An 80% funded ratio often has been cited in recent years as a basis for whether a pension plan is financially or “actuarially” sound. Left unchallenged, this misinformation can gain undue credibility with the observer, who may accept and in turn rely on it as fact, thereby establishing a mythic standard. This issue brief debunks that myth and clarifies how actuaries view funding levels for pension plans and how the funded ratio relates to the general idea of “soundness” or the “health” of a pension plan or system. The Pension Practice Council of the American Academy of Actuaries finds that while the funded ratio may be a useful measure, understanding a pension plan’s funding progress should not be reduced to a single measure or benchmark at a single point in time. Pension plans should have a strategy in place to attain or maintain a funded status of 100% or greater over a reasonable period of time.
- Frequent unchallenged references to 80% funding as a healthy level threaten to create a mythic standard.
- No single level of funding should be identified as a defining line between a “healthy” and an “unhealthy” pension plan.
- Funded ratios are a point-in-time measurement. The movement or trend of the funded ratio is as important as the absolute level.
- Most plans should have the objective of accumulating assets equal to 100% of a relevant pension obligation.
- The financial health of a pension plan depends on many factors in addition to funded status—particularly the size of any shortfall compared with the resources of the plan sponsor.
What a Funded Ratio Is and Is Not
The funded ratio of a pension plan equals a value of assets in the plan divided by a measure of the pension obligation. Confusion sometimes can result when the term “funded ratio” is used without a clear understanding of how the pension obligation is measured or whether some form of asset smoothing is being used. Actuaries use different methods to measure a pension obligation for different purposes. For example, the measurement of the obligation used to determine a contribution strategy is often different from the measurement used for financial reporting or estimating settlement costs. The context for a funded ratio is important; but a detailed discussion of the various reasons for or methods used to measure different types of pension obligations is outside the scope of this brief.
Actuarial funding methods generally are designed with a target of 100% funding—not 80%. If the funded ratio is less than 100%, contribution patterns are structured with the objective of attaining a funded ratio of 100% over a reasonable period of time.
While it is unclear when widespread use began, an 80% benchmark has appeared in research reports, legislative initiatives, and in the media as a dividing line between healthy and unhealthy plans. A 2007 Government Accountability Office (GAO) report on government pension plans identified 80% as a de facto standard, citing experts without attribution. Subsequent uses of the 80% level often cite the 2007 GAO report.
The Pension Protection Act of 2006 (PPA) limits benefit improvements, lump sum payments, and use of the funding balances based on an 80% ratio of assets to the PPA funding target. Also under PPA, multi-employer plans use 80% as a level below which stricter funding rules become effective. As a final note, credit rating agencies use various funded ratios, including 80%, as a general indicator of a public pension plan’s financial health.
Identifying specific levels of funding as “too low” as PPA does is useful for some purposes (e.g., implementing benefit restrictions); but it does not follow that achieving or maintaining a funded ratio at some particular level should be considered healthy or adequate. A plan with a funded ratio above 80% (or any specific level) might not be sustainable if the obligation is excessive relative to the financial resources of the sponsor, if the plan investments involve excessive risk, or if the sponsor fails to make the planned contributions.
Read the rest of this policy brief here.
This article republishes selections from “The 80% Pension Funding Standard Myth” a policy brief from the American Academy of Actuaries in July 2012. The whole policy brief is available here.