Under ERISA, as revised by the Pension Protection Act (PPA), the sponsor of a defined benefit plan must generally contribute:

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1 April 2010 By Brian Donohue, Senior Vice President, Aon Consulting In this article we discuss three fundamentally different ways to view defined benefit (DB) plan finance: (1) a "cash" view, generally defined by the funding requirements under ERISA; (2) an "earnings" view, generally defined by accounting treatment; and (3) a "real world" view. By DB finance we mean, generally, contributions and contribution strategy and investments and investment strategy. We begin with cash and the regulatory regime. That regime defines what sponsors "have to do" and is, practically, the most intuitive. Moreover, in times of cash stress, the cash approach is probably most sponsor's default. Cash/regulatory A company primarily focused on the cash consequences of its DB funding and investment policy might, for instance, be a highly leveraged company whose primary concern is financing (with cash) its debt burden. For this company, funding strategy is defined primarily by ERISA minimum funding standards, so let's review what those are. Basic regulatory requirements Under ERISA, as revised by the Pension Protection Act (PPA), the sponsor of a defined benefit plan must generally contribute: The plan's "normal cost" for the current year (that is, the cost of the benefits earned in the current year), plus An amount sufficient to amortize the plan's shortfall (defined as the beginning-ofyear value of benefits minus beginning-of-year value of assets) over seven years. Compared to accounting rules or pre-ppa ERISA rules, there is relatively little latitude in: Choosing the interest rate at which to value liabilities generally, a corporate bond yield curve must be used, smoothed over two years and "summarized" into three rate segments short-, medium- and long-term. Sponsors may alternatively use "spot" rates. Valuing assets generally, fair market value must be used. Sponsors may (and most do) alternatively use an asset value "smoothed" over up to 24 months, but the result must stay within a 10% corridor of market value. PPA also includes a set of rules (what we have called "funding regime two") including benefit restrictions, at-risk rules, PBGC reporting and a limitation on funding of executive April 2010 page 1

2 compensation that, in effect, punish a sponsor for allowing a plan to drop below specific funding thresholds generally 60% or 80%. This second funding regime forces plans that wish to avoid the application of, for instance, restrictions on lump sum payments, to fund shortfalls in the current year, and not over seven years, at least up to, e.g., the 80% threshold. As a general matter (and with some exceptions), a sponsor does not have to conform to regime two funding requirements, so long as it is willing to put up with the restrictions that apply if, e.g., funding falls below 80%. Finally, there are relatively few features of PPA that allow sponsors funding flexibility. Perhaps the main one is the provision for the accumulation of credit balances (oversimplifying, contributions in excess of required contributions) that may, subject to some limitations, be used to satisfy minimum funding obligations. Summing up, regulatory requirements provide for a fairly rigid funding regime based on a seven year amortization of shortfalls, with special "negative incentives" for sponsors to fund significantly underfunded plans. The key "moving parts" areas where sponsor planning and judgment may come into play are the use of smoothing (both of interest rates and asset values) and the use of credit balances. Implications for contribution strategy In any case, the brute fact is that regulatory requirements define a contribution minimum, and, even where a sponsor's main concern is earnings or "real life," the sponsor will still have to live within that regulatory regime. In English: an earnings- or "real life"- strategy can only result in greater contributions. If you only want to put in the minimum, you only care about the regulatory regime. Implications for investment strategy The utopian goal of any investment policy is to maximize returns (and thus reduce future contribution requirements) while minimizing volatility and increasing predictability (of asset values and future contributions). While, in the market, there is generally a direct tradeoff between these objectives, smoothing of interest rates and, more significantly, asset values does allow DB plan investors an advantage. That is, relative to a generic investor, a sponsor primarily concerned with minimum (cash) funding requirements under ERISA has more room to seek returns (and risk increased volatility and reduced predictability) because of the smoothing available under ERISA. It should be noted that ERISA smoothing is less accommodating than pre-ppa rules. For companies that cannot risk large required contributions in the wake of a financial reversal (such as 2008), PPA rules provide some incentive for a less risky investment strategy compared with the prior regulatory regime. Now let's turn to a different sort of company one primarily concerned with earnings and accounting treatment. April 2010 page 2

