Measuring Pension Obligations

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Clarissa Francis
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Measuring Pension Obligations Present Value The current worth of a future sum of

3 Measuring Pension Obligations Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations. Source: Investopedia All Rights Reserved. 3

4 Discount Rates The appropriate discount rate depends upon the purpose of the calculation. Possible purposes: For inclusion in financial statements To establish a funding target To transfer or settle an obligation To determine risk exposure All Rights Reserved. 4

5 Financial Statements Appropriate discount rate depends on the standard setter: Federal - Federal Accounting Standards Advisory Board Treasury rates Private - Financial Accounting Standards Board High Quality Corporate Bonds (AA) State and Local Governments Government Accounting Standards Board Expected Return on Assets (EROA) All Rights Reserved. 5

6 Actuarial Perspective Standard setters do not seem to agree. Do actuaries agree on interest rates for present values? Perhaps more agreement than you think If purpose and meaning is clearly defined, general agreement Let s look at the two broad categories All Rights Reserved. 6

7 Two Measurements of Obligation Solvency Value Similar to: settlement value, market value, marketconsistent value Budget Value Similar to: funding target, actuarial accrued liability Either value can be based on any benefit stream, including accrued benefits at measurement date or projected benefits at retirement date. All Rights Reserved. 7

8 Solvency Value Amount needed to transfer obligation from one party to another without additional funds Amount invested in default free securities with maturities and cash flows that match benefit payments All Rights Reserved. 8

9 Solvency Value Funding obligation at Solvency Value allows sponsor to: Transfer obligation to insurer if desired, or Maintain fund with near 100% certainty of sufficiency, and Sleep like a baby All Rights Reserved. 9

10 Budget Model Sponsor contributes to Trust Benefits guaranteed by Sponsor Contributions based on EROA, ultimate contributions dependent on investment results Sponsor adjusts future contributions based on experience All Rights Reserved. 10

11 Expected Return on Assets Funding target and contributions based on EROA: EROA based on asset allocation of portfolio Higher potential return implies greater risk Returns are less certain Wide range of possible returns EROA usually set at median of range of returns Median means half higher, half lower All Rights Reserved. 11

12 Budget Value The amount that is expected to be sufficient to pay all benefits if the amount is invested in a portfolio and earns the anticipated return of the actual portfolio. All Rights Reserved. 12

13 Budget Value Amount expected to be sufficient with expected return on assets to pay all benefits Additional funds needed if return < EROA Surplus develops if return > EROA Is Budget Value Enough? All Rights Reserved. 13

14 Funding the Budget Value Is Funding with large variability acceptable? What if amount is not sufficient? Probably not ok if no other sources of funds Probably ok if sponsor can fund shortfalls All Rights Reserved. 14

Sponsor promises to fund any deficiencies Promise is equivalent to a call option on sponsor

16 As Diversification Increases Range of uncertainty increases Investment returns more volatile than treasury securities Keeping plan 100% funded will necessitate volatile contributions If contributions smoothed, unfunded or surplus amounts are created All Rights Reserved. 16

18 As Asset Diversity Increases EROA generally increases Funding target decreases Certainty that assets are sufficient decreases Volatility of contributions increases Volatility of funded status increases Potential demand on Call Option increases Obligation to provide benefits does not change All Rights Reserved. 18

19 As Asset Diversity Increases Sponsor obligation to provide benefits is constant. Does the current value of this obligation change? GASB says yes FASB says no What do you say? All Rights Reserved. 19

20 As Asset Diversity Increases Sponsor Obligation = Funding Target + Call Option Funding Target decreases Call Option increases by offsetting amount Sponsor Obligation is unchanged by asset allocation changes But reported liability by GASB rules does change All Rights Reserved. 20

21 Budget Method Budget method can be effective way to fund benefits at lower cash cost (not lower risk-adjusted cost). Effective use requires: Sponsor recognizes the risk and reward Sponsor has financial capability to deal with adverse consequences All Rights Reserved. 21

Recognition of Risk and Reward What is your

23 Reward of Budget Method Budget method seeks lower cash cost than Solvency method Target Gain = Solvency Value Budget Value Target Gain = PV of Benefits at risk-free rate minus PV of Benefits at EROA All Rights Reserved. 23

Summary Solvency and Budget values have different purposes Understanding the risk in a pension plan with a diversified asset portfolio requires knowledge of both measures Solvency value is benchmark

24 Summary Solvency and Budget values have different purposes Understanding the risk in a pension plan with a diversified asset portfolio requires knowledge of both measures Solvency value is benchmark for risk measurement You cannot fully understand your risk without knowledge of risk free levels Financial strength of sponsor is an integral part of the health of a diversified pension program All Rights Reserved. 24

Retirement Shares Plan

Retirement Shares Plan Donald E. Fuerst, MAAA, FSA, FCA, EA Senior Pension Fellow American Academy of Actuaries Presented at Wharton Pension Research Council Symposium May 1, 2014 All Rights Reserved. A Variable Annuity Plan