Lower DB Funding Not Solely Driven by Lower Interest Rates

An analysis suggests discount rates are likely not the driving force behind different funding levels, despite the general belief lower discount rates produce greater liabilities.

When it comes to funding defined benefit (DB) pension plans, it is commonly understood that the discount rate used to compute liabilities plays a significant role, as a lower discount rate results in a higher liability, which could lead to a lower funded status.

“Discount rate” refers to the interest rate used to compute the present value of future benefit payments.

The Society of Actuaries (SOA) did comparisons from 2009 to 2014 of all three major categories of defined benefit pension plans in the United States: single employer (SE) plans, multiemployer (ME) plans, and state and large city public plans (PP). Reflection was limited to the question of whether discount rates were driving the differences in funded status, without any attempt to explain why funded status differs.

The SOA found SE plans averaged the lowest discount rate at 6.8%, followed by ME plans at 7.4% and PP plans at 7.74%. PP plans had the highest discount rate and the highest total unfunded liabilities, while on average, SE plans have the lowest level of unfunded liabilities despite utilizing the lowest average discount rate.

Although the category with the greatest discount rates (PP) was the least well-funded, statistical analysis reveals that discount rates were probably not driving the differences in funding levels. While they are not explored by the SOA, many other factors involved in pension plan funding also differed among and within pension plan categories, including methods for computing unfunded liabilities, overall approaches to plan and risk management, and the way that contributions are determined.

The SOA notes that DB plan funding levels can be impacted by inadequate contribution levels, varying investment returns and plan funding analyses that do not respond fast enough to changing market conditions, among other factors.

A download of the analysis report is available here.