3 Earnings/accounting Why does a company care about earnings? Generalizing, companies, particularly those raising capital in the equity markets, are often valued based on their ability to produce earnings, net of expenses. An accounting regime is designed, among other things, to give investors some notion of a company's earnings-producing capacity. In the US that accounting regime is "generally accepted accounting principles" (GAAP) as defined by the Financial Accounting Standards Board (FASB). In determining earnings, the accountants must have some way of allocating the cost of funding the pension plan. One alternative would be to simply book the cost under the regulatory minimum funding regime (that is, the cash cost). FASB has adopted a different and more elaborate approach. Basic pension accounting rules Current pension accounting rules are very complicated, here is a very brief summary: Generally under current rules (Financial Accounting Standard 87) a company's pension expense for a DB plan it sponsors includes: Service cost (similar to "normal cost" under regulatory rules) An interest charge on the plan's projected benefit obligation ("PBO") (oversimplifying: PBO = current liabilities plus a salary increase assumption) A charge for amortization of unrecognized prior service cost A credit/charge for experience gains and losses Expected earnings on plan assets are credited against these charges. In determining the current year charge to income for DB funding there is, under current rules, considerable "buffering" of period-to-period changes in interest rates and asset values: Smoothing of asset values and the expected rate of return. The value of plan assets may be smoothed for a period of up to five years. An expected rate of return, based on the makeup of the plan's asset portfolio, is then credited on this amount as an offset to the current year's cost. Any losses differences between real asset value and real returns on the one hand and smoothed values and expected returns on the other are only recognized (if at all) pursuant to the rules for limited recognition of gains and losses. Limited recognition of gains and losses. Gains and losses are netted, and net gains/losses are only recognized to the extent they exceed 10% of the higher of the April 2010 page 3

4 plan's (smoothed) value of plan assets or its PBO. If gains/losses do exceed the 10% "non-recognition corridor," then that excess is not charged to the current year but is amortized in future years over the "average remaining service of active plan participants." Delay in recognition of gains and losses. As described above, net gain or loss is only recognized if it exceeds the 10% liability/asset non-recognition corridor. The recognition of that excess is also delayed. It is not recognized in the current year but is amortized thereafter generally over the average remaining service of active plan participants. The delay is even more pronounced for asset returns. For instance, losses (actual returns that are less than expected returns) are only eligible for recognition to the extent they have been smoothed into the asset value (e.g., over five years); only then are they amortized over the average remaining service of active plan participants. The recognition of prior service cost is also delayed under current rules. When a sponsor amends a plan to increase benefits it is common to apply the benefit increase to prior periods of service. The liability for that prior service benefit is, under current rules, charged against future income over time generally over the average remaining service of active plan participants. Unlike the charge to income, the balance sheet treatment of pension-related costs now reflects, in essence, the "fair value" of pension assets and liabilities. For many companies, balance sheet adjustments for pension experience are a secondary or tertiary issue, but for a minority of companies, balance sheet volatility is of significant concern. Implications for contribution strategy All of the foregoing makes for more manipulable plan funding, for accounting/earnings purposes, by plan sponsors. Crudely oversimplifying, for accounting purposes unfunded liabilities don't show up as quickly in net income. If accounting were the only regime the sponsor had to conform to, these rules might lead some plans to systematically underfund. But the new PPA funding rules generally limit a sponsor's ability to do so. There may, however, be accounting reasons to overfund. Implications for investment strategy A key feature of current GAAP rules, as described, is that plan "income" is booked to company (operating) income. And plan income is (over-generalizing somewhat) based on an expected rate of return. "Expectations" here are determined by the plan's asset portfolio, with riskier assets generally producing higher expected returns. Also, returns in the plan are pretax. All of which may produce an interesting approach for companies for whom earnings are important to plan contributions and investments. $100 outside the plan invested in stock April 2010 page 4

