By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Ever wonder why future pension contributions aren’t part of the funded ratio calculation, yet future benefit payments are? Ironically, under GASB 67/68, which requires an Asset Exhaustion Test (AET), which is a test of a pension plan’s solvency, future contributions are an instrumental part of the equation. Why the disconnect? 

Also, the fact that future contributions, which in many cases are mandated by legislation or through negotiations, are not in the funded ratio means that the average funded ratio is likely understated. Furthermore, given the fact that the funded ratio is likely understated, the asset allocation, which should reflect the funded status, is likely too aggressive placing the plan’s assets on a more uncertain path leading to bigger swings in the funded ratio/status of the plan as the capital markets do what they do.

As part of the Ryan ALM turnkey LDI solution, we provide an AET, which often highlights the fact that the annual target return on asset assumption (ROA) is too high. A more conservative ROA would likely lead to a much more conservative asset allocation resulting in far smaller swings and volatility associated with annual contributions and the plan’s funded status. As you will soon read, contributions are an important part of the AET for public pensions. When performing the test, you need to account for future contributions from both employees and employers. These contributions, along with investment returns, help to sustain the pension plan’s assets relative to liabilities over time.

Here’s a quick summary of how contributions fit into the asset exhaustion test:

1. Current Assets: Start with the current market value of the plan’s assets.
2. Benefit Payments: Forecast the actuarial projections for future benefit payments
3. Administrative Expenses: Add in the actuarial projections for administrative expenses
4. Future Contributions: Subtract the actuarial projections for future contributions from employees and employers to get a net liability cash flow.
5. Investment Returns: Grow the current market value of plan’s assets at the expected investment return on the plan’s assets (ROA) plus a matrix of lower ROAs to create an annual asset cash flow
6. Year-by-Year Projection: Perform a year-by-year projection to see if the asset cash flows will fully fund the net liability cash flows. Choose the lowest ROA that will fully fund net liability cash flows as the new target ROA for asset allocation

By including contributions in the test, you get a more accurate picture of the plan’s long-term sustainability. So, I ask again, why aren’t future contributions included in the Funded Ratio calculation? Isn’t it amazing how one factor (not including those contributions) can lead to so many issues? With less volatility in funded status and contributions, DB plans would likely have many more supporters among sponsors and the general public (aka taxpayer) . It is clearly time to rethink this issue.