Pension Plans: Understanding the Actuarial Methods and Assumptions

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In order to provide managers of state and local governmental entities with useful information, accountants must be able to communicate with actuaries concerning pension plans. This requires a basic understanding of the models and assumptions that follow in this article. With this understanding, accountants and managers should appreciate that issues such as low required contributions in the initial years may necessitate much higher contributions in later years, or that a low amortization cost could lead to an endless amortization cost. Thus, the political decision to initiate, continue or change benefits in a pension plan should be made with a full grasp of the current and future cost implications. The complex issue of determining the annual pension cost should be addressed by a broad group of interested parties including accountants and not left to the determination by a single viewpoint.

November of 1994 marked the completion by the Governmental Accounting Standards Board (GASB) of its major project on pension benefits.' Three standards resulted from this activity: Statement 25 dealt with the financial reporting and related notes for defined benefit pension and contribution plans; Statement 26 addressed post-retirement health care plans administered by defined benefit pension plans; and Statement 27 looked at accounting for the employer's cost of participating in a pension plan. These pronouncements will change existing financial reporting and lay the foundation for acceptable methodologies regarding actuarial cost methods and assumptions for public sector defined benefit pension plans.

Providing retirement income, exclusive of social security, for employees is a common practice in both the public and private sector. Money is set aside in a trust to accumulate for the future use of the employees when they retire. When a qualifying event occurs, the employee is eligible to receive their benefits from the trust. Payments usually take the form of either a defined monthly payment or a lump-sum distribution. The qualifying event is always retirement as defined by the pension plan but may also be death, disability or termination depending on the benefits incorporated in the plan. The method of determining the employee's benefit depends on the retirement income arrangement.

The plan may either:

set a methodology to have contributions on a specified basis to the trust each year, or provide a stream of income from the trust to the retirees based on a stated formula.

In the first case, the plan sponsor is obligated to provide specific inputs to the trust, while under the second, the plan sponsor is obligated to insure that the trust has sufficient funds to payout a stream of benefits. The first arrangements are called defined contribution plans and include 403(b) and 457 arrangements in the public sector. These plans provide an individual account for each participant. Employee benefits are solely determined by the amount that is contained in their account. Accounts increase by employer and, sometimes, employee contributions plus any income earned on the account. The sponsor's financial obligations are met with the payment of the stated contribution on the specified basis.

Contrasting this arrangement is the defined benefit plan, which provides a formula-based stream of income for the retiree. There are no individual participant accounts but the retirees draw on the funds in the trust to provide their defined benefits. Many different formulas are available to determine the benefit. For example, the formula could state that a participant will receive $40 times the number of years worked per month. If a plan member retired with 30 years of employment, they would receive $1,200 ($40 times 30 years) per month for life. Stream of income benefits can also be based on a percentage of income per year employed times salary (2% times years employed, times average final three-year monthly salary). …