Pension Interest 101
In an increasingly complex interest rate environment, pension plan sponsors may find themselves asking questions about the various pension discount rates that are used to measure pension liabilities. To help navigate that uncertainty, we highlight several key interest rates that are used to calculate liabilities for pension plans.
Federal Funds Rate
We start with the most commonly known interest rate in the marketplace which happens to have the smallest impact on pension liabilities. The federal funds rate is the interest rate set by the Federal Reserve to facilitate monetary policy. This rate is the overnight rate at which banks borrow and lend money and therefore impacts the very short end of the yield curve. Pension plan liabilities are most sensitive to long-term interest rates and therefore, the federal funds rate has minimal impact on the measurement of pension plan liabilities.
FASB/IASB — Pension Balance Sheet Measurement
The discount rate used to measure balance sheet liability, the projected benefit obligation (PBO), is derived from a market-based discount curve based on high quality corporate bond yields rated AA or better. This yield curve changes daily with changes in market yields and prices of the underlying bonds. Therefore, the value of the PBO is entirely dependent on the prevailing yields as of the measurement period, which is typically an organization’s fiscal year end. We see a significant amount of volatility in these yields and resulting liabilities which has led to high uptake in liability-driven investment strategies to offset the volatile liability measure. There are many proprietary yield curves developed by actuarial firms that may be based on the universe of AA bonds or might select a subset of the highest yielding AA bonds such as those above the median yield in the space. Proprietary curves tend to be more volatile than a broader universe, which could lead to more fluctuations in liabilities.
Internal Revenue Service (IRS) — Pension Minimum Required Contributions
The discount rates used to determine the minimum funding requirements for a pension plan are prescribed by the IRS. These rates were introduced by the Pension Protection Act of 2006 and implemented in 2008. Prior to funding relief later described, these rates were introduced as segment rates that represented the average discount rate of A to AAA bonds over a 24-month period, aggregated into three sections of the yield curve. Alternatively, plan sponsors could use a 1-month averaged full yield curve which serves as an option that allows assets and funding liabilities to move together in a mark-to-market approach. Many plan sponsors with heavy, long-duration bond investments choose to use a full yield curve approach, since assets and liabilities will move more in tandem. Several acts of funding relief have changed the original 24-month average segment rates to be constrained by a corridor of rates based on the 25-year historical bond yield average. It is expected that these funding rates will be more stable than other rates since funding relief that was designed to mitigate large liabilities associated with the historically lower interest rates post-Financial Crisis.
Pension Benefit Guaranty Corporation (PBGC) — Insurance Protections
The PBGC provides insurance for pension plans and charges premiums to corporate defined benefit plans for that protection. A part of that premium is based on the underfunded status of the pension (assets minus liabilities) and plan sponsors can elect to use the standard method for discounting the liabilities or the alternative method. Plan sponsors are locked into a method for a period of time and cannot switch back and forth easily. The standard method uses 1-month segment rates, similar to those used for minimum lump sum calculations, resulting in more volatile liabilities, and is generally preferred by plans with high allocations to long-duration bonds. The alternative method uses the 24-month average segment rates, as described above for IRS calculations. This results in “stickier” liability valuations that are slower to respond to changes in yields and can produce less-volatile PBGC premiums for plans with heavier allocations to equity investments.
Insurance Companies — Settlement Discount Rates
Frequently, the last discount rate plan sponsors will consider in the lifecycle of the pension is the interest rate used to determine the cost to settle the plan liabilities. There are no standard requirements for this rate (annuitization costs are set by the individual insurance companies), but broadly the rate is highly correlated with corporate bond and Treasury yields. Because of this market-based movement, one convention is to use the underlying balance sheet liability, the PBO, and apply an increase factor based on the type of liability. This factor can be as low as 100% of the PBO for retiree liabilities to 130% of PBO for deferred liabilities with more complex benefit formulas. Importantly, this scaling factor will be higher for PBO measurements that use a selective and higher discount rate to measure the ongoing balance sheet obligation.
Conclusion
Understanding bond markets is difficult in its own right. Introducing additional measurements for pension liabilities only further complicates the understanding of how market realities affect pension plans. Please reach out to understand how investment strategies can be coordinated with liability measurement to help navigate volatile interest rate environments.
