10.2 Funding methods and actuarial cost methods
6 min read•august 20, 2024
Funding methods and actuarial cost methods are crucial for managing defined benefit pension plans. They determine how to finance promised benefits and impact contribution timing and levels. Different approaches, like vs and terminal vs , offer varying advantages.
Actuarial cost methods, including and approaches, calculate plan liabilities and costs. These methods, such as traditional unit credit, projected unit credit, and entry age normal, have distinct characteristics that affect contribution stability and intergenerational equity in pension funding.
Types of funding methods
- Funding methods determine how to finance the benefits promised under a defined benefit pension plan
- The choice of funding method impacts the timing and level of contributions required to fund the plan
Pay-as-you-go vs prefunding
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- Pay-as-you-go funding only pays benefits as they become due, with no advance funding
- Prefunding accumulates assets in advance to pay future benefits
- Prefunding allows for investment income to help pay benefits and can enhance benefit security
Terminal vs spread funding
- aims to have assets equal the liability at the end of the funding period
- Spread funding aims to have a level contribution rate over the funding period
- Spread funding can reduce volatility in contribution rates compared to terminal funding
Characteristics of actuarial cost methods
Benefit allocation vs cost allocation
- Benefit allocation methods (traditional unit credit, projected unit credit) assign a portion of the total benefit to each year of service
- Cost allocation methods (entry age normal, aggregate cost) allocate the total cost of benefits over the employee's career
- Cost allocation methods tend to produce more level costs as a percentage of pay over an employee's career
Individual vs aggregate methods
- Individual methods (traditional unit credit, projected unit credit, entry age normal) calculate costs separately for each employee
- Aggregate methods (aggregate cost) calculate costs for the plan as a whole
- Aggregate methods can be simpler to administer but provide less detailed information
Accrued liability
Definition of accrued liability
- The represents the portion of the total benefit liability attributed to past service
- It is the present value of benefits earned to date based on the actuarial cost method
- The accrued liability is a key component in determining the funded status of the plan
Role in funding methods
- The accrued liability is used to determine the (accrued liability minus assets)
- Funding methods often aim to pay off any unfunded liability over a specified period
- The accrued liability is used in setting the
Normal cost vs accrued liability
- The represents the cost of benefits earned in the current year
- The normal cost plus amortization of the unfunded liability equals the actuarially determined contribution
- The normal cost and accrued liability are both calculated based on the actuarial cost method
Types of actuarial cost methods
Traditional unit credit method
- Assigns the cost of the benefit earned in the current year based on the benefit formula
- Produces an accrued liability equal to the present value of benefits based on service and pay to date
- Can result in rapidly increasing costs as a percentage of pay for older employees
Projected unit credit method
- Similar to the but considers expected future pay increases
- Results in a higher accrued liability and normal cost than the traditional unit credit method
- Produces a more level cost as a percentage of pay over an employee's career compared to traditional unit credit
Entry age normal method
- Calculates the level percentage of pay required to fund the projected benefit over the employee's career
- The normal cost is calculated as a level percentage of pay from entry age to retirement age
- Produces a more stable cost as a percentage of pay compared to unit credit methods
Aggregate cost method
- Calculates the level percentage of pay required to fund the benefits for all employees in the plan
- Does not directly calculate an accrued liability for each employee
- Can be more volatile than other methods if the demographics of the plan change significantly
Attained age normal method
- Similar to the but with the normal cost based on the employee's current age
- Results in a higher normal cost for older employees compared to the entry age normal method
- Less commonly used than other methods
Frozen initial liability method
- Calculates the accrued liability as of a certain date and then "freezes" that portion of the liability
- Normal cost is calculated based on the entry age normal method for benefits earned after the freeze date
- Often used when a plan changes actuarial cost methods
Supplemental costs
Amortization of unfunded liability
- The unfunded liability (accrued liability minus assets) is typically paid off over a specified period
- Amortization methods can be based on a level dollar amount or a level percentage of pay
- The amortization payment is added to the normal cost to determine the total actuarially determined contribution
Actuarial gains and losses
- arise when actual experience differs from the actuarial assumptions
- Gains and losses are typically amortized over a period of time (15-20 years) to reduce volatility in contribution rates
- Actuarial gains reduce the unfunded liability while losses increase it
Changes in actuarial assumptions
- If the actuarial assumptions (, mortality, etc.) are changed, the impact is treated as a liability gain or loss
- The impact of assumption changes is typically amortized over a period of time to reduce volatility
- Assumption changes can have a significant impact on the accrued liability and contribution rates
Actuarial valuation process
Data requirements for valuation
- Participant data including age, service, pay, and benefit elections
- Plan provisions detailing the benefit formula, eligibility, vesting, etc.
