In order to understand the basics of actuarial methods of valuing pension liabilities, one must consider the fundamental equation of pension plan funding, which is:
Where (C) Contributions + (I) Income = (B) Benefits + (E) Expenses
First, actuaries will calculate the future benefits to be paid. With this information actuaries are able to calculate contribution rates based on a Return on Assets (ROA) forecast for investment income (returns). However, if investment income or contributions fail to meet expectations, the stability of the plan may be affected and benefits may have to be adjusted. Please note that the actuary has no input for asset growth to exceed liability growth since they both have the same ROA forecast (error). Given the same forecasted growth rate (ROA) any deficit would also grow at the ROA causing higher projected contributions (not acceptable).
Prefunded defined benefit plans allow for assets to be built up funding future benefits. The more “income” earned the less the need for contributions. In order to determine future benefits an actuarial valuation is calculated. There are many factors in an actuarial calculation, but the most important is likely the discount rate. Actuaries, guided by plan sponsors and investment professionals/consultants, use a discount rate to value future benefits. In public pension funds, actuaries generally use the forecasted return on investments (GASB), whereas corporate plans using guidelines from FASB value future benefits at market rates using a discount rate yield curve of Corporate AA zero-coupon bonds.
When discussing multiemployer defined benefit plans, their funding is not as straightforward. The benefits in DB plans subject to ERISA are required to be prefunded, which means that in the current year the plan sponsor sets aside adequate funds, taking into account expected future investment returns, for pension benefits earned in that year.
Plan sponsors may also be required to make additional contributions for investment losses that occurred in previous years and increases in the present value of future plan obligations (actuarial losses). Plan participants receive their monthly benefit in retirement from these funds that have been set aside. The required contributions for employers in multiemployer DB pension plans are negotiated and tend to fixed for several years as established in collective bargaining agreements. Given that contributions are negotiated, “make up” contributions are not always available should investment returns fall short of expectations.
Two significant market declines during the last 19 years have been one of the major factors in creating a funding shortfall among multiemployer pension plans in Critical and Declining status. The focus on earning the ROA as the target asset return as a means to control contribution expense has lead many plans to strive for outsized return expectations. This more aggressive return profile increases the volatility associated with the plan’s asset allocation and subjects the plan to greater downside risk.
Within H.R. 397, the proposed legislation calls for the loan proceeds to be used to defease the plan’s Retired Lives and Terminated Vested Liabilities through one of three possible implementations: 1) annuities, 2) duration matching, or 3) cash flow matching. Ryan ALM and KCS have for years written about the benefits of cash flow matching to meet near-term liabilities chronologically. This strategy enables the plan to extend the investing horizon for those assets not deployed to meet liabilities, reduce interest rate sensitivity from traditional bonds, and improve liquidity to meet the promised benefits. If implemented successfully, a cash flow matching strategy should defease Retired Lives, help to stabilize both the plan’s funded status and contribution expense, while setting the plan on a de-risking path toward full funding. There are only two ways to truly defease liabilities, which are insurance buyout annuities (IBA) and cash flow matching. Since IBA is expensive, cash flow matching is the only practical way to defease Retired Lives.