Buck Bond Group
Do we really need an experience study?

Do we really need an experience study?

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Experience studies, which look at a pension plan’s valuation assumptions compared to recent actual rates, are an important part of pension plan actuarial practice. However, they cost money and require considerable effort. So it is fair to ask whether they are necessary and what an appropriate scope for review is. Here are several common arguments against an experience study, along with information indicating why these arguments may not make sense.

“The last few years have been atypical.”

The truth is that all plan sponsors constantly deal with change. It’s just a matter of what was exceptional in any given year. The experience study process entails reviewing plan experience and understanding the underlying societal, economic, industry, and employer forces that generated that experience. For example, perhaps there was a layoff, a spike in demand that necessitated significant overtime, a slowdown in business, or a wave of retirements. Armed with that knowledge plus the plan’s experience, the actuary, sponsor, and plan administrator can discuss likely future trends and make informed forecasts of plan experience.

Unlike non-governmental sponsors, who look to ERISA and the IRS to establish discount rates for funding pension plans, public-sector plan trustees are responsible for selecting the rates used to value their liabilities and set funding requirements. Market volatility and a prolonged low-interest-rate environment have led public plan trustees around the country to lower these rates as future expected returns have declined. A result has been political pressure to look closely at discount rates used for public pension plans. When selecting this important actuarial assumption, an experience study reflecting the plan’s asset allocation and future market expectations is invaluable for public plan trustees.

“We don’t want our plan costs going up unnecessarily.”

In reality, a pension plan’s true cost is not established by actuarial assumptions. Over the life of a retirement system, contributions plus investment return must equal benefits and expenses paid. There is no free lunch. If a retirement plan’s actuary underestimates costs through the use of overly optimistic assumptions, the sponsor will eventually have to cover the true cost of the plan through the amortization of experience losses and additional administrative burdens or contribution requirements. Appropriate actuarial rates help the plan sponsor avoid surprises and budget appropriately for the true costs of the plan.

“Our plan is too small to provide credible results.”

It depends on what you mean by “credible.” Events that happen infrequently, such as deaths, do require large amounts of data to be “fully credible” – which means there is enough experience to use that information as the sole basis for predicting future incidence. But smaller amounts of data can be “partially credible,” and more frequent events such as turnover and retirement can be reviewed for plans with even 100 or fewer employees. Again, the goal is to verify that overall plan experience, and the general distribution by age at exit, do not contradict the assumed decrement rates. Similarly, participant elections for forms of payment at termination or retirement can often be tabulated to see if one particular choice is overwhelmingly popular (for example, sometimes a lump sum is the predominant option in a cash balance plan).

“Our auditors have never asked about one.”

They might, and when they do, it’s easier to respond quickly if you have had a recent study. Further, actuarial standards of practice – which apply to all actuaries practicing in the U.S. – anticipate that experience studies will be performed at regular intervals, with actuarial valuation rates adjusted over time as necessary. Under multiple professional standards, actuarial assumptions must be collectively reasonable without significant bias, and in some contexts should be individual best estimates of the specific rates used. There may come a time when your actuary cannot support the plan’s assumptions because there is no history of analyses to verify or adjust rates as appropriate. A defined benefit plan can become very significant relative to an organization’s size and financial health, making it just the kind of obligation an auditor must examine closely in assessing an organization’s financial statement.

The Government Finance Officers Association (GFOA) has stated that “the reliability of an actuarial valuation also depends on the use of reasonable methods and assumptions. Experience studies, performed no less frequently than every five years, can help to ensure the assumptions are in line with the plan’s demographic and economic experience, or can be used as a guide to make necessary changes.” Therefore, even if auditors haven’t inquired about an experience study, commissioning periodic experience studies is a best practice for public pension trustees and helps them to meet their fiduciary obligations.

“Our organization’s budget doesn’t have room for another study.”

For non-governmental plan sponsors, an actuarial experience study can, in most cases, be considered part of the reasonable administrative duties of the plan, and hence be paid from trust assets. Of course, you should discuss this with plan or ERISA counsel, but paying from trust assets alleviates the short-term budget pain of a study’s cost.

Depending on your contribution method, these additional expenses may lead to future contribution costs, subject to the plan’s funded status and the rules applicable to sponsor contributions. However, these costs can pale in comparison to pension plan costs to the sponsor if the assumptions are “off” significantly over time.

“We don’t have time or staff to begin such a project.”

While some sponsors want to take an active role in collecting and tabulating experience study data, most plans will rely heavily on the plan’s actuary who already has the census data upon which the valuations were based. The assumptions used for the valuation were applied to the census records maintained by the actuary, and this data is probably the most relevant and helpful in investigating plan experience. The actuary can review not just who left and why, but the impact to liabilities – relative to assumed rates – associated with individuals who left or who stayed, who selected a certain form of payment, or what pay increase someone received. Occasionally a few questions will be asked of the plan sponsor or administrator regarding gaps in the data or ambiguous information, but mostly it’s up to the actuary to do the heavy lifting.

“Why didn’t we do an experience study last year?”

That’s a good question. Some plans, especially in the public sector, are required to perform experience studies – often every 5 years. But for nearly every sponsor, there are plenty of good reasons to incorporate periodic experience studies into the valuation process. Not just to appease auditors, it can help align plan contributions and cost accruals with the reality of benefit and expense obligations so there are fewer surprises. An accurate assumption basis also opens the door to sound evaluation of contribution strategies or investment policies, even potential plan changes.

Especially in times of rapid change, you need to know where you’ve been to understand where you might be headed.