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Aon Retirement and Investment Blog

Application of the Spot Rate Approach to US Pension Expense Calculations – An Investment Perspective

Since 2015, many companies using U.S. GAAP accounting have disclosed a change to a “spot rate” approach for determining the service cost and interest cost components of their pension expense. As of June 30, 2016, nearly 200 companies had publicly announced such a change, with more such announcements expected. An internal Aon Hewitt survey of 2015 year-end accounting assumptions showed that about 1/3 of companies reporting under U.S. GAAP had decided to make this change at 2015 year-end. Viewing the pension accounting model through an investment lens can help clarify the application of this new approach.
 
What is the Spot Rate Approach?
 
Traditionally, most companies had developed a single discount rate based on high quality corporate bond yields, and used this single rate for calculating all components of pension expense. The spot rate approach more directly ties the spot rates along a corporate bond yield curve to the applicable projected future cash flows, so that the discount rate assumption is essentially the full yield curve rather than a single rate. While a plan’s projected benefit obligation (PBO) is unchanged under the spot rate approach, the resulting pension expense can be significantly lower in the near term than under the traditional approach. Over the life of the plan, the total expense will be the same, so the lower near-term expense will ultimately be offset by higher future expense. However, it may take many years for this to play out. As plan sponsors switch to the spot rate approach, monitoring the level and shape of the yield curve becomes more important to understanding expense volatility and the factors that may influence it.
 
Spot Rate Approach and Expectations for Future Interest Rates
 
Any approach for determining the service cost and interest cost components of expense carries an implied expectation for future changes in interest rates, and the resulting year-end PBO. The traditional method implies an expectation that the discount rate at year-end will equal the discount rate at the beginning of the year. Under the spot rate approach, there is an implied expectation that the rates along the yield curve will “shift to the left” – e.g., the five year spot rate at year end will equal the six year spot rate at the beginning of the year. This is consistent with a modest rise in the overall level of interest rates.
 
Historically, yield curves have not been a very accurate predictor of future interest rates, and interest rates are likely to move in a manner different from the implied expectations discussed above. If this occurs, a liability loss or gain will result. For example, if a plan sponsor uses the spot rate approach and the year-end yield curve is the same as the beginning-of-year curve, a liability loss will result when the yield curve is upward-sloping. However, if the plan sponsor follows a liability-driven investment (LDI) strategy using a fully immunized bond portfolio, any liability loss would be offset by a corresponding change in the assets.
 
Expense Volatility and Shape of the Yield Curve
 
As the yield curve flattens, the accounting benefit from the spot rate method (in the form of reduced pension expense) diminishes compared to the traditional approach. As a result, it becomes more important for plan sponsors using the spot rate approach to monitor the shape or “slope” of the corporate bond yield curve and any possible earnings “headwinds” which may result.
 
For a plan sponsor invested in a fully immunized bond portfolio, this expense volatility can be hedged if the expected long-term rate of return on plan assets (EROA) assumption is set equal to the effective interest cost rate, which is essentially the current yield on the hedged portfolio. In this case, the assets and liabilities move in tandem as the overall level of rates changes, and the interest cost and expected asset return move in tandem as the yield curve changes shape. It is important to note that there could still be some limited expense volatility from rate movements in the service cost. Some auditors may also question whether the EROA should change each year based on current bond yields, or be based on longer-term capital market assumptions instead – though this is an issue for any immunized portfolio, not just when a plan sponsor uses the spot rate approach.
 
Many plan sponsors are not invested in a fully immunized bond portfolio. Rather, many look to hedge plan liabilities with a portion of the plan’s investment portfolio – sometimes referred to as the liability hedging or LDI portion – by matching the overall duration of this portion of the portfolio with that of the liabilities. While this approach provides for ease of implementation and general effectiveness, it does present curve exposure by not matching the key-rate duration of the liability across the entire yield curve. The spot rate approach may prompt plan sponsors to revisit this strategy, and consider a more granular approach to duration matching across the yield curve.
 
If not invested in a fully immunized portfolio, then expense will likely increase, year over year, if the yield curve flattens but the overall level of rates (effective PBO discount rate) remains unchanged. The effect of a flatter yield curve may be mitigated if accompanied by an overall rise in rates, since the resulting actuarial gain would be amortized into expense per the company’s accounting policy.
 
The flatness of the Treasury curve is driven by action of the Federal Reserve and expectations for economic growth, among other factors. There has been some recent flattening, as expectations for a Fed rate increase at the short end of the curve have changed over time. The flatness of the corporate bond yield curve may be driven by other factors, such as credit spreads and supply and demand. We have observed somewhat less flattening in the corporate bond yield curve than in the Treasury curve. As of June 30, 2016, the slope of the Treasury yield curve, measured as the difference between the yields on 10-year and 2-year Constant Maturity Treasuries, had flattened by about 80 basis points over the previous year. In contrast, the slope of the corporate bond yield curve, measured as the difference between the PBO discount rate and the effective interest cost rate under the spot rate method, had flattened by only about 10 basis points over the same period.
 
What’s Next?
 
Thus far, we have addressed plan sponsors who select their discount rate assumption with respect to a corporate bond yield curve. However, some plan sponsors select their discount rate by reference to a “bond matching model” rather than a yield curve. The spot rate approach has been far less prevalent for sponsors using such a bond model due to the reluctance of auditing firms to allow it without further FASB or SEC guidance. Since a yield curve can be derived from the bond model, the spot rate method could potentially be used in a similar manner as for sponsors using a yield curve to set the discount rate. The investment lens helps to clarify that the interest cost rate should match the EROA on the fully matched portfolio implied by that yield curve. Discussions are ongoing between the audit community and SEC regarding this possibility.
 
While some might view the spot rate approach as primarily a method of reducing accounting expense, it might be better described as matching the discount rate assumption with the yield on a fully immunized bond portfolio. This increased granularity comes with the need to monitor and understand the related volatility.
 
Eric Keener is a Partner and Chief Actuary of Aon Hewitt’s U.S. Retirement practice, and is based in Norwalk, CT. 
Dan McFall is a Partner and actuarial consultant in Aon Hewitt’s U.S. Retirement practice, and is based in Lincolnshire, IL.

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