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

### Objectives of Actuarial Methods

• Estimate future payments for benefits under a plan, both timing and amounts.
• Set forth an orderly and convenient way to provide the funds necessary to make future payments. Orderly ways of providing for future payments are called funding methods or actuarial cost methods.

### Financial Dimensions of Pensions

• benefit payments, cash paid to participants
• funding, cash paid by the sponsors to an investment fund. Benefits are paid from the fund.
• accounting cost, cost assigned under accrual accounting to specific periods of time
• tax deductions, costs recognized on tax returns for specific periods of time

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.

• The "pay as you go" method ignores the possibility of setting aside funds now to pay benefits in the future. This method is banned for private pension plans that receive favorable federal tax treatment. "Pay as you go" is the method used for Social Security, because the system embraces the national economy, and because its benefits are subject to continual revision in the political process.
• Pure "single premium" is so inflexible that it is rarely used. However, any funding payment can be thought of as a sum of single premiums for particular portions of benefits.

### 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

• the total benefit for each individual participant
• the specific amount of benefit accrued in a given year
• initial past service benefit, that is, benefits conferred for service before the start of the plan

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

• a set period of time, say 10 years for amortizing past service cost;
• a varying period of time, such as time from hire to retirement for each plan participant;
• total future salary for all participants.

Classification of Cost Methods

• Accrued versus Projected
• Accrued Benefit methods split the benefit into portions "earned" by the participants each year under the provisions of the particular plan.
• Projected Benefit methods first project what the total of a plan benefit will be, then spread the cost of the benefit over one or more costs bases. There are many such methods. These methods are commonly used when the benefit formula of the plan is in terms of compensation in the final years before retirement.
• Individual versus Aggregate
• Individual cost methods determine the cost of benefit portions for each participant and add up the individual costs to get the cost of the whole plan.
• Aggregate cost methods assign a benefit for all participants as a whole directly to a cost base. Aggregate methods tend to average out the extreme characteristics of any one participant, such as age or salary.
• Level Payment versus Level Percent of Payroll.
• Level Payment methods use a period of years as a cost base, and each year receives an equal amount of cost. The result is similar to constant payments on a insurance policy.
• Level Percent methods use total payroll over a period of time as a cost base. Over that time each dollar of payroll receives an equal amount of cost. That is equivalent to saying that cost is a level percent of payroll.
• Single Benefit versus Separate Past Service Benefit
• Single Benefit methods put all benefits for each individual into one cost pool before allocation to any cost base.
• Separate Past Service Benefit methods regard the total benefit as split into a benefit portion for initial past service and a portion for service after the start of the plan. Flexibility in defining cost is achieved by spreading the cost of each portion over a different cost base. The cost of the past service portion is often referred to as the initial supplemental liability of the plan.

Determination of Past Service Liability Determination of Annual Cost None Unit Credit Entry Age Normal Indv. UC ILP ISL EAN 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

• Also called: Level Cost
• Characteristics
• Individual
• Projected Benefit
• Level Payment
• Single Benefit
• The full benefit for each participant is estimated, for example, \$1,200 a month for life from age 65. The cost base for the benefit is the period of time from the start of the pension plan to when the individual reaches age 65. Each year in that period is assigned the same, that is, level amount of cost.

Aggregate Cost

• Also called: Percent of Payroll method, Remaining Cost method
• Characteristics
• Aggregate
• Projected Benefit
• Level Percentage of Payroll
• Single Benefit
• Under the Aggregate Cost method the benefits of all participants are rolled into one benefit portion. The cost base is the combined future salary of all the participants. The cost of the plan is computed as a level percentage of payroll each year. From year to year the percentage is adjusted so that the remaining cost of the plan incorporates the effect of actuarial gains and losses.

Unit Credit

• Also called: Accrued Benefit method with Supplemental Liability, Single Premium method
• Characteristics
• Individual
• Accrued Benefit
• Specific Payment
• Separate Past Service Benefit
• The cost base for past service benefits is a fixed period of time, generally 10 to 30 years. The initial past service benefit is also known as the supplemental liability of the plan. The current service benefit is further split into the units of benefit "earned" each year. The cost base for each unit of benefit is the year in which it is earned. In effect, a "single premium" is paid each year for the benefit earned.

