Underlying Assumptions of Pension Obligation Bonds
Pension funding can skew in the wrong direction if there is an imbalance between returns and expenditures. When managing assets and liabilities long-term, it is best to be cautiously optimistic about expectations. The best practice is to set levels of anticipation that err on the side of caution on both sides of the coin.
The wide spectrum of complex actuarial calculations is based on detailed data, both historical and current. The same is true for a municipality’s anticipated rate of return on investments. Actuarial accrued liability, a concrete monetary amount subject to annual re-calculation, is based on a number of assumptions. The following is a list of four such primary assumptions.
Regarding Projected Assets:
Investment Rate of Return – a rate of 7.75% (net of expenses) is common. For public sector plans, this is well within the range utilized by plan sponsors. The key issue would be to review your investment policy statement (“IPS”) to determine if that is consistent with this assumption. If not, you will want to either adjust your asset allocation to meet this 7.75% target or reduce the assumed rate of return to match the IPS.
Regarding Projected Liabilities:
Mortality Table – A variety of published mortality tables exist, but for a municipal plan, we’d normally suggest the RP-2000 Mortality Table – projected 17 years by Schedule AA.
Disability Rates – In a poor economy, plan sponsors have seen significant increases in disability claims. Given the benefit structure and longer payout period, this can cause substantial plan losses. You will want to aggressively monitor disability retirees to ensure that they meet the plan requirements.
Salary increases – 3.5% per year is a cautious assumption. As of 2013, the national average salary increase is hovering at around 3%, and that figure accounts for both the private and public sector. Statistics from recent (post-recession) years are revealing stagnation in the private sector, as opposed to a trend toward steadily increasing benefits for public sector employees. Given the final average pay nature of the pension plan, salary increases beyond expected will cause actuarial losses. The 3.5% figure includes both cost-of-living, merit, step and other increases. As such, when negotiating contracts, you will want to measure the long-term pension impact as well as the short-term annual cash costs.