Absolute funding ratio

What Is Absolute Funding Ratio?

The Absolute Funding Ratio is a key metric in pension finance and actuarial science that assesses the financial health and solvency of a defined benefit plan. It represents the proportion of a pension plan's assets that are available to cover its accrued liabilities at a specific point in time. Essentially, it indicates whether a pension plan has enough Plan Assets to meet all its promised Retirement Benefits if it were to terminate immediately. A ratio of 100% or more implies full funding, while a ratio below 100% signifies an underfunded status. This metric is critical for evaluating the long-term viability and Solvency of pension obligations.

History and Origin

The concept of evaluating the funding status of pension plans gained significant prominence in the mid-20th century as private sector Pension Plan proliferated. Prior to comprehensive legislation, many workers faced the risk of losing their promised pensions if their employer's plan became insolvent. A pivotal event that highlighted the need for better pension protection and standardized funding measures was the 1963 closure of the Studebaker auto plant, which resulted in thousands of workers losing a portion or all of their promised benefits.⁷ This incident, among others, spurred the passage of the Employee Retirement Income Security Act (ERISA) in 1974. ERISA established minimum funding standards for private-sector defined benefit plans and created the Pension Benefit Guaranty Corporation (PBGC) to insure those benefits.⁶,⁵ The absolute funding ratio became a fundamental tool for regulators, plan sponsors, and participants to gauge compliance with these standards and the overall financial stability of pension schemes.

Key Takeaways

• The Absolute Funding Ratio measures a pension plan's ability to cover its accrued liabilities with current assets.
• A ratio of 100% or higher indicates a fully funded plan, while below 100% indicates underfunding.
• It is a crucial indicator of a defined benefit plan's financial health and solvency.
• The ratio is influenced by investment performance, actuarial assumptions, and employer contributions.
• Regulatory bodies often use the Absolute Funding Ratio to monitor pension plan compliance.

Formula and Calculation

The Absolute Funding Ratio is calculated by dividing the current fair market value of a pension plan's Plan Assets by the Present Value of its accrued Plan Liabilities.

The formula is expressed as:

Where:

• Fair Market Value of Plan Assets: The current market value of all investments and other assets held by the pension plan.
• Present Value of Accrued Plan Liabilities: The estimated total value of all benefits earned by plan participants up to the valuation date, discounted to their present value using a specific Discount Rate. This calculation is typically performed through an Actuarial Valuation.

Interpreting the Absolute Funding Ratio

Interpreting the Absolute Funding Ratio requires understanding its implications for a Defined Benefit Plan. A ratio of 1.0 (or 100%) signifies that the plan has precisely enough assets to cover its accrued obligations. Ratios above 1.0 indicate a surplus, meaning the plan is overfunded, which provides a buffer against adverse market movements or unexpected increases in liabilities. Conversely, an Absolute Funding Ratio below 1.0 suggests a deficit, indicating that the plan is underfunded and may not be able to meet all its promised benefits without additional contributions or improved investment performance.

Regulators and plan sponsors monitor this ratio closely. A persistently low Absolute Funding Ratio can trigger requirements for increased employer contributions or adjustments to the plan's Funding Policy. The selection of the discount rate, which impacts the present value of liabilities, plays a significant role in this interpretation. Lower discount rates will result in higher calculated liabilities, potentially reducing the funding ratio, while higher discount rates will reduce calculated liabilities, increasing the ratio.

Hypothetical Example

Consider a hypothetical corporate defined benefit pension plan, "Evergreen Retirement Solutions," at the end of its fiscal year.

1. Determine Plan Assets: Evergreen's investment professionals calculate the fair market value of its Investment Portfolio, which includes stocks, bonds, and other securities. The total fair market value of plan assets is determined to be $500 million.
2. Calculate Plan Liabilities: An actuary performs a detailed Actuarial Valuation of all accrued pension benefits for current and future retirees. This involves projecting future benefit payments and discounting them back to their present value using an assumed discount rate (e.g., based on high-quality corporate bond yields). The actuary determines the present value of accrued plan liabilities to be $550 million.
3. Compute Absolute Funding Ratio: $$\text{Absolute Funding Ratio} = \frac{\$500,000,000}{\$550,000,000} \approx 0.909 \text{ or } 90.9\%$$

In this example, Evergreen Retirement Solutions has an Absolute Funding Ratio of approximately 90.9%. This indicates that the plan is underfunded, holding about 90.9 cents in assets for every dollar of accrued benefit obligations. This situation would likely prompt Evergreen's management to review its Funding Policy and consider strategies to address the deficit.

