June 22, 2012

Pension Funding Proposal Could Lower Contributions Initially, Increase Over Time: SOA

Short-term impact could be significant

The Society of Actuaries released in June a report that analyzes provisions in the Moving Ahead for Progress in the 21st Century Act that would affect pension funding requirements in private, single-employer defined benefit plans.

The Moving Ahead for Progress in the 21st Century Act (MAP-21) was passed by the Senate on March 14 and focuses largely on public transportation and highway safety. However, the bill contains several provisions that would affect private pensions.

“What we’re trying to do is provide analysis on the bill,” Joe Silvestri, an actuary at SOA and lead researcher for the report, told AdvisorOne on Friday. “We have no opinion on the bill itself or its merits. It must be considered in the larger context of the voluntary defined benefit system.” 

Section 40312 of the bill states that the interest rate used to measure pension obligations would be constrained within a specified range. As such, the provisions “challenge one of the fundamental aspects of the Pension Protection Act of 2006 (PPA)—that calculated pension obligations closely track market conditions,” Silvestri wrote in the report. Over the next several years, Silvestri wrote, the provisions would create a pattern of interest rates that reduce contributions at first, then subsequently increase them annually until they exceed the level required by current law.

Joe Silvestri, Society of Actuaries

“Plan sponsors need to keep that pattern in mind when they budget for contributions,” Silvestri (left) said.

Furthermore, because those interest rates are set for several years, changes in the market level of interest rates would have little effect on funded statuses and contribution requirements. The provisions don’t address non-interest rate sources of volatility like asset returns, so they would continue to affect contribution requirements.

The short-term effects of MAP-21 would be significant, Silvestri wrote. Contribution requirements and solvency levels would fall, and reduced contribution requirements would give plan sponsors more flexibility to invest in their business. This could lead to long-term consequences, though, as sponsors would have to plan for subsequent increases in requirements.

The report notes that sponsors who use a full or non-smoothed yield curve to measure plan obligations, as opposed to a smoothed, segmented curve, won’t be affected by the interest rate changes caused by the provisions. “It should be noted, however, that while the funding stabilization provisions would affect valuation interest rates, they would widen the gap between smoothed interest rates and the full yield curve, making the transition from one curve to the other more disruptive,” Silvestri wrote. “Thus, the proposed law could deter movement toward such hedging strategies.”

Contribution requirements would be lowered initially under the bill, but would increase in later years. Eventually, requirements under the provisions would exceed those of the current law because the same obligations need to be funded, and sponsors would need to make up for lower initial contributions. “The provisions would defer funding requirements by the amount of time it would take for the valuation interest rates […] to return to market levels,” according to the report.

The provisions could affect how predictable aggregate contribution requirements are, especially looking ahead to 2016 and 2018, the report notes, when many plans are likely to pass the 100% funded threshold currently required. A “significant amount of volatility” remains under the provisions, as they don’t address some sources of volatility. The report notes that the bill could improve predictability in the short term; sponsors would have to be “proactive” about managing cash contributions to maintain stable cash flows.

Silvestri expects that under the proposed bill, the funded ratio of a typical plan would drop rapidly as falling interest rates would lead to valuation losses. Sponsors who don’t fund more than the minimum required would run the risk of falling below the 80% funded threshold required.

While most obligations would be at least 60% funded in 2012, the report notes, “significant disparities” occur at other ratios. For example, under current law rates, 62% of obligations would be 80% funded, compared with 92% under proposed rates. “Measurement under the current law would suggest that plans are in much better shape than a market measurement would suggest, while the proposed law would suggest that, contrary to market measurements, plans are generally in good health,” according to the report.

Under the provisions, plan solvency would decline initially, but eventually return to current law levels, the report found. The difference between the median funding level under current law and the proposed bill exceed $100 billion for the six years between 2014 and 2019, “so even a small percentage of defaults could result in losses measured in the billions.”

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