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October 31, 2014 (PLANSPONSOR.com) – The Government Accountability Office (GAO) studied measures of private and public defined benefit (DB) plan valuations and found varied opinions over discount rates used for different measurements of plan liabilities and benefits.
However,
the GAO said it found one significant area where there is some, but not
universal, room for agreement. Specifically, many experts supported providing
multiple measures of liabilities for different purposes to provide a more
complete picture of pension plan finances.
Though
it made no formal recommendations, in a report to Tom Harkin (D-Iowa), the Chairman of
the Committee on Health, Education, Labor, and Pensions in the United States
Senate, the GAO said there may be value in providing multiple measures of
liability and cost, using both assumed-return and bond-based discount rates—carefully
labeled to describe their purpose (e.g., with some measures, such as funding
targets, not even necessarily labeled “liabilities”)—and with explanations of
what these measures do and do not represent.
“The
measurements resulting from these different discount rate approaches can
ultimately improve the understanding, management, and governance of the
finances of pension plans. In short, there may be value in having multiple
liability measures to arrive at funding, benefit, and investment policies that
will better balance risks and rewards to plan participants and all other stakeholders,”
the agency wrote in its letter.
The
GAO said policy options to address DB plans’ challenges may be addressed by
fostering the use of appropriate liability measurements and discount rate
assumptions and increased transparency concerning their financial health.
However, options should also be sensitive to the crucial need to ensure that
benefits remain adequate.
In
its report, the GAO explained that determining which discount rate to use to
estimate plans’ future liabilities is important because different rates can
cause great differences in calculations. For example, the present value of corresponding
liabilities for a $1,000 benefit payable seven years from today is $760 at a 4%
discount rate and $583 at an 8% discount rate. For a benefit payable seven
years from today, the liability measured at 4% is 30% higher than the liability
measured at 8%. Further, for a benefit payable 15 years from today, the
liability measured at a 4% discount rate is 76% higher than the liability
measured at an 8% discount rate.
The
report said methods for determining a plan’s discount rate can be categorized
into two primary approaches—the assumed-return and bond-based approaches. These
primary approaches in turn can have different variations, such as the use of “smoothing”
with bond-based approaches, as is used by private sector single-employer plan
sponsors under the Employee Retirement Income Security Act (ERISA), where bond
interest rates are averaged over multiple current and historical years.
The
assumed-return approach bases the discount rate on a long-term assumed average
rate of return on the pension plan’s assets. As employed by U.S. public pension plan sponsors,
this approach often produces discount rates between 7% and 8%. The bond-based
approach uses a discount rate based on market prices for bonds, annuities, or
other alternatives that are deemed to have certain characteristics similar to
pension promises. Under this approach, the discount rate is independent of the
allocation of plan assets. The relevant bond quality (e.g., AAA-rated, AA-rated,
etc.) can depend on the specific purpose of the liability measurement, which
can result in rates that vary considerably.
Public plans and
private sector multiemployer plans—which typically use an assumed return
approach, and thus, higher discount rates—generally report higher funded ratios,
and their liabilities generally appear lower, than those of comparable private
sector single-employer plans. GAO noted that this approach generally produces
lower liabilities than variations of bond-based approaches with little or no
smoothing (which often produces lower discount rates), as used by private
sector single-employer plan sponsors for financial reporting purposes. For
example, the report said, Mercer estimated that at the end of 2013 an average
private sector single-employer plan sponsor would have a discount rate of 4.88%,
and according to the National Association of State Retirement Administrators, public
plan sponsors assumed a return of 7.72% on average as of December 2013.
Some
experts the GAO spoke with view differences between public sector and private
sector single-employer discounting approaches as appropriate because they believe public plans can best estimate their pension costs using
very long-term assumed returns as their discount rate. There were other experts,
however, who disagree with this viewpoint or see value in both types of
measures.
Some
experts said that the assumed-return approach could incentivize public plan
sponsors to invest in riskier assets because doing so can increase the assumed-return
discount rate, thereby lowering reported liabilities and reducing funding
requirements. Some experts told the GAO it is also possible that a plan’s discount
rate approach could influence future benefit levels. At the most basic level,
the cost of benefits typically will appear lower using an assumed-return discount
rate than using a bond-based discount rate, perhaps leading to compensation
packages that are weighted toward more retirement benefits or to larger overall
compensation packages.