Individual Level Premium with Initial Supplemental Liability

• Characteristics
• Individual
• Projected Benefit
• Level Payment
• Separate Past Service Benefit
• 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

• Characteristics
• Aggregate
• Projected Benefit
• Level Percentage for normal cost
• Separate Past Service Benefit
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 expressed as a percentage of payroll as in the aggregate method.

Entry Age Normal

• Also called: Individual Level Cost with Supplemental Liability
• Characteristics
• Individual
• Projected Benefit
• Level Payment
• Separate Past Service Benefit
• The cost of the full benefit for each participant is first spread as a level amount each year, from year of hire to year of retirement. In the years from the start of the plan until the individual retires, this amount is called the normal cost. The cost from hire to the start of the plan is then reassigned to a fixed period of time, generally 10 to 30 years. This becomes the supplemental cost.

Frozen Initial Liability

• Characteristics
• Aggregate
• Projected Benefit
• Level Percentage for normal cost
• Separate Past Service Benefit
• The past service benefit for each participant is defined as in the Entry Age Normal Method. The cost of that benefit is spread over a fixed period, generally 10 to 30 years. The current service benefit is what remains after the past service benefit is subtracted. The cost of the current service benefit is called the normal cost of the pension plan.

The normal cost is expressed as a percentage of payroll as in the aggregate method. Actuarial gains and losses for the plan as a whole are reflected in adjustments to the normal cost percentage. The cost of initial past service benefits remains frozen, unaffected by actuarial gains and losses.

## Role of the Actuary in Pensions

### Gathering Actuarial Data

. What actuaries need to do their work.
• Plan Provisions
Census Data
• number of participants
• birth dates
• hire dates
• salaries
• Plan Assets
• conditions in the economy

### Making Actuarial Determinations

. What the actuary supplies.
• turnover
• salary increases
• retirement rates
• mortality
• investment earnings
• Costs
• the minimum annual cost of the plan
• the maximum annual cost of the plan
• the actuarial cost of the plan

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

• 1966 Accounting Principles Board
APB Opinion No. 8
Accounting for the Cost of Pension Plans
• Expense in a given year is defined by an Actuarial Cost Method.
• Underpayment results in a balance sheet Pension Liability.
• Overpayment results in a balance sheet Prepaid Pension Expense.
• Prior Service Costs must be amortized over at most 30 years.
• Changes in experience or assumptions amortized prospectively.
• 1974 U. S. Government
Employee Retirement Income Security Act (ERISA)
Funding Requirements
• 1980 Financial Accounting Standards Board
Statement of Financial Accounting Standards No. 35
Accounting and Reporting by Defined Benefit Pension Plans
• Standards apply if a CPA certifies statements for a plan.
• Nothing new is required of the sponsor of the plan.
• Plan statements include
• Net Assets available for benefits
• Changes in net assets during the preceding year
• Actuarial Present Value of Accumulated Plan Benefits
• Significant factors affecting Actuarial Present Value in the preceding year.
• Recommends showing statements for a series of years.
• Net assets are stated at fair value, market or estimated.
• Accumulated Plan Benefits include those
• for present recipients under the plan;
• for retirees or other beneficiaries;
• vested benefits to current employees;
• unvested benefits.
• Future Benefits are based on current salary levels.
• Contractual cost of living adjustments are included.
• Consistency of assumptions about rate of return and inflation.
• 1985 Financial Accounting Standards Board
Statement of Financial Accounting Standards No. 87
Employers' Accounting for Pensions
• balance sheet recognition
• single cost recognition method
• "explicit" actuarial assumptions
• amortization of past service cost
• 1985 Financial Accounting Standards Board
Statement of Financial Accounting Standards No. 88
Settlements and Curtailments
• Later statements concern non-pension post retirement benefits.

## References

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