Menu

Resources

Timely, relevant, and actionable investment perspective, best practices, and planning insights for institutional and wealth management clients from CAPTRUST's Consulting Research Group.

Advanced Filter

Don't Discount the Importance of Using the Right Rate

James Stenstrom
Senior Associate | CAPTRUST Consulting Research Group

In last quarter’s Strategic Research Report, we discussed the defined benefit pension plan funding implications of new discount rates introduced by the Moving Ahead for Progress for the 21st Century Act (MAP-21). Essentially, the bill increases the discount rate used to estimate the present value of pension plan obligations for funding purposes for plan sponsors, subject to the Pension Protection Act of 2006 (PPA). Incorporating a variety of additional discount rates offers new insights into a pension plan liability’s true cost. In order to provide plan sponsors with a better understanding of actuarial and accounting pension liability valuation complexities, we will demystify a few differences between some of the most commonly referenced discount rates.

The new MAP-21 pension discount curve, which instituted interest rate ranges determined by long-term averages, will replace the segment rate method introduced in the PPA. While the switch has added complexity to the liability present value calculation, a central implication is that most defined benefit plan sponsors will see their funding status greatly improve on a temporary basis under the new discount rate regime. In fact, many of our clients may see funding rates approach 100%, which begs a key question: “Do we now have enough assets to terminate the plan without making any more contributions?” The answer, in most cases, is probably not.
 
Although MAP-21 improves the actuarial funding level of most plans today, the legislation doesn’t impact the cost of plan termination. Plan termination cost is the amount of capital required to purchase a single premium group annuity from an insurance company or otherwise settle benefit obligations. Insurance companies use economic factors such as observable interest rates to determine annuity costs and, therefore, termination costs. The Pension Benefit Guaranty Corporation publishes ERISA 4044 discount rates that enable plan sponsors to estimate termination costs based on a plan’s general liability characteristics. However, the actual cost will depend upon which insurance company provides the annuity and assumes the plan’s liability.
 
If MAP-21 interest rates determine funding, and ERISA 4044 discount rates estimate termination cost, why do we use the PPA full yield curve discounted liability to estimate funding in CAPTRUST’s quarterly dashboard reports? 
 
There are two main reasons:
 
• First, under the current rule set, plan sponsors can still select full yield curve rates introduced in the PPA for actuarial funding purposes.
• More importantly, full yield curve interest rates are the most investable discount rates, so they provide the best economic measure of funded status. The IRS creates this curve using high-quality corporate bond prices. This option allows plan sponsors to purchase similar quality bonds with similar duration characteristics as the liability, to mimic the month-over-month economic funding volatility.
 
Plan liability measurement can be complex and overwhelming, even for those with considerable pension experience. What aspects should plan sponsors focus on?
 
• MAP-21’s introduction does nothing to decrease the ultimate cost of defeasing plan liabilities over time or through termination via single premium group annuity purchase. Therefore, plan sponsors should continue to focus on the economic measure of their liabilities when assessing investment and capital allocation decisions. Plan sponsors should not use arbitrarily selected accounting curves or rates used in annual valuation methods, because they often do not reflect economic reality.
• Plan sponsors should work with their plan actuary and accounting partners to ensure alignment of their liability discount rates and plan objectives. For example, if a plan sponsor intends to terminate a plan in the short term, focusing on either full yield curve or annuitization rates may be most appropriate — while MAP-21 rates remain central to plan sponsors concerned primarily with minimum funding requirements.
 
In the spirit of simplifying the complexity of this topic we summarize many of the discount rates discussed, plus a few not covered, for your reference below (Figure 1). If you have additional questions related to the various discount rates and their practical application, please contact your CAPTRUST Financial Advisor.
 
Figure 1
 
Sources:
1 29 USC 1001 303(h)(1)(D)(ii) (http://www.gpo.gov/fdsys/pkg/PLAW-109publ280/pdf/PLAW-109publ280.pdf)
2 H.R. 4348 Section 40211(a)(1) (http://www.gpo.gov/fdsys/pkg/BILLS-112hr4348enr/pdf/BILLS-112hr4348enr.pdf)
7 29 USC 1001 303(h)(2)(A) (http://www.gpo.gov/fdsys/pkg/PLAW-109publ280/pdf/PLAW-109publ280.pdf)