5 earns what it earns and is then taxed and that net amount is booked to earnings. $100 inside the plan earns what it is expected to earn and is not taxed and is then booked to earnings. All of which provides an incentive to (1) add cash to the plan and (2) invest that cash aggressively. In this regard, FASB has sought to give "users of financial statements" (e.g., investors and analysts) more information about what sort of assets the plan holds. Now let's consider, briefly, a third alternative funding based on the "real" cost of sponsoring a plan. "Real world" For companies under cash stress, it is often the case that the only concern is what the regulatory regime requires. For companies focused on earning, the only concern is often the consequences of one or another strategy under GAAP rules. But there are situations for instance, a long-term private investor not under cash stress and under no GAAP reporting obligation where the question is: what is the "real" cost of the plan? The "real world" valuation of assets is relatively straightforward. The simplest value is fair market value that is a real and, except with respect to hard-to-value assets, readily available number. If, for one reason or another, an investor prefers a different asset valuation approach, reflecting, e.g., the longer investment horizon of the plan, the methodologies for doing so are also relatively straightforward, and the consequences of using them should be clear to the investor. The problem comes when trying to establish a value for liabilities. Unlike most asset classes, pension liabilities are not routinely traded in a liquid market, so measurements of liabilities do not enjoy the same objectivity or precision as for assets. Perhaps the closest proxy for such a value is the current annuity purchase rate for such a benefit. But there are exogenous factors affecting annuity purchase rates: it's our understanding that the DB annuity settlement market is not particularly liquid; and regulatory costs and insurance company margins would not necessarily factor into a "real world" valuation of a benefit. So our hypothetical investor is left to choose between different valuation models in trying to determine the value of a plan's liabilities (which is why we keep putting "real world" in quotes). Valuation here may involve a rejection of, or an adaptation of, regulatory or accounting concepts, or some other actuarial theory, but the investor is still in the realm of the relatively theoretical. It certainly can be argued that any methodology that does not use spot interest rates does introduce a layer of "non-transparency." Bottom line: where the investor has the freedom to do so, he, she or it can disregard regulatory or accounting methodologies that obscure valuation (especially on the asset side) but will still be left with some "guesses." On this basis, funding may, in the "real world," be improved but not perfected. April 2010 page 5

6 Implications or non-implications It's not clear to us that a "real world" sponsor has a bias towards any particular funding or investment methodology. Indeed, the notion of an investor totally free of cash or accounting constraints seems more like a theoretical construct than a real (not in quotes) person. So, we could say, that a "real world" investor "should" pay all current costs currently and "should" invest in annuities or fixed income securities that match anticipated future cash flows. But in the really real world, funding and investment decisions are likely to be more typically driven by, e.g., tax considerations or the possibility of a future IPO than by more theoretical concerns. Other considerations affecting DB finance There are other considerations that sponsors may want to consider and, indeed, in some circumstances these considerations may dominate funding or investment policy. These include: Exit strategies. If a company is considering terminating a plan in the near future, both contributions and investments will reflect that. A contribution strategy targeting full funding by the target termination date may result in accelerated funding. And the shorter investment time horizon may result in a more conservative investment policy. Tax-driven funding. Companies with a preference for tax deductions and the cash to support them may be more concerned with regulatory maximum contribution limits than with minimums. The ability to pass on expenses. Companies that can pass on plan costs, e.g., to rate-payers, will generally have a preference for full funding and (in some cases) a conservative investment strategy. * * * Many sponsors will, of course, manage plan contributions and investments based on a mix of objectives. And strategies will change from year to year. But it is useful, in considering any question of DB funding or investment to begin with the question what are the priorities for our company? ##### For more strategies on retirement programs, contact Brian Donohue at or . April 2010 page 6