Actuaries calculate retirement plan liabilities by taking a stream of benefit payments, or cash flows, expected to be received from a plan and assigning a measure of current day value to each payment in the stream, expressed as a single cash amount as of a valuation date. Current day value is the concept that money available today has the potential to earn interest. When describing a sum of money to be provided in the future, its value today should be less in order to account for earnings potential. It is the sum of all expected payments, measured at current day value, which defines an actuarial liability. This article by Milliman actuary Reid Earnhardt explains how cash flows and present value are used to calculate the duration of actuarial liabilities.
In October 2017, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released final regulations prescribing new mortality tables that apply to single-employer defined benefit pension plans for the purpose of calculating the actuarial liabilities for minimum funding requirements, benefit restrictions, and Pension Benefit Guaranty Corporation (PBGC) variable-rate premiums. As with the prior regulations, the new regulations give plan sponsors the option to use either the standard mortality tables developed by the IRS, or to develop plan-specific mortality tables.
The new regulations significantly revised the rules regarding plan-specific substitute mortality tables. Under the prior rules, a plan was required to have fully credible mortality experience in order to use substitute mortality tables. The new rules allow for the use of substitute mortality tables for plans with smaller populations that do not have fully credible mortality experience. As a result, Treasury and the IRS expect that significantly more plan sponsors will request approval to use substitute mortality tables.
Using substitute mortality tables should theoretically improve the fit between expected and actual mortality rates, thereby producing smaller experience gains and losses over time. In addition, for plans employing a workforce that exhibits heavier mortality than the standard tables, using substitute mortality tables could potentially lower both minimum required contributions and PBGC variable-rate premiums.
For these reasons, plan sponsors may want to consider the use of substitute mortality tables. A written request must be submitted by the plan sponsor at least seven months before the first day of the first plan year for which the substitute mortality tables are to apply.
Note that the regulations do not allow plan sponsors to use plan-specific tables for determining minimum lump-sum values; standard IRS tables continue to be used for this purpose.
Now that the presidential election is behind us, much of the political uncertainty that existed prior to the election has subsided, but uncertainty about the investment markets remains high. Interest rates spiked upward after the election and have continued moving higher. U.S. equity prices also spiked upward and have continued climbing. Now that we’re into December, plan sponsors are trying to gauge the impact of these recent events on end-of-year pension plan assets and liabilities. The longer-term impact of the Trump victory, however, is more difficult to predict.
President-elect Trump’s plans for corporate tax cuts, infrastructure spending, and deregulation are cited as some of the factors driving interest rates and expected inflation higher. The yield on the 10-year U.S. Treasury bond has increased about 50 basis points (0.50%) since the election, while the yield on the 10-year U.S. Treasury Inflation-Protected (TIP) bond has increased about 30 basis points (0.30%). The difference between the two yields, known as “breakeven inflation,” is a measure of inflation expectations. By this measure, expected average inflation over the next 10 years has increased by about 20 basis points (0.20%) since the election.
High-quality corporate bond yields—the basis for pension discount rates for accounting disclosure purposes—have increased by about 35 basis points (0.35%) since the election. If these yields remain at this level through the end of the year, plan sponsors could benefit from a drop of several percentage points in the value of their pension obligations (since the election), although yields are still below where they were at year-end 2015.
The Federal Open Market Committee (FOMC) is widely expected to raise its federal funds target interest rate when it meets this week. This would be the first increase since December 2015. It’s too early to predict whether this will be a single increase or the first of many increases over the next couple of years. If the Fed raises its target rate several more times, this could help support the recent spike in longer rates and possibly contribute to additional increases.
In 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).
Lump-sum windows are common ways for defined benefit (DB) plan sponsors to shed pension liabilities. According to Milliman consultant David Benbow, effective communication is essential when employers consider offering of a lump-sum window. He offers his perspective in a recent Money Management Intelligence article.
Here is an excerpt:
Three things are necessary to make a lump-sum window successful: communication, communication, communication. In addition to the required legal notices informing participants of their rights, you should do your best to create a package that is eye-catching (not many people read their mail after it goes in the trash) and easy to read (if it reads like stereo instructions, people will jump to the election forms and make up their own rules). The communication should spell out the pros and cons of taking a lump sum so that the participant can make an informed decision. The last thing anyone wants is for a well-intended offer to turn into a class action because participants were misled.
It takes time to create a good communication package, and usually there will be several people who wants to take a whack at the piñata, including legal counsel. Just know that clear communication up front will reduce the number of questions and follow-up on the back end.
For more Milliman perspective on lump-sum distributions, click here.
In July 2012, Moody’s released to subscribers a “request for comment” draft of proposed adjustments to be made by Moody’s to the pension data reported by U.S. state and local governments. These adjustments, if adopted, could influence local government credit ratings. Moody’s has indicated in this draft report that state credit ratings might not be impacted by the changes; however, the proposed adjustments would still be made and considered for state plans.
The proposal would involve several key changes to be made to the reported liabilities of state and local government pension plans. These would include adjusting liabilities to reflect a 5.50% discount rate using a uniform assumed liability duration of 13 (an assumption which would result in an approximate 13% increase in liabilities for every decrease in discount rate of 1%); using market value of assets rather than any smoothed value reported by the plan; amortizing any resulting unfunded actuarial accrued liability over a 17-year period on a level-dollar basis; and allocating liabilities for cost-sharing plans according to proportionate share of total plan contributions.
Moody’s has stated that these adjustments, if adopted, “would likely result in rating actions for those local governments where the adjusted liability is outsized for the rating category,” and where the plan has not shown the ability to increase funding or otherwise respond to shortfalls.
However, some actuaries and plan sponsors have voiced concerns that these adjustments may be too broad to appreciably improve metrics for individual plans. In particular, using a duration of 13 to adjust liabilities may cause some very mature plans to appear more sensitive to changes in the discount rate than they actually are, while some younger plans may in fact be more sensitive to changes in discount rate than a duration of 13 would predict. Additionally, amortizing the resulting unfunded actuarial accrued liability (based on market value of assets) over a 17-year period on a level-dollar basis is likely to show significantly higher contribution amounts in early years of the unfunded liability amortization, because most systems use a level percentage of pay methodology, which results in increasing contribution dollars over time.
The deadline for comment on the Moody’s proposal was August 31, 2012; however, no final Rating Implementation Guideline has yet been published, so it remains to be seen to what extent any final guideline will mirror the draft proposal. Follow Moody’s here.