The spot rate method, lump sums, and potential audit requirements

Use of the spot-rate method in developing pension cost is a practice which is increasingly being used, and which requires special care when applied to plans where lump-sum payment is available. In my experience as an actuary assisting auditors with their review of financial accounting pension cost, I have encountered one particular issue in several different audits related to pension plans that pay lump sums, which carries with it the risk of increased pension cost. According to the Employee Benefits Survey conducted by the U.S. Bureau of Labor Statistics for 2017, 36% of traditional defined benefit pension plans and 90% of non-traditional defined benefit pension plans (including cash balance-type plans) offer payment of benefits as a lump sum¹ —so the risk may be relevant for a large number of pension practitioners. At issue is a requirement by some auditors to use a certain approach and technique in application of the spot-rate method for pension plans offering lump sums.

Background

The traditional method of calculating interest cost is to use a single interest rate, which is the same weighted average discount rate used to calculate the obligation.² The spot-rate method applies specific spot interest rates along a yield curve, which is the same yield curve used to calculate the obligation.³  

In February 2019, the American Academy of Actuaries published a public policy practice note titled “Valuing Benefits Payable as a Lump Sum,” which provided a framework for the actuarial valuation of pension plans that provide lump sums as a form of payment. Specifically, the practice note describes several different techniques of applying the “spot-rate” method in the calculation of the interest cost component of the pension cost for such plans and how these techniques relate to concepts used in regulatory and accounting frameworks. In addition to the practice note, the Academy has also addressed different approaches to calculating pension cost in an August 2015 issue brief titled “Alternatives for Pension Cost Recognition—Issues and Implications.”

Although companies adopting the spot-rate method often refer to the idea of making a more precise measurement, it is actually not inherently more precise than the traditional method for the purpose of calculating interest cost—rather, each of these methods implies a year-end interest rate environment that would result in no gains or losses. Assuming no changes in expected cash flows, under the traditional method there are no gains or losses if the year-end weighted average discount rate remains unchanged.⁴ Similarly under the spot-rate method, there are no gains or losses if there is a one-year shift in the yield curve.⁵ These end-of-year implications are true for annuity cash flows and also hold true for most techniques used to value lump sums.⁶  

With exception to certain cash balance pension plans, the lump sums paid from most defined benefit pension plans are “interest rate sensitive” because the lump sum value of the underlying annuity depends on the interest rates required to be used under IRS rules.⁷ The practice note broadly defines two categories of approaches to valuing interest rate-sensitive lump sums: the best-estimate approach and the settlement approach. Under the best-estimate approach, the weighted average discount rate and the conversion interest rate are separate assumptions, and the lump sum is considered to be a fixed amount for purposes of developing the discount rate.⁸ Under the settlement approach, a discount rate is developed which aligns to the underlying annuity cash flows, and there is not a separate assumption for the conversion interest rate.⁹ Both best-estimate and settlement approaches can be used under the traditional and spot-rate methods of calculating interest cost.

The practice note describes different settlement approach techniques, two of which are important to the discussion of interest cost calculations under the spot-rate method. The annuity substitution technique uses the underlying annuity cash flows for calculation of interest cost,¹⁰ while the individual implied lump-sum rates technique uses lump-sum amounts derived from implied forward rates of the yield curve.¹¹ While the obligation and effective duration developed using both annuity substitution and individual implied lump-sum rates techniques are identical to the results using the underlying annuity cash flows (in the absence of significant subsidies), the two techniques will generate different interest cost—the individual implied lump-sum rates technique interest cost is typically lower (in an upward sloping yield curve environment).

Emerging practice and preferable method considerations

An employer’s adoption of the spot-rate method can be an attractive option because it can have the effect of lowering the interest cost and service cost components of pension cost. The practice note provides a comparison of interest cost calculated using the spot-rate and traditional methods (using different valuation approaches and techniques), and shows that in a typical upward sloping yield curve environment the spot-rate method amounts are consistently lower (when approach and technique are held constant). Note that the practice note does not address service cost considerations, and comments in this article are limited to the potential effects of auditor requirements on interest cost calculations.

AT&T was the first large entity to use the spot-rate method in calculating the pension cost disclosed in its financial statements. The Office of the Chief Accountant of the Securities and Exchange Commission (SEC) consulted with the employer and did not object to their adoption of the new method.¹² Given that the SEC has not objected to use of the spot-rate method, why would an employer hesitate to adopt it if the result would be lowered financial disclosure cost?

