Parker Elmore, ASA, MAAA, EA, FCA

Brexit means lower interest rates, higher unfunded liabilities & higher PBGC premiums Brexit only affects the United Kingdom & Europe, right?  If you sponsor a defined benefit pension plan (especially if covered by the PBGC), you’ll likely find out that it impacts you as well. As of the date of the Brexit vote, the yield on the 10-year US Treasury bond was 1.75% and less than a month later, that yield is now at 1.55% (it reached a low of 1.36% in the immediate aftermath of the vote). While interest rates go up & down, many experts are now predicting that this rate may approach 1.00% by year end.

Why do I care about interest rates?

If you’re looking to refinance your mortgage or buy a new car, this is all great news. Unfortunately, if you sponsor a defined benefit pension plan you know that plan liabilities & interest rates move in the opposite direction. Therefore, this move in interest rates will increase disclosed plan liabilities under FASB 87/158 (ASC 715-30) and have a negative balance sheet impact.

What about PBGC premiums?

If your plan is covered by the Pension Benefit Guaranty Corporation (“PBGC”), you’ve already seen sizable increases in your premiums due to recent legislative changes that have increased both the fixed and variable contribution rates. These decreases in interest rates will further increase unfunded plan liabilities (assuming no corresponding increase in plan assets) which will further increase the premiums due.

What can I do?

This may be a good time to review your plan’s investment policy statement with the plan’s financial advisor to ensure that it meets your needs. If “Other Comprehensive Income” and balance sheet disclosures are a concern for your organization, you may also wish to consult your actuary to perform some year-end projections so you can make preparations for what may need to be disclosed.

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Parker Elmore, ASA, MAAA, EA, FCA | Sarah F. Rothenberg, ASA, MAAA

Historically low interest rates and average 20 year returns that are significantly below expectations have led many to question whether the discount rate assumptions that have been traditionally used (around 8.25%) are realistic. Based on recent experience, many auditors, rating firms & supervisory agencies are pushing for valuations with lower interest rates (closer to 7.5%). This significantly increases disclosed liabilities and will force plan sponsors to make larger contributions to their pension plans.

1. Liability Driven Funding
   Consider the goal of your investments—to meet pension obligations as they come due.The problem is that both your pension liabilities and the returns on your investments can be volatile. Consider an investment strategy that complements the needs of your pension plan by matching your assets and your liabilities. This will help to hedge your risk. As interest rates increase, the value of a bond will decrease, however this is offset by the fact that your liabilities have also decreased. Conversely as interest rates decrease liabilities decrease, but the value of your bonds increase.
2. Lump Sum
   Consider offering a lump sum payment to pensioners, who have yet to begin taking benefits. While this has a significant up front cost that cost is known. It eliminates uncertainty, and the risks associated with interest rates, longevity, inflation etc.
3. Annuitization
   a. Buy-in
   A buy-in is an insurance contract whereby the insurer makes pension payments as they come due, thus removing longevity, investment, and inflation risk. A plan sponsor may choose to buy a contract that covers all plan participants, or a subset of plan participants. Buy-ins do not reduce a plan’s liability as the plan sponsor is still required to make all payments. The buy-in is considered an asset to offset the cost of these payments. Buy-ins are easy to implement and can be converted to buy-outs at a later date. Also note that they do not negatively impact plan solvency.
   b. Buy-Out
   With a Buy Out, an annuity contract is purchased on behalf of each retiree. As such, liability is completely transferred from the plan sponsor to the insurer and is no longer reflected on the plan sponsor’s financial statement. There are a few considerations to keep in mind. First off, federally regulated plans must ensure that a buy-out does not negatively impact the plan’s solvency ratio, as it has the potential to do so. Also a buy-out may trigger a settlement under accounting rules.c. Longevity Swap
   A longevity swap is used to hedge longevity risk. In a longevity swap, a plan sponsor makes predetermined premium payments to the insurer. In return the insurer makes payments based upon actual mortality experience or based on an agreed upon index.
4. Freeze (Soft or Hard)
   a. Soft Freeze
   Continues service and/or pay related accruals for at least a portion of participants. No new participants are introduced into the plan.
   b. Hard Freeze
   Freezes all future accruals. No new participants are introduced into the plan.
5. Termination
   When a pension plan is frozen, employees may stop earning benefits, but the plan remains in operation. In the case of a termination, all benefits are distributed in the form of lump sums or annuities, after which the plan ceases to exist.

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