26.7 million.

NOTE We would recommend waiting to execute a
fixed to floating rate swap until fixed rates are
higher. Like bond rates, swap rates are at a
very low point, so the amount the issuer receives
is low. Locking in a low rate for a long period
may not be the best strategy. A graph showing the
history of swap rates is shown on p. 7.
33
Savings depend on how much the fixed rate exceeds
the variable rate index.

• This chart shows the results of a 26.7 million
  swap over 12 years. The swap should be sized to
  reflect the issuers actual debt profile, risk
  preferences, and balance sheet. Some factors to
  consider in sizing a swap are
• Size of investment balances.
• Overall tolerance for variable rate risk
• Future rate environment
• Future bond issue plans
• Potential impact on bond ratings

34
Historical Swap Rates
35
Why do Swap Providers do these deals?

• Swap Providers work a two-sided market, and make
  their money from bid/offer spreads, not from
  forecasting interest rates.
• The Swap Provider immediately hedges each swap
  though various methods, so that it is indifferent
  as to what happens to interest rates.
• In the example on the next page, the Issuer is
  converting a floating liability to a fixed
  liability. Issuer B, on the other hand, may want
  to have more floating rate exposure.

36
Swap Providers hedge their swaps.
37
Suitability for a Swap

• Not all municipalities make good candidates for
  swapping into a variable rate mode.
• Best candidates for a swap have the following
  characteristics
• Sufficient investment balances to provide a
  natural hedge against rising interest rates if
  rates rise, the higher swap payments are offset
  by higher interest earnings
• Sufficient liquidity to handle posting of
  collateral or termination payment, if this
  becomes necessary
• Good credit ratings. Best with A1 or A or
  better doable with lower ratings, but higher
  risk of running into difficulty with collateral
  or termination payment
• Management ability (sufficient time, energy, and
  sophistication) to understand and manage the swap

38
Risks
39
What are the Risks?

• It is important to understand the risks of swap
  transactions
• To make good decisions.
• Because the rating agencies care that you
  understand the risks.
• Because you will need to disclose swap
  transactions in financial statements.

40
Interest Rate Risk

• Rate risk The risk that the variable payment
  made by the issuer is higher than the fixed rate
  the issuer is receiving

41
Risk of Having to Post Collateral

• Swap agreements usually protect the parties by
  requiring that collateral is posted if a partys
  financial condition is lower than certain
  thresholds.
• Measurement can be by credit rating, financial
  criteria, or both.
• Collateral is posted only if the swap is in the
  money to the swap provider above pre-determined
  thresholds AND financial status is below the
  pre-determined thresholds.
• In the money to the swap provider means that if
  the swap were terminated at that point in time,
  the issuer would owe a termination payment.

42
Termination Risk

• Only the issuer has the option to terminate, BUT
  involuntary termination may happen because of
  events beyond the issuers control.
• Voluntary termination may be difficult because of
  the need to make a termination payment to the
  provider to get out of the swap.
• Termination can occur because of a default by
  either party.
• In entering into a swap, the issuer should make
  sure it believes the risk of a provider default
  is extremely low.

43
Early Termination

• Risks associated with early termination of the
  swap
• Upon termination, the party who is out of the
  money must make a termination payment to the
  other party. It could be the issuer who is out of
  the money.
• Early termination can happen voluntarily or
  involuntarily
• Issuer has the right to terminate early swap
  provider does not
• Some examples of voluntary termination
• Issuer wants to retire bonds sooner than
  scheduled (partial or total unwind)
• Issuer sees large termination payment from swap
  provider possible and decides to take the money
  by terminating the swap
• Examples of involuntary termination (or
  requirement to post collateral)
• Either party defaults on the swap or on another
  agreement designated as a cross-default event
  with the swap
• The providers credit rating falls below an
  acceptable level
• The rating of the swap credit support falls

44
Legal Aspects of Swaps
45
Existing Authority- ORS 287.025

• Effective January 1, 2004
• Who can do swaps?
• The swap legislation applies to an issuer.
  Issuer is further defined as a public body
  under ORS 288.605 which includes any entity that
  can issue General Obligation Bonds, Revenue Bonds
  or Certificates of Participation.
• Key concept of issuer is that swaps must relate
  to debt issues.
• What can they swap?
• Issuer is allowed to enter into agreements to
  exchange interest rates related to an
  obligation the issuer has issued or will issue.
  
• Obligation is defined as a bond, note, bond
  anticipation note, commercial paper, certificate
  of participation or other agreement made in
  exercise of borrowing powers.

