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Measuring Pension Liability

Practice Management
A pension plan’s funded status is critical information. A recent blog entry argues that calculation of a pension plan’s funded status involves more than measuring the values of the plan’s assets; it also entails measuring its liability. How best to do that? There’s the rub.
 
In “What Is the ‘Right’ Measure of Pension Liability?” Patrick Kendall, FCA, EA,
MassMutual’s Head of DB Product and Distribution for Institutional Solutions, argues that “it’s usually very simple to measure the current value of DB plan assets, but it’s not as simple to arrive at an answer for the liability side of the equation.” He adds that the “real question” is what measure of pension liability to use. “It’s important to help plan sponsors clarify and identify which liability measure is appropriate to use given the situation,” writes Kendall.

This is especially important, given the results of the MassMutual’s Pension Risk Study Kendall cites. They found that 75% of the plans they studied are in a financial shortfall. Further, plans’ situation is often worse than they imagine, according to MassMutual, which reports that 56% of the plan sponsors that responded said their plans are fully funded, while less than one-quarter said their funded status was at least 90%.

MassMutual arrived at the following findings concerning the most commonly used measures of liability, as well as their calculation bases and assumptions:
 
  • The Pension Protection Act of 2006 (PPA) liability is the appropriate basis to use when determining the required contribution to the plan that will satisfy minimum funding rules. It adds that additional relief provided after the PPA’s enactment has effectively extended the 2-year averaging period to 25 years.
  • For accounting purposes, the pension benefit obligation liability is determined using a spot rate based on the plan’s cashflows using double-A corporate bond yields.
  • The calculation of Pension Benefit Guaranty Corporation (PBGC) premiums is similar to that for determining the PPA basis, except that the averaging period remains 2 years—it has not been extended.
  • Regarding plan termination, insurance company annuity rates generally are the basis to use for measuring liability. However, corporate bond yields are also used in that calculation when plans permit lump sum distributions.
“Although each of these liability calculations is very important and each serves a different purpose, the key is to understand the various measures and uses to ascertain a holistic view of the plan’s finances,” writes Kendall. He adds that discount rate and yield rate trends are important considerations.