Smoothing May Distort Financial Picture for DBs

February 27, 2013 ( Understanding the financial status of a defined benefit (DB) plan requires understanding how smoothing methods have affected the plan’s reported data, according to a report by the Society of Actuaries (SOA).

“This report demonstrates that, while smoothing mechanisms play an important role in the management of funding requirements, smoothed results may not provide an appropriate basis for understanding a plan’s current financial status,” said Joseph Silvestri, retirement research actuary with the SOA and lead researcher of the report.  

“Observations on Input and Output Smoothing Methods: How do they affect the funding of defined benefit plans?” investigates the differences between two types of smoothing methods (input and output) from an actuarial perspective. In doing so, it demonstrates how input smoothing affects reporting of two critical variables in the determination of plan financial statusplan assets and plan liabilities.   

By examining three alternative statutory schemes—current law, current law modified to increase input smoothing and current law modified to increase output smoothing—the research aims to inform the public and policymakers of how the two families of methods can affect three key principles of funding regulation: the solvency of the plans, the predictability of statutory requirements and the transparency of financial information about the plans.

Observations surrounding the three principles include:  

  • The choice between input and output smoothing methodologies does not directly affect the solvency of defined benefit plans or the predictability of statutory requirements. 
  • Input smoothing methodologies change the relationship between market-based and reported values of pension assets and liabilities. Users of the reported values need to understand their relationship to market-based values to ensure appropriate use of the information. 
  • Smoothing methods spread the recognition of volatile plan experience over time so that, in the case of funding requirements, sponsors can better manage the effect that plan experience has on their operations. However, smoothing methods do not reduce the underlying risks associated with defined benefit plans.  

“Smoothing may defer increased contribution requirements caused by poor plan experience, but it does not prevent them,” Silvestri said. “Sponsors wishing to manage the risks associated with their plans have several options available to them, including modification of asset allocations and settlement of plan obligations.”   

By illustrating the three statutory schemes, the SOA suggests that, when using reported data about a defined benefit plan, users should understand how smoothing has affected the data and assess whether it provides the best information for their purpose.  

The report can be downloaded from here.