Administration

There Is No Single 'Right' Measurement for DB Plan Funding

The purpose of the measurement determines which number is “right,” according to the American Academy of Actuaries.

By Rebecca Moore editors@plansponsor.com | July 17, 2017
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“A single number often cannot comprehensively address an issue as complex as the obligation or funded status of a pension plan,” the American Academy of Actuaries notes in an Issue Brief

The academy notes that news reports may indicate that a defined benefit (DB) retirement plan of a major local employer is underfunded by $50 million, while the employer’s leadership reported in an interview the previous week that the plan was in solid financial shape and consistent with its financial plan. Both could be telling the truth.

“The primary reason why there is more than one right number [for reporting pension funding] is that different measurements of actuarial obligations can communicate very different information,” the paper says. “Settlement” measurements can include measurements designed to show how much it would cost a plan sponsor to transfer the responsibility of supporting a plan to an insurance company or other financial institution; the amount of assets that would be necessary to back the pension obligations with a dedicated portfolio of low-risk bonds with cash flows that are aligned with the projected pension benefit payments; or the price at which pension obligations would trade, should a market exist on which they could be bought and sold. A “budget” measurement could represent an estimate of how much money the plan would need to have in order for a projection to show that the assets are expected to be sufficient to cover projected benefit payments.

One difference between a budget measurement and a settlement calculation is that the budget approach includes an estimate of the future investment returns that the plan assets will earn, including any expected incremental return from investing in risky assets. The paper notes that for most diversified investment portfolios, such an estimate is inherently uncertain, and assumptions can vary among those making the calculation. “A settlement valuation relies only on financial information available in today’s financial markets,” the paper explains.

A plan that is 100% funded on a budget basis is subject to the risk that experience may be less favorable than anticipated, which could cause the plan to become underfunded in the future and may jeopardize the security of participant benefits. Being 100% funded on a settlement basis means that the actuary has concluded that a plan holds sufficient assets to transfer the responsibility for supporting the plan’s obligations to a third party. “This suggests that it is possible, and perhaps likely, that a lesser amount of assets would be sufficient to pay all benefits if the plan sponsor were willing and able to take on risk. Therefore, the sponsor of a plan that is 100% funded on a settlement basis may have contributed more to the plan than was actually needed to pay all participant benefits,” the brief says.

NEXT: The purpose of different measurements

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