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Measuring Pension Obligations

National Conference of State Legislatures

December 11, 2013

Donald E. Fuerst, MAAA, FSA, EA

American Academy of Actuaries

Senior Pension Fellow


All Rights Reserved. 2


Present Value

The current worth of

a future sum of

money or stream of

cash flows given a

specified rate of

return.




Determining the

appropriate discount rate is

the key to properly valuing

future cash flows, whether

they be earnings or

obligations.

Source: Investopedia

http://www.bigstockphoto.com/image-47250991/stock-photo-the-words-interest-rates-on-a-sphere-of-percentage-signs-to-illustrate-comparing-bank-fees-and-perce



Discount Rates

The appropriate discount rate depends upon the

purpose of the calculation. Possible purposes:

For inclusion in financial statements

To establish a funding target

To transfer or settle an obligation

To determine risk exposure



Financial Statements

Appropriate discount rate depends on the standard setter:

Federal - Federal Accounting Standards Advisory Board

Treasury rates

Private - Financial Accounting Standards Board

High Quality Corporate Bonds (AA)

State and Local Governments – Government Accounting

Standards Board

Expected Return on Assets (EROA)



Actuarial Perspective

Standard setters do not seem to agree. Do actuaries agree

on interest rates for present values?

Perhaps more agreement than you think

If purpose and meaning is clearly defined, general agreement

Let’s look at the two broad categories



Two Measurements of Obligation

Solvency Value

Similar to: settlement value, market value, market-

consistent value

Budget Value

Similar to: funding target, actuarial accrued liability

Either value can be based on any benefit stream, including

accrued benefits at measurement date or projected benefits

at retirement date.



Solvency Value

Amount needed to

transfer obligation from

one party to another

without additional

funds

Amount invested in

default free securities

with maturities and cash

flows that match benefit

payments



Solvency Value

Funding obligation at

Solvency Value allows

sponsor to:

Transfer obligation to

insurer if desired, or

Maintain fund with near

100% certainty of

sufficiency, and…

Sleep like a baby



Budget Model

Sponsor contributes to Trust

Benefits guaranteed by Sponsor

Contributions based on EROA, ultimate contributions

dependent on investment results

Sponsor adjusts future contributions based on

experience



Expected Return on Assets

Funding target and contributions based on EROA:

EROA based on asset allocation of portfolio

Higher potential return implies greater risk

Returns are less certain

Wide range of possible returns

EROA usually set at median of range of returns

Median means half higher, half lower



Budget Value

The amount that is expected to be sufficient to pay all

benefits if the amount is invested in a portfolio and

earns the anticipated return of the actual portfolio.



Budget Value

Amount expected to be

sufficient with expected

return on assets to pay all

benefits

Additional funds needed

if return < EROA

Surplus develops if

return > EROA

Is Budget Value Enough?



Funding the Budget Value

Is Funding with large variability acceptable? What if

amount is not sufficient?

Probably not ok if no other sources of funds

Probably ok if sponsor can fund shortfalls



Plan has Call Option

Sponsor promises to fund

any deficiencies

Promise is equivalent to

a call option on sponsor

assets

Call option is similar to

insurance company

capital



As Diversification Increases

Range of uncertainty increases

Investment returns more volatile than treasury securities

Keeping plan 100% funded will necessitate volatile

contributions

If contributions “smoothed,” unfunded or surplus

amounts are created



Budget Method

Requires greater

involvement

Continual adjustment to

experience

Risk management to

accomplish intended

gains



As Asset Diversity Increases

EROA generally increases

Funding target decreases

Certainty that assets are sufficient decreases

Volatility of contributions increases

Volatility of funded status increases

Potential demand on Call Option increases

Obligation to provide benefits does not change




Sponsor obligation to provide benefits is constant. Does

the current value of this obligation change?

GASB says yes

FASB says no

What do you say?




Sponsor Obligation = Funding Target + Call Option

Funding Target decreases

Call Option increases by offsetting amount

Sponsor Obligation is unchanged by asset allocation

changes

But reported “liability” by GASB rules does change



Budget Method

Budget method can be effective way to fund benefits at

lower cash cost (not lower risk-adjusted cost). Effective

use requires:

Sponsor recognizes the risk and reward

Sponsor has financial capability to deal with adverse

consequences



Recognition of Risk and Reward

What is your

reward?

What is your

risk?



Reward of Budget Method

Budget method seeks lower cash cost than Solvency

method

Target Gain = Solvency Value – Budget Value

Target Gain = PV of Benefits at risk-free rate minus

PV of Benefits at EROA



Summary

Solvency and Budget values have different purposes

Understanding the risk in a pension plan with a

diversified asset portfolio requires knowledge of both

measures

Solvency value is benchmark for risk measurement

You cannot fully understand your risk without

knowledge of risk free levels

Financial strength of sponsor is an integral part of the

health of a diversified pension program



Funding Target and Sleeping

Solvency Level Budget Level



Contact Information

Donald E Fuerst, Senior Pension Fellow

American Academy of Actuaries

202-785-7871

[email protected]

mailto:[email protected]

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