What is the ‘right’ measure of pension liability?

When having discussions with defined benefit (DB) plan sponsors, financial intermediaries, and many of my “non-actuary” peers, we frequently land on a somewhat technical and confusing question. When determining a plan’s funded status, it’s usually very simple to measure the current value of DB plan assets, but it’s not as simple to arrive at an answer for the liability side of the equation. When someone asks, “what’s my funded status,” the real question should be, “what’s the right measure of pension liability to use?” And, the answer is, it depends.

As we mentioned in our Pension Risk Study, it’s important to help plan sponsors clarify and identify which liability measure is appropriate to use given the situation. Here’s a quick summary of some of the most commonly used measures of liability for a variety of objectives, and the associated calculation bases and assumptions:

  • When determining the required contribution to the plan that will satisfy minimum funding rules, the PPA (Pension Protection Act of 2006) liability is the appropriate basis to use. While initially the liability number for required contribution purposes was determined based on a 2-year average of corporate bond yields, additional relief subsequent to PPA has effectively extended the 2-year averaging period to 25 years.
  • For accounting purposes, the Pension Benefit Obligation (PBO), the liability is determined using a spot rate based on the plan’s cashflows using double-A corporate bond yields.
  • To calculate Pension Benefit Guaranty Corporation (PBGC) premiums, the calculation is similar to the PPA basis noted above with one exception: there is no relief with respect to the averaging period; it remains at 2-years.
  • To measure the liability associated with a plan termination, generally, insurance company annuity rates are the basis to use. However, for plans that permit lump sum distributions, corporate bond yields are also used in the calculation.

Now, although each of these liability calculations is very important and each serves a different purpose, the key is to understand the various measures and uses to ascertain a holistic view of the plan’s finances.

In addition, it’s very important to consider discount rate and yield rate trends when performing financial forecasting. This is best accomplished by obtaining frequent market updates, such as the MassMutual Quarterly DB Market Commentary, and basing forecasts on the most current economic data available.

Here at MassMutual, our team of actuarial consultants are available to provide expert support and guidance to help sponsors and their financial intermediaries navigate this technical subject matter. We’d appreciate the opportunity to discuss ways we can help achieve plan sponsor goals with you. To learn more, please contact us today at DBSales@MassMutual.com or 1-800-874-2502, option #4.