The financial strengths of defined-benefits pension funds have come under increasing scrutiny because differing methods of gauging the strength of a fund have spurred confusion.
Changes in the actuarial assumptions used by ratings agencies to determine the likelihood a pension system would be able to pay its promised benefits decades from now have put pressure on public and corporate plan sponsors forcing them to decrease costs. These changes come at the same time they look for ways to increase returns on investments.
A brief by the American Academy of Actuaries explains how different accounting methods used to measure the health of a pension fund create different results as to the solvency of a retirement plan.
Assessing the likely ability of a pension plan to make all payments to future retirees first requires actuaries to determine the interest rate, or discount rate, at which funds will grow, the brief said.
There are two methods for determining the discount rate: the market-based method and the expected-return-based method. The market-based method uses the yield data on fixed-income investments like Treasury bonds to make its estimates. Because the rates are assured, the calculations of future pension fund estimates are considered reliable.
On the other hand, many public pension funds and some private plans use the expected-return method, which relies on data assuming a diversified portfolio that includes equities. Because the investments are more subject to market volatility than in the market-based method, assessing future growth is more prone to error.
As Moody’s and others have used expected returns as the benchmark for assessing pension plans, the amount of unfunded future liabilities has exploded because the assumed discount rate has shrunk.
In turn, governments across the country have seen their budgets eaten away by annual pension obligations. Chicago and other cities have seen their credit ratings dropped because of the condition of their pension systems.
Some argue that with interest rates at historically low rates, the calculation of unfunded liabilities when using the market-based method is artificially high because as rates rise the assets in pension funds will climb.