Is your (defined benefit) company pension safe? Is your Defined Pension (DB) Plan Adequately Funded? Pension Plan Valuation: Art, science or magic? …and, the answers are: No, Maybe, Not science!

Is your (defined benefit) company pension safe? Is your Defined Pension (DB) Plan Adequately Funded? Pension Plan Valuation: Art, science or magic? …and, the answers are: No, Maybe, Not science!
Problem Statement A number of readers have approached me to see if I can help them get a sense of how secure is their company pension. The questions in the title are intended to reflect their questions. These are very difficult questions to answer. The answers involve art and at times magic, and may even be at risk of being influenced by what the sponsor (your employer) would like the outcome to be, even though it is prepared by an independent professional actuary.
Here are some concerns expressed by the Ontario Teachers’ Pension Plan which were included in its submission to the Ontario Expert Commission on Pensions in the fall of 2007:
“First is the position of conflict in which many pension plan actuaries can find themselves. As they are hired by the employer, they may feel pressure (real or perceived) to provide the answer they know the employer wants to hear (regarding short term plan funding obligations), rather than the information and advice that plan stakeholders need to receive (regarding the long term sustainability of the plan given existing benefit levels and contribution rates).”
“The second issue concerns the standards of practice for pension actuaries, and the time it takes the actuarial profession (through the Canadian Institute of Actuaries) to create new standards, or update existing ones, as pension plan funding evolves. The standards are also silent with respect to the important process of how the economic assumptions, contained within the funding valuation, should be developed. Consequently, the application of such assumptions can vary significantly between individual actuaries and between actuarial firms.”
What does this mean? It sounds like a pretty strong indictment of the current valuation methods and possibly even the independence/objectivity of the actuarial profession: -lack of (adequate) standards on economic assumptions leading to significant variation between (assumptions and) funding status of pension plans -perceived or real pressure on actuaries as to the desired outcome (the annual funding obligation) by the sponsor (employer) who happens to hire and pay for the actuarial opinion
Sounds like a recipe for potential disaster: -employees and pensioners may be misinformed about the “true” funded status of their plan -employer may be contributing an inadequate amount to meet the commitments implicitly made to employees -regulators/legislators acting as toothless watchdogs over deteriorated/deteriorating state of Canada’s private DB pension plans (while allowing a continuation of traditional opaque, infrequent and incomplete disclosure)
So next time you get your (tri-) annual DB pension statement from your employer which states that your plan is 85% funded on a “going concern basis” (assuming that the pension plan will continue indefinitely) or say 85% funded on a “solvency basis” (assuming the pension plan is wound up at the valuation date- i.e. no further salary increases), what additional questions should you be asking the sponsor of your plan (your employer) and/or the regulator? (Full disclosure: I am not an actuary, an accountant or a pension expert but I will try to share with you how I try to assess the state of a pension plan.)
The additional questions relate to actuarial assumptions that were used in generating the opinion. Even small changes in these actuarial assumptions can make a dramatic difference in the outcome of the opinion, and it is just an opinion as you no doubt know that forecasting is very difficult, especially about the future. By the way, you may be also be able to get some of these numbers from the company’s annual report, though there is little likelyhood that an international company or even a national one operating in multiple jurisdictions will use the same assumptions everywhere. This is not intended to be an exhausting explanation how pension valuation is done, as this is very complex, but it is intended to look at some of the most important parameters which may give you an indication as to the likely significance of the percent funded level provided to you. A lot of the data will be Ontario based, but the principles are applicable more broadly.
In a 2007 FSCO (Financial Services Commission of Ontario) report entitled “Funding Defined Benefit Pension Plans: Risk-Based Supervision in Ontario” the following findings are reported: -median (last filed at the time of the FSCO report) solvency ratio was 86%, and 78% of the Ontario plans were underfunded (interest rate for solvency calculation was specified at 4.5% for 2005) -median going concern basis funded ratio was 98%
On the solvency measure the FSCO suggests that “A report is said to indicate solvency concerns if (i) the solvency ratio is less than 80%, or (ii) the solvency ratio is between 80% and 90% and the solvency liabilities exceed the market value of assets by more than $5 million.” Given that the median solvency ratio was 86%, and over 70% of the plans had solvency ratios under 90%, i.e. in the FSCO’s solvency concern range, Ontario’s pension plans are not in good shape!
