Smoothing affects the asset and liability values of pension funds
Smoothing methods do not directly affect the solvency of defined benefit plans or the predictability of statutory requirements, but they do affect the asset and liability values that are reported by corporate pension plans, according to a new report by the Society of Actuaries.
“Smoothing methods don't mean a lot when it comes to solvency or predictability,” said Joe Silvestri, Schaumburg, Ill.-based retirement research actuary for SOA and lead researcher on the report. “But it affects the ability to manage the finance of these plans, and what it means for the transparency of what financial results get disclosed in terms of funding rules, reported values and statutory reporting.”
The SOA report, which doesn't advocate for a specific smoothing method but rather aims to provide research and education on smoothing methods, identifies the similarities and differences between input and output smoothing methods from an actuarial standpoint.
Input methods smooth a single source of volatility, such as asset returns or interest rate changes, and affect multiple statutory requirements, such as minimum funding requirements and benefit restrictions.
Conversely, output methods smooth the effects of multiple sources of volatility and affect a single statutory requirement.
Input and output smoothing have the same effect on solvency and predictability: both methods determine when plan experience is factored into statutory requirements and the amount of time sponsors have to adjust for their effects.
“These methods can be designed to have very similar effects,” Mr. Silvestri said. “The real difference occurs when you talk about the values being reported. Input smoothing affects the variables that go into the calculation, so that is going to calculate the value of the asset or liability that is being reported.”
As a result, input smoothing creates a disconnect between what happens in the market and what gets reported.
Output methods, on the other hand, do not affect the calculation of asset and liability values, so their relationship to the market remains unchanged.
“There's a lot of debate over what is the real asset or liability and there are a lot of different points of view,” Mr. Silvestri said. “We just want people to understand that when you have input smoothing involved in calculations, there's going to be a disconnect between the way the reported asset or liability moves and the way the market moves.”
The greater implication in understanding smoothing methods is that it can also provide more transparency on a plan's financial information and help better manage risk. For example, if a plan prefers market-based measures, then it might also prefer less input smoothing in the reported values used.
“The main thing we want to get across is that when policymakers are deciding on what smoothing they allow, they have options,” Mr. Silvestri said. “We want them to understand what it means when we do input smoothing and output smoothing.”