If you haven’t read the latest revision to Actuarial Standard of Practice No. 4 (ASOP 4)*, or if you still have questions, it’s not too late. We break it down here, focusing on what it is, why it matters, and how it might affect investment portfolios. That’s crucial for pension plan sponsors, but it’s also essential information for other stakeholders, including bond investors.

What it is

The Actuarial Standards Board sets norms for actuaries in the U.S. Enhancements to its ASOP 4, “Measuring Pension Obligations and Determining Pension Plan Costs or Contributions,” recently went into effect. Outside of public employee retirement system groups and some consulting firms, it hasn’t received much attention. Yet, for public pension plans and their stakeholders, which include all residents and taxpayers of those municipalities and states, as well as municipal bond investors, it’s important to understand the implications.

The key message is that all pension plans’ actuarial reports are now required to disclose a liability value known as the Low-Default-Risk Obligation Measure, or LDROM. Essentially, this means that actuaries will calculate a market value of the liability by discounting future benefit payment projections at high-quality bond yields. This is a new requirement for public pension plans.

Why it matters

While corporate pension plans have used high-quality bond yields to calculate a market valuation of liabilities for their balance sheet and funding calculations since 2006, state and local plans have used— and will continue to use—the so-called accrued actuarial liability value. This liability value discounts projected benefit payments based on the expected return of the asset portfolio. The median expected return on assets for public plans is currently about 7%.[1] However, public plans will now also disclose the market value of the liability (LDROM) using a discount rate tied to high-quality bond yields, which has averaged about 5% over the past six months.[2] Disclosing the LDROM improves the comparability among corporate and public plans’ liabilities and, therefore, comparisons of funded status.

For public plans, this LDROM liability value will be significantly greater (perhaps in the range of 30%[3]) than the accrued actuarial liability value. It will also introduce mark-to-market volatility to this new liability valuation disclosure, meaning the LDROM liability value will go up and down as bond yields change (and vice versa).

What it could mean to investment portfolios

For municipal bond investors, it’s too early to tell how this might affect the perceived risk/return of a given investment. Pension deficits and funding have a large impact on the creditworthiness of state and local bond issuers. Investment analysts keep a keen eye on pension obligations. Since the LDROM is not a change to accounting and funding rules—it’s merely an additional disclosure—we expect no immediate effects on the municipal bond market. However, as investors digest and track the LDROM disclosures, they may begin to prefer those pension plans with investments that better track the liability.

For public plans, this presents an opportunity to tweak the bond portfolio, though wholesale changes are unlikely, in our opinion. When corporate plans adopted market-value accounting and funding rules, they began to transition their portfolios toward long-dated bonds that better matched the liability value (known in some circles as liability-driven investing, or LDI). Public plans are unlikely to follow this path, but the composition of the bond portfolio might evolve.

Broad-based bond portfolios, such as those benchmarked to the Bloomberg U.S. Aggregate Bond Index, are common among public plans. This index has exposure across the yield curve, with maturities ranging from 1 to 100 years across government, securitized, and credit sectors. Instead, public plans could choose to tailor their bond portfolios to meet specific outcomes.

For example, public plans have very long investment horizons because their plans are typically open to new members. They use this long horizon to their advantage by investing in assets with higher expected returns. These assets are typically more volatile (such as public equities) or less liquid (such as private markets). At the same time, the pension plan still has short-term obligations in the form of benefit payments to members and capital calls from their private market asset managers. A bond portfolio could be devised to meet both short- and long-term needs:

A) A portion of the fixed income assets could be allocated to ensure short-term liquidity needs are met, thereby allowing riskier assets time to ride out downturns and harvest risk premia.

B) The remaining fixed income allocation could be allocated to longer-dated bonds. This has three benefits:

  1. Longer bonds have higher yields than shorter bonds when the yield curve is upward sloping. This could be an added source of return.
  2. Longer bonds are a better match to the LDROM. Investing a portion of the bonds will help the assets move a bit more like the LDROM valuation over time.
  3. Longer bonds offer greater duration, which helps balance the riskier assets’ exposure to economic growth risk. In times of economic downturns, risky assets like equities and credit tend to fall while rate-sensitive assets tend to rally. More duration provides more macroeconomic diversification.

Putting these two ideas together, the bond portfolio could be reconfigured to a barbell strategy of short-term and long-term bonds. The message for pension plan sponsors? Don’t call it LDI. Call it better bonds.

Reading beyond the headlines

Changes to actuarial rules rarely make headlines, and ASOP 4 is no exception. However, greater understanding of liability risk provides greater transparency to taxpayers and municipal bond investors. It may also motivate public pension plan investors to reconfigure bond portfolios to balance the competing interests of the accrued actuarial liability and LDROM. Allspring will continue to monitor regulatory changes and market dynamics, offering investors our views and tools to adapt to the changing landscape.

Comparing liability values

 Accrued actuarial liability valueLDROM
Discount rateExpected return on assets (EROA), presently around 7% for many plansHigh-quality bond yields (approximately 5% currently)
VariabilityEROA changes slowly over time, hence the liability also only changes slowlyChanges with market yields; hence, can be much more variable
How to think about liability valueThe expected value of funding liabilities if long-term asset return expectations are achieved

In other words, the assumed long-term cost of benefits provided
The cost of securing the liability through currently available low-risk investments

In other words, it is closer to the price another entity (e.g., insurance company) might charge to take over the liability
Source: Allspring


[1]. Source: Allspring calculations based on the Public Plans Data* for fiscal-year 2022

[2]. Source: Bloomberg as of 17-Apr-23

[3]. Estimate based on liability with 15 years of duration

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