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HomeMy WebLinkAbout20040319Fowler Rebuttal.pdf, " . PI :\ ~- ' ' t j \ f71i;:.,i r- (", i :., :~, zno!: r;Y'( J 9 Pi'! 4: 33 U i I,,: i i:::'~~ CJli .iSS!OH BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION IN THE MATTER OF THE APPLICATION OF IDAHO POWER COMPANY FOR AUTHORITY TO INCREASE ITS RATES AND CHARGES FOR ELECTRIC SERVICE TO ELECTRIC CUSTOMERS IN THE STATEOF IDAHO CASE NO. IPC-O3- IDAHO POWER COMPANY DIRECT REBUTTAL TESTIMONY BRADLEY FOWLER Would you please state your name, business address, and present occupation? My name is Bradley Fowler, and my business address is Milliman USA, Sui te 3800, 1301 5 th Avenue, Seattle I am a Principal and Consulting ActuaryWashington 98101. specializing in pensions and employee benefits. What is your general educational background? I graduated from the Uni versi ty of Washington in Seattle in 1969 with honors, receiving a Bachelor of Science degree in, Mathematics.In 1971, I received a Master of Arts degree from Cornell University in Mathematics. 1979, I completed The Management Program in the Business Department of the Uni versi ty of Washington. What is your professional educational background? The highest-level professional designation in the actuarial profession is Fellowship in the Society of This is obtained through a series ofActuaries. examinations covering actuarial mathematics, principles of insurance and employee benefi ts, investments, economics, taxation, insurance and benefi t law, accounting and financial reporting, model building, underwriting, benefit plan design , and plan funding.During the period when I was pursuing the examinations, there were nine examinations, requiring an average of 300 to 400 hours of study for FOWLER, Di-Reb Idaho Power Company successful completion of each exam.I completed my Fellowship in 1976.Wi th the passage of the Employee Retirement Income Security Act (ERISA) of 1974, actuaries practicing in the area of pension plans were required to become Enrolled Actuaries under ERISA to certify plan funding to the IRS as required annually.I became an My enrollment number is 02-3089.Enrolled Actuary in 1980. In order to maintain my status as an Enrolled Actuary, I am required to complete a minimum of 30 hours of continuing education in supervised settings during each three year I have completed this continuing education throughperiod. seminar attendance, and presenting seminars to others. have also made presentations to clients and other professionals on topics such as pension funding, pension accounting, and proj ection of pension funding and expense I am also a member of therequirements into the future. American Academy of Actuaries since 1978 Thi s is the body that develops qualification standards for its members to sign statements of actuarial opinion, such as those supporting the pension expense and obligation measurements reported by companies like Idaho Power in their annual reports to shareholders. would you outline your business experience? Milliman USA is an international firm of Mi 11 imanactuaries and consultants with 1800 employees. FOWLER, Di-Reb Idaho Power Company provides actuarial and administration services to many pension plan sponsors, including Idaho Power Company. began working for Milliman USA, then called Milliman and Robertson, in Seattle as a summer student in 1966, and I continued working part time until 1972 when I joined In 1974, I transferred to M&R Services,Milliman full time. the data processing company of Milliman responsible for large scale actuarial system development, and for operating In 1979, I became thethe firm s mainframe computer center. Chief Operating Officer of M&R Services.In 19 8 4, returned to Milliman as an actuary and consultant in the I was elected a Shareholder ofretirement practice. Milliman in 1985, and a Principal in 1987.I began working as the senior consultant and actuary for Idaho Power Company in 1986, and have had responsibility for the actuarial valuation of the Idaho Power Company Pension Plan since I am a senior Principal in the Seattle Employee1987. Benefi ts practice wi th management responsibility for several maj or practice areas in addition to my consulting role. primary consulting relationships are with corporate clients similar to or larger than Idaho Power Company, and with several large non-profit hospitals. What services do you provide to Idaho Power and its pension plan that are related to the Company current revenue requirement filing? FOWLER, Di-Reb Idaho Power Company In my role as Idaho Power s plan actuary, I supervise the annual valuation of the pension plan The valuation process measures the expectedliabilities. payouts that will be due to participants from the plan, using