New Risk Measures in Effect for Defined Benefit Plans

A new actuarial standard intended to help governments and public officials better understand the financial risks associated with their defined benefit (DB) pension plans will be included in plans’ funding valuations dated after November 1, 2018. Actuarial Standards of Practice (ASOP) 51—also known as the “Pension Risk” ASOP, will provide stakeholders with a better understanding of their plan and any potential risks associated with their pension obligations.

What are ASOPs?

Actuarial standards of practice identify what an actuary should consider, document, and disclose when performing an actuarial valuation. According to the ASB, ASOPs “serve to assure the public that actuaries are professionally accountable.” In addition to the public benefits, ASOPs also provide the actuaries themselves with a basis for assuring that their work conforms to appropriate actuarial practices.

“Pension Risk” ASOP Measurements

In addition to the routine actuarial calculations included in a funding valuation—which cover a range of elements including the system’s funded status, the “normal cost” of annually pre-funding employee benefits, employer and employee contribution requirements, and more—actuaries will be expected under ASOP 51 to identify and report potential risks that can possibly impact a plan’s future financial condition, including:

• Investment risk: Investment returns could be different than the plan’s assumed rate of return;
• Contribution risk: Contributions to the plan could be different from expected contributions;
• Longevity and other demographic risk: The possibility that demographic assumptions (mortality rates, disability rates, termination rates, retirement rates) will differ from expectations;
• Plan maturity risk: The potential risks associated with fewer active employees supporting more and more retirees.

One of several ways to measure these risks is through a sensitivity analysis, which is a test on the impact of a change in a plans’ assumptions. One example—which is already used due to recently enacted reporting rules promulgated by the Government Accounting Standards Bureau (GASB)—is to direct plans to calculate their funding levels on a projected investment return of plus and minus one percent of their assumed investment return.

ASOP 51 expands on the GASB analysis by recommending plan actuaries use a multitude of tests on potential stressors to the plan, which will help guide stakeholders through times of poor plan performance.

Investment Risk

The investment return assumption is the most important of all actuarial assumptions in terms of its effect on pension finances. This is because earnings on investments typically account for over 60% of a plan’s revenues. Earnings that consistently fall below the plan’s assumed rate of return will result in underfunding and will require larger contributions from employers and employees to make up the gap.

Historical performance data from Cliffwater, a global investment advisory firm, shows that over the last 18 years, state pensions’ investment returns have been almost two percentage points below their assumed rate of return (7.75% assumption versus 5.87% actual return). This gap between assumptions and actual returns is the primary reason the average plan’s funded status dropped from 100% to 73% over the last two decades.

ASOP 51 encourages plans to compare its liabilities using its current return assumption to what its liabilities would be if it used a risk-free return assumption. The risk-free rate is most commonly tied to the current treasury bill rate.

Contribution Risk

Contribution risk is the possibility that actual future contributions deviate from what was expected. One measurement of contribution risk is the plans’ ability to rapidly raise contribution rates due to funding shortfalls from not making the actuarially determined employer contribution (ADEC). The risk of underfunding may manifest from either the adoption of benefit enhancements, or from poor experience as it relates to plan assumptions. Another measurement is the risk for plans that have a locked contribution rate in the statute. If the ADEC is higher than the locked-in rate, contribution rates will inevitably have to rise in the future for the plan to stay solvent.

Longevity and Other Demographic Risk

Longevity risk exists due to the increasing life expectancy among those receiving benefits, which results in more pension payouts than what the plan had accounted for. Actual experience deviating significantly from the plan’s demographic assumptions also presents risk. For instance, if the number of people in the plan comes in low, which directly affects the payroll level used to determine contributions, then contributions will be lower than what was assumed. This can lead to funding shortfalls, decreasing plan solvency, and decreasing plan affordability in the long run.

Plan Maturity Risk

Older, more mature pension plans tend to operate under different dynamics than newer pension plans. Older plans have an active to retiree ratio that is steady, while newer plans will have a rapidly decreasing ratio as members reach retirement age. Nationwide this ratio continues to fall, meaning plans are seeing more retirees in relation to actives, which adds more risk into future employer contributions. This is because any increase in unfunded liabilities—usually due to poor investment returns or poor plan experience—will have to be amortized and funded using the payroll of a smaller group of active members.

Another measure is net cash flows, the difference between what the plan pays in benefits and what it takes in through contributions. Most mature plans have negative cash flows, which means the benefits the plan is paying out exceeds the plan’s contributions. Negative cash flows alone are not a symptom of a plan in distress. Cash flow risk manifests when a plan is poorly funded because those negative cash flows now represent a much larger percentage of the assets; or when retirees are outpacing the growth in active membership, resulting in a smaller contribution base to help fund existing benefits during a market downturn.

Benefits of New Measurements

ASOP 51 is a direct result of the volatility that pension plans have seen this century. Most plans were not educated enough on the potential risks that come with missing their actuarial assumptions and were too slow to implement a course correction to improve solvency. The more informed stakeholders are on risk, the better decisions they can make to keep their plans healthy.