20050512Degann rebuttal.pdf

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Dean J. Miller
McDEVITT & MILLER LLP
420 West Bannock Street
O. Box 2564-83701
Boise, ID 83702
Tel: [phone]
Fax: [phone]
ioe (g)mcdevitt - miller .com
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Attorneys for Applicant
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF UNITED WATER IDAHO INC. FOR
AUTHORITY TO INCREASE ITS RATES
AND CHARGES FOR WATER SERVICE IN
THE STATE OF IDAHO
Case No. UWI-04-
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
REBUTTAL TESTIMONY OF DA VE DEGANN
ON BEHALF OF UNITED WATER IDAHO INC.
Please state your name and business address.
My name is David Degann. My business address is 125 Chubb
Avenue, Lyndhurst, New Jersey 07071.
Please state the purpose of your testimony in this case.
I was requested by United Water Idaho to review and comment on the
testimony of Staff Witness English regarding the appropriate
ratemaking allowance for pension cost.
Please state your qualifications.
I serve as the Enrolled Actuary under ERISA for the United Water
Plans and offer the advantage of almost two decades of experience in
working specifically with these Plans. I have provided expert witness
testimony for regulated entities related to this area of specialty of
pension actuarial issues. I am Cum Laude graduate of the College of
Insurance, with a bachelor of Business Administration. I hold a
Master of Business Administration from Pace University, with a
concentration in Taxation. I am an Enrolled Actuary (#25) and a
Fellow in the American Society of Pension Actuaries and the
Conference of Consulting Actuaries and a member of the American
Academy of Actuaries. I have served as a General Chairman
American Society of Pension Actuaries Education & Examination
Committee, and as a member of the Joint Board for the Enrollment of
Actuaries Advisory Committee on Testing and Education. I am an
Executive Vice President of Aon Consulting Group. My current
Degann, Re 1
United Water Idaho Inc.
responsibilities are to manage and supervise all actuarial and benefit
consulting in the Northeast Region, and for Aon s Merger &
Acquisition Practice. As the actuary for United Water, my
responsibilities are to accurately measure the liabilities and costs of the
Company s benefit programs, and to advise the Company of
appropriate expense, accrual or funding rates so that such costs and
liabilities are accounted for and so that assets are accumulated by a
rational method.
I bring more than 40 years of actuarial and benefits plan
consulting experience. In my present position, I am responsible for
actuarial and benefit consulting for some of the largest and most
complex corporate organizations in the United States, such as Crown
Cork & Seal Company, Inc., Bethlehem Steel Corporation and Cathay
Pacific Airways, Ltd.
Please state your understanding of Staff Witness English's testimony
and recommendations.
Mr. English recommends that the Company s recoverable pension
expense be determined by reference to its ERISA contribution, rather
than its actuarially determined pension cost under FAS 87. This
reduces the 2004 recoverable cost from $637 046 as claimed by the
Company to $162,454 as recommended by Staff (Exhibit 108). This
cash methodology has some serious flaws as I will demonstrate in
Degann , Re 2
United Water Idaho Inc.
more detail below. As I read his testimony, he bases his
recommendation on several points:
1. The F AS cost is "artificial" and has "no connection to real world
values . (p. 20)
2. The sizable revenue increase requested justifies a reduction in
pension cost. (p. 21)
3. Required plan funding under ERISA will not cause future costs to
rise dramatically. (p. 24)
4. "There is growing concern among accounting professionals
regarding the use of F AS 87 and the potential for manipulation of
financial statements
" (p.
16)
It is my professional opinion that Staff's reliance on these points
inappropriate, and that established accounting and regulatory
principles require the use of F AS 87 to determine recoverable pension
cost.
Please explain.