Actuarial Assumptions Let’s look at a few of the actuarial assumption that you may want to ask about for your specific plan:
discount rate- this is perhaps the most important number as it is used to determine the present value of the future liabilities of the plan. This the rate at which a pension plan sponsor (employer) could get an insurance company to assume the responsibilities of the pension plan. The 2007 FSCO report found that the “average interest rate assumption used for going concern valuation decreased from 6.79% to 6.33% over 2002 to 2005 period”. (Recall that in 2005 going concern and solvency ratios were 98% and 86%, respectively) Over the same 2002 to 2005 period Government of Canada Long-term and 10 year bond rates went from 5.7% to 4.3% and 5.4% to 3.8%, whereas all-corporate long-term rates went from 7.0% to 5.8%. (The so called “spread”, i.e. difference from similar term government bond, is variable over time and is usually a reflection of the perceived risk in the markets). Using the most conservative (use government bond rates) and most liberal interpretation for the appropriate discount rate (the IAS recommendation is to use high quality corporate bond rate), it would be fair to say that the average Ontario plan interest rate assumption is 0.8 %( 2002)-1.8 %( 2005) too high (and many individual plans are even higher). What exactly this means is difficult to determine as it is a function of the timing of the liabilities, but a 10% underestimation of liabilities using say 6.25% as opposed to 5.0% discount rate is not unreasonable. Therefore the more likely median going concern valuation could be closer to 89%, than 98% indicated; and of course half the plans would by definition (of median) be even worse than that, especially if you consider that the FSCO report (Table 10) indicates that in 2005 57% of the plans used discount rates of at least 6.5%! So for each 0.1% that the discount rate used is above the average of long- term government and high-grade corporate rates, decrease stated going concern funding ratio by 1%.
annual wage/salary increase– this is another critical parameter in valuation, especially for final average plans (43% of the plans in the FSCO study). Low-balling this assumption can also significantly underestimate the liabilities after 30 years of employment. For example assuming wage growth of 3% instead of 3.5% can reduce liabilities by about 15%. (I suspect that this will increasingly be less important as DB plans are capped/closed/eliminated). The figure of merit used in the FSCO report is the difference between the Interest (discount) rate and the salary increase. You could argue that long-term salary increases track inflation plus productivity increases(1.5%), and mid to long-term government interest rates are about inflation plus 2.5-3% and if you add another 0.5% for high grade corporate bonds, the difference is still of the order of 1.5%. The FSCO study shows that only 19% of final average plans had a difference of <2% and 42% of the plans had a difference of >2.5%. This is an indication that assumed compensation rate increases are too low and/or discount rates are too high. For each 0.1% assumed compensation rate increase less than inflation plus 1.5%, you can reduce going concern funded ratio level by 2%.
inflation rate– a few pension plans provide some level of indexing, but Ontario allows some benefits (such as inflation) to be excluded from the solvency calculation (about $10B such benefits were excluded from an estimated $150B liabilities); ask if your plan’s solvency ratio calculation included or excluded inflation (if included what was the assumed rate?)
