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When plan sponsors of single employer corporate defined benefit pension plans want to know their plan’s liability or funded status, they can refer to their actuarial valuation reports.
The challenge for plan sponsors is that these reports often contain several different liability measurements: funding target liability with segment rate stabilization, funding target liability without segment rate stabilization, PBGC premium target, PVAB under FASB Topic ASC 960, FASB Topic ASC 715 PBO. For many plan sponsors these acronyms are just a jumble of letters and numbers. This article will help make sense of the different acronyms, what they represent, and what their intended purpose is.
The ultimate cost of a defined benefit pension plan is the value of the benefits expected to be paid by the plan to participants in the future (“expected payments”). All of the liability measures are estimates of the present value of the expected payments.
The basic methodology for determining each of these different liability measures is the same. The actuary incorporates the plan’s participant data and benefit provisions along with demographic and economic assumptions to project expected payments. The most significant assumptions used to determine projected benefit payments are mortality and retirement rates. The actuary then discounts those expected payments back to the liability measurement date using some kind of interest or discount rate.
The discount rate is the most significant economic assumption used to calculate a plan’s liability. It is also the assumption that varies most among the different liability measurements, ranging from current yields on high-quality corporate bonds to long-term expected rates of return on assets.
This article will discuss how actuaries determine the different liability measurements and their intended purpose.
Funding target liability is a measurement that determines the plan’s cash funding requirements under ERISA. The minimum required and maximum tax deductible contribution amounts are determined based on the plan’s funding target liability.
The interest rates and mortality assumptions used to determine the funding target liability are prescribed under IRS regulations. The funding target liability is the present value of future expected benefit payments determined by discounting projected benefit payments back to the valuation date based on their time horizon, using yields on corporate bonds.
The full yield curve approach discounts each future year’s projected benefit payments back to the valuation date, using the applicable interest rate from the full yield curve.
The segment rate approach uses three different segment rates to discount future payments. The segment rates themselves are set by formula in Internal Revenue Code and are based on 24-month rolling average of high quality corporate bond rates. The first segment rate is used to discount payments to be made in the first five years. The second segment rate applies to payments made in years six to 20. The third segment rate applies to all payments after the first 20 years. The segment rates are determined as 24-month averages of the full yield curve rates.
As yields on bonds continued to decrease over the past decade, Congress passed laws to provide relief to plan sponsors. The relief provides that rates must also take into account the 25-year average of bond yields, which produces significantly higher rates than the 24-month averages. Higher interest rates result in lower funding targets, and as a result, lower minimum required contributions. The interest rate stabilization only applies to the funding target liability for purposes of determining the minimum required contribution. The funding target liability for maximum deductible contribution purposes is determined without segment rate stabilization.
Sponsors of underfunded corporate pension plans are also required to pay an annual variable rate premium to the Pension Benefit Guaranty Corporation (PBGC). For this purpose, the plan’s funded status is determined using the PBGC premium funding target liability measure. The PBGC premium funding target is determined using interest rates prescribed by the PBGC. Two permissible methods determine the premium funding target liability: the standard method and the alternative method. Both methods utilize the three-segment rate approach and do not reflect the 25-year average constraints applicable to minimum funding.
The standard method uses three spot-segment rates. These segment rates are the same segment rates used for the determining the premium funding target liability, however, they are spot rates instead of 24-month averages.
The alternative method allows the plan sponsor to use the 24-month average segment rates instead of the spot segment rates. In an effort to minimize PBGC premiums, many plan sponsors have elected to use the alternative premium funding target in recent years in order take advantage of the higher 24-month averages as rates continue to drop.
The Projected Benefit Obligation (PBO) as reported under FASB ASC Topic 715 is part of annual financial reporting of the plan sponsor. For this purpose, the funded status of the plan is measured as the difference between plan assets at fair value and the PBO. ASC 715 takes more of a short-term approach and determines the PBO based on the cost to settle the liability on the measurement date. The discount rate for determining PBO is an estimate of the rate to settle the benefit obligation on the measurement date and is based on high-quality, fixed-income investments that reflect the duration associated with the plan’s projected cash flows. Because the obligation is calculated based on rates as of the measurement date, there is no average or smoothing of the rates.
The present value of accumulated plan benefits (PVAB) as reported under FASB ASC Topic 960 is used for the annual financial statements of the plan, which report accumulated plan benefits and assets sometimes referred to as “plan accounting.” ASC 960 does not prescribe specific assumptions to be used when determining the PVAB. ASC 960 determines the PVAB under more of a long-term approach. Under ASC 960, the most common approach is to use a discount rate equal to the assumed rate of return on plan assets.
Many plan sponsors question which of these liability measures is “correct.” The answer is that no single liability measure is correct. Instead, each of these liability measures is correct for its intended purpose. If the focus is on cash funding, then the funding target liability would be the appropriate measurement. If plan sponsor financial reporting or the cost to settle the obligation is the focus, then ASC 715 would be appropriate. ASC 960 PVAB is appropriate when looking at the liability on a long-term basis. By knowing the intended purpose of these liability measurements, a plan sponsor can better determine its plan’s liability.
|Liability Measure||Interest Rate Basis||Purpose of Measurement|
|Funding target liability without stabilization With stabilization||Bond yields Bond yields restricted to 25-year averages||Cash funding|
|PBGC funding target||Bond yields||PBGC variable rate premium|
|ASC 715 PBO||Current market rates||Plan sponsor financial accounting|
|ASC 960 PVAB||Long-term rates of return||Plan accounting|