Further, some experts expressed concern that sponsors of
plans that have earned more than the assumed return, such as in a bull market,
have given this extra return to participants as a benefit increase, but that
benefits would not be cut at the same rate during periods of low returns. To
the extent this occurs, it would mean that an assumed-return discount rate
would need to be lowered, or the plan liability increased in some other manner,
to reflect the fact that future bull-market gains would not be fully available
to offset future bear market losses.
In
contrast to the investment incentives that public plan sponsors (and multiemployer
plans) may face, the use of a bond-based discount rate for private sector
single-employer plan sponsors can create an incentive to invest in bonds to
make pension contributions more predictable or financial reporting results less
volatile, GAO said. It explained there are various legal constraints on the
ability of plan sponsors to reduce future or current benefit accruals, which
vary further for public and private sector plans. For plans using bond-based discount
rates (with little or no smoothing), liability values will fluctuate with
changes in market interest rates. A bond-based investment policy can be used so
that plan asset values will move in tandem with liability values as interest
rates fluctuate. The greater the match between a plan’s investment assets and
the amount and timing of its projected benefit payments, the more stable the
plan’s funded status will be.
However,
GAO notes that holding bonds means forgoing potentially higher returns from
equities. Thus, the more that a plan matches assets to liabilities by
purchasing similar-duration low-risk bonds, the more expensive the plan may
become to fund, which may provide a disincentive to invest more in bonds.
Some
experts GAO spoke with believe the appropriate discount rate to use depends on
the purpose of the measurement. Regardless of whether they believed that, all
experts interviewed pointed to at least one among six considerations that
influenced their views about discount rate policy:
Level
and predictability of cost – Bond-based discount rates can lead to costs that are
too high (depending on market conditions), or too volatile from year to year
for sponsors to bear. On the other hand, an emphasis on ensuring predictable
and level costs from year to year may mean plan sponsors are not contributing
enough to adapt to changing market conditions.
Benefit
security and risks to stakeholders – Basing funding on assumed returns increases
the risk that insufficient assets could be on hand when needed, or that
contributions will have to be increased, or promised benefits reduced, in the
future.
Plan
and sponsor characteristics – Key risk factors include the size of the plan
relative to the size of the plan sponsor, the maturity of the plan, and the
strength of the plan sponsor.
Intergenerational
equity – Experts agreed that each generation should pay its fair share for
pension costs, but disagreed about what this meant in practice. One viewpoint
is that using assumed returns passes uncompensated risk to future generations.
The other viewpoint is that using bond rates charges current generations an
amount greater than the expected long-term cost.
System
sustainability – One viewpoint is that the use of bond-based rates pushes plan
sponsors to abandon sponsoring DB plans. The other viewpoint is that use of
assumed returns leads to poor risk management practices (for both investment
and benefit policy) and to crises of poorly funded or failing DB plans that
cause sponsors, or create pressures, to abandon these plans.
Transparency
and comparability – Providing a bond-based measure in addition to an assumed-return
measure may help outside parties get a transparent, comparable view of plan
liabilities, based on market measures. However, some experts argued that
multiple measures might not enhance transparency because such information could
be confusing or misleading about the likely cost to fund a plan.
Nearly
half of the experts GAO interviewed supported the use of multiple measures for
valuing pension plan obligations. Many experts stated that reporting multiple
measures of liabilities would be useful in providing transparency. Some said
that reporting liabilities based on multiple discount rates would provide
fuller transparency into a plan’s finances than using a single rate. Some
experts also took the view that public plans providing liabilities at both a
bond-based and assumed-return discount rate could provide a broader range of
information to plans and employers to guide plan policies, and could
potentially provide a useful check on the assumed-return measurement.
Nearly
one-quarter of the experts GAO interviewed argued that only a bond-based
approach should be used to value plan obligations, while nearly one-third favored
use of only the assumed-return approach.
The
GAO looked at practices in other countries—Canada, the Netherlands, and the
UK—and found they apply a variety of approaches to discounting. Canada requires
determination of multiple measures of plan obligations, based on both assumed
returns and high-quality bond rates and annuity prices. The Netherlands requires
that plan obligations be measured based on market interest rates, but allows
the use of assumed returns for determining plan contributions or developing
recovery plans. In the United Kingdom, discount rates are determined on a plan-specific
basis and can include some allowance for assumed returns in excess of high-quality
bond rates, depending on plan characteristics and the strength of the sponsor.
To the extent that
plans in these countries use long-term assumed rates of return, they are generally
lower than those used by many U.S. public plans under recent market conditions,
the GAO found. Experts GAO interviewed in these countries described a greater
degree of government oversight which the GAO said might help explain their use
of lower assumed returns.