-mortality data – Table 11 in the FSCO report shows what appears to be good news on longevity assumptions in that the plans using 1994 (rather than 1983) mortality data has increased from 48% to 96%. However longevity has been increasing at the rate of about 0.1 years/year in the last 20 years, so even the 1994 mortality tables underestimate longevity by about over 1 year in 2005. This could lead to the order of 5% liability underestimate. For each year that valuation year is past the mortality survey date reduce going concern funded level by 0.5%.
expected return rates– this assumption impacts the required annual pension contribution; the higher the expected long-term return assumption the lower the required contribution (and the less likely closure of the underfunding gap of the pension plan). The current forecast is for reduced equity returns (and equity risk premiums) as compared to historical rates. In the next 10 years lower returns are expected due to various factors (lower than historical dividend rates, average or higher P/Es, and historically high earnings). For 2005 the FSCO reports a median expected return of 13%, clearly an unsustainable long-term rate for a balanced pension portfolio. (There is also considerable debate among experts about the advisability of a significant equity component in a pension fund, because of the corresponding significant volatility associated with such a portfolio and, unlike for an individual, there is no flexibility in the required payout from pension plans. Some could also argue that underfunded plans, especially those with <100% solvency, should not be allowed an equity component in the fund assets as they cannot afford the additional downside risk to the fund portfolio). Check to see to what extent the expected return rate exceeds expected inflation plus 4.75% (which is a reasonable expected return for balanced 50:50 portfolio in the current environment of lower return expectations)
So what numbers you should be looking for in your pension statement, in addition to going concern funded ratio and solvency ratio, and what should you do about them?
You should ask for the following numbers and then generate a ballpark estimate of the real funded going concern ratio: -discount rate (and compare to the long-term Canadian government and high-grade corporate interest rates) – For each 0.1% above the average reduce going concern ratio by 1% -inflation rate assumed, is it consistent with Canadian expectations; also ask if impact of inflation was included in solvency calculation; if not, it may be an indication of not using conservative approach to valuation -compensation rate increases assumed less than inflation plus 1.5%? Then reduce going concern funded ratio by 2% for each 0.1% lower assumption -expected return rates- if your plan has a balanced portfolio and assumed expected return rates are above inflation plus 4.75% then it may be an indication that your sponsor is under-contributing -survey year that mortality data is based on- For each year that valuation year is past the mortality survey year reduce going concern funded level by 0.5% -a final indicator is the actuarial opinion on how consistent are the actuarial estimates with the cost to have an insurance company assume the liability of the pension plan (an opinion is usually available from the actuarial report). An interesting related article, in the Financial Times, entitled “UK Pension transfers seen as potential marker for future M&A activity” it discusses a significant increase in competition among insurance companies and that they are now prepared to assume responsibility for pension plans at about 10% above the outstanding liabilities of the plan. It is also common for companies planning to be merged or acquired to devolve themselves of their pension plans. Perhaps this is a sign of things to come in North America as well.
Most of the benchmarks are available at Bank of Canada website. So any solvency ratio of <90% should be of significant concern, because the plan doesn’t have sufficient funds to pay for its obligations even if it winds up today (or valuation day). Furthermore the sponsor would have to come up, based on the UK experience referred to earlier with an additional 10% to have an insurance company assume responsibility for the liabilities. Then to get a ball-park adjusted going concern funding ratio in the current interest rate range correct it as indicated above.
So the answers to the questions posed in the title are: No, Maybe and Not science.
Those interested in further reading on this subject may consider looking at CGA’s (approximately 2004 vintage, covering pensions to end of 2003) “Addressing the Pensions Dilemma in Canada” which does a fairly comprehensive overview of the much-in-need-of-repair state of Canada’s private defined benefit pension system.
Most Canadian pensioners and prospective pensioners are living in a state of ignorance and/or confusion about the true state of their pensions. They are treated like mushrooms, kept in the dark and fed a load of you know what. Clearly a lot of them are at risk ending up with a lot lower standard of living than they thought they had locked in and may even end up relying on some form of government handouts.
What can pensioners do if they find current state of affairs unacceptable? They can lobby the plan sponsor, regulators and legislators for: urgent changes in communication practices pertaining to the real state of pensions, demand urgent action on fair/realistic assessment and disclosure of the funded level of plans, demand elimination of underfunding of plans on both solvency and going concern basis and demand immediate pension reform. Individuals’ earned pension obligations were part of the compensation package for which many laboured a lifetime. If at risk, it is time to secure these obligations.

One comment

  1. Hugh Solomon · · Reply

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