census data and assumptions regarding how long participants are expected to work for Idaho Power, their rates of salary growth, their expected lifetime following retirement, and other contingencies affecting the amount of The valuation results are measured under thebenefits due. FAS 87 required methods and assumptions for use in financial reporting in Idaho Power s financial statements, and separately under the IRS required methods and assumptions for tax deductibility and minimum contribution purposes. sign the report that is used by Idaho Power and relied upon by their auditors supporting pension expense in the I also sign the annual actuarialfinancial statements. report and filings made to the IRS under ERISA, certifying that minimum contribution levels have been met.I consul t with Idaho Power regarding forecasts of future pension expense and pension contributions, and recommend changes to assumptions when appropriate. What is the purpose of your testimony in this proceeding? The purpose of my testimony is to offer expert opinion on the pension cost items in Idaho Power FOWLER, Di-Reb Idaho Power Company filing and to respond to Staff witness Mr. Donn English' recommendation that the Commission exclude all pension expense from Idaho Power s revenue requirement. Idaho Power used the Service Cost methodology to compute its pension cost in this case.Wha t is your opinion regarding the use of Service Cost as the basis for pension cost recovery? Service Cost computed on the basis ,of' the assumptions used for financial reporting represents a fairly stable measure of the value of benefits being earned each It is often used to convey the value of the plan toyear. participants, because it is independent of experience gains and losses, and is relatively stable as a percentage of However, for the purpose of utility ratecovered payroll. making, Service Cost does not include several other important costs of providing the pension benefits.These are the financing cost, which is the net effect of interest cost on liabilities offset by investment income on plan assets, and the cost of gains or losses due to experience more or less favorable than assumed.Gains and losses occur from assets earning more or less than assumed, retirees living longer than assumed, salaries growing more slowly or more rapidly than assumed, etc.In my opinion, the financing cost, and the cost of gain or loss experience are appropriately shared by the Company and its customers The FOWLER, Di-Reb Idaho Power Company impact of these elements may be either to lower total cost below the Service Cost, or raise it above Service Cost. What is the most important characteristic to consider in selecting a method for recognizing the cost of pension benefits in utility rate making? Consistency is the primary characteristic that should be present in the treatment of pension cost for By consistency, I mean consistency from onerate making. This is also a primaryrate filing to the next. characteristic necessary for measurement of pension costs for financial reporting purposes, and was one driver behind the development of FAS 87, the accounting standard required for financial reporting purposes. What basis for measuring the cost of pension benefi ts do you believe is appropriate for utility rate making purposes? I support the use of FAS 87 Net periodic Pension Cost as the best measure of pension costs for rate making purposes, because it is a publicly disclosed and audited value, controlled by a well defined and consistent This view is supported by the directaccounting standard. FAS 87 was specifically developedtestimony of Mr. English. to create consistency of measurement from period to period, and to facilitate comparison of pension costs on a consistent basis from one company to another.Therefore, I FOWLER, Di-Reb Idaho Power Company support using the net periodic pension cost included in the Company s rate filing of $7,018,000, the net periodic pension cost is the value prior to application of the service cost adjustment proposed by the Company.Removing the service cost adjustment results in a reduction of 170,160 from the Company s proposed pension expense To that extent I agree that the adjustment proposedamount. by Mr. English is appropriate. Does consistency mean that the Net periodic Pension Cost is stable from period to ,period? Changes in prevailing interest rates,No. rates of inflation, rates of return on plan assets, and other experience will impact the amount of the Net periodic Large changes will impact the pension costPension Cost. The recent downward changes in interestsignificantly. rates and large losses on pension assets have had a major upward impact on pension expense for virtually all plans. But the underlying methodology