Future Values Versus Present Values

Actuarial practices use present values (PV) to calculate the funded ratio and funded status. But benefit payments are future values (FV). This suggests that the future value of assets versus the future value of liabilities is the most critical evaluation, but this comparison is rarely seen in the consultants' reports, if at all. Why? Most asset classes are difficult to ascertain their future value. Do you know what the price of GM's, or any company's stock will be three years from now? This is why the PV is used. Only bonds (and insurance annuities) have a known future value and that is why they have historically been used to cash flow match liabilities (i.e. defeasance, dedication, etc.). To prove our point as to the potential misinformation with using a PV calculation, let’s use a simple example below.

Pension	Composition	YTM	PV	FV
A	100% Treasuries	3.00%	$100 million	$150 million
B	100% Corporates	4.00%	$100 million	$180 million

Two pensions both at $100 million market value would have the same funded ratio in PV dollars. But pension B is 100% invested in corporate bonds that out-yield pension A (100% invested in Treasuries) by 100 bps per year. Certainly, plan B has a much greater future value (20% higher) and funded status if we used future values. This suggests that the funded ratio and funded status are not that accurate or even good indicators of the true economic solvency of a pension system.The point of all this is that we need to focus more on the FV of assets versus liabilities. If we value liabilities at market rates, they would have discount rates of AA corporates (FASB method) or even better U.S. Treasury STRIPS (defeasance method). A corporate bond portfolio matched to liabilities that out-yields liabilities would enhance the funded ratio on a future value basis thereby reducing funding costs (i.e. contribution costs). This is why “cash flow driven investing” (CDI) of liability future values is the most prudent risk and lowest cost methodology to de-risking a pension through asset-liability management (ALM).