One reason would be that the SEC comments relate to the adoption of the method by a specific employer, AT&T. In the absence of explicit general guidance from the SEC, there remains a lack of consensus from audit firms related to application of the spot-rate method. In addition, the audit firms will have evolving views on this topic as the method is further put into practice. If an employer were to change auditors or if its current auditor’s practices were to change, the employer’s approach and techniques could be further scrutinized and possibly could be required to change.

However, auditors tend to agree that adopting the spot-rate method is generally irreversible. The rationale provided in AT&T’s 2014 year-end annual disclosure stated, “We have made this change to provide a more precise measurement of service and interest costs by improving the correlation between projected benefit cash flows to the corresponding spot yield curve rates.”¹³ AT&T additionally included as part of its disclosures a letter from its auditor,¹⁴ Ernst & Young, stating that the method was preferable for the employer. Many companies have followed this example and provided a similar rationale for the change in method, and if the spot-rate method is determined to be preferable by their auditors, then typically a return to the less preferable traditional method will not be allowed.

The combination of lack of consensus on proper application of the new method, along with agreement that it is preferable and the change is irreversible, has on occasion led to some unfortunate results. Auditor requirements related to application of the spot-rate method may have adverse effects on an employer’s pension cost, and if the change is irreversible then the employer is stuck with the bad effect.

Impact of requiring annuity substitution

In my experience, Ernst & Young has required that, when interest-sensitive lump sums are offered by a plan, the annuity substitution technique settlement approach must be used when the spot-rate method is adopted (and other big four audit firms may take similar positions). Using annuity substitution can actually result in a significant increase to interest cost when compared to the best-estimate approach or the individual implied lump-sum rates technique settlement approach, even after considering the typical reductions due to using the spot-rate method. If an employer were using the best-estimate approach or the individual implied lump-sum rates technique settlement approach under the traditional method, then made the change to using the spot-rate method, and then subsequently were required by its auditor to use the annuity substitution technique settlement approach, the employer might be very disappointed to see the increase in interest cost and therefore P&L. I have seen this impact occur in two separate instances related to audits of large public companies.

As an example of the increase to interest cost, consider a simplified situation: a pension plan with three participants, each of whom will receive a $10,000 annual annuity for a certain period of 20 years. Participant #1’s payment will commence in 10 years, Participant #2 in five years, and Participant #3 in 15 years. Using a 4.00% lump sum conversion interest rate assumption for the best-estimate approach, the cash flows would be as follows: 

After applying the discount factors, we would arrive at the following results:

In this example, an employer using either the best-estimate approach or individual implied lump-sum rates technique settlement approach under the traditional method would expect, upon changing to the spot-rate method, a decrease in pension cost ranging from $400 to $500. If the employer were required at a later date to use annuity substitution, there would instead be an overall increase ranging from $500 to $1,000. 

Cash balance design considerations

Some cash balance plans define the accumulated benefit as the balance of a hypothetical account,¹⁶ and, per final IRS regulations issued in 2014, lump sums paid by these plans are not subject to IRC 417(e). Lump sums paid from these plans are not interest-sensitive, and annuity substitution would not be applicable. Other cash balance plans have benefits that are defined as an annuity calculated from the account balance, using a conversion basis different from IRC 417(e) interest and mortality. For these plans, lump sums are based on an annuity and are therefore subject to the IRS rules for lump-sum distributions. Because these plans pay interest-sensitive lump sums, they may be required to use annuity substitution as discussed above.

In the Employee Benefits Survey conducted by the U.S. Bureau of Labor Statistics for 2017, 35% of pension plans are cash balance plans.¹⁷ While many of the plans included in the Employee Benefits Survey are small plans, it is not uncommon for larger plans to use a cash balance design. There may be a fair number of clients whose cash balance plans use an annuity-based benefit formula, and for such plans, the employer’s auditor could potentially require using the annuity substitution technique upon adoption of the spot-rate method. Plan administrators and actuaries should effectively communicate to the employer any risk of increased interest cost related to adopting the spot-rate method for these plans.

Final thoughts

The spot-rate method is an emerging practice and auditor views are evolving. Understanding and communicating the potential auditor requirements, and the potential effects on interest cost calculations, could help clients avoid an unpleasant surprise.