Alternatives for Pension Cost Recognition—Implementation Approaches Using Bond Models

KEY POINTS: An alternative approach to developing pension cost involving the application of the spot rates for each year—rather than aggregated rates appropriate for the plan as a whole—has become widely accepted in recent years. While the application of this methodology is essentially straightforward for plan sponsors using yield curves to develop discount rates, its application is less obvious for those using bond models.  A number of approaches can be identified to implement more granular expensing approaches within bond model applications. Some reflect information from the more general bond market, as a complement to that from the identified bond portfolio, to develop a full array of spot rates across the range of maturities (similar to yield curve models). Others work more directly from the yield information for the identified bonds and do not consider any external information. The approaches can be differentiated based on the extent to which external capital market data is relied on, the compatibility of the derived spot rates with the individual bonds in the bond portfolio, and the means necessary to ensure the consistency of the identified rates with PBO and bond portfolio values.  A recently articulated SEC staff view may present obstacles to the adoption of some of the approaches described in this issue brief.      1850 M Street NW Suite 300 Washington, DC 20036 202-223-8196 | www.actuary.org Craig Hanna, Director of Public Policy Ted Goldman, Senior Pension Fellow © 2016 American Academy of Actuaries All rights reserved. Members of the Pension Cost Work Group, a joint effort of the Pension Committee and the Pension Accounting Committee, include: James Burke, MAAA, FSA, EA, FCA; Bruce Cadenhead, MAAA, EA, FSA, FCA; David Driscoll, MAAA, EA, FSA, FCA; Timothy Geddes, MAAA, EA, FSA, FCA; Eric Keener, MAAA, FSA, EA, FCA; Gerard Mingione, MAAA, FSA, EA, FCA, CERA; Keith Panetta, MAAA, EA; Todd Peterson, MAAA, EA, FSA, FCA; Francis Ratna, MAAA, FIAA, FSA; Mark Spangrud, MAAA, FSA, EA; and John Stokesbury, MAAA, FSA, EA, FCA.	For a print-ready PDF of this page, click here. Alternatives for Pension Cost Recognition—Implementation Approaches Using Bond Models An issue brief published in August 2015, Alternatives for Pension Cost Recognition—Issues and Implications, explored the use of discount rates from a full yield curve instead of a single aggregated discount rate to develop pension costs. This issue brief extends that discussion to the development of a yield curve (and associated spot rates) from a bond model. Five different approaches are explored, each with different attributes to be considered. This information is provided to educate actuaries regarding the issues involved and to inform their practice in this area. Because it is not an actuarial standard of practice promulgated by the Actuarial Standards Board, this issue brief is not a definitive statement as to what constitutes generally accepted practice in the area under discussion. Actuaries are not bound to adhere to the conclusions that may be identified in American Academy of Actuaries issue briefs or to conform their work to the practices described therein. Because this paper addresses emerging issues, there is likely to be future discussion, professional dialogue, and potential regulatory guidance that could either confirm or negate the appropriateness of proposed methodologies. Introduction Statements from the Financial Accounting Standards Board and comments offered by Securities and Exchange Commission (SEC) staff have provided strong support for cash-flow matching as a means for determining discount rates under Accounting Standards Codification (ASC) No. 715, so that many companies—in particular large companies with complex pension obligations—now use this approach. Using a bond model to develop a pension plan’s discount rate entails identifying a specific portfolio of bonds that closely matches the overall cash flow timing and duration of plan benefits. The projected benefit obligation (PBO) is measured as the market value of that bond portfolio; under traditional cost recognition methods, a single aggregated discount rate is developed that reflects the portfolio’s internal rate of return.

Relevant Guidance Under U.S. Generally Accepted Accounting Principles (GAAP)
There has been substantial guidance over the years with regard to the use of bond market data in the selection of discount rates. It is broadly accepted that discount rates should be based on high-quality fixed-income investments and reflect the duration associated with a given plan’s cash flows. Where zero-coupon bonds are not available at all required durations, determination of the assumed discount rate will incorporate expectations for future reinvestment rates.

While guidance exists around the selection of a discount rate for determining a plan’s benefit obligation measures (such as PBO) and service cost, there is much less guidance provided on the determination of interest cost. ASC 715-30-20 defines interest cost as simply, “the amount recognized in a period determined as the increase in the projected benefit obligation due to the passage of time.”

