2010 Annual Funding Notice Liabilities Could Surprise Plan Sponsors and Participants

For calendar year pension plans, the Annual Funding Notice (AFN) to participants is due no later than April 30, 2011. One potential issue with this year’s notice is the impact of low interest rates on the liabilities disclosed in the document. There are two interest rates that affect liabilities in the AFN:

–  PBGC segment interest rates: These are based on “spot” interest rates which are essentially a snapshot view of the current interest rate environment.

–  Funding segment interest rates: These are generally based on 24-month averages of the spot rates. Although the 24-month averaging helps smooth out interest rate spikes and valleys, it will also delay the recognition of future rate increases.

The AFN must show a three-year history of the plan’s funded status (calculated using the funding interest rates) as well as an estimate of year-end assets and liabilities (calculated using the PBGC interest rates). The potential problem with the 2010 AFN is that the estimated year-end liabilities could appear much larger than the funding liability history. Although this may not directly impact plan operations, it could cause confusion among participants who actually read their AFN.

The reason that the year-end liabilities could appear much larger is that PBGC spot segment rates are currently much lower than the funding segment rates. The December 2010 PBGC spot rates haven’t been released yet, but the November 2010 segment rates were 1.65%, 4.91%, and 6.52%. This compares to January 2010 funding segment rates of 4.60%, 6.65%, and 6.76%. Since the largest discrepancies are in the first two segment rates, this will have a greater impact on mature pension plans where there are a significant amount of pension benefits expected to be paid within the next 20 years.

It’s difficult to gauge the exact impact, but here’s a recent example: We had a client with a 9/1/2009 valuation date whose expected 8/31/2010 liability shown in the AFN was almost 25% higher than the funding liability and appeared to reduce their funded status from 88% to 67%. Although it did not affect the actual operations of the plan, the client was concerned that the liability increase might alarm participants.

So, what can you do about it? Unfortunately, the interest rates are mandated so there aren’t many calculation options. One possible action would be to add some explanatory text to the AFN about how the year-end liability estimate is a very conservative measure and does not affect the operations of the pension plan.

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