and discipline for measurement, for selection of assumptions, and for recogni tion of gains and losses is consistent.The consistent use of Net periodic Pension Cost also avoids significant discretionary adjustments because of the public and audited nature of the values. Mr. English proposes to adjust Idaho Power pension cost by an additional $1,379,148.Wha t is your FOWLER, Di - Reb Idaho Power Company opinion regarding this additional Staff adjustment to pension cost? The rationale provided by Staff for this addi tional adjustment is invalid, and represents a misunderstanding of the requirements of FAS 87.As reported by Mr. English, the discount rate for 2003 was reduced from 00% to 6.75% and the future expected return on plan assets was reduced from 9.00% to 8.50%.These changes resulted in an increase in pension expense for Idaho Power.However, these changes in assumptions were fully consistent with the Milliman tabulated FAS requirements of FAS 87. assumptions for 2003 for the largest 100 companies in the The median discount rate used by these companies forus. 2003 was 6.75%, down from a median of 7.25% in 2002.The median assumed long term rate of return on assets for these 100 companies declined from 9.50% in 2002 to 9.00% in 2003. Additionally, the 2004 Greenwich Associates report states that the mean reduction in rate of return on plan assets of 032 corporate pension plans between 2002 and 2003 was .40% from 8.9% to 8.5%, as seen on Exhibit No. 70.The size of Idaho Power s Plan is better represented in the Greenwich Associates data which places Idaho Power at their median. In general, smaller companies with smaller plans tend to use slightly lower assumptions than the largest funds (Fortune 100 companies), in part because they incur greater FOWLER, Di-Reb Idaho Power Company investment expenses as a percentage of assets. Is changing actuarial assumptions common? Under FAS 87, it is not only common, but required that the assumptions be re-examined annually.The discount rate under FAS 87 is defined as the rate of interest at which the obligations could be settled, prevailing on or close to the measurement date for financial This means that in an environment of rapidlystatements. falling interest rates, such as occurred from 2002 to 2003, it was required that companies change their discount rate. 98 of the 100 largest companies in our study reduced their discount rate from 2002 to 2003.The assumed long-term rate of return on assets assumption is changed less often than annually by most companies.Due to the fall in interest rates over several years, and the fall in inflation, however, it became increasingly hard for companies to support the long-term rate of return assumptions used in 2001 and 2002 with the asset mix in the plans.This is because yields on bonds, comprising for most plans 35% to 40% of the portfolio, had dropped into the 4% range.From 2002 to 2003 the great majority of companies reduced their long-term rate of return assumptions on pension plan assets. Under the conditions described, would a change in the investment policy of the pension plan be needed to justify a reduction in the assumed return? FOWLER, Di - Reb Idaho Power Company No. The basis for the reduction rested on the fall in interest rates and inflation, not on a change in the asset mix. Mr. English asserts that it is unusual or irregular for the Company to document in a letter to the Company s actuaries, Milliman USA, their choice of financial assumptions for FAS 87 reporting purposes.Is he correct? No. It is in fact appropriate and routine. FAS 87 requires that the assumptions used for measuring pension obligations and pension expens,e in 'the financial statements of the Company represent management's best estimate, subj ect to the requirements of FAS 87 for selection of assumptions.This is consistent with the general requirements of financial reporting, that the annual statement is the report of management.The role of the actuary is to advise the Company on their selection of assumptions by providing advice on what we believe is appropriate under the requirements of FAS 87 for the current year, the actions of other similarly situated organizations, and data on external relevant measures, such as bond yields Ultimately, it is the Company s decisionand annui ty rates. The actuary is required in ourwhat assumptions to use. report to state that we believe the reported results based on these assumptions meet the requirements of FAS 87.I did that on behalf of Milliman for Idaho Power Company for 2003. FOWLER, Di - Reb Idaho Power Company The assumptions the Company selected were entirely consistent with our recommendations, and with our Further, therecommendations to other clients we serve. entire annual report