- Asset information including market value and cash flow
Actuarial assumptions in valuation
- Economic assumptions such as the discount rate, inflation, and salary scale
- Demographic assumptions such as mortality, retirement, termination, and disability
- The choice of assumptions can have a significant impact on the valuation results
Valuation report components
- Participant data summary and reconciliation
- Actuarial assumptions and methods
- Funded status and funding progress
- Determination of the actuarially determined contribution
- Projection of future contributions and funded status
Funding method selection
Factors influencing method choice
- Plan sponsor goals and risk tolerance
- Workforce demographics and projected cash flows
- Consistency with accounting standards
- Regulatory requirements
Regulatory requirements for funding
- ERISA sets minimum funding standards for private sector plans in the US
- Governmental plans are subject to GASB accounting standards and state and local laws
- Different countries have different regulatory frameworks for pension funding
Funding policy vs accounting policy
- The determines the actual contributions made to the plan
- The determines the expense recognized on the plan sponsor's financial statements
- The funding and accounting policies may differ based on regulatory requirements
Comparison of actuarial cost methods
Impact on contribution levels
- Plans using spread funding (entry age normal, aggregate) tend to have more stable contributions over time
- Plans using terminal funding (unit credit) may have lower contributions initially but more volatile contributions over time
- The choice of actuarial assumptions also impacts the contribution levels
Sensitivity to actuarial assumptions
- Unit credit methods are more sensitive to the discount rate assumption
- Entry age normal and aggregate methods are more sensitive to the salary scale assumption
- Aggregate methods are more sensitive to the demographic assumptions
Intergenerational equity considerations
- Spread funding methods (entry age normal, aggregate) tend to allocate costs more evenly across generations
- Terminal funding methods (unit credit) can result in higher costs for current employees and lower costs for future employees
- The choice of funding method can impact the allocation of costs between generations of taxpayers for public sector plans
Key Terms to Review (28)
Accounting policy: Accounting policy refers to the specific principles, bases, conventions, rules, and practices that an entity selects and consistently applies in preparing its financial statements. These policies help ensure transparency and consistency in reporting, which is crucial for stakeholders who rely on financial information for decision-making. Accounting policies can vary between organizations and can significantly impact the interpretation of a company's financial health and performance.
Accrued Liability: Accrued liability refers to the accounting concept where a company recognizes expenses that have been incurred but not yet paid, typically associated with obligations like pensions and other post-employment benefits. This term is crucial for accurately assessing a company's financial position and determining how much it needs to set aside for future payouts, especially when it comes to funding methods and actuarial cost methods.
Actuarial gains and losses: Actuarial gains and losses refer to the changes in the value of pension plan obligations and plan assets that arise due to differences between expected outcomes and actual outcomes, as well as changes in actuarial assumptions. These variations can occur from shifts in mortality rates, interest rates, or other demographic factors that impact future cash flows. Understanding these gains and losses is crucial for assessing the financial health of a pension plan and determining funding requirements.
Actuarial present value: Actuarial present value (APV) is the current worth of a future cash flow or series of cash flows, considering the time value of money and the probability of occurrence. It incorporates factors such as interest rates and mortality rates to provide a realistic assessment of future liabilities or benefits, making it essential for evaluating pensions, insurance policies, and other financial products tied to life contingencies.
Actuarially determined contribution: An actuarially determined contribution is the amount of money that a pension plan sponsor is required to contribute to the plan, calculated using actuarial methods to ensure the plan remains adequately funded. This contribution takes into account various factors such as the plan's liabilities, the expected investment returns, and demographic factors like employee mortality and turnover rates. It is critical for maintaining the long-term sustainability of retirement plans and ensuring that future obligations can be met.
