Are most pension plans really close to being ‘fully funded’?

With the increase in interest rates leading to an improvement in funded status for the majority of frozen corporate defined benefit plans, these plans are ever closer to their goal of plan termination.   This path to termination calls for a coordination of contribution strategy, investment strategy and liability management.  However, if the plan termination funded status is not accurate it can lead to a multitude of issues such as taking excessive investment risk, over-funding the plan, or burdening the plan sponsor with additional administration expenses.

Based on our experience with pension plan terminations, the corporate defined benefit industry has a systemic problem: the funding level estimates given by many service providers are simply inaccurate. In cases we have reviewed, plan sponsors are being told that their termination basis funding levels are significantly lower than they actually are. Said another way, many plan sponsors are much closer to being able to fully settle their plan liabilities than they are being told.

Our basis for this conclusion has come through our experience of being brought in to assess whether or not a plan is ready to terminate. We often get hired a few years before a plan is terminated to help a plan sponsor prepare (it is an involved process) and we speak with many sponsors who are interested in possibly terminating. We have seen many reports from other providers that give sponsors a demonstrably and materially false impression of their true funding level.

Why is my plan termination cost estimate wrong?

The two situations where we see this misinformation crop up most commonly are:

• Funding level estimates from investment firms that do not also provide actuarial services and;
• Smaller actuarial firms with limited or no plan termination experience.

In both cases we believe that the service providers are not intentionally providing poor information, and that they think they are being “conservative” by providing plan termination funding estimates that end up being much worse than they actually are. However, being “conservative” in this estimate leads many plan sponsors to maintain higher equity allocations for longer than necessary, risking large losses as well as risking ending up over-funded once a termination is complete, which is unnecessary and undesirable as it can create tax headaches.

Why is this?  Many service providers estimate that the termination liabilities will be valued materially higher than liabilities are valued for accounting purposes. This may have been true a decade ago, but for many plan sponsors it is not true today. If a plan sponsor is using a market-standard methodology for valuing liabilities for accounting, then this value is likely to be very close to the value that will be realized in a plan termination. If a plan sponsor is using an accounting liability valuation method that is using an “above median” corporate bond curve or equivalent, then the termination liability value may be a few percent higher than the accounting liability value. But it should be nowhere near 10%, which is what we have seen in multiple cases.

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In addition, many service providers use liability discount curves that they obtain from third parties to help them generate plan termination funding level estimates. The most egregiously incorrect of these uses estimated pension annuity rates to generate a curve. The estimates generated by this method might be reasonable if all pension liabilities are settled by purchasing annuities in a plan termination. However, in most cases a substantial amount of plan liabilities (often 50%+) are settled by paying participants lump sum amounts. These lump sum amounts are based on interest rates published by the IRS and are far higher than published annuity rates – so the liability values are much lower in total. This can make a material difference in the estimated plan termination funding level.

Plans differ widely in their mix of current retirees, active participants and terminated participants. This mix is a primary determinant of whether a plan termination liability value is higher than, equal to or even below the liability value shown on the plan sponsor balance sheet. Likewise, the demographic profile of the plan, such as whether it is heavily male and blue collar or heavily female and white collar, can have a significant impact as well. Most plans use generic assumptions for calculating their accounting liabilities – but plan termination estimates are highly plan luspecific.

What happens if the plan termination liability estimate is wrong?

This overstatement of the plan termination liability can lead to many issues.  For the investment policy, many plan sponsors utilize “glide paths” tied to plan funding level estimates to set their asset allocations. If these funding level estimates are materially off, then plan sponsors may end up taking unnecessary investment risk to try and close a funding gap that may be much smaller than they think.  The difference between where a plan sponsor is on a termination basis, and where they think they are, is often 10% or more in funding terms. For example, a plan sponsor may think the plan is 85% funded on a plan termination basis, when it is actually 95%. This will have a material impact on many glide-path driven asset allocations and might be the difference between being 50% invested in equities and 25% invested in equities. This matters!

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The same can be true for plan sponsors that are looking to minimize their funded status risk and contribute their way to being 100% funded on a termination basis. If the plan termination liability estimates are materially off, a plan sponsor may over-contribute to the plan resulting in trapped surplus once all liabilities are settled.

It is important for corporate defined benefit plan sponsors to understand what the real cost of terminating their pension plan may be. If they see that there is a large difference in the funding level of their plan on an accounting basis and their plan termination basis, then they should interrogate the assumptions behind this. They can work with their actuary, if the actuary has plan termination experience, or an independent provider to produce a more accurate estimate of their termination liability and then use this to calibrate their funding estimates. Service providers that give these estimates should evaluate how accurate they may be and question whether using overly pessimistic estimates is actually “conservative.” They can help their clients and reduce their own risk by working with a provider to ensure that their funding level estimates are robust.

Ryan McGlothlin is a Managing Director at Agilis.