was subj ect to review by the Company' auditors. Is the responsibility for selection of assumptions different for reports to the IRS under ERISA? Yes.Under ERISA, the Enrolled Actuary and not the Company is responsible for th~ selection of actuarial assumptions, and must certify that they represent The definition of thethe actuary s best estimate. assumptions used under ERISA differs from the requirements under FAS 87, and the ERISA assumptions are changed less frequently. What is your opinion about the Staff' proposed final reduction of $5,638,851 to pension expense? I do not support the third adjustment.This adjustment abandons FAS 87 Net periodic Pension Cost entirely as the basis for rate making, and substitutes the The critical need for usingcash contribution methodology. a consistent methodology from year to year is disregarded when the pension cost allowed is switched from a FAS basis in one rate filing to a cash basis in the next. Why is FAS 87 Net periodic Pension Cost for the Idaho Power pension plan currently higher than the FOWLER, Di-Reb Idaho Power Company required cash contribution? There are two primary reasons. (1) The liabilities under FAS 87 are measured using a 6.75% discount rate for 2003.For cash contributions, liabilities are measured using an 8% discount rate.The FAS 87 basis produces a higher value for the liabili ties in the current interest rate environment.For many years after the initial adoption of FAS 87, this relationship was reversed.The discount rate for FAS 87 was higher than the rate used for cash contributions. (2) Idaho Power uses market value of assets for determining their Net periodic Pension Cost, and a smoothed value of assets for computing the cash contribution.At the beginning of 2003, the market value was $282 million , while the smoothed value was $339 million. The smoothed value recognizes gains and losses on plan investments over a period of five years I so much of the very bad asset performance in 2000-2002 was not yet reflected in the cash contribution calculation.However, those losses are still to be phased into that calculation.In tha sense, the FAS 87 cost is more up to date, because the effect of the losses is more completely reflected. Will the FAS 87 Net periodic Pension Cost always remain higher than the cash contribution amount? Looking at the period from 1986 when FASNo. FOWLER, Di-Reb Idaho Power Company 87 was adopted through 2003, a period of 18 years, Idaho Power s contribution exceeded the Net periodic Pension Cost (NPPC) in 12 years, and was less than NPPC in 6 years.The years where NPPC was higher have been primarily times when the discount rate was low, and/or asset performance was poor The times when cash contributionsrelative to assumptions. have been higher have been times when the discount rate was high and/or asset returns were well above assumptions. Is the cash contribution method recommended by Mr. English less subj ect to discretion than the FAS Net periodic Pension Cost? No, there is a greater level of discretion in The IRS permits several differentthe cash contribution. For a particular year, different methodsfunding methods. produce different levels of minimum contributions.The IRS allows companies to change methods every five years without approval , and in certain cases more often wi th approval. The IRS allows companies to use a smoothing method on plan Companies may change assetassets or to use market value. methods wi thou t approval every five years. In many years, the calculation of the minimum and maximum cash contributions produces a very large range. The Company has the opportunity to select the amount of their contribution within this range, and may vary their contribution considerably from year to year. FOWLER, Di-Reb Idaho Power Company All of these factors make the cash contribution method recommended by Mr. English less stable and consistent in methodology from year to year than the FAS 87 Net periodic Pension Cost. Why not simply allow the lesser of the cash contribution and the Net periodic Pension Cost? This is the equivalent of saying to the Company, heads I win, tails you lose. The size of ,the cash contribution and the Net Periodic Pension Cost will vary differently from year to year , but over time, both calculations reflect the size of the benefits actually paid Any over or under estimate madeout to plan participants. along the way becomes an adjustment to amounts needed in Taking the lower of the two results is afuture periods. method that will not ultimately pay the cost of the benefi ts, because the cumulative amounts considered will be less than the amounts calculated under either a cash method or a FAS 87 method. What is prepaid pension expense? Prepaid pension expense represents the