Aggregate cost method: The aggregate cost method is an actuarial technique used to determine the present value of future pension plan obligations by considering the total expected costs for all participants in the plan. This approach aggregates the individual costs for all participants and focuses on the overall funding requirement of the pension plan rather than the costs for each participant separately. It provides a simplified view of the financial health of pension plans, helping organizations manage their retirement benefits effectively.
Attained Age Normal Method: The attained age normal method is an actuarial funding approach where the cost of benefits is calculated based on an individual's current age, rather than their age at entry into the plan. This method allows for the systematic allocation of costs over time, reflecting the increasing risk and benefit entitlement as members age. It focuses on ensuring that contributions are adequate to fund benefits as members reach various stages in their lives.
Benefit Allocation: Benefit allocation refers to the systematic process of distributing the costs and benefits of a pension or retirement plan among participants, ensuring that each individual receives an equitable share based on their contributions and accrued benefits. This concept is crucial for understanding how financial resources are managed within retirement systems and is intertwined with various funding methods and actuarial cost methods that determine how future liabilities are met.
Changes in actuarial assumptions: Changes in actuarial assumptions refer to the adjustments made to the underlying estimates and predictions that actuaries use to calculate the present value of future cash flows related to insurance, pensions, and other financial obligations. These changes can have significant impacts on funding requirements, reserve calculations, and overall financial health of organizations, especially in the context of funding methods and actuarial cost methods.
Cost Allocation: Cost allocation is the process of identifying, assigning, and distributing costs to various cost objects, such as products, services, departments, or projects. This concept is crucial for determining the actual cost of activities and making informed financial decisions within organizations, particularly in pension plans and insurance settings.
Discount rate: The discount rate is the interest rate used to determine the present value of future cash flows. It reflects the time value of money, accounting for the risk and opportunity cost of capital. A higher discount rate results in a lower present value for future cash flows, which is crucial for evaluating the financial health and obligations of retirement plans and pension funding strategies.
Entry Age Normal Method: The Entry Age Normal Method is an actuarial cost method used to allocate the costs of a defined benefit pension plan over the working lifetime of an employee, ensuring that contributions made are level throughout their career. This method calculates the normal cost as a level percentage of pay from the employee's entry age until retirement, facilitating predictable funding and aiding in determining the overall liability of the plan. Its structure allows for efficient planning and funding of retirement benefits by smoothing the costs across different ages and salaries.
ERISA Regulations: ERISA regulations refer to the Employee Retirement Income Security Act, which establishes standards for pension and health plans in the private industry to protect individuals in these plans. These regulations govern how plans are funded, including requirements for funding methods and actuarial cost methods, ensuring that employees receive promised benefits and safeguarding their rights.
Frozen initial liability method: The frozen initial liability method is an actuarial cost method used to determine the funding requirements for pension plans by assessing the present value of liabilities based on a specific point in time. This approach essentially locks in the initial liability, ignoring any subsequent changes in assumptions or demographics, allowing for a clearer understanding of the funding status at the outset. It serves as a foundational strategy within the broader context of funding methods and actuarial cost methods by establishing a benchmark for future evaluations.
Funding Policy: Funding policy refers to the set of guidelines and strategies that govern how a pension plan manages its financial resources to meet future obligations to participants. It encompasses decisions related to the contribution levels, investment strategies, and the methods used to determine the funding requirements needed to ensure that a pension plan is able to pay out benefits as promised. Effective funding policies are crucial for maintaining the long-term sustainability and financial health of pension plans.
Funding Ratio: The funding ratio is a financial metric that compares the assets of a pension plan to its liabilities, expressed as a percentage. It indicates the financial health of a pension plan, showing whether the plan has enough assets to cover its future obligations to retirees. A higher funding ratio reflects a more secure pension plan, while a lower ratio may signal potential difficulties in meeting those obligations, impacting various aspects such as pension plans and retirement benefits, funding methods, valuation of pension liabilities and assets, and stochastic modeling of pension funds.
