Spot rate methodology: Plans are making the switch

Moliterno-MariaIn April, Milliman released its 2016 Pension Funding Study. The study looks at the 2015 year end GAAP accounting results for the 100 largest defined benefit corporate pension plan sponsors. A surprising feature of this year’s study is that 37 of the 100 companies in the study disclosed on their Form 10-K financial statements their intentions to value their 2016 net periodic pension cost results using an alternative spot rate method.

Under the standard method typically used for determining pension expense, the yield curve is used to first determine the present value of plan liability. A single equivalent discount rate is determined that produces the same liability. This equivalent discount rate is then used for all purposes in the expense calculation that requires interest adjustments, including calculation of interest and service costs.

The spot rate method is an alternative method to calculate interest and service costs. Calculating the plan’s liability under the spot rate method is similar to the standard method, as the yield curve is used to determine the liability as the present value of payout streams. However, under the spot rate method, costs are developed using the individual spot rates of the yield curve for each year of expected costs. The interest cost for the year is developed by applying each individual spot rate under the yield curve to each corresponding cash flow discounted to the beginning of the year. Because the current shape of the yield curve has low interest rates in the early years and higher rates over time, payouts expected in the next few years are valued at lower rates than in the future. For example, the December 31, 2015, Citigroup Yield Curve has a rate of 1.34% for year 1 and 4.54% for year 20.

With 37 of the 100 pension plan sponsors analyzed planning on adopting the spot rate methodology in 2016 for some or all of their plans, the change is expected to result in savings in the 2016 pension expense for them. According to the 2016 Pension Funding Study, if all 100 companies adopted the spot rate methodology for all of their plans, the 2016 pension expense savings is estimated to be $14 billion (assuming a 20% reduction in the interest cost for a typical company).

Before changing to the spot rate methodology, there are some additional considerations plan sponsors should make.

First, the current yield curve is an increasing yield curve. What happens if the yield curve becomes inverted with higher interest rates in the early years and decreasing over time? The initial payouts will result in a higher interest cost and may increase the plan’s expense cost.

Second, when calculating the gain or loss at the end of the year, the liability is projected based on a single effective interest rate, even though the expense was determined using the spot rate method. This can potentially lead to larger losses that will need to be amortized in later years. This may offset some gains in the expense costs that were initially produced by the spot rate method.

Third, note that, while an auditor may approve a change to the spot rate method, they may not allow a plan sponsor to change back to the effective discount rate method in the near future. They would want to avoid plan sponsors taking advantage of interest rate movement.

Also note, because the yield curve is used to calculate both the present value of service cost and the interest adjustment on the service cost, frozen plans without a service cost will see less of an impact in changing to the spot rate method than open plans.

Finally, if a plan were to offer lump sums to participants as a method of de-risking, the lower interest cost under the spot rate method is more likely to prompt settlement accounting.

The spot rate methodology may not be appropriate for all plans and plan sponsors. Each plan sponsor should review the impact with its consultant before electing this method.