Measurements of DB Plan Funding Serve Different Purposes

A paper from the American Academy of Actuaries gives examples of which DB plan funding measurements are useful for different plan sponsor situations.

“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

Understanding the purpose of the measurement is a prerequisite for selecting the methodology or multiple methodologies most useful to satisfying that purpose, the academy points out. 

According to the paper, some of the key questions to consider include:

  • Can the plan sponsor afford the downside risk of increased cost if assumptions are not realized?
  • Do participants expect there is 100% certainty that their benefits will be paid?
  • Is it critical that there be no risk of an obligation being unmet?
  • Is it more important that scarce resources are allocated between competing priorities?
  • Is determining when resources will be allocated to a particular purpose most important?

For example, some DB plan sponsors may focus on guaranteed benefit security, while also taking into consideration expected cash flow needs, a desire for level expenditures, and the ability to liquidate assets. In some cases, the continuing viability of the entity sponsoring a pension plan might be a concern, so ensuring the solvency of the plan to pay all promised benefits may be paramount. In such a case, the measurement might use risk-free rates of return and the other conservative assumptions. 

Alternatively, for a sponsor that is economically healthy with strong growth prospects, creditworthiness and/or fluctuation in cash contributions to the plan may not be a significant concern. According to the paper, the measurements needed in these cases may focus on planning for how much will be contributed to the plan and for when those contributions will be made. Assumptions that reflect a higher level of risk may be acceptable within that context. 

Another example the academy gives is a situation in which investors are considering acquiring an enterprise that sponsors a pension plan. If they intend to terminate the plan, the measurement of the plan obligation that is most important is likely to be a settlement measurement that considers the cost of placing the pension obligation with a third party. If they will continue sponsoring the plan, then determining future contributions in a manner that reflects their anticipated investment strategy may be appropriate. 

Important points to note, according to the paper, are:

  • For many plans, multiple obligation measures must be calculated and used in different ways to assess plan funding levels;
  • Regulators do not always agree on the best measurement type for a given purpose; and
  • The type of measurement used for a given calculation can, and often does, change over time.

“Because there is more than one right number, an informed follower of pension issues would want to become familiar with the measures commonly used in each area,” the academy concludes.