Is your pension plan worth less than you think?

• Author: Benovitz, David M.
• Position: Includes related article - Pension Fund Management

If you haven't been paying much attention to your pension-fund discount rates lately, maybe it's time you took a second look. Because of low interest rates, the SEC is cracking down on companies that set their discount rates too high. Read on for alternatives.

Remember life before Financial Accounting Standard 87? If you do, then you may also know that most U.S. companies used the same actuarial assumptions for both funding and accounting. In particular, actuaries determined the discount rate as the long-term return expected from plan assets, taking into account the plan sponsor's investment philosophy. This approach to setting the discount rate was sanctioned by APB Opinion 8 and required by FAS 35 for plan (as opposed to employer) accounting. In 1985, just before FAS 87 was issued, a typical rate might have been 8 percent, based on an underlying long-term inflation rate assumption of 4 percent. Rates had evolved upward over a period of years as employers factored an expectation of higher continuing inflation into their assumptions.

In its early deliberations, including the preliminary views issued in 1982, the Financial Accounting Standards Board maintained this position on the discount rate. However, the final version of FAS 87 as well as FAS 106 reflects a different view in two major respects. Instead of showing how plan assets are actually invested, the discount rate must reflect a specific asset class -- high-quality bonds whose cash flows match those of the pension obligation. What's more, instead of focusing on a long-term estimate of the returns expected from that hypothetical investment, the rates available on the measurement date must be used.

In practice, most companies found the results quite positive when they adopted FAS 87 in 1986. High-quality corporate bonds yielded almost 10 percent, while 30-year government bonds were at 9.25 percent. Never mind that these rates were anomalously high relative to the 1985 Consumer Price Index increase of 3.6 percent, or the 5.5 percent average CPI increase over the prior five years or, in hindsight, the 4.1 percent average we would experience over the next five years. You weren't supposed to think about the discount rate in those terms. Rather, you chose an appropriate bond portfolio, determined its yield and used that result.

Most companies found that the mandate to use a higher discount rate, coupled with a requirement to at least partially reflect the fair value of assets at adoption (rather than an existing average asset value that was in many cases 20 percent below market value), sharply decreased their pension costs. In fact, many companies discovered that...