According to Segal, current practice for measuring the pension liabilities of public sector pension plans provides useful information to plan stakeholders and decision makers about how much money it will cost and over what period to satisfy the financial obligations to participants by calculating what is called an actuarial accrued liability (AAL), which encompasses both current information and reasonable expectations of future events. The AAL measure takes into account the service and pay earned by employees, but also anticipates future service and pay raises, which will increase the plan’s obligations.
Current practice also incorporates information about the past and future investment earnings attributable to the plan’s assets in selecting what is called the “discount rate,” Segal contends. In determining the AAL, the discount rate used to calculate public sector pension liabilities is the long-term expected investment return on the plan’s investment portfolio.
Segal notes that the MVL approach differs from AAL in that it ignores expected investment earnings and instead uses a market rate of interest on fixed-income instruments. It also uses a much narrower definition of future benefits to calculate a plan’s liabilities, one that assumes pay and service are frozen at current levels.
“Clearly, these two approaches to discounting – using long-term expected returns versus current market bond rates – will result in very different measures of a plan’s liabilities,” Segal said. In a low interest rate environment, an MVL measure will produce a liability greater than the current expected rate of return method, and vice versa.
According to the report, the informational value of either measurement depends on what it is that users really want to know. If funding costs are the overriding concern, the AAL measurement provides viable information that can be used for decision-making. Because AAL incorporates more information that MVL measurements – information about future increases in the plan’s benefit obligations and about long-term earnings on plan assets – it more accurately measures the likely financial burden of the plan on an employer.
As a result, it provides useful information to an employer seeking to understand how the plan fits in with its overall financial position, or to trustees seeking to ensure the long-term viability of the plan.
“It is difficult to find similar, practical applications in the public sector for MVL measurements…” Segal said. “For discussions about the likely cost of a public sector plan to a sponsoring employer or the long-term financial health of the plan, MVL estimates will be inaccurate at best and misleading at worst.”One critical open question is how to reconcile AAL measurements with the actual contribution behavior of the plan sponsor. The liability and cost estimates will only be accurate if the plan sponsor is actually funding the plan in accordance with the actuarially determined needs of the plan. If the sponsor fails to fund the ARC, the plan will fail to achieve the investment earnings expected.