The approach to determining interest cost has been the subject of much recent discussion. ASC 715-30-35-8 articulates that “measuring the projected benefit obligation as a present value requires accrual of an interest cost at rates equal to the assumed discount rates.” Therefore the same discount rates used to discount to present value must also be used to determine interest cost. However, as discussed further below, there are different approaches for determining the rates used to measure the PBO. Within the context of a bond model (and historically for yield curve models), that objective has generally been accomplished by determining interest cost using the single effective discount rate that equates the present value of plan cash flows to the market value of the bond portfolio.

In considering potential approaches for redefining the calculation of interest cost, it should be noted that there is an important distinction between the application of yield curve and bond model approaches. With yield curves, the projected benefit obligation is developed by applying a series of annual spot rates to the plan’s projected cash flows; i.e., individual spot rates are explicitly referenced in determining the PBO value. In a bond model approach the PBO is taken to be the market value of a selected hypothetical portfolio that provides for the plan’s cash flow with coupon and principal payments. As such, there is no explicit/direct connection between a term structure of interest rates and the determination of PBO. Recent commentary from SEC staff³ indicates that this distinction was a significant consideration in the SEC’s assessment of alternative approaches for determining interest cost within bond models.

ASC 715 requires consistency among assumptions reflecting expectations of the same future economic conditions, raising the question of whether it is permissible to apply different discount rates to benefit payments assumed to be paid in the same year. This issue will be examined further in this issue brief as the alternative approaches for deriving and applying spot rates in a bond model context are explored.

Making significant changes to bond model methodology—particularly ones that significantly affect the discount rate and the measured obligation—would require justification of the facts and circumstances that have changed to support or necessitate such reconsideration.⁴ ASC 715-30-55-28 states, “If the facts and circumstances do not change from year to year, it would be inappropriate to change the basis of selection” of the discount rate. SEC staff commentary further indicates that the predominant rationale for evaluating which method is preferable should be the determination of an appropriate obligation amount rather than the effect on annual accounting cost.

Appendix 2 of this issue brief contains additional background including relevant citations from ASC 715 and other guidance pertinent to the issues discussed in this paper, such as the selection of a discount rate (including the use of bond models as a basis for the selection), determination of separate discount rates for subgroups of plan liabilities, and the relationship between the discount rate and interest cost determination.

 
The remainder of this issue brief will examine a variety of alternatives to the aggregated method and evaluate them using this same framework.

Both the traditional aggregated approach and the subgroup approach rely on the determination and application of aggregated rates to selected cash flows (either for the plan in total or as divided into groups). These rates are then applied to the respective obligation amounts to determine the interest cost related to those obligations. The sum of those interest costs is the total interest cost for the plan.

The following alternative approaches involve developing year-by-year spot rates to facilitate the application of a granular interest cost method on a year-by-year basis for plans using a bond model as the basis for developing a discount rate under ASC 715. Approaches 1 and 2 operate similarly in that both determine a single yield curve by combining information from the selected portfolio with additional information on bonds across the range of maturities. In contrast, approaches 3 and 4 develop a varying set of spot rates associated with each individual bond, then combine results at the present value level. Approach 5 represents an entirely new concept for developing interest cost based on estimating a return for the measurement year on the portfolio of matching bonds.

Approach 1: Theoretically derived yield curve
This approach estimates the credit spread resulting from use of the selected bond portfolio and applies it to a baseline/broader-based yield curve. The bond model would be run as usual to identify a bond portfolio and determine an aggregated discount rate. This rate would be compared to the (generally lower) discount rate produced by using a second, broad-based yield curve. The difference between the two discount rates would be designated as credit spread. An increment based on that credit spread would then be applied to rates from the baseline curve (e.g., as a percentage addition or load), and rates from this adjusted curve would be used as part of a granular approach to determining the net periodic cost.

Other observations

• The underlying logic and the use of external curve information are comparable to the approaches used in developing any high-percentile variation of a yield curve⁶ (an approach with very similar objectives to a bond model) and approximated curves in markets where corporate yield data is less than robust. (In this case, data from the selected bond portfolio can be viewed as similarly less than robust.)
• The resulting adjusted yield curve rates and yield curve slope are stable and consistent, and presumed to be reasonable in the context of overall high-quality corporate bond information.
• Because this approach is relatively simple and relies on outcomes from two already-standard methodologies, it may not require a significant addition to existing audit procedures.

