80% Funded Status Not a Definitive Measure of DB Plan Health

The American Academy of Actuaries says a defined benefit plan’s funded ratio should be measured along with investment and contribution strategy, as well as the size of any shortfall compared with plan sponsor resources.

The American Academy of Actuaries contends in a new report that the oft-cited 80% funded status benchmark used to determine defined benefit (DB) plan health is inappropriate.

In its issue brief, “The 80% Pension Funding Myth,” the group notes that financial entities, regulatory bodies, governments and media sources have all cited an 80% funded ratio as a basis for whether a pension plan is “healthy” or “actuarially sound.” For example, a 2007 Government Accountability Office (GAO) report on state and local government pension plans portrayed 80% as a de facto benchmark for a healthy pension system, attributing that criteria to unidentified public sector experts and stakeholders.

In addition, for private-sector DB plans, the Pension Protection Act of 2006 (PPA) limits benefit improvements, lump-sum payments and the use of advance funding balances for single-employer plans based on an 80% ratio of assets to the PPA funding target. Also under PPA, multiemployer plans use 80% as a level below which stricter funding rules become effective.

The American Academy of Actuaries says it is important to remember that the funded ratio is a measure of a plan’s status at one point in time. Funded status can vary from year to year, and something as simple as market movements can affect a plan’s funded status. For example, the academy says plan sponsors should expect to see high funded ratios following periods of strong economic growth and investment returns such as the period leading up to the 2008-2009 financial crisis. And they should expect lower funded ratios after years of poor investment returns, such as the downturn that began in 2008. “Funded ratios should be examined over several years to determine trends and should be viewed in light of the economic situation at each time,” the report says.

The group adds that certain changes such as the adjustment of actuarial assumptions could also cause a funded ratio to decrease in the near term but may strengthen the plan’s funding over the long term. The report says that, in general, whether a funded status shortfall affects the financial health of the plan depends on many other factors—including the size of the shortfall compared with the resources of the plan sponsor.

“Using actuarial projections of benefit payments, expenses and anticipated contributions together with a range of economic and investment return scenarios, the plan’s expected funding trajectory can be evaluated,” the report says. “A plan that is expected to see a steady rise toward the 100% funded level, even if the current ratio is below 80%, would be healthier than a plan currently above the 80% level but that is projected to experience a stagnating or steadily declining funded ratio over time. If the contributions required to reach a 100% funded ratio appear to place too significant a burden on the sponsor, or if the investment returns needed to do so require an imprudent level of risk, the health or soundness of the pension plan could be in jeopardy.”

The American Academy of Actuaries suggests other factors that should be considered in assessing the financial health of a DB plan, including:

  • The sufficiency of funding or the contribution policy;
  • Consistent adherence by the plan sponsor to the funding or contribution policy;
  • The history of recent benefit provision changes;
  • The size of the pension obligation relative to the financial size of the plan sponsor, as measured by metrics such as revenue, assets or payroll;
  • The financial health of the plan sponsor, as measured by metrics such as level of debt, available fund balance, profit or budget surplus;
  • Investment strategy, including the level of investment volatility risk and the possible effect on contribution levels; and
  • The degree of conservatism in significant actuarial assumptions used to value the pension obligation.
The group concludes that no particular funded ratio should be identified as the definitive measure of whether a DB plan is financially healthy or not.