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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
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Measuring Pension Obligations
Present Value
The current worth of
a future sum of
money or stream of
cash flows given a
specified rate of
return.
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Measuring Pension Obligations
Determining the
appropriate discount rate is
the key to properly valuing
future cash flows, whether
they be earnings or
obligations.
Source: Investopedia
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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
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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)
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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
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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.
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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
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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
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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
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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
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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.
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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?
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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
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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
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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
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Budget Method
Requires greater
involvement
Continual adjustment to
experience
Risk management to
accomplish intended
gains
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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
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As Asset Diversity Increases
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?
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As Asset Diversity Increases
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
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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
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Recognition of Risk and Reward
What is your
reward?
What is your
risk?
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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
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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
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Funding Target and Sleeping
Solvency Level Budget Level
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Contact Information
Donald E Fuerst, Senior Pension Fellow
American Academy of Actuaries
202-785-7871
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