Administration December 10, 2012

Pension Funding Equation Is Not So Simple

December 10, 2012 (PLANSPONSOR.com) - On a basic level, defined benefit (DB) pension plan funded status is the ratio of assets to liabilities.
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However, as you examine the calculation in more detail, several moving parts can affect funded status in ways plan sponsors do not think of, Eric Keener, partner and chief actuary in Aon Hewitt’s U.S. retirement practice, told PLANSPONSOR.  

Bond Downgrades  

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A Pension Pulse newsletter from J.P. Morgan Asset Management noted that when J.P. Morgan, Credit Suisse, Barclays, UBS and Deutsche Bank were downgraded below AA in June, pension liabilities on company financial statements rose and funded status deteriorated by 3%—solely because the composition of the discount rate index changed. Karin Franceries, executive director of J.P. Morgan Asset Management’s Strategy Group, said the way the discount rate index is constructed is very artificial; it is not investable. Pensions are required to use AA or better-rated bonds.  “Ten issuers alone account for 75% of the index at the long end of the curve, creating the potential for considerable volatility,” Franceries pointed out. It is hard for large companies to match liabilities; they are very worried about major market moves and not finding enough bonds to match liabilities. It reduces the overall credit spread when financial institutions drop from the index, so interest rates are smaller, which results in a higher liability for pension plans.  

Franceries said in this case, if sponsors did not drop the bonds that have been downgraded, it did not make much difference because these bonds are strong and held up in the market. But in another example, in 2001, when Enron was downgraded and went bankrupt, bond investors would have very quickly lost their money.  

Keener noted that some yield curves may or may not include those bonds being downgraded, so some may not move much, depending on which yield curve a company is using. So, some companies may see a change, while others may not. It is important for companies to understand which yield curve they are using and whether it is weighted in certain financials, he said.

Revised Mortality and Accelerated Benefits  

Mike Dulaney, consulting actuary in the defined benefit group at The Principal, said anything that affects the amount of expected future benefit payments—such as higher mortality, assumptions for when participants will retire and enhanced early retirement subsidies—will affect funded status. The Pension Pulse newsletter said changing actuarial assumptions for mortality could increase pension liabilities by 2% to 5%.  

Keener explained that, using current mortality tables, if a participant lives longer, a pension plan will not realize that liability until later, but if mortality tables are updated, pension accounting will see a shock to liabilities sooner. “This is more of a regulatory or mortality table risk than a mortality risk,” Keener said. The Society of Actuaries is currently developing a study of pension mortality and will issue updated tables in the next two years.   

This longevity risk is why sponsors are going to lump sum or buyout solutions; they would rather an insurer carry the risk instead of them, Franceries said. Keener said Aon Hewitt has seen a fairly large number of companies explore a lump-sum window to terminated, vested participants. It would reduce their liability because they would not have to carry that liability on their balance sheet anymore, but it could also affect funded ratio because the plan is paying out assets. Plan sponsors may want to accelerate contributions in the plan; assets may not earn as much as before.  

According to Dulaney, some plans include shutdown benefits—enhanced benefits for closing locations—which are not disclosed until the events actually happen; however, these subsidies affect actuarial assumptions about when people will retire. They also affect retiree medical, or other post-employment benefits (OPEB), accounting, Keener added.

Accounting Changes  

Franceries said clients typically are wrestling with minimizing their annual contributions, which recent relief in the MAP-21 legislation has addressed. However, Dulaney said The Principal is telling clients that if interest rates do not recover, they will end up with much higher contributions than they would have without the relief. Franceries said DB plan sponsors are looking at mark-to-market accounting so the conflict between contribution volatility and expected return on assets is disappearing (see “Transparencies of Liabilities a Growing Trend”).  

In addition, when paying lump sums, plan sponsors may have to do settlement accounting of actuarial losses that may not have gone into the balance sheet yet, depending on the number of lump sums paid.  

Finally, Keener noted, in the past year, there has been a general decline in pension plan sponsors’ outlook for expected returns in the market, so more are lowering their expected rates of return. This can increase pension expense in sponsors’ P&L statement, but it will not affect funded status.

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