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Constructing the Corporate Pension Liability

Actuaries must forecast the future along two dimensions to construct the liability: demographic and economic. The relative stability of the former contrasts starkly with the variability of the second.

Demographic Assumptions – These include measures that impact the rate of participation in the plan. Critically, the plan sponsor knows most of the criteria at inception and as the plan evolves. Thus, there is a little uncertainty in their projections.

Changes in the Labor Force – The number of participants in the pension plan changes with hiring or terminating employees. It is a function of the strategic human resource objectives of the firm.

Retirement Age – The retirement age will impact the plan, with a lower (higher) retirement age increasing (decreasing) the mandatory payments. The plan sponsor mostly fixed these variables at inception. It tends only to change when offering buyouts (e.g., early retirement) to employees.

Life Expectancy – People that live longer will have a higher cost as the benefits paid will increase as the term of retirement increases. The rate of mortality in the employee population defines this measure. There is a hierarchy of life spans based on the nature of work in the US. In increasing order, they are the uninsured general population, blue-collar (e.g., labor), the insured general population, white-collar (e.g., office workers), the most affluent five percent.[1]

Disability (Morbidity) – Employees who become disabled impact the liability by entering the plan sooner than expected or leaving the plan altogether. The rate of morbidity will determine the incidence of disability in the employee population based on the sponsor’s experience or the general population with health access to health care positively related to the measure.

Changes to the labor force are the most impactful and the least variable of these demographic measures. Labor force and retirement age changes tend to occur during combinations or cost reduction initiatives. The other two measures, life expectancy and morbidity, are more stable in the long-run and tend to vary minimally. Companies with sufficient size and time measuring life expectancy and morbidity, may use their projection tables, which are usually more favorable to the liability valuation and may differ from the general population.

Exhibit 1. Impact of Demographic Changes on the Liability Valuation

The crucial decision point is offering the defined benefit pension, which is part of the broader strategic human resource process. Predicating this decision is the sponsor's ability to earn excess returns on the assets above the sponsor’s capital cost. The demographic outlook materially influences this election because it determines future payment timing. When the employees skew younger (e.g., offer a plan) or skew older (i.e., limit the plan), the decision becomes more apparent.

Economic Assumptions – The valuation of the liability and invested assets incorporate these assumptions and include:

Inflation – It is used to forecast the expected future salary rate increases and reflects the Consumer Price Index (CPI). It is also a key component in constructing future interest rate assumptions and asset returns.

Interest Rates – The discount factor is the critical variable in valuing the liability. Components of the interest rate include inflation, a real interest rate, and a risk factor that reflects the investment strategy of the pension plan. The first two are consistent across all pension plans, while variations in the discount reflect differing risk premium views.

Return on the Invested Assets – This variable reflects the average expected return that the plan’s asset allocation strategy will generate. It is composed of the real rate of return, the expected inflation, and the risk premium that will directly scale to the portfolio’s risk. Higher returns come with an increased risk in the asset allocation strategy.

Changes in Salary – For plans with final benefits linked to the plan participant’s salary, their final pay is a crucial component. This salary growth reflects expected inflation, productivity of the employees (related to the real growth rate), seniority (a linear progression that is parallel to productivity in a production environment), and other tertiary factors.

All the economic factors impact the liability valuation (exhibit 2). The unexpected inflation component has the most substantial impact on the cash flows via increases in the beneficiaries' future salary. In a low inflation environment, the expectation is for smaller increases of the future wage for this liability component. Conversely, higher than expected inflation increases the future salary requirement and the liability. This uncertainty contrasts with salary, which the plan sponsor exercises material control. Thus, it delivers little uncertainty because of this control.

Exhibit 2. Impact of Economic Changes on the Liability Valuation

Interest rates are where the uncertainty resides for the liability valuation with little ability for the plan sponsor to influence control. Lower interest rates drive the valuation higher, with the converse occurring for higher interest rates. While interest rates include an expectation for inflation that could offset the inflation in the salary inflation, they are not usually equal. This inequality leads to a divergent impact of the liability, with the interest rate levels overwhelming the salary inflation component. Thus, their forecast is material to the long-term (e.g., decades) liability valuation.

Asset returns display the highest year-to-year variability with convergence to the average over the long-term (e.g., 10-years). The implication is the occurrence of material short-term (e.g., annual) deviations in asset valuation. Managing this variability is a function of the plan’s funded status, the contribution strategy of the sponsor, the required return, the asset allocation, and the risk management culture of the plan sponsor.

The key performance indicators for the plan sponsor are the risk management of short-term asset returns and the long-term inflation level. Trade-offs between the two diverging objectives impact the variability. The plan sponsor’s choice is between higher variability in the short-term or long-term. Either option is prudent and contingent upon the sponsor’s competitive environment and its strategic objectives.

Learn more in our Accounting for Corporate Pensions Primer and follow out Corporate Pension Index.

[1] Samaras, Thomas Theodore. 2017. Longevity of Specific Populations. International Encyclopedia of Public Health (second edition).

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