Types of Funding Methods
Funding methods determine how a defined benefit pension plan finances the benefits it has promised. The choice of method directly affects when contributions are made and how large they are, so understanding the trade-offs is essential.
Pay-as-You-Go vs. Prefunding
Pay-as-you-go funding makes no advance provision for future benefits. The plan simply pays benefits as they come due, drawing from current revenue. This keeps early contributions low but creates serious risk: if the sponsor's financial position weakens, benefit payments may be in jeopardy.
Prefunding accumulates assets in advance of when benefits are paid. The key advantage is that investment income on those accumulated assets helps cover future benefit payments, reducing the total contributions the sponsor needs to make over time. Prefunding also strengthens benefit security because assets are set aside and (in most jurisdictions) legally protected for participants.
Terminal vs. Spread Funding
- Terminal funding aims to have the full present value of a participant's benefit funded at a specific point, typically at retirement. Contributions can be uneven over time.
- Spread funding distributes contributions more evenly across the funding period, often as a level percentage of payroll. This produces more predictable year-to-year contribution requirements.
Spread funding is generally preferred when contribution stability matters, while terminal funding may result in lower early contributions at the cost of higher and more volatile later ones.
Characteristics of Actuarial Cost Methods
Actuarial cost methods are the mathematical frameworks that determine how much a plan owes (the accrued liability) and how much it should contribute each year (the normal cost). Two major classification axes apply.
Benefit Allocation vs. Cost Allocation
Benefit allocation methods (traditional unit credit, projected unit credit) assign a specific portion of the total projected benefit to each year of service. The normal cost for a given year equals the present value of the benefit increment attributed to that year.
Cost allocation methods (entry age normal, aggregate cost) take the total present value of projected benefits and spread it over the employee's career, typically as a level percentage of pay. These methods tend to produce smoother costs over time because they don't tie each year's cost to the specific benefit accrued that year.
Individual vs. Aggregate Methods
- Individual methods (traditional unit credit, projected unit credit, entry age normal) compute costs separately for each plan participant. This gives detailed, participant-level information.
- Aggregate methods (aggregate cost) compute a single contribution rate for the entire plan. They're simpler to administer but provide less granular insight into individual liabilities.
Accrued Liability
Definition
The accrued liability (sometimes called the actuarial liability) is the present value of benefits attributed to service already rendered, as measured under the chosen actuarial cost method. It represents what the plan "should" have in assets right now to be on track for the benefits earned to date.
Role in Funding
The accrued liability is central to assessing a plan's financial health:
- Unfunded liability = Accrued Liability − Plan Assets
- Funding methods typically require the sponsor to amortize (pay off) any unfunded liability over a specified period.
- The actuarially determined contribution is built from the normal cost plus any amortization payment on the unfunded liability.
Normal Cost vs. Accrued Liability
These two quantities work together but measure different things:
- The normal cost is the cost of benefits being earned this year under the chosen method.
- The accrued liability is the cumulative present value of benefits earned in all prior years.
- Together: Actuarially Determined Contribution = Normal Cost + Amortization of Unfunded Liability.
The specific values of both the normal cost and accrued liability depend on which actuarial cost method is used.
Types of Actuarial Cost Methods
Traditional Unit Credit (TUC)
The normal cost equals the present value of the benefit increment earned in the current year, based on the benefit formula using current salary and service. The accrued liability equals the present value of all benefits earned to date, again based on current salary.
Because benefits tied to salary grow as employees age and earn more, the normal cost as a percentage of pay tends to increase over time, especially for older employees. This makes TUC a poor choice if contribution stability is a priority.
Projected Unit Credit (PUC)
PUC works like TUC but uses projected salary at retirement rather than current salary when valuing each year's benefit increment. This front-loads costs relative to TUC because each unit of benefit is valued at a higher salary level.
