Are Corporate Plans Really Close to Being Fully Funded?

Incorporating future service costs and benefits for future participants into a plan’s liability metric can significantly bring down the funding ratio.

(June 2, 2014) — Corporate defined benefit (DB) plans may be too quick to de-risk based on inaccurate calculations of liabilities and funding ratios, a consulting firm has claimed.

According to Russell Investments, the current liability metric that only measures benefits for retirees, active employees, and deferred vested participants is not enough to present a full picture to plan effective funding and investment policies for open and closed DB plans.

“It is also necessary to understand and examine how future benefits will accrue and how large they will ultimately be,” said Marcus Muetze, one of Russell’s senior consultants.

A new metric—dubbed Total Future Benefit Obligation (TFBO) by the firm—“looks at the present value of all benefits that will ever be earned by current plan participants as well as by future participants.”

Specifically, it takes into account not only the Projected Benefit Obligation—liabilities for retirees, current employees, and deferred vested participants—but also future service costs and liabilities for future participants.

These changes in calculations would significantly change funding ratios and the “understanding of the long-term funding and investment challenges” a plan could face. For example, a seemingly healthy open DB plan with a funding ratio of 97% on a PBO basis would actually be only 59% funded when calculated with TFBO. A closed plan with the same funding ratio would be 69% funded when future service costs were including in liability calculations.

“The challenge is not a 3% PBO deficit—in fact, it is the 41% TFBO deficit that we are going to have to figure out to fund over the long term,” Muetze said.

To close the bigger funding gap, pension plans need to reevaluate its investment and contribution policies, Russell argued.

With a lower funded status, plan sponsors would not need to de-risk and take full advantage of improvements in funding. De-risking becomes imperative only for plans that are close to being fully funded to avoid putting its current funded status at risk for returns that could end up being “trapped capital,” according to the firm.

Plan sponsors will also need to alter contribution policies over the long term as investment returns are unlikely to make up such a large funding gap on their own.

“Knowing your TFBO means knowing your true long-term economic deficit and will allow you to make more realistic choices on how much might be made up through asset returns versus how much will ultimately need to be funded through contributions,” Muetze said.