Let me address each of the flaws in Mr. English's testimony:
F AS 87 expense results are, in fact, a direct function
of "real-world" plan financials. F AS 87' s entire methodology is
geared to developing a realistic, accurate measure of the costs of a
year s worth of pension accrual. F AS 87 expense is calculated by
recognizing the value of plan assets at market value, reflecting the
current economic conditions in the marketplace and explicitly
recognizing the benefit accruals earned in pensions for participants
each year. One example of how much F AS 87 is tied to actual "real
Degann, Re 3
United Water Idaho Inc.
world" conditions relates to the fact that the discount rate selected
must be the rate "at which the pension benefits could be effectively
settled"
..
.looking at current prices of annuity contracts. .. and rates of
return on high-qualify fixed income investments currently available
(F AS 87, paragraph 44- Italics added for emphasis)
Mr. English suggested that the fact that pension
expense increased means that the FAS 87 method should be
abandoned and another (cash funding) be applied. Selecting a cost
method based upon how high or low costs are in a given year is not an
appropriate decision process, particularly for pension costs which rely
upon cost over many years (usually 20 to 30) not a given year.
If rate recovery were based upon selecting the minimum
cost of the various methods without any regard to the actual
fundamentals of continuing program costs, rate recovery would be
insufficient to maintain the program. The fact that program costs
increased merely reflects what has actually occurred in the real world
with respect to the program liabilities growing and the value of plan
assets in today s market underperforming. Please see the table below.
Contrary to Mr. English's suggestions, the required
ERISA Minimum Funding contributions are expected to dramatically
increase for these particular qualified pension plans, given their funded
history, current asset values and current liability levels. As the plan
actuary, I have advised United Water that the cash contribution
Degann, Re 4
United Water Idaho Inc.
requirements for its defined benefit plans will increase dramatically to
address the significant unfunded status of these plans. Below we show
the deficit position of both plans as of 1/1/05:
UW Idaho UW Idaho Total
N on- Bargaining Bargaining
Current Liability for ERISA 162 000 053 000 $11 215 000
Funding at 1/1/05
Assets at Market Value at 1/1/05 044 000 $3,711 000 $7,755 000
Funded Status $(2 118 000)342 000)(3,460 000)
Funding Ratio 66%73%69%
Because of the pension plan s funded status with plan assets covering
only 69% of liabilities, the ERISA Minimum contributions will require
that United Water contribute significantly higher amounts to bolster
the funded position. When plans fail to retain a satisfactory funded
position, the ERISA Minimum contribution adds a Deficit Reduction
Contribution, which accelerates contributions and requires an
employer to make cash contributions that payoff the unfunded
obligations in 3 to 5 years.
Contrary to Mr. English's testimony, FAS 87 is a
stable accounting measure which has now been in effect for over 20
years in the U.S. and is serving as a model in many respects for
international standards. FAS 87 has served to provide plan sponsors a
consistent method of computing an annual expense amount, separate
and distinct from a plan s generally voluntary and variable funding
deposits to the plan. The annual expense amount was defined to
reflect accrual accounting for pension plans, making sure that the cost
Degann, Re 5
United Water Idaho Inc.
of pension benefits are expensed during the time earned - supporting a
matching principle of whatever a company is promising in benefits to
be charged against company revenue at that time.
I believe that Mr. English is referring to the highly
publicized recent debates revolving around the appropriate actuarial
assumptions, rather than any issues related to the fundamentals ofF AS
87 expense. Further, such debates on assumptions impact both
funding and expense. Selecting appropriate actuarial assumptions has
been a focus largely because of turbulent economic times. In general
virtually all plan sponsors , including United Water, have made
adjustments to the expected long-term yield on plan assets to reflect
the lower investment yields. Finally, with reduced inflation levels, the
discount rate used to determine program liabilities has been
dramatically reduced (resulting in increased liabilities).
Why is FAS 87 the proper approach in setting rates?
FAS 87 is the proper approach for rate recovery. Only FAS 87
provides accurate accrual accounting which produces equitable results
for generations of customers, and also offers a consistent stable
methodology with no discretion from a company on how it is
determined. Below we describe the major advantages that
distinguishes F AS 87 as the proper approach for rate setting:
Degann, Re 6
United Water Idaho Inc.