Practical Applications

The Absolute Funding Ratio is a critical measure with several practical applications across various financial domains:

• Pension Plan Management: Plan sponsors and fiduciaries regularly use the Absolute Funding Ratio to monitor the financial health of their Defined Benefit Plan. It guides decisions on employer contributions, Investment Portfolio allocations, and risk management strategies to ensure future Retirement Benefits can be paid.
• Regulatory Oversight: Regulatory bodies, such as the Pension Benefit Guaranty Corporation (PBGC) in the U.S., utilize this ratio to assess the risk exposure of pension plans and ensure compliance with minimum funding standards. The IRS also provides guidance and regulations related to the funding requirements for qualified defined benefit plans.⁴,
• Corporate Financial Reporting: Companies sponsoring defined benefit plans must disclose their funding status, including variations of the Absolute Funding Ratio, in their financial statements. This provides investors and analysts with insight into potential future cash flow requirements related to pension obligations and the overall Financial Risk of the entity.
• Mergers and Acquisitions (M&A): During M&A activities, the Absolute Funding Ratio of an acquired company's pension plan is a significant due diligence item. A poorly funded plan can represent a substantial contingent liability that could impact the acquisition price and overall deal structure.

Limitations and Criticisms

While a vital metric, the Absolute Funding Ratio has certain limitations and is subject to criticisms:

• Sensitivity to Assumptions: The ratio is highly sensitive to the Actuarial Valuation assumptions, particularly the Discount Rate used to calculate the Present Value of Plan Liabilities. A slight change in this rate can significantly alter the reported funding status. For example, lower interest rates generally lead to higher calculated liabilities and thus lower funding ratios.³,²
• Market Volatility: The fair market value of Plan Assets can fluctuate significantly due to Market Volatility. This can lead to swings in the Absolute Funding Ratio, making it a snapshot in time that may not reflect long-term trends or the true underlying health of the plan. The 2008 global financial crisis, for instance, severely impacted pension funding levels due to asset value declines.¹
• Focus on Termination Basis: The "absolute" nature often implies a termination basis, meaning it assesses if a plan could pay out all accrued benefits if it ceased operations today. This perspective may not fully align with the ongoing, long-term nature of a healthy pension plan, which anticipates future contributions and investment growth.
• Regulatory Arbitrage: Different accounting standards or regulatory frameworks may allow for varying discount rates or asset valuation methods, leading to different reported Absolute Funding Ratios for similar plans. This can create complexities when comparing plans across jurisdictions.

Absolute Funding Ratio vs. Funded Ratio

While often used interchangeably, the Absolute Funding Ratio and the broader term "Funded Ratio" generally refer to the same core concept in pension finance: the relationship between a plan's assets and its liabilities. However, "Funded Ratio" can sometimes be a more general term that encompasses various methodologies for calculating both assets and liabilities, depending on the specific accounting standards (e.g., GAAP, IFRS) or regulatory requirements (e.g., ERISA, national pension laws).

The term "Absolute Funding Ratio" often emphasizes a strict, termination-based valuation of liabilities, valuing assets at fair market value and liabilities at their present value based on accrued benefits. This contrasts with other funding measures that might incorporate different actuarial methods for projecting future benefits or smoothing asset values. The key distinction, if any, often lies in the precision and specific assumptions underlying the Actuarial Valuation of the Plan Liabilities. Both terms aim to provide a snapshot of a pension plan's financial strength and its ability to meet future obligations.

FAQs

What does it mean if a pension plan has an Absolute Funding Ratio of 80%?

An Absolute Funding Ratio of 80% means the pension plan has 80 cents in Plan Assets for every dollar of its accrued Plan Liabilities. This indicates that the plan is underfunded and would need additional resources to cover all promised benefits if it were to terminate immediately.

Why is the discount rate important for the Absolute Funding Ratio?

The Discount Rate is crucial because it is used to calculate the Present Value of future pension obligations. A lower discount rate increases the present value of liabilities, making the plan appear less funded, while a higher rate decreases liabilities, making the plan appear more funded.

Who is responsible for monitoring a pension plan's Absolute Funding Ratio?

The primary responsibility falls on the plan sponsor (e.g., the employer) and its designated Fiduciary Duty. Actuaries provide the necessary calculations, while regulatory bodies, like the PBGC, oversee compliance with funding standards.

Can an Absolute Funding Ratio change frequently?

Yes, the Absolute Funding Ratio can change frequently due to fluctuations in the market value of Plan Assets (e.g., due to Market Volatility) and changes in actuarial assumptions or interest rates that affect the calculation of Plan Liabilities.

Is a high Absolute Funding Ratio always desirable?

Generally, a high Absolute Funding Ratio is desirable as it indicates a strong financial position for the pension plan. However, an excessively high ratio might suggest that the employer is contributing more than strictly necessary, which could impact the company's other investment or operational priorities. The optimal ratio often balances security for beneficiaries with efficient capital allocation for the sponsoring entity.