46
Existing Authority, continued

• What findings must be made?
• Issuer must find that the swap agreement benefits
  the issuer and is for a permitted purpose (i.e.
  to manage payment, interest rate spread or
  similar exposure).
• Issuer must also find that the agreement complies
  with ORS 287.025 and related OARs.
• Issuer must notify the State Treasurer of the
  execution of a swap agreement.

47
Existing Authority, continued

• Restrictions
• Swap provider must be rated A category or
  better by two or more rating agencies.
• Contract must be fully collateralized.
• Can not have a term that exceeds original term of
  obligation.
• OAR (OAR 170-60-1010)
• Administrative Rules have been promulgated.
• Requires filing of MDAC Form 3.
• Issuer must adopt swap policy.

48
Proposed Legislation

• Proposed Legislation (Senate Bill 23)
• Provides that limited tax pension bonds of a
  county are subject to the 5 of real market value
  limitation and not the 1 of real market value
  limitation for other limited tax bonds.
• Prohibits a termination payment by a governmental
  unit (except for the state) to be paid from taxes
  levied outside of the limitations of sections 11
  and 11b, Article XI of the Oregon Constitution.
• Deletes the requirement for full
  collateralization of termination payments and
  allows issuer (or MDAC by rule) to determine how
  much collateral is required.

49
Proposed Legislation, continued

• Clarifies that a swap agreement is subject only
  to the debt and other limitations contained in
  ORS 287.025 and not to any other limitations
  applicable to the related obligation.
• Revises definitions and other provisions in ORS
  287.025 to conform with mechanics of transactions
  and increase internal consistency.

50
General Legal Questions

• Do swaps count for purposes of constitutional,
  statutory or charter debt limits?
• May General Obligation property tax levies be
  used for termination payments?
• How do bond indentures or resolutions treat swap
  payments and termination payments?
• What happens if the indenture or resolution is
  silent on swaps?
• Does a swap impact my arbitrage/rebate
  calculations?

51
What do swap documents actually mean in English?

• Swap documentation typically includes four
  documents
• ISDA Master (International Swaps and Derivatives
  Association)- serves as the indenture for all
  swaps between Issuer and Counterparty and
  identifies the rules and definitions governing
  the swaps market including
• Payment provisions
• Representations, events of default/termination
  events and covenants
• Early termination provisions and methods for
  calculating payments on early termination
• Schedule to the Master identifies which of the
  options contained in the ISDA will be operative
  in Issuers transaction

52
What do swap documents actually mean in English?
(continued)

• Credit Support Annex (CSA) provides each
  party credit protection, including the rules
  governing the mutual posting of collateral
• Confirmation defines the specific terms and
  conditions of the transaction
• Potential points of negotiation
• Choice of law
• Jurisdiction
• Bankruptcy
• Indemnification
• Cross-default
• Set-off

53
What are my disclosure responsibilities for SWAPS?

• The Governmental Accounting Standards Board has
• created disclosure requirements for derivatives
• In June 2003 GASB issued the Technical Bulletin
  No. 2003-1 regarding disclosure requirements for
  derivatives not reported at fair value on the
  statement of net assets
• The purpose is to provide information to
  financial statement users that will enhance their
  understanding of the significance of derivatives
  to a governments net assets
• Disclosure should include
• Objective of the interest rate swap
• Terms of the transaction
• Fair Value
• Risk exposures
• The bulletin also includes non-authoritative
  illustrations of disclosures for various
  structures
• Provisions of the technical bulletin are
  effective for financial statements for periods
  ending after June 15, 2003

54
Questions to ask the Swap Provider

• What are your credit ratings?
• What are the risks of this particular swap?
• How would this affect the calculation of my tax
  levy? How would I budget the swap payments?
• Can you show me a range of potential termination
  payments with different future interest rate
  environments, at various times during the term of
  the swap?
• Under what conditions would we have to post
  collateral? How likely is this? Under what
  conditions would you post collateral?
• Can you show me a range of potential outcomes for
  our cash flow, under varying interest rate
  assumptions, including a worst case scenario?
• How will I know youre quoting me a fair swap
  rate?
• Might I be better off by waiting?

55
Conclusions

• Swaps could be a useful new tool for Issuers in
  some situations.
• New risk elements are introduced know what they
  are!
• Ask for assistance.

56
For more information

• Seattle-Northwest Securities
• Jean Baker [phone]
• Carol Samuels [phone]
• Rob Shelley [phone]
• Dave Taylor [phone]
• Preston Gates Ellis
• Harvey Rogers [phone]
• Ann Sherman [phone]
• Carol McCoog [phone]