~ A voids volatility in expense from year to year
~ Avoids underfunding and ensures as much as possible that plan assets
will be sufficient to meet retiree needs over the long term
Matches costs with benefits under accrual basis
Provides a stable F AS methodology
Is consistent across companies
Follows generally accepted regulatory practice
Follows the recommended past decisions of the PUC in the last case
when F AS pension income REDUCED expense
Follows the current recommended basis of the PUC related to FAS 106
costs, which mirror the same principles as under F AS 87
I discuss each of the above briefly below:
~ Avoids volatility in expense from year to year. FAS 87 expense
methods include defined amortizations of actuarial gains/losses,
making such method less volatile from year to year.
~ A voids underfunding. In the event the Commission were to modify its
past decisions to move to a cash contribution basis , United Water
would be faced with deferred recognition of expense/cost in rates and
in fact may not have proper financial reserves to properly make
contributions to the pension plan. In other words, without accrual
recognition of program costs, when the cash requirements are
demanded, United Water may not have the financial ability to pay such
contributions as ERISA demands. If United Water cannot afford to pay
the contributions , then the programs are ultimately remanded to the
PBGC for insufficient funding. Certainly, I do not recommend that any
situation put such risks on a long-standing program designed to address
fundamental retirement security needs.
Degann, Re 7
United Water Idaho Inc.
Matches costs with benefits under accrual basis. Accrual accounting under
F AS 87 aligns program costs with the proper generation of customers in
the rates. By using FAS 87 expense/(income) methods, the costs
associated with active employees working to deliver water services to
customers in each year are recognized during that year - not assigned to
another year.
Accrual accounting has long been recognized as the
preferred method of charging back the costs of pensions. "Accrual
accounting goes beyond cash transaction to provide information about
assets, liabilities, and earnings" (F ASB 87 Introductory Comments).
The concept is that while an employee is actively working and
delivering services to the company and customers, any deferred
compensation must be recognized against company books during active
employment. Waiting to recognize benefits promised - and earned-
until retirement or until the company is required to make cash
contributions to the fund results in inequitable and volatile year-by-year
results.
If the PUC were to apply a method that does not follow
accrual accounting, there is a mismatch of revenues and expenses, and
the wrong generation of customers winds up paying for costs of other
customers. Accrual accounting under F AS 87 offers an equitable
method that follows the PUC guiding principles of matching revenue
and expenses.
Degann, Re 8
United Water Idaho Inc.
Provides a stable F AS methodology. Unlike cash funding requirements
which have been modified numerous times, the specific requirements
ofFAS 87 have been retained virtually unchanged since 1985. That'
20 years of stability and reliability. On the pension cash funding side
we see a much different picture in the past and going forward, with
multiple changes to the methods of computation. In fact, in 2005, the
Administration has proposed funding legislation (if passed, to be
effective in 2006) which will be the most sweeping fundamental
change since ERISA's passage. The Administration s funding
requirements are intended to force many plan sponsors to contribute
far more than current Minimum funding requirements. On the FASB
side, there are no plans for any changes - merely a continuation of the
20 years of stability we have seen already.
Is consistent across companies. F AS 87 is the consistent US GAAP
methodology for recognizing the annual costs of pension benefits. All
companies in the US follow this method.
Follows generally accepted regulatory practice.
Follows the recommended past decisions of the PUC in the last case
when FAS pension income REDUCED expense.
Follows the current recommended basis of the PUC related to F
106 costs, which mirror the same principles as under F AS 87. We
note that the commission has endorsed F AS 87 in all prior years, and
Degann, Re 9
United Water Idaho Inc.
currently continues to apply accrual expense accounting for FAS 106
purposes for rate recovery.
Do you have experience with the regulatory treatment of this cost for
other clients in other jurisdictions?
Based upon Aon Consulting s experience with regulated utility
companies, the general practice adhered to applies annual expense
under F AS 87 for pensions and F AS 106 for retiree medical benefits to
determine:
Annual expense recognized for purposes of computing an
organization s P&L (Profit & Loss), and also for
consistency;
Annual rating costs recognized for purposes of passing on a
company s pension costs to the consumer.