Approach 2: Yield curve derived from selected portfolio bonds
This approach augments the bond model portfolio with a set of strategically selected bonds so that the portfolio includes bonds across the broad spectrum of maturities. A yield curve is then derived from the expanded set of bonds. The additional bonds will be expected to reduce the degree of cash flow matching and may also reduce portfolio yield, but would presumably be added in nominal amounts so that these impacts are minimized.

It may be appropriate to select bonds at similar percentile levels so as to define a reasonably smooth and homogeneous curve. The derived yield curve would be constrained to ensure that when applied to the cash flows, it produces a value that aligns with the bond portfolio value (which normally defines the PBO value under a bond model approach). The derived yield curve would also be reviewed to ensure that the level and slope are reasonably consistent with more broad-based yield curve models.

Other observations

• The selected portfolio of bonds is used to define a yield curve that provides the spot rates for each year.
• Expanding the selection of bonds included in the portfolio could be viewed as a methodology change. However, including bonds from a broad array of maturities in nominal amounts should not significantly affect the market value of the matching portfolio or the level of cash flow mismatch. Thus, even with the added bonds, the methodology remains generally consistent with the bond-matching concept in attempting to determine a balance between optimizing portfolio yield and providing a good fit to plan cash flows.
• The small number of bonds implies less statistical validity than a broad market yield curve. The derived curve would not be expected to fit the data as well as a broader market yield curve; thus, the outcome will rely more heavily on the curve-fitting/smoothing methodology employed. It may be appropriate to institute constraints on the relative yield levels for the added bonds to ensure a reasonable progression of rates and rate patterns generally aligned with the overall bond market.
• Due to an unequal weighting of bonds (for curve-building vs. PBO measurement), the curve-fitting methodology requires a secondary constraint to ensure that the fitted curve results in a PBO that aligns with the outcome from the bond model (including the added bonds).

Approach 3: Different single yield for each bond
This approach applies a highly simplified assumption that spot rates in each year equate to the bond’s overall yield. Under this approach, the bond yield (i.e., the single rate that equates the present value of these cash flows with the bond’s market value) is applied to discount the benefit payments at varying maturities that the bond is selected to settle. The present value of each benefit payment is calculated as the sum of the present values of the bond cash flows used to settle it, each measured at its own respective bond yield. The overall plan/portfolio spot rate for each maturity is derived from the (combined) present values for the bond components addressing the benefit payments at that maturity.
Other observations

• Given that a full term structure of rates is not developed, the presumption of a single rate across time provides a less refined estimate, and reduces the impact of applying the spot rate approach.
• The progression of overall plan/portfolio spot rates across the array of maturities will likely be uneven and discontinuous. (The underlying rates would presumably be somewhat upward sloping, but not to the same extent as a typical market-based yield curve.)
• Because each year’s benefit payment may be settled by a combination of bonds, this could be viewed as using different discount rates for payments made in the same year. However, because present values for all bond cash flows related to a given year’s benefit payments are combined, this methodology could also be viewed as applying a single average rate to all cash flows for a given year.
• It is noteworthy that this approach allows the calculation of interest cost to potentially be reduced to a simpler form—interest cost can be determined as the sum for each bond held by the selected portfolio of (1) the market value of the bond multiplied by (2) the yield of that bond.

Approach 4: Different term structure for each bond
This approach builds on two of the concepts that were applied in previously defined approaches:

• Each bond is recognized based on its market yield (as in Approach 3); and
• A broad-based term structure is calibrated (as in Approach 1) to align with each individual bond’s yield.

In this case, a credit spread applicable to each bond is derived. This differs from the application in Approach 1 where the theoretically derived yield curve approach reflects a credit spread associated with the entire bond portfolio. In both cases, an increment based on that credit spread is then applied to the baseline curve rates (e.g., as a percentage addition).

Once each bond’s term structure has been developed, a present value is determined for each component of bond cash flow. The present value of each benefit payment is calculated as the sum of the present values of the bond cash flows used to settle it, each measured at its respective yield. The overall plan/portfolio spot rate for each maturity is derived from the (combined) present values for the bond components addressing the benefit payments at that maturity.

Other observations