While the funded ratio may be a useful measure, understanding the health or soundness of a pension plan cannot be reduced to a single measure or benchmark at a single point in timeA new issue brief from The American Academy of Actuaries summarizes their findings and the details of the 80% Pension Funding Myth.
WASHINGTON, Oct. 6, 2021 /PRNewswire/ — The American Academy of Actuaries is publishing an issue brief, “The 80% Pension Funding Myth,” to alert the public, pension plan participants and other stakeholders, including policymakers, that the financial health or soundness of a pension plan cannot be reduced to a single measure or benchmark at a single point in time.
“While the funded ratio of a pension plan is certainly a useful measure, its reporting of 80% funding—or any other funded ratio percentage—simply doesn’t provide enough information to accurately gauge its financial health,” said Academy Senior Pension Fellow Linda K. Stone. “While the funded ratio is a useful measure and important aspect of a pension plan’s financial condition, it is most meaningful when viewed in the context of other relevant information. A plan that is funded at 80% at a single point in time could be anywhere in the spectrum from excellent to poor financial condition, depending on other factors.”
Pension Funding Basics
Actuarial funding methods generally are designed with a target of 100% funding—not 80%.5 If the funded ratio is less than 100%, actuarially determined contributions are structured with the objective of attaining a funded ratio of 100% within a reasonable period of time.
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 mean 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, relative to the financial resources available to the sponsor, the obligation is large or the plan investments involve excessive risk. Sustainability is also threatened if the sponsor fails to make planned contributions.
Just as attaining more than an 80% funded ratio does not assure a plan is adequately funded, a plan with a funded ratio below 80% should not necessarily be characterized as unhealthy without further examination. A plan’s funding strategy should have a built-in mechanism for achieving the target of at least 100% funding over a reasonable period of time. Provided the plan sponsor has the financial commitment and the means to make the necessary contributions, a particular funded ratio does not necessarily represent a significant problem.
It is important to understand that the funded ratio is a measure of a plan’s status at one time. A plan that is responsibly funded can easily have its funded status vary significantly from one year to the next solely because of external events. Funded ratios should be examined over several years to determine trends and should be viewed in light of the economic situation at each time. High funded ratios are to be expected following periods of strong economic growth and investment returns such as the period leading up to the 2008-2009 financial crisis.
Lower funded ratios are to be expected after years of poor investment returns such as the downturn that began in 2008. Furthermore, certain changes (like the adjustment of actuarial assumptions) may cause a funded ratio to decrease in the near term but may strengthen the funding of the plan over the long term. Generally, whether a particular shortfall affects the financial health of the plan depends on many other factors—including the size of the shortfall compared to the resources of the plan sponsor.
A funded ratio of 80% should not be used as the primary criterion for identifying a plan as being either in good financial health or poor financial health. No single level of funding should be identified as a defining line between a healthy and an unhealthy pension plan. All plans should have a reasonable funding or contribution strategy to accumulate assets equal to 100% of a relevant pension obligation, unless reasons for a different target have been clearly identified and the consequences of that target are well understood.
While it is unclear when widespread use began, an 80% benchmark has appeared in research reports, legislative initiatives, and in the media as a misleading bright line between healthy or well-funded plans and unhealthy or underfunded plans. The Academy’s issue brief notes:
- Using an 80% funded ratio as a benchmark for whether pension plans are healthy is inappropriate.
- No single level of funding defines a line between a “healthy” and an “unhealthy” pension plan.
- Pension plans are generally better evaluated on the strategy in place to attain a funded ratio of 100% within a reasonable period of time.
- The financial health of a pension plan depends on many factors in addition to funded status, including the size of any shortfall compared with the resources of the plan sponsor.
- Projections under a range of scenarios can be particularly useful in evaluating the plan’s expected funding trajectory and assessing plan health.
Learn more about the 80% funding myth and the Academy’s work on pension public policy issues at actuary.org.
The American Academy of Actuaries is a 19,500-member professional association whose mission is to serve the public and the U.S. actuarial profession. For more than 50 years, the Academy has assisted public policymakers on all levels by providing leadership, objective expertise, and actuarial advice on risk and financial security issues. The Academy also sets qualification, practice, and professionalism standards for actuaries in the United States.