Dear Actuary: ASOP 4 is here

I read that some changes have been made to the actuarial standards. Are these changes going to impact my community’s pension plan?
- Anxious in Aurora

Dear Anxious:

The actuarial profession in this country is guided by a collection of principles, techniques, and procedures embedded in a set of 56 documents, which are collectively known as the Actuarial Standards of Practice, or ASOPs. The ASOPs are periodically revisited to make sure that they continue to reflect current thinking and best practices drawn from the actuarial community. One of the recent rewrites was to ASOP 4, Measuring Pension Obligations and Determining Pension Plan Costs or Contributions. This rewrite will apply to any pension valuation reports that are issued on or after February 15, 2023, with measurement dates (aka valuation dates) that are likewise on or after February 15, 2023. The rewrite includes four changes in particular that have some bearing on public pension plans. Let’s talk about each of them in turn.

1. Include more detailed information about how the plan’s funded status changes from one valuation to the next

As you know from past issues of Dear Actuary, traditional defined benefit (DB) pension plans need an actuary to periodically prepare an actuarial valuation—typically once a year, or sometimes once every other year. The process starts with gathering updated information on all of the current members of the pension plan. The actuary uses this census data, along with a variety of actuarial methods and assumptions and the details of the plan’s benefit provisions, to determine the liability for all of the pension benefits that the plan is expected to pay over the remaining lifetimes of the plan’s members. By comparing this liability to the plan’s current asset value, the actuary can report back to the stakeholders on how well funded the plan is, and can recommend a funding policy that is designed to ensure that the plan becomes fully funded within a reasonable period of time.

As part of the valuation process, the actuary spends time analyzing how the plan’s membership and the plan’s assets have changed since the prior valuation, and compares those changes to what the actuarial assumptions had predicted would happen. For instance, did fewer retirees die than expected? Did pay levels increase more than the actuarial assumption? How did the investments perform relative to the interest rate assumption? The actuary can quantify how these differences changed the plan’s funded status. For instance, if pay levels went up more than expected, then the liability measured by the current valuation would be a little higher than it was expected to be based on the prior valuation.

When the liability is higher than expected or the assets are lower than expected, actuaries refer to this as an actuarial loss, and when the liability is lower than expected or the assets are higher than expected, actuaries refer to this as an actuarial gain.

The actuary’s analysis of these gains and losses is very important, because it helps the actuary understand how well the actuarial assumptions are tracking with the plan’s actual experience. For instance, if pay levels go up more than expected for several valuations in a row, this may be a sign that the pay increase assumption needs to be adjusted upward. A pattern of continued gains or losses may indicate that the actuary needs to conduct an experience study to reevaluate the actuarial assumptions. (We answered a reader’s question about experience studies in this issue of Dear Actuary.)

Because of the importance of the gain/loss analysis, ASOP 4 now requires actuaries to include more information from the gain/loss analysis in pension valuation reports. In particular, actuaries must now separate the gains or losses that are due to investment performance from the gains or losses that are due to changes in the plan’s membership. This additional information will help stakeholders have a better understanding of the forces that are impacting the plan’s funded status.

2. Include more information to help plan sponsors understand the consequences of investment risk in the plan’s portfolio

Pension plan portfolios consist of investments in a wide range of asset classes, such as different kinds of stocks, bonds, real estate, commodities, and so forth. Each asset class has a particular expected long-term return, as well as an expected risk level (that is, how much the returns are likely to move up and down from year to year). Figure 1 illustrate the expected returns and expected risks for a wide variety of asset classes. Asset classes that have lower expected returns also typically have lower risk levels; that is, a lower likelihood of experiencing either very good returns or very bad returns. These asset classes are toward the lower left-hand side of the chart. Asset classes that have higher expected returns also have higher risk levels, and are clustered toward the upper right-hand side of the chart.

Plan sponsors typically construct a portfolio that has a mix of asset classes from across the spectrum. The dark gray dot in Figure 1 represents one such mix. The risk and return characteristics of that particular mix are a blend of the risk and return characteristics of the various asset classes that are in the mix. Choosing the asset allocation mix for a given pension plan requires the plan sponsor to consider a fundamental trade-off between risk and returns:

• Investing in lower-risk asset classes with lower expected returns should produce lower investment income, which would mean that the plan sponsor would need to make higher contributions over the long term in order for there to be enough money in the plan to pay all of the pension benefits. However, the lower risk levels would result in less year-over-year volatility in the contribution level. Lower risk levels might also provide more benefit security for plan members.
• On the other hand, investing in higher-risk asset classes with higher expected returns should produce higher investment income and therefore lower the amount of contributions that would be needed from the plan sponsor. But the higher risk levels would mean that contribution levels might bounce around more from year to year, which could be difficult for the plan sponsor’s budget to cope with. Higher risk levels might also cause plan members to worry about whether there will be enough plan assets to pay for their pension benefits.

In order to help stakeholders understand this risk/return trade-off, ASOP 4 requires the actuary to include in the valuation report what the plan’s liability and funded status would look like if the plan’s asset allocation were shifted to the very low-risk end of the spectrum—toward the lower left-hand corner of Figure 1. With a very low-risk asset allocation, the actuary would use a correspondingly low interest rate assumption, and this would result in a higher liability. ASOP 4 terms this higher liability a low-default-risk obligation measure or LDROM. By comparing the LDROM liability to the liability the actuary uses to determine funding levels, plan sponsors will be able to better understand how the investment risk/return decisions they make will impact the plan’s liability and the plan’s funded status.

3. Comment on a ”reasonable” Actuarially Determined Contribution

I talked earlier about how actuaries can construct a funding policy that is designed to ensure that the plan becomes fully funded within a reasonable period of time. Some plans have funding policies that are set by law, contract, or collective bargaining agreement, or they use funding policies that are not based on ASOPs. A funding policy that is fully based on the ASOPs will produce a contribution amount that is referred to as an Actuarially Determined Contribution or ADC. ASOP 4 identifies six key elements that go into how the ADC is calculated, and sets forth a number of conditions for each one. If the ADC meets all of the conditions, then the ADC is termed reasonable. The six elements are:

1. The actuarial assumptions, both individually and taken together.
2. The actuarial cost method, which is used to allocate pension costs over an active member’s working lifetime.
3. The amortization method, which specifies how any unfunded accrued liability is paid off over time.
4. The asset-smoothing method, which helps dampen the impact of market volatility on contribution levels.
5. The output-smoothing method, which some plans use to further smooth contribution volatility, for instance by phasing in the impact of assumption changes over several years, or by limiting year-over-year changes in the contribution.
6. The cost allocation/contribution allocation procedure.

If the actuary concludes that the plan’s funding policy does not meet all of the conditions and does not produce a reasonable ADC, then ASOP 4 requires the actuary to comment on that conclusion, calculate a reasonable ADC, and put this information in the valuation report. Note that ASOP 4 does not require the plan sponsor to make any changes to the current funding policy, or to contribute a reasonable ADC. Rather, ASOP 4 lays out a detailed yardstick that actuaries can use to evaluate the plan’s current funding policy and provide additional information about it, including what a reasonable ADC would be.

4. Include more information on the plan sponsor’s funding policy

ASOP 4 requires the actuary to comment on a list of specific details of the plan’s funding policy. For instance, what are the implications of the current funding policy in terms of the plan’s future contribution levels and funded status? How long will it take for the plan to become fully funded? Will the plan be able to pay benefits when they are due? Will the plan run out of assets?

This information will help stakeholders understand the implications of their current funding policy on the long-range health of their plan.

- Your Milliman Actuary

This edition of Dear Actuary was written by Becky Sielman, FSA.