“Each year we struggle with setting the economic assumptions used for determining our pension expense and disclosure. Can you discuss what procedures should be used for setting the assumed rate of return on assets? Are there alternatives available when selecting the discount rate to be used for determining liabilities? If so, what documentation or process would be required to support the selection?”
At the end of each fiscal year, sponsors of defined benefit (DB) plans are required to report the financial position of their plans. This end-of-year disclosure requires that certain assumptions be made – from demographic to economic – in order to calculate the plan’s funded status. The assumption-setting process is a joint effort that reflects information and input from the plan sponsor and the investment advisor, with a recommendation from the plan’s actuary and approval by the plan’s auditor.
Demographic assumptions are generally easier to set since they are based on the actual experience of your employees and organization. How many years do your employees work before terminating? When do participants in your plan retire? What form of payment do they elect at retirement? These statistics can be obtained by studying the history of your plan’s participants over time.
Economic assumptions, however, are more complicated since past experience does not as easily predict future expectations. That said, there are accounting standards and guidelines that assist the actuary in defining and selecting assumptions like the discount rate, the expected return on assets and salary scale.
Let’s take a look at each of these individually:
DB plan liabilities behave like a bond, which means that the higher the discount rate, the lower the liability and vice versa. Consequently, accounting standards state that the discount rate must be based on high quality bond yields that could be used to settle the liabilities on the measurement date. A precise method of setting this rate is to match a bond portfolio to the projected benefit payments of the plan. The yield on these bonds translates to your discount rate. This methodology, while accurate, is not commonly used because it is time consuming and, therefore, costly. A more common method that mimics this process is to apply your plan’s future benefit payments to a yield curve where different discount rates for each future cash-flow date are used to discount the payments back to the measurement date. From there, a single equivalent rate is determined which, when applied to the same cash flows, results in the same present value of benefits.
This process is normally performed by your actuary, and while some actuarial firms may develop their own yield curve, an investment-grade corporate bond yield curve – like the Citigroup Pension Discount Curve – measures today’s market value of future payments quite accurately. Because it is still based on a plan’s unique cash flows, the methodology is widely accepted by most accounting firms.
Expected Return on Assets
The expected return on assets is a long-term assumption meant to reflect the average anticipated return for the plan (normally net of fees) over its lifetime. This assumption is strongly influenced by the particular asset mix of the plan and, once set, does not usually change from year to year unless the plan’s target mix changes. While the allocation may fluctuate somewhat during the year, the expected return on assets should not change from year to year unless the long-term investment strategy changes.
To come up with an expected return, a building block approach is often used that relies on a range of returns for each asset category and computes a weighted-average based on these projections. Input from the plan’s investment advisor can also help determine an appropriate rate of return which may be based somewhat on past performance, but should also reflect the expectation for the next 20 years, including projections for inflation, as well as forecasts for each individual asset category in the portfolio.
This assumption is used to estimate a participant’s future compensation for a pay-related benefit formula. It can be based on a company’s historical data or future outlook. When setting this assumption, separate consideration should be given to inflation expectations in addition to merit increases.
While not an economic assumption, mortality has a significant impact on plan liability and can be unique to specific plan populations. While certain industries have built their own mortality tables, most DB plan sponsors do not have a large enough population or sufficient history to make it credible. Instead, the use of published mortality tables – like the recently released RP-2014 table by the Society of Actuaries – is widely accepted. This table, along with MP-2014 scale for future mortality improvements, has different rates for active employees, healthy and disabled retirees, as well as considerations for blue and white collar employees. Most pension plan sponsors have already adopted this table for disclosure purposes.
Almost as important as the assumptions themselves is the process of selecting and documenting these expectations. Professional standards of practice require actuaries to adhere to certain guidelines when setting assumptions. These same standards require auditors to review and approve the processes and data used to support such assumptions. If followed properly, these guidelines ensure an accurate picture of a plan’s financial status.