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Defining the Corporate Pension Liability

There are two drivers of the liability’s size. First, the forecast of the amount of cash flows payable during retirement. Second, the valuation method employed for the cash flows at the time of measurement. Both drivers contain variables that involve assumptions about future economic states that may or may not become a reality. Thus, a measurement error exists in the liability valuation.


Calculating the obligated cash payments during retirement for the plan participants is the domain of actuaries who follow Actuarial Standards of Practice (ASP). The cash flows are a function of four key components, which includes the following in order of magnitude:

  • the final compensation at retirement,

  • the amount of accrued service with the employer,

  • the expected life span of the employee after retirement,

  • the expected inflation rates (inflation adjustments may not be included).

The former two variables are fixed at retirement, while the latter two features are forecast, which may vary from their experience (e.g., people may live longer than expected or inflation may differ from that forecast). Changes of either compensation or the accrued service will alter the amount of the liability. The changes are all positively related, with increases delivering a higher liability and decreases reducing the liability.


Increased life spans (and increased retirement payments) are called longevity risk. Fortunately for people, life spans are increasing, which the projections consider. Thus, the longevity changes are not usually associated with material changes to the liability. The inflation risk was benign for the last few decades as declining inflation brought realized inflation below expectations. While this latter risk may change, it is a manageable risk through plan design (e.g., limiting inflation protection) or hedging. Thus, the threat from changes in the underlying liability cash flows is usually not material.


The valuation of the liability is where the risk resides. The relationship between the liability valuation and interest rates is negatively related. Higher interest rates will lower the present value of the pension liability. In contrast, lower interest rates will increase the liability value. The latter is the outcome of the last four decades, where declining interest rates led to a continuously higher liability valuation. The bull market of the 1990s hid this outcome as asset return swamped the higher liability. Since the 2000, asset portfolio returns lagged the liability valuation gains. Funded status deficits are the result.


One challenge for the liability is that there are different calculations for measuring funded status. This challenge occurs not only between the accounting regimes (i.e., statutory or financial), but within each one. While the names differ within the regime, the three principal measures include some variation of the following:


Accumulated Benefit Obligation (ABO) – This measure is the least inclusive with only the benefits of the current employees and retirees earned to date at the current salary level.


Projected Benefit Obligation (PBO) – This broader measure includes the benefits earned by the current employees with their expected final salary.


Expected Benefit Obligation (EBO) – This comprehensive measure adds the expected benefits earned until retirement to the PBO.


Each liability is progressively more inclusive (exhibit 1). Critically, each of these projected cash outflows is valued using the corporate bond rates applicable at the valuation time. They are then discounted to the present value to derive the aggregate liability value.


Exhibit 1. Constructing the Liability

There is one fundamental distinction between the statutory and the financial liability. The statutory liability uses the Pension Protection Act (PPA) discount curve, while financial accounting employs market-based yields.[1] The result is a liability with identical cash flows will vary in value depending upon the accounting standard. Further, both regimes must use high-quality bonds (e.g., investment grade of single-A or higher). This definition gives some leeway to the valuation consultant in defining the yield curve. The result is the valuation may differ depending upon who does the valuation.


For financial accounting purposes, the Projected Benefit Obligation (PBO) is the primary liability used for reporting. It is a parsimonious trade-off between the more inclusive EBO that contains all expected (but unearned) liabilities, and the ABO that reflects no future service accruals and is the current economic liability for the firm. Due to the sponsor’s leeway in determining salary levels and the aggregate staffing numbers of the firm, there is some degree of control over the probable payments in the PBO.



 

[1] See ASC 715 for further details on financial statement disclosure of defined benefit pensions: https://asc.fasb.org/imageRoot/03/64938803.pdf

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