Last Friday, the President signed the highway trust funding bill.  One part of the debate over the bill was how it would be funded.  Ultimately, the bill was paid for using  so-called “pension smoothing” that some decried as a “gimmick.” But what is it and might it be beneficial?

To understand smoothing, we have to first understand how pension plans are funded.  Pensions are typically funded with company contributions. Put simply, the amount of these contributions are determined by an actuary based on the expected future benefits to be paid (i.e., the future liability) relative to the amount of assets already in the plan.

Because actuaries don’t have crystal balls, they have to make certain assumptions in making these calculations. The assumptions center around the anticipated mortality of the participants (i.e., how long the plan will have to pay benefits) and the rate at which the plan’s assets are expected to grow (i.e., an interest assumption).  The law establishes what these mortality and interest assumptions are for funding purposes.

The problem that pension smoothing seeks to address is with the interest assumption.  Absent pension smoothing, the law mandates that the assumption be based on relatively current interest rates. As you can imagine, with interest rates at historic lows, the assumed rate of the plan’s return is relatively small.  This means that larger contributions are required now to fund benefits in the future than there would be if interest rates were higher.

One could argue that such an assumption is unreasonable.  For a plan designed to pay benefits over decades, does it really make sense to assume such a low rate? Couldn’t that result in significantly overfunding the plan (potentially to the detriment of the company since it can’t really get that money back) when interest rates rise? Conversely, when interest rates rise, does it make sense to potentially underfund the plan at those higher rates since interest rates may go down?

Simply described, what smoothing does is even out the interest assumption by looking at an average rate over several years.  This helps even out historically low (or high) rates.  Consequently, it reduces the contributions companies can or are required to make.  It leaves that money in the company where it can be used by the company for other purposes (and, Congress hopes, be subject to tax). Congress likes it because it raises revenue without looking like a tax hike.  Companies like it because it reduces their potential pension contribution obligations.

Some argue that this has the potential to underfund pension plans and put the PBGC in further jeopardy.  However, the effect of that is unclear.  By reducing contribution obligations, it may make a company less likely to terminate a pension plan since it is less of an immediate financial burden, thus allowing the plan to continue and not be handed over to the PBGC.

The bottom line is that the benefits and drawback of pension smoothing are complex; it’s not as simple as saying its universally good or bad for pension plans or the companies that sponsor them.  There are benefits that are perhaps less tangible than those that simply allow us to keep our highways freshly paved.