Funding Policy Objectives
There is widespread agreement that public pension plans should have and follow a funding policy. Funding policies typically address the following objectives:
- Sustainability – a methodical approach that substantially provides for sufficient annual contributions to pay for the benefits offered under the plan.
- Fair Allocation – a method to reasonably pay for the pension benefits earned during the working years of each employee.
- Limitation of Volatility – management of the negative fluctuation of the plan’s funded status and annual contribution requirements.
- Transparency – disclosure of the methods and objectives, as well as the reporting of the current funded status, progress made on the attainment of objectives and assessment of whether the policy is expected to meet objectives.
The following will further elaborate on these funding policy objectives and provide additional information for plan sponsors to consider.
The plan sponsor needs to understand the cost of the pension plan and confirm whether sufficient resources exist to meet those costs. The determination of the cost is based on many underlying assumptions and methods, such as investment return, pay increases, rates of termination of employment and retirement and mortality rates (to name a few). Each assumption used to determine cost should be reasonable. An annual actuarial valuation will provide the plan sponsor with an actuarially determined contribution amount for that year. Additionally, the actuary can determine a long-term projection of annual contributions and funded status. This will help the plan sponsor determine whether they can sustain the level of contributions expected to fund the benefits earned and to be earned in future years by employees.
Fair Allocation and Limitation of Volatility
Fair allocation and limitation of volatility both relate to the objective of intergenerational equity for the cost of providing pension benefits. A primary factor is the amortization period to pay off the unfunded liabilities. However, the funding policy may need to balance between: 1) relatively shorter amortization periods to match the costs to the period in which the benefits are earned or adverse plan experience occurs which creates unfunded liabilities; and 2) longer amortization periods to manage volatility in the amount of the contribution.
A significantly adverse plan experience in a year, such as a negative investment return, may result in an actuarially determined contribution that significantly increases from the prior year or over the next several years. This may put stress on the resources of the plan sponsor to contribute the full amount. Sufficient thought is needed when developing the funding policy to anticipate years in which the plan has poor experience to address the objectives of fair allocation and limitation of volatility. These are addressed, in part, by the policy’s selection of methods used to smooth the assets and amortize the unfunded actuarial accrued liability. However, regardless of the amount of planning, there may be events that occur which create more contribution volatility than the plan sponsor is comfortable. In these rare instances, temporary deviation from the plan’s funding policy may be acceptable as long as it is for a limited period of time, and then the plan can get immediately back into compliance with the funding policy.
Another benefit of adhering to a funding policy is that the plan sponsor can be transparent with its stakeholders and be confident it’s meeting its fiduciary responsibilities with regard to prudent funding of the plan. Once a good funding policy is implemented, good results generally follow. For poorly funded plans, this should include a long-term trend of improved funding. Most public pension plans are subject to reporting and disclosure requirements of the Governmental Accounting Standards Board (GASB). This reporting adds to the transparency of such plans and provides meaningful information to help compare a plan’s funded status and progress.
Areas of Disagreement
As mentioned, these objectives are widely agreed upon. However, there are many complexities in the calculations and underlying assumptions that offer fodder for debate. For example, there are proponents for measuring pension plan obligations based on a current market value approach. This typically includes calculating the plan liability based on a discount rate that is based on current bond yields. Others argue that the most reasonable discount rate is based on the plan’s long-term expected investment return. The outcomes based on these two approaches may be vastly different. Also, some advocate for the unfunded actuarial accrued liability to be amortized as a level percent of pay, while others favor a level dollar amortization. These methods result in very different contribution patterns. Furthermore, the time period over which to amortize the unfunded liability may vary among pension plans and again result in different contribution patterns.
In early 2016, legislation was reintroduced in the U.S. House of Representatives to require public pension plans to disclose, among other items, the plan’s funded status based on a current market value approach. While the debates continue, one positive outcome is that awareness has increased and more plan sponsors are adopting reasonable funding policies. For additional guidance on funding principles for public pension plans, please contact the Defined Benefits specialists at SilverStone Group.
This article originally appeared in the 2016 | ISSUE THREE of the SilverLink magazine under the title “Funding Principles: Public Pension Plans.” To receive a complimentary subscription to the SilverLink magazine, sign up here.