By: Russ Kamp, Managing Director, Ryan ALM, Inc.
We’ve had the opportunity to produce Custom Liability Indexes (CLIs) for several multiemployer plans going through the ARPA/SFA process. In all but one case, the SFA grant received or likely to be received falls far short of the goal to secure 30-years of benefits through 2051. Why? More than anything, it really comes down to the discount rate used by the multiemployer plan. The ARPA legislation allows a plan’s actuary to use the lower of either ARPA’s 3rd segment (PPA) plus 200 bps rate (roughly 5.5%) or the plan’s current discount rate. Most plans have been using a discount rate equal to the return on asset assumption (ROA) or one quite similar (>7%). The one case where our CLI shows full 30-year coverage of pension liabilities net of forecasted contributions is for a plan that adopted a 4% discount rate given its severe funding challenges.
As a reminder, the size of the SFA is determined through multiple factors, such as the size of the current legacy assets, the discount rate used to determine the present value of the plan’s future liabilities, future “earnings”, and forecasted/estimated contributions. A discount rate much greater than the ARPA rate will significantly reduce the future value of the benefit payments. We’ve encouraged the PBGC through our outreach to use all three segments and not just the 3rd segment rate while eliminating the kicker of 200 bps. It is inconsistent and unfair to use the third segment rate (20+ years) since benefits are paid chronologically and the SFA grant may only be able to fund less than the next 20 years of benefits. Although the PBGC hasn’t released its Final Final Rules (as they are still being reviewed by the OMB), it is highly unlikely that the discount rate formula will be amended given the potentially dramatic increase in the cost of the legislation currently estimated at about $95 billion.
I mentioned above that the plan using the 4% discount rate could defease net pension liabilities through 2051. How comforting would that be to plan participants? If the pension plan were to use the contributions to support the current legacy assets, the SFA assets alone would defease 15-years and 9 months of benefit payments – still very attractive! My question to our readers, would you rather use contributions to support a full defeasement through 2051, as the legislation intended, or use future contributions (which are truly unknown) to support the legacy assets with the hope that future returns on those contributions would be outsized relative to the return generated by the cash flow matching strategy (CDI)? Please remember that plans receiving SFA assets cannot increase benefit payments prior to 2051’s conclusion. The higher potential return on future contributions would have to be used to beef up the number of assets to meet pension promises after 2051. If risk is best defined as the uncertainty of achieving the objective, wouldn’t it be most risk-averse to use contributions and the SFA grant to fund benefits as far out as possible through a cash flow matching strategy?
Like future contributions, future returns are not guaranteed either. A plan striving for a 7% annual return may have a two standard deviation (95% of observations) volatility in the return pattern of +/- 24% to 30%. One way to reduce some of the uncertainty would be to include only those contributions that have been fully negotiated in the net calculation of future benefit payments. If a plan has a 3- or 5-year negotiated rate for their contributions, only use those contributions in the cash flow matching strategy which would extend the life of the CDI program beyond the 15+ years. Again, how comforting it is for both sponsor and participant to know that the promised benefits have been absolutely secured for that length of time.