Every year, when tax time comes around I dutifully provide my accountant with the requested items needed to complete my tax returns. After a few nail-biting weeks, one of two things happens: I either get a notice to pay the IRS some [seemingly] illogical amount, or, if I am lucky, I receive the positive news that I will be receiving a refund. The arbitrary nature of tax season in my household may sound familiar to you if you are a Defined Benefit (DB) Plan Sponsor.
For many Defined Benefit Plan Sponsors, the uncertainty around the annual pension valuation and the calculation of the pension liabilities can sometimes feel like a mystery—that there is a special secret code to calculating liabilities for which only actuaries know. However, rest assured, the calculations themselves are quite straight forward. Unfortunately, however, the assumptions these calculations are based on is where art and science collide, which can make the simple and straightforward feel complex and overwhelming.
To help demystify pension liabilities, in this paper we break down the liability calculation to its simplest form to help you better understand how various assumptions impact its outcome.
Breaking Down Pension Liability
First, we will define the liability. The pension liability is simply today’s values, or the “present value,” of all the future benefit payments projected to be paid by the plan to participants over the life of the plan.
Let us start with a basic example: the present value of one single payment of $10,000 that will be received one year from today. The $10,000 received in one year must be “discounted” to today to adjust for the fact that money received today can be invested, earning a rate of interest in the meantime. In our example, assume the money today could earn 5% over the next year. Therefore, the value of $10,000 received one year from now is about $9,520 today.
Now, if the interest rate is lower than 5%, say 2.5%, the present value of $10,000 received one year from today increases. Since your investment return is assumed to be lower than in the first example, you need more dollars today to grow to the same $10,000 in one year from now. At a 2.5% interest rate, the present value of $10,000 payable in one year is approximately $9,750, an increase of over $230. Notice this important relationship — as interest rates decrease, the present value/liability increases and vice versa.
Next let us extrapolate this simple present value calculation into a lifetime of benefit payments, not just one payment received next year. Each participant in a pension plan is expected to receive his or her benefits for a number of years based mainly on the specific plan provisions and mortality expectations.
The present value of all these future benefit payments for this one participant represents the pension liability for this individual.
To calculate the total pension liabilities, the future annual benefit payments for every participant for every year of the plan’s lifetime must be aggregated. These aggregated future benefit payments are then discounted to today following the same method as the present value approach outlined above for one individual. The present value of all these aggregate future benefit payments results in the total liability of the pension plan today.
Armed with the schedule of the plan’s aggregate future benefit payments, the impact of a changing interest rate environment can be easily assessed and analyzed.
The Collision of Art and Science
Now that you have a better understanding of pension liabilities, your next question may be “So how are the future benefit payments calculated?” This is where actuarial art and science collide.
For retirees, the future benefit payments are relatively straight forward. Since these participants are already receiving their benefits, the only unknown is how long each retiree’s benefit will continue, which depends on the type of benefit they elected and their life expectancy based on actuarial models.
For participants not yet receiving their benefits, there are many more unknowns related to their future benefit payments. Not only do we not know how long each participants’ benefit payments will continue once they commence their benefits, we also do not know when they will decide to start collecting their benefit and the form in which they will elect to receive their benefit. For plans that are not frozen, the amount of future benefit accruals is another unknown piece of the puzzle.
To estimate future benefit payments from the plan, the actuary must make assumptions regarding all of these ‘unknowns. Many of the unknowns require the actuary to use their expertise to select appropriate assumptions; however, other assumptions are prescribed by the various regulatory bodies that oversee defined benefit plans (i.e., IRS, PBGC, FASB).
Unfortunately for Plan Sponsors, regulatory bodies have not established consistency across their prescribed assumptions. As a result, various future benefit payment streams for the same plan are generated based on each regulator’s assumption requirements, which generates different liability measures.
While each liability measure is used to determine a specific plan requirement, it certainly adds confusion for the Plan Sponsor.
When thinking about which liability measure a Plan Sponsor should focus on, the short answer is that it depends. For the purpose of evaluating Liability Driven Investment strategies, we suggest looking at the measure that most accurately captures the economic value of the pension plan which tends to align best with the Financial Accounting Standards Board’s (FASB) requirements.
For more help demystifying your pension plan or with constructing or evaluating the plan’s investment strategy, please reach out to any of the professionals on the Fiducient Advisors defined benefit team.
The information contained herein is confidential and the dissemination or distribution to any other person without the prior approval of Fiducient Advisors is strictly prohibited. Information has been obtained from sources believed to be reliable, though not independently verified. Any forecasts are hypothetical and represent future expectations and not actual return volatilities and correlations will differ from forecasts. This report does not represent a specific investment recommendation. The opinions and analysis expressed herein are based on Fiducient Advisor research and professional experience and are expressed as of the date of this report. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Past performance does not indicate future performance and there is risk of loss.