cumulative amount since the adoption of FAS 87 by which cash contributions to the Idaho Power Pension plan have exceeded So it representsthe recorded Net periodic Pension Cost. the excess of funding over what has been expensed. Is prepaid pension expense an asset of the FOWLER, Di-Reb Idaho Power Company Company? Yes, under generally accepted accounting principles, as defined by FAS 87.Under FAS 87, the amounts recognized as Net periodic Pension Cost are by definition the proper allocation of pension cost to current and past I f the Company has paidperiods for accounting purposes. more cash into the plan than the amount of NPPC recognized, they have prepaid pension benefit cost, and there ,is' an expectation that this will be reversed in some future period, with expense exceeding the contribution.The asset is not a claim on investments that are inside the pension trus t .As described by Mr. English, plan assets may not easily be removed by the Company due to ERISA law.The use of plan assets is limited to providing benefits to plan participants until all the promised benefits have been The prepaid pension expense asset is a creditdelivered. for having given up cash in excess of the NPPC.That cash did not get charged as an expense, so i t represents the exchange of one asset, cash, for another asset, the prepaid pension expense. Why should this asset be included in the rate base? It is aThis asset represents a use of cash. consequence of providing a pension plan for employees, following the required rules for funding the plan, and FOWLER, Di-Reb Idaho Power Company recording the expense of the plan on the Company s books. The pension plan is an important benefit for attracting and retaining the employees needed to provide reliable electric service to the Company s customers.In addi tion, the prepaid pension expense was allowed as an asset in the Company s last rate filing (Case No. IPC-94-5). Mr. English calculates Idaho Power s 15-year average annual rate of return in its pension fund at 12.97% and states that his calculated return , was below the DJIA, S&P 500 and the NASDAQ wi th returns of 13.89%, 15.02% and Mr. English opines that the investment21.6%, respectively. results of Idaho Power s pension fund are no better than the performance of the general market.Do you agree wi th that opinion? I do not agree with that assessment.First of all, Mr. English compares Idaho Power's pension fund return against stock market index averages.This is not an appropriate comparison , as a prudent pension fund normally holds 35% to 40% in fixed income securities like bonds and Secondly, as a part of creatingonly 60% to 65% in stocks. our annual Actuary s Report Milliman USA calculates a rate of return based on the change in fund assets from period to Idaho Power s investment performance hasperiod. consistently been among the best of all of the pension plans I review. FOWLER, Di - Reb Idaho Power Company Mr. Fowler, can you summarize your rebuttal testimony? Staff wi tness Mr. English advocatesYes. making three downward adjustments to the Company s test year pension expense and removing the entire prepaid asset from ra te base.I disagree with the reduction of $1,379,148 based on recalculating the 2003 pension expense at a higher rate of return on plan assets of 9%, the removal of $5,638,851 of the remaining FAS 87 Net periodic Pension Cost to equate FAS 87 pension expense to zero, ahd the removal of the prepaid pension asset of $17,800,477 from rate base. do agree with Mr. English's reduction in pension expense in the amount of $2,170,160 which results from not applying the Company s 2003 Service Cost adjustment to the 2003 FAS Net periodic Pension Cost of $7,018,000. Does this conclude your rebuttal testimony in this case? Yes, it does. FOWLER, Di - Reb 1 7 Idaho Power Company BEFORE THE IDAHO PUBLIC UTiliTIES COMMISSION CASE NO. IPC-03- IDAHO POWER COMPANY EXHIBIT NO. 70 B. FOWLER Actuarial Earnings Rate of Return On Plan Assets Ac t u a r i a l E a r n i n g s R a t e o f R e t u r n o n P l a n A s s e t s To t a l F u n d s ( 1 . 03 2 ) ( 1 , 04 5 ) Ch a n g e d Ra t e i n Me a n Pa s t Y e a r 20 0 2 20 0 3 20 0 2 20 0 3 Co r p o r a t e F u n d s ( e x U n i o n s ) 24 % 43 % Ov e r $ 5 b i l l i o n $1 - 5 b i l l i o n $5 0 1 m i l l i o n - $1 b i l l i o n $5 0 0 m i l l i o n a n d u n d e r 8. 4 Pu b l i c F u n d s 12 % St a t e Mu n i c i p a l Ov e r $ 5 b i l l i o n $1 - 5 b i l l i o n $5 0 1 m i l l i o n - $1 b i l l i o n $5 0 0 m i l l i o n a n d u n c l e r Un i o n F u n d s 17 % 10 % To t a l f u n d s 16 % 26 % No t e : M e a n s e x c l u d e " No n e . Ex h i b i t N o . 7 0 Ca s e N o . I P C - 03 - B. F o w l e r , I P C o Pa g e 1 o f GR E E N W I C H A S S O C I A T E S