GASB Standards: GASB Standards are guidelines established by the Governmental Accounting Standards Board to enhance the transparency and consistency of financial reporting for state and local governments. These standards aim to improve the usefulness of financial statements for stakeholders, ensuring that government entities present their financial information in a clear and understandable manner, which is crucial for informed decision-making regarding funding methods and actuarial cost methods.
Mortality rates: Mortality rates refer to the measure of the number of deaths in a specific population, often expressed per 1,000 individuals per year. They are crucial for understanding the longevity and health trends of a population and are key indicators in assessing risk and financial stability in areas such as funding methodologies, pension liabilities, and insurance contracts.
Normal cost: Normal cost refers to the actuarially determined cost of benefits that are expected to be earned by employees in a given period, typically for a pension plan. It represents the portion of the total pension cost that is allocated to the current service period, emphasizing the importance of recognizing the value of benefits as employees work. This concept is vital for understanding how pensions are funded and managed over time, influencing both defined benefit and defined contribution plans, and impacting funding methods and actuarial cost methods.
Pay-as-you-go: Pay-as-you-go is a funding method where benefits are financed through current income rather than accumulated reserves. This approach requires that contributions or taxes collected in a given period are used to pay for benefits or services provided during the same period. It emphasizes immediate funding and can impact long-term financial stability and planning for future obligations.
Prefunding: Prefunding refers to the practice of setting aside funds in advance to cover future liabilities or expenses, particularly in the context of retirement and pension plans. This approach helps ensure that sufficient resources are available when needed, thereby reducing the risk of underfunding. By using prefunding, organizations can create a more stable financial environment for future payouts and manage costs more effectively over time.
Projected Unit Credit Method: The projected unit credit method is an actuarial technique used to determine the present value of future pension benefits, where the benefits are allocated to each year of service as employees earn them. This method is particularly important for assessing defined benefit pension plans, as it helps calculate the plan's liabilities based on the projected future salary increases and service years.
Sensitivity analysis: Sensitivity analysis is a technique used to determine how the variation in the output of a model can be attributed to different variations in its input parameters. This method is especially relevant in financial contexts, allowing actuaries and decision-makers to assess the impact of uncertainties and assumptions on funding methods and actuarial cost methods. By understanding how sensitive outcomes are to changes in key inputs, organizations can better manage risks and make informed decisions.
Spread Funding: Spread funding is a method used to finance pension plans by gradually allocating contributions over time to meet future obligations. This approach helps manage the financial risk associated with funding pensions, ensuring that there are adequate resources available when benefits are due. By spreading out the funding, it allows for a more stable contribution rate, smoothing out the impact of market fluctuations and demographic changes on the plan's overall financial health.
Stress Testing: Stress testing is a risk management tool used to evaluate the resilience of financial systems and institutions under extreme conditions. It involves simulating adverse scenarios to assess potential impacts on capital, liquidity, and overall financial stability. This technique is crucial for understanding vulnerabilities and ensuring that organizations can withstand severe economic shocks.
Terminal Funding: Terminal funding is a method used in pension plans that involves financing future benefit payments through a lump-sum contribution or a series of contributions made just before the benefits are paid. This approach is designed to ensure that sufficient funds are available to meet the obligations of the plan at the time of benefit payment, often aligning with actuarial cost methods that calculate the present value of future liabilities. Terminal funding aims to reduce financial risks associated with underfunding and to provide certainty in the payment of promised benefits.
Traditional unit credit method: The traditional unit credit method is an actuarial funding approach used to determine the annual cost of a defined benefit pension plan, allocating benefits based on service earned in each year. This method emphasizes that each year of service earns a unit of benefit, which is then projected to determine the total liability of the plan at retirement. It provides a systematic way to calculate how much needs to be set aside each year to ensure that future obligations can be met.
Unfunded liability: An unfunded liability occurs when an organization has promised benefits, such as pension payouts or healthcare, but does not have enough assets set aside to cover those future obligations. This situation highlights a shortfall between the expected future payouts and the current assets available, which can lead to financial challenges and necessitates careful planning and management to ensure these liabilities are met in the long run.