Future Values Versus Present Values

Actuarial practices use present values (PV) to calculate the funded ratio and funded status. But benefit payments are future values (FV). This suggests that the future value of assets versus the future value of liabilities is the most critical evaluation, but this comparison is rarely seen in the consultants’ reports, if at all. Why? Most asset classes are difficult to ascertain their future value. Do you know what the price of GM’s, or any company’s stock will be three years from now? This is why the PV is used. Only bonds (and insurance annuities) have a known future value and that is why they have historically been used to cash flow match liabilities (i.e. defeasance, dedication, etc.). To prove our point as to the potential misinformation with using a PV calculation, let’s use a simple example below.

Pension

Composition

YTM

PV

FV

A

100% Treasuries

3.00%

$100 million

$150 million

B

100% Corporates

4.00%

$100 million

$180 million

Two pensions both at $100 million market value would have the same funded ratio in PV dollars. But pension B is 100% invested in corporate bonds that out-yield pension A (100% invested in Treasuries) by 100 bps per year. Certainly, plan B has a much greater future value (20% higher) and funded status if we used future values. This suggests that the funded ratio and funded status are not that accurate or even good indicators of the true economic solvency of a pension system.

The point of all this is that we need to focus more on the FV of assets versus liabilities. If we value liabilities at market rates, they would have discount rates of AA corporates (FASB method) or even better U.S. Treasury STRIPS (defeasance method). A corporate bond portfolio matched to liabilities that out-yields liabilities would enhance the funded ratio on a future value basis thereby reducing funding costs (i.e. contribution costs). This is why “cash flow driven investing” (CDI) of liability future values is the most prudent risk and lowest cost methodology to de-risking a pension through asset-liability management (ALM).

6 thoughts on “Future Values Versus Present Values

  1. Something else different about pension funds is it’s not like a family fortune. when the last retiree retires the fund only needs enough to pay his benefits. That is why the loans to get some funds over the hump make so much sense. CSPF will have 46k old enough to retire during the next 30 years and only 35k with enough time for a full retirement. The employment to retiree ratio will be in balance if the industry just holds it’s own or even loses 10k employees.

    • You are correct. Plans can’t generate enough investment returns to compensate for the significant negative cash flow in the near-term. As a result, only an infusion of meaningful assets through a loan program will provide the necessary protection for the promised benefits, while extending the life of these plans by a minimum of 30 years. It is the only program that keeps these plans going. All others basically drive them to the PBGC where crumbs await the participant.

  2. Why can’t pension funds de-risk like is being done in the UK. They purchase insurance products that guarantees an annuity for the pension fund to shift its liabilities. i know its more complicated than this but can it work. any thoughts on de-risking/

    • Good morning, Joe, and thanks for your comment and question. Absolutely! Pension plans in the US once immunized and defeased pension liabilities just like lottery systems still do. In fact, a pension plan can accomplish this objective without having to use an insurance company annuity, which is pretty expensive. Ron Ryan and I were involved in helping to frame the Butch Lewis Act implementation. If a plan were to get a loan, they would have to defease all of the Retired Lives liabilities through one of three methods – insurance annuities, LDI, or cash flow matching, which is the method that I prefer (least costly and more accurate than LDI). I run around the country speaking about de-risking pension plans, and I’m particularly focused on this issue right now because we have enjoyed a long period of equity and bond outperformance that is likely unsustainable. Happy to speak with you in greater detail if you wish.

      • Thank you Russ.It looks like the BLA IS the answer hands down.I can’t understand why so many funds made it through 2008 now 12 years past while our fund could not.I just hope Congress realizes that the Butch Lewis act is the best solution. Thanks for all you work. Joe

  3. There are many factors that impact pension plans on a daily basis. Not all of them are in the control of the plan sponsor. However, asset allocation is and it should be focused on the plan’s liabilities and funded status, but most plans only focus on the return on asset assumption – that is not the correct objective. I want to do more to help secure these important benefits. Don’t hesitate to ask for my assistance and I will help, if possible. Have a great day.

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