In this way, complete consistency exists between:
What a company is required to report as annual
expense/(income) for pension benefits; and
What customers pay for in rates.
This one-to-one correlation ensures that as a company records pension
expense or (income), the same amount is reflected in rates. If cash
funding or another approach were employed a company s rating basis
could be dramatically different than what is recorded each year in its
books.
Below are specific cases where the Regulatory Commission
ruled that annual expense under FAS 87 is the required rate basis:
Degann, Re 10
United Water Idaho Inc.
Since 1995, the Board of Public Utilities of the State of New
Jersey has based its rating costs on the pro forma pension
expense/(credit) as computed by the pension actuary each year.
Specifically, the Commission applied a "pay-as-you-
expense approach for rate recovery purposes. The amount
accrued as an expense in determining the organization
financial status is the same amount applied in rate recovery.
Since 1992, the Public Service Commission of the State of New
York has also required the application of F AS 87 pension
expense/(income), with only a review of the key assumptions
applied in such computation.
In your opinion, what would be the result if the Commission follows
the Staff recommendation of applying ERISA Minimum Cash
Contributions instead of F AS 87?
First, if no rate recovery would be available until cash ERISA
contributions were required, United Water Idaho would still be
required by GAAP to record the F AS expense on its books and
revenues with no matching rate recovery amount. Then, at the time
that cash contributions would be required, it is quite possible that the
Company will not have the financial reserves and strength to cover
such contributions, because insufficient rate recovery was provided in
the past. Essentially, providing rate recovery at a fraction of the
program costs puts the Company in a compromised financial position
Degann, Re 11
United Water Idaho Inc.
most likely forcing the Company to reduce and/or eliminate future
pension plan benefits in entirety for active employees. By deferring
the costs of benefits promised (essentially by insisting on an interest
free loan with balloon payments at the end), the PUC is gambling with
the retirement security of active long-service employees. In fact, this
is precisely the situation that FAS 87 was trying to correct numerous
companies opting to recognize only "pay-as-you-" cash costs
instead of matching accrual costs with revenue. It was all too common
for companies to make benefits promises, book no program costs and
later renege on promises by eliminating benefits when the cash costs
were too great a burden. Essentially, a decision to apply ERISA
Minimum Cash Contributions instead of F AS 87 may force a decision
by the Company to reduce or eliminate the promised pension benefits
forUnited Water Idaho active employees retiring in the future.
Second, this approach has equally serious long-term
impacts on the Company s customers, as was the case when ERISA
existed in 1974 prior to the accounting profession issuing the F AS 87
standard in 1985. Without the discipline and requirements of F AS 87
companies had too much discretion under ERISA to defer the costs.
For regulated companies, the ERISA approach forces future customers
to pay for past costs.
Third, ERISA Minimum rules require that pension deficits be
funded in a very short time (3 to 5 years), much akin to a balloon loan
Degann, Re 12
United Water Idaho Inc.
structure. This makes the problem of deferring what is being spent
today much more severe. There is never any guarantee that a
Company can later pay for amounts spent today, and chances of
payment later are riskier when the payments are so large that are being
deferred. United Water Idaho s current pension plans have plan assets
insufficient to cover existing benefits promised by some $3.5 million.
This suggests cash funding of millions of dollars each year, when the
time comes for the payments. As the plan actuary, I expect such cash
contributions to be required in the next 3 to 5 years, with the ERISA
Minimum Contribution requirements already applying for the
bargained plan in 2003 and 2004, with future cash contributions
forecasted to dramatically accelerate. If no rate recovery is provided
using the traditional F AS 87 accrual method, the Company will not
have proper financial reserves to make these payments. Only FAS 87
expense accrual adequately prepares the Company to be able to make
these cash contributions.
Does this conclude your testimony?
Yes.
Degann, Re 13
United Water Idaho Inc.