Interest-Rate Smoothing’s Impact on Single-Employer Pensions

Pension funding and liabilities numbers change with the controversial yet permissible accounting practice of pension smoothing.

The latest data from the Society of Actuaries contain good news for the state of single-employer pension plans.

According to the SOA’s recently updated analysis of pension plans in the private sector, 89% of single-employer plans were not carrying any unfunded liability at the end of 2014, and even more are fully funded when factoring in Form 5500 data available for part of 2015.

That most recent analysis shows the continued improvement in the overall status of single-employer pension plans since the financial crisis. In 2013, 78% of plans were fully funded.

But the SOA’s analysis also shows that the single-employer system reaps considerable benefits from so-called pension smoothing, a statutorily permissible-- albeit controversial--accounting practice.

The Moving Ahead for Progress in the 21st Century Act, an infrastructure spending bill signed into law in 2012 by President Obama, included a provision allowing sponsors of defined benefit plans to apply higher interest rates to assess future liabilities. The pension smoothing provision was written as a “pay for” to fund the spending bill.

By allowing sponsors to use the 25-year average of the corporate bond yield, instead of lower near-term rates, plans were allowed to estimate lower liability values, in turn requiring lower annual contributions to plans.

Lower contribution rates meant less money corporations could write off at tax time, translating to more revenue the feds could use to fund infrastructure spending.

But pension smoothing also has the effect of artificially improving pensions’ funded status, say critics of the tactic. According to the SOA, the impact of pension smoothing on plan funding is considerable. When applying lower, “unsmoothed” interest rates to assess liabilities, the number of fully funded plans drops from 89% to 28%.

What’s more, pension smoothing vastly affects the number of plans that contribute enough to maintain their unfunded liability and maintain a seven-year funding pace, or the amount of annual contributions needed to close a funding gap over seven years. By law, those two benchmarks are used to assess a plan’s annual minimum contribution rate.

Using smoothed interest rates, 8% of plans with an unfunded liability contributed enough to at least maintain funding ratios in 2014. Only 3% of unfunded plans fell short of that benchmark.

But when applying unsmoothed rates, almost half of the 72% of plans with an unfunded liability did not contribute enough to maintain funding ratios in 2014. And 55% of plans did not contribute enough to close funding gaps within seven years.

In 2014, the smoothed corporate bond rate used to project liabilities was around 6.5%, compared to the unsmoothed rate of about 4.75%.

The overall pension liability for single employer plans was $1.9 trillion in 2014 when using the higher smoothed rate. As a lot, the plans were 98% funded with $30 billion in unfunded pension obligations.

But when applying the lower unsmoothed rate, total liabilities jump to $2.4 trillion, with a funded rate of 91%, and $218 billion in unfunded liabilities, according to the SOA.

 

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