Often there can be confusion in more ways than one when trying to understand why actuaries report liabilities for defined benefit plans.
The reason actuaries report plan liabilities in different manners has to do with the interplay between interest rates, the economy, and the reporting purpose.
Wide-eyed and eager to learn, I started my actuarial career in the third quarter of 2008. Amid the many words of wisdom provided early on, one line that stuck out to me was “when interest rates go down, liabilities go up. When interest rates go up, liabilities go down.” As if on cue, the economy quickly greeted me with a housing bubble and a stock market crash. It was at this time I quickly realized how the current interest rate environment affects the different bases for which actuaries report liabilities.
For example, under the Pension Protection Act (PPA) of 2006, Congress intended to improve the funded status of pension plans in the US by mandating the interest rates that were used in calculating plan liabilities. Before PPA, actuaries themselves set the interest rate for calculating plan liabilities, which could result an interest rate used for calculating liabilities that differed from the current environment. With PPA, Congress stipulated that interest rates used to calculate plan liabilities be based on a 24?month average of current corporate bond segment rates. This was done so that plan liabilities more closely reflected the current economic environment.
While trying to improve the funded status of pension plans is a novel endeavor, the timing of PPA turned out to be a perfect storm.
Just as Congress mandated using a 24-month average of current corporate bond segment rates to calculate plan liabilities, the stock market crashed due to the housing bubble. This greatly decreased the value of assets for pension plans in the United States. At the same time, interest rates plummeted, which over time significantly increased plan liabilities. Decreasing plan assets, accompanied with increasing liabilities, created a nightmare scenario for plan sponsors.
Different situations call for this use of different interest rates. Consequently, actuaries must report plan liabilities on several different bases:
Minimum Funding Target (Internal Revenue Code Section 430(h))
Each year, what is known as a minimum required contribution must be calculated. With PPA, Congress had intended these liabilities to be calculated using the 24-month average of current corporate bond segment rates to better reflect the current economic environment. However, with the 2008 stock market crash these minimum required contributions soon became burdensome.
Funding relief was soon passed in 2012 under MAP-21 Legislation to constrain these segment rates by applicable percentage limits on the 25?year average yield curve segment rates. This resulted in higher interest rates and lower liabilities for pension plans in the United States, reducing the funding burden on pension plans. Additional interest rate funding relief legislation was passed in 2015 and 2021 under HATFA and ARPA, respectively.
Maximum Funding Target (Internal Revenue Code Section 404(o))
In addition to the minimum required contribution, each year what is known as the maximum tax?deductible contribution must be calculated. This represents the maximum amount a pension plan can contribute while still receiving a tax deduction. Congress had intended for the liability used to determine the minimum required contribution and the maximum tax?deductible contribution to be the same. However, with the passage of interest rate funding relief, the result was that one set of segment rates is now used to determine the liability in the minimum required contribution calculation, and another set of segment rates is used to determine the liability in the maximum tax?deductible calculation.
Termination Liability (Internal Revenue Code Section 417(e)(3)(D) Minimum Present Value Segment Rates). When a pension plan participant reaches their retirement age, they may elect to receive their benefit as a lump sum. Also, when a pension plan terminates, participants must be offered a lump sum option. Before PPA, the interest rates used to determine these lump sums were based on the 30?year Treasury securities rates. Like the minimum and maximum funding target, PPA changed the interest rates used for participant lump sum calculations to better reflect the current economic environment. However, the interest rates used to calculate participant lump sums is based on average corporate bond segment rates for a month, as opposed to a 24?month average.
Pension Benefit Guaranty Corporation (PBGC) Premium Funding Target. Certain pension plans in the United States are covered by the PBGC, a federal agency that protects the accrued pension benefits of plan participants in the event a plan sponsor becomes insolvent. The PBGC acts like an insurance program for pension plan participants. All covered plans are required to pay what is known as a PBGC premium annually. One aspect of this premium is the variable rate premium, which reflects the current unfunded liability of the plan. To determine the premium funding target liability, a plan sponsor may elect to use the 417(e) interest rates (standard) or the same interest rates used for the maximum funding target (alternative).
Accounting Codification Standard (ASC) 715 Disclosure Reporting. Certain plan sponsors (such as publicly traded employers or private employers subject to a loan agreement) are required to disclose plan assets and liabilities on an annual ASC 715 valuation report. Information within an ASC 715 valuation is disclosed on a company’s financial reports to assess the status of a plan. A key assumption used in an ASC 715 valuation is the interest rate assumption used to value plan liabilities. Typically, a plan’s auditor would require the use of a yield curve of current spot rates to determine the interest rate used for calculating plan liabilities, though other methods (such as using the 30?Year Treasury rates or a simple flat rate) may be used.
Accounting Codification Standard (ASC) 960 Disclosure Reporting. While ASC 715 reports plan liabilities on current market rates, ASC 960 takes a more long?term approach in determining plan liabilities. Rather than reflecting the current economic atmosphere, ASC 960 focuses on a long?term interest rate to determine plan liabilities and ignores swings in the market. Usually, the ASC 960 interest rate is set to be equal to the plan’s long?term expected rate of return on plan assets. An ASC 960 report is disclosed on a plan’s annual financial statements.
Depending on what a particular liability is used for, the interest rates used can vary greatly from the interest rates used to calculate a different liability.
While not exhaustive, I hope this information offers insight on to why actuaries report liabilities on numerous bases.
Jonathan Murello, FSA, EA, MAAA, CERA, is an actuary and senior consultant with Dunbar, Bender & Zapf, Inc.
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