Pensions and Cost Methods

Actuarial Aspects

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

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.

Further Description of Cost Methods

Individual Level Premium

• 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