Pension discount rates continued to drop during 2012 and plan sponsors should prepare for yet another potential upward spike in balance sheet liabilities for the fiscal year ended December 31, 2012.
Using the Citigroup Pension Liability Index (CPLI) and Citigroup Pension Discount Curve (CPDC) as proxies, pension accounting discount rates may decrease by roughly 35 basis points. This could present yet another increase in the pension liability compared to FY2011 (when many thought rates couldn’t get any lower). Fortunately, many plans also experienced strong investment returns during 2012 so the combined effect on the net balance sheet liability may be muted.
Analysis
In the chart below we compare the CPDC over the past four years at different dates (12/31/2009, 12/31/2010, 12/31/2011, and 12/31/2012). We also highlight the CPLI at each measurement date. The CPLI can be thought of as the discount rate produced by the curve for an average pension plan.
Rates on the long end of the spectrum dropped slightly since 12/31/2011, while short and medium-term rates had a more pronounced decrease. This means plans whose liabilities are “front-loaded” (i.e., significant portion of benefits expected to be paid in the next 15 years) will see larger liability increases. Examples are plans with high concentrations of retirees or those that have been frozen or closed to new entrants for many years.
Net Effect on Balance Sheet Liability
If asset performance was strong during 2012, then this will moderate the situation since the net shortfall (assets minus liabilities) is reported as the balance sheet liability.
Below is a simplified illustration for a plan that was 80% funded on 12/31/2011 and we assume a 5% increase in pension liability during 2012. We then compare the funded status results under two asset scenarios: (1) Level assets since 12/31/2011 and (2) Assets 5% higher than 12/31/2011.
Depending on the starting funded status, the change in pension liabilities and assets can have a leveraging effect on the reported balance sheet liability.
Conclusions
So, what’s a plan sponsor to do when faced with a big increase in pension accounting liability? Here are a few ideas.
- Your plan’s specific cash flows could have an enormous impact on how much the drop in fixed income rates affects the pension liability. If you’ve just used the CPLI in the past, it’s worth looking at modeling your own projected cash flows with the CPDC to see how it stacks up.
- Additional plan funding (above the IRS minimum requirements) may be appealing in 2013. Not only will it increase the plan’s funded status, but it will also help lower your pension plan’s PBGC variable rate premiums.
- If you’ve implemented an LDI strategy for a portion of the pension trust portfolio, then the drop in discount rates should be accompanied by a corresponding increase in your asset value. If you haven’t adopted an LDI investment strategy yet, now may be a good time to revisit this policy.
- There are some alternatives to the CPDC and CPLI as a basis for setting accounting discount rates, such as “above-median” versions of these rates. Check with you actuary or auditor to see what your options are.
