Last updated 1996 Sep 29

Pensions and Cost Methods

Actuarial Aspects | Cost Methods | Actuary's Role | Accounting Chronology | References

Actuarial Aspects

Actuarial Objectives | Financial Dimensions | Cost versus Funding

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Objectives of Actuarial Methods

Financial Dimensions of Pensions

Benefit payments are the peculiar feature of pension and other benefit plans.

The distinction between the three other dimensions is found in other areas of business. For example, a company might have bought a building on January 1, 1982 for $1,000,000 and financed it with a 20 year note at 11% interest, payable in equal annual installments.

The funding would be $125,576 per year. In the first year the payment would be $110,000 interest and $15,576 principal.

If the company chooses straight line depreciation over 40 years, then the accounting cost is $25,000 per year for deprecation. The $110,000 in interest is a cost. It is difficult to quantify precisely how much of the value of the building is used up in any one year. The practical and recognized ways of making the assignment are called depreciation methods. The are a number of depreciation methods accepted in practice.

The related tax deduction would be $120,000 in the first year and $100,000 in the second. The computation comes from the tax law in effect for 1982, namely the ACRS (Accelerated Cost Recovery System) 15 year class. Changing tax laws specify other amounts for buildings put in to service in other years.

Note that all above amounts are different.

Cost versus Funding

Cost is an accounting term related to but different from spending money. Accrual accounting is a method of tracking what we do for other people and what we use up independently of current cash flows. The distinction between charging goods and services on a credit card and actually paying the credit card balance is an example of the distinction between accruing cost and funding the cost.

Accounting Periods

When something is acquired, used up, and paid for all in a short period of time, cost and funding are the same thing. When payment is spread over time, "Cost" divides between cost of the original asset and interest cost.

Cost may be "cash price" or financed cost including interest. Informally we often think of the cost of something as the cash we pay in order to have it. A car dealer may, for example, advertise that a certain model "costs" only $399 a month. For assets with long lives there is the problem of spreading the cost over accounting periods as well as the funding.

Pension Cost Methods

The potentially long time span of a pension plan makes funding in any one year a matter of choices and assumptions as well as computation. All sound funding methods estimate the timing and amounts of benefits to be paid. The various methods differ in how the funding of benefits is spread over time. The two extremes in timing are pay as you go which provides funds only when a benefit is paid and single premium which estimates all future benefits and makes a single payment at the very start of the pension plan.

Classification of Cost Methods

How actuaries and accountants distinguish cost methods.

The first choice is whether to emphasize the contributions made into a plan, that is, the funding, or to emphasize the benefits paid out.

The annual cost of a defined contribution pension plan is the stipulated contribution each year. The defined contribution approach offers simplicity of accounting and the possibility of year to year flexibility for the contributing organization. The benefits to be received can be estimated but are not certain.

A plan intended as an inducement to employees is more attractively [in times of low inflation] presented in terms of a defined benefit. Actuarial funding methods convert estimates of the benefits that will be paid under a plan into an orderly pattern of payments into a separate fund. A distinct method of cost recognition assigns a "financial pension cost" to each year.

The distinguishing features of defined benefit cost methods are:

Definition of benefit portions

Intermediate cost bases used before cost is finally assigned to periods of time

Classification of Cost Methods

Relationships between Cost Methods
Determination of Past Service Liability
Determination of Annual Cost None Unit Credit Entry Age Normal
Indv. Aggr. Indv. Aggr. Indv. Aggr.
Present Value of Specific Benefit UC
Level Dollar over Period of Years ILP ISL EAN
Level Percent of Payroll AGC AAN FIL

Indv. Individual Method
Aggr. Aggregate method
AAN Attained Age Normal
AGC Aggregate Cost
EAN Entry Age Normal
FIL Entry Age Normal with Frozen Initial Liability
ILP Individual Level Premium
ISL ILP with Initial Supplemental Liability
UC Unit Credit

Further Description of Cost Methods

Individual Level Premium

Aggregate Cost

Unit Credit

Individual Level Premium with Initial Supplemental Liability

  • The past service benefits for all participants, defined as in the Unit Credit method, are lumped and spread evenly over a fixed period of years. The current service cost is calculated as in the Individual Level Premium method.

    Attained Age Normal

    Entry Age Normal

    Frozen Initial Liability

    Role of the Actuary in Pensions

    Gathering Actuarial Data

    . What actuaries need to do their work.

    Making Actuarial Determinations

    . What the actuary supplies.

    For small pension plans the minimum, maximum and actuarial cost of the plan are often the same. For large plans the actuarial cost is sometimes a figure between the minimum and maximum which can accommodate the economic circumstances of the sponsoring employer. An actuarial cost method acceptable to the government.

    Pension Accounting Chronology


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