Mike Clark
Consulting Actuary
Most defined benefit (DB) plan sponsors would agree that pension accounting can be the pits, which makes it tempting to do a bit of cherry-picking when it comes to supporting the discount rates used in calculating their annual accounting liability, aka “projected benefit obligation” (PBO).
The kernel of the matter is the Financial Accounting Standard Board’s (FASB) statement that the PBO discount rate should “reflect the rates at which the pension benefits could be effectively settled” as in an annuity purchase at plan termination. Alternatively, sponsors may “also look to rates of return on high-quality, fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits.”
Farmers’ market values?
Over time, the latter method ripened into today’s common practice of using a yield curve built from high-quality bonds to derive a discount rate. The settlement approach is seldom used for accounting disclosures since it typically produces higher liabilities, though it too is estimated through yield curves based on an unbiased sampling of slightly higher-quality bonds.
Original FASB language suggests that termination liability and PBO are apples-to-apples market value measurements. So similar are the two that consultants, sponsors, and financial professionals often reference one in terms of the other. (“Termination cost equals 105% of the PBO.”) Though slightly different, the two are a near-perfect pear, veritable peas in a pod.
Raisin’ liabilities
Original yield curve methodologies are based on a broad universe of bonds, so spot rates reflect a reasonable average of high-quality corporate yields except for obvious outliers. But a decades-long slide of bond rates eventually drove rates to historic lows and PBOs to historic highs. The negative effect on balance sheets and income statements triggered annual lemon-tations from CFOs each fiscal year as they searched for higher discount rates. (Watermelon-choly situation!!!)
A bowlful of cherries
Fortunately, currant bond yields are much higher than previously so the urgency to juice discount rates has abated. By now, though, the practice of cherry-picking bonds has firmly taken root. Consulting actuaries now offer an array of alternative options to mathematically support higher discount rates (and lower PBOs) in a way that satisfies the literal language of FASB and many plan auditors.
Seeking to plum the depths of their craft, firms began creating yield curves based on only portions of the high-quality bond universe. Not coincidentally, the chosen portions are usually those bonds with higher yields. “Above median” curves include only those bonds whose yields are in the top half of the sample at the date of measurement. Other versions include only the top third or quarter of the highest yields.
Even highly customized services are available that select a small number of individual bonds that produce theoretical cash flows sufficient to cover the plan’s expected benefit payments. (For those who orange opposed to pushing the cantaloupe.)
I come not to praise Caeser but to berry him …
Olive creativity as much as anyone, and I’m certainly not questioning the validity of any sponsor’s PBO (particularly my clients’ if you’re reading this!) Far be it from me to impeach the integrity of my craft. I’m merely looking to plant these seeds of wisdom.
Once you start down the cherry-picking garden path, your PBO apple is going to fall farther from the termination liability tree. So instead of termination costs being 105% of PBO, it could be 110% or 115% depending on how aggressive one is on the balance sheet. This is an important fact to keep in mind if plan termination is the actual goal!
Not to squash fiduciaries’ hopes, but you may also get a raspberry from your liability-driven investment (LDI) manager. Most LDI investment options use broad bond universes as benchmarks, the behavior of which may vary significantly from a cherry-picked PBO. The fewer bonds included in a basket, the more likely that the sample changes significantly over time introducing increased curve and spread risk and mismatch vs. LDI portfolios. (Hedging results may not be as gourd as expected.)
Keep your eye on the apple!
So, use whatever you like for accounting disclosures within your auditor’s tolerance. I get it! I’ve banana few tight financial spots myself. But always remember that at the end of the day, lump sums and annuity prices are based on broad bond universes. Neither the IRS nor the insurance industry cares how you produce your PBO discount rate!
And when you’re hedging liabilities, settling obligations, or terminating a plan, just be sure you don’t accidentally compare an apple to a cherry, lest your outcome be less fruitful than hoped.
Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA) who can now scratch writing a corny blog about cherry-picked PBO discount rates from his honeydew list.
