In determining minimum funding requirements under the Pension Protection Act (PPA), a significant amount of asset and liability smoothing is permitted, and legislated funding relief starting in 2012 allowed plans to use substantially higher than market discount rates in determining their PPA liabilities. Because liabilities are inversely related to discount rates, funding relief produced lower PPA liabilities and inflated PPA funding levels. Most plan sponsors have taken advantage of these elections over the past 10+ years, often resulting in lower or no minimum funding requirements even for plans underfunded on a mark-to-market basis. However, since current market rates are now more aligned with smoothed PPA interest rates and funding relief has a minimal impact, adjusting PPA elections to use the market values of liabilities and market value of assets could prove more effective in the future, especially for those plan sponsors who are hedging a significant portion of the liability interest rate risk.

At the heart of the issue is the disconnect between stabilized segment rates and market rates. This means a conventional interest rate hedging approach, designed to be effective at managing interest rate risk associated with mark-to-market liabilities and assets, is generally not effective at hedging PPA liabilities. While this concern was largely ignored when stabilized segment rates were much higher than market rates and generated a PPA liability that resulted in lower or no contribution requirements regardless of actual yield levels or changes over time, it may have more of an impact going forward. To better align PPA liabilities with interest rate hedging strategies, some plan sponsors have taken a serious look at moving to the PPA Full Yield Curve (FYC), which reflects current market conditions and does not use smoothing. To better align their hedging assets with their liabilities, we think these sponsors should consider switching to a market value of assets as well, since it reflects current market interest rates.

While the impact of these elections can vary based on individual plan characteristics and market conditions, there are potential advantages to aligning the funding methodology with the plan's investment policy and reducing the volatility of funded status and contributions. There are a host of factors to consider when evaluating the decision to change PPA funding elections, so such a decision requires careful consideration. The election decisions not only affect the current year but also future years, and given the uncertainty in the market, plan sponsors must consider the potential impact in the future. Some of the key factors to consider are:

It is critical to assess the potential risks and uncertainties associated with these changes. Robust modeling and analysis can help plan sponsors evaluate the various scenarios and make informed decisions. Ultimately, each plan sponsor should carefully evaluate their unique circumstances and consult with professionals to determine the most effective PPA funding elections for their pension plan.

For a deeper dive into these issues, please read our full paper, Liability Hedging and PPA Funding Elections.

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