The Time Has Come

Using the return on asset assumption (ROA) as the discount rate for pension plan liabilities has masked the true funded status for those pension systems operating under a GASB accounting framework. As most everyone knows, liabilities are bond-like in how they move with changes in interest rates.  However, because the ROA is the discounting mechanism that fact is hidden from plan trustees.

The U.S. has enjoyed an incredible bull market for bonds since the early 1980s. In fact, my entire 38-year career in this industry has basically witnessed a bond bull market with only the occasional short-term “correction”. Most market practitioners felt that the bond market was about to enter bear market territory some three years ago only to have interest rates rally considerably since last November. In fact the U.S. 10-year Treasury yield has fallen to 1.76% as of this morning for an incredible rally from 3.24% just 9 months ago.

But, we believe that now is the time to adopt a true mark-to-market valuation for pension plan liabilities.  Why? There isn’t much more room for rates to fall given the rapid decline in rates that we’ve witnessed and the absolute level of yields today. Gaining a greater understanding of the true funded status will help plan sponsors and their consultants make more informed funding decisions.

Furthermore, because liabilities are bond-like, a rising interest rate environment will create a scenario in which liability growth could be negative.  In such an environment, asset growth of only 5% could dramatically improve the plan’s funded status.  Link together a few years of negative liability growth with modest asset growth and a plan could enjoy a rapid improvement in the system’s funding.

Most pension systems are reluctant to adopt a mark-to-market accounting of their plan’s liabilities given the potential optics associated with a more negative story. However, continuing on the current course may not show well either, as asset growth after a 10+ year bull market for equities may not deliver returns in line with the ROA. In an environment in which plans fail to deliver against the ROA the funded status will continue to deteriorate.  However, with a greater knowledge of plan liabilities plans my actually see improved funding even in an environment in which returns are more muted.

Let’s remember that the goal of a pension system should be to secure the promised benefits at reasonable cost. We believe that the objective is much more attainable when all of the relevant facts are known, including the true value of plan liabilities.


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