The impact of inflation on defined benefit pension plan liabilities might surprise you. For private plans, the news is mostly good. For public plans, it is more challenging and provides a good reminder that public plan sponsors need to keep making their full pension contributions even if times are difficult.
Let’s take corporate plans first. Corporate plan sponsors measure the present value of their liabilities using floating interest rates or “discount” rates. When rates go down, as they have done for much of recent history, liabilities rise. However, as inflation leads to higher discount rates, the measurement of those liabilities will fall. This will likely result in lower required contributions for most corporate plans.
Moreover, since most DB plans are frozen, the pay increases that will accompany inflation will not be reflected in higher liabilities for those plans. And since most corporate plans do not have cost-of-living adjustments, their liabilities are not tied to inflation.
For public plans, the outlook is notably different. The rates that public plans use to measure their liabilities are fixed; the average public plan currently uses a discount rate of about 7% for that purpose. Many economists believe that rate is too high, and has already resulted in a stated present value of future liabilities that is lower than it should be. Thus, public plans with already high, but fixed, discount rates will not benefit from an increase in interest rates and corresponding decrease in measured liabilities.
In addition to the fact that public plans’ liabilities will not decrease, there are two further challenges regarding inflation that plan sponsors must keep in mind as they consider their contribution levels.
First, unlike corporate plans, most public plans are open (not frozen), so they continue to accrue liabilities. How does this relate to inflation? In an inflationary environment, wages rise. As public plans calculate their future liabilities, the wages upon which those liabilities are based will surely rise. Even though the discount rate has not changed, the liabilities will be higher.
Second, and just as important, most public plans do have COLAs built into the pension payments themselves. As inflation rises, pension payments tied to inflation or to a related index must also rise.
There is debate among economists about whether public plans’ discount rates should be lower. But there is no dispute that these two inflation-driven challenges—increased wages and COLAs—will have a significant impact on the funded status of public plans.
Public plan sponsors sometimes engage in the unfortunate practice of finding ways to underestimate and under-calculate their required contributions. The result is funding gaps that threaten to decrease the sustainability of public plans. With recent market returns, funded status for many public plans has improved substantially, but with these inflation challenges, plan sponsors must be sure to continue to their full pension contributions.
This point is particularly timely because (surprisingly in these difficult times) many states and cities find their budgets in positive territory. This is due in significant part to Federal pandemic relief funds, which have shored up state government funding; however, those pandemic relief funds are also mostly prohibited from being used to fund state and municipal pension plans. That creates a disincentive for public plan sponsors’ full funding commitments.
With these inflation challenges, plan sponsors and participants must keep their eyes on proper calculations of liabilities and full funding of their obligations.
Charles E.F. Millard is a former director of the Pension Benefit Guaranty Corporation and is a senior adviser with Amundi US Asset Management.This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.
« Lawmakers Unveil Multiemployer Pension Rescue Tracker