The result:
- Higher accrued liability and normal cost than TUC at any given point
- A more level cost as a percentage of pay over an employee's career
- This is the method required under IAS 19 (international accounting standard for employee benefits)
Entry Age Normal (EAN)
EAN calculates the level percentage of pay that, if contributed from the employee's entry age to retirement, would exactly fund the projected benefit. The normal cost is that level percentage applied to current pay.
- Produces the most stable contribution pattern of the individual methods
- The accrued liability equals the present value of projected benefits minus the present value of future normal costs
- Widely used for governmental plans in the U.S. and is the most common method for GASB reporting
Aggregate Cost Method
Instead of computing individual liabilities, the aggregate method calculates a single contribution rate for the entire plan. It takes the present value of future benefits for all participants, subtracts current assets, and spreads the remainder over future payroll.
- Does not separately identify an accrued liability (the unfunded liability is implicitly zero by construction each year)
- Can become volatile if plan demographics shift significantly (e.g., a wave of retirements)
- Simpler to administer than individual methods
Attained Age Normal
This method is similar to EAN but recalculates the level percentage of pay starting from the employee's current age rather than entry age. Because there's less time remaining to fund the same projected benefit, the normal cost rate is higher for older employees than under EAN. It's less commonly used in practice.
Frozen Initial Liability (FIL)
FIL is a hybrid approach, often used during a transition between actuarial cost methods:
- Calculate the accrued liability as of a specific date and "freeze" it.
- For benefits earned after the freeze date, compute normal costs using the entry age normal method.
- Amortize any difference between the frozen liability and plan assets separately.
This method smooths the transition when a plan changes its actuarial cost method.
Supplemental Costs
Amortization of Unfunded Liability
When plan assets fall short of the accrued liability, the unfunded liability must be paid off over time. Two common amortization approaches:
- Level dollar: Fixed dollar payments each period (like a mortgage). Payments are higher as a percentage of payroll early on and decline over time.
- Level percentage of pay: Payments grow with payroll. Payments start lower but increase in dollar terms, which can defer more cost into the future.
The amortization payment is added to the normal cost to produce the total actuarially determined contribution.
Actuarial Gains and Losses
Gains and losses arise whenever actual experience deviates from assumptions. For example, if investment returns exceed the assumed discount rate, that's an actuarial gain; if a large number of participants retire earlier than expected, that could be a loss.
- Gains reduce the unfunded liability; losses increase it.
- To prevent wild swings in contributions, gains and losses are typically amortized over 15 to 20 years rather than recognized immediately.
Changes in Actuarial Assumptions
When assumptions like the discount rate, mortality table, or salary scale are updated, the resulting change in accrued liability is treated as an actuarial loss (if liability increases) or gain (if it decreases). These changes are also amortized over time to smooth their impact on contributions. Even small assumption changes can have large effects: for example, a 50-basis-point decrease in the discount rate can increase accrued liabilities by 10% or more for a mature plan.
Actuarial Valuation Process
Data Requirements
Every valuation starts with three categories of data:
- Participant data: age, service, compensation, benefit elections, and status (active, terminated vested, retired)
- Plan provisions: the benefit formula, eligibility rules, vesting schedule, early retirement subsidies, and any recent amendments
- Asset information: market value of assets, asset allocation, and cash flow data (contributions in, benefits out)
Actuarial Assumptions
Assumptions fall into two groups:
- Economic: discount rate, price inflation, wage inflation / salary scale, and expected return on assets
- Demographic: mortality rates, retirement rates, termination (turnover) rates, and disability incidence
The discount rate is typically the single most influential assumption. A higher discount rate reduces the present value of liabilities; a lower rate increases it. Mortality assumptions have grown increasingly important as life expectancy continues to rise.
Valuation Report Components
A complete actuarial valuation report typically includes:
- Summary and reconciliation of participant data
- Description of actuarial assumptions and methods used
- Funded status (accrued liability vs. assets) and funding progress over time
- Calculation of the actuarially determined contribution
- Projections of future contributions and funded status under various scenarios
Funding Method Selection
Factors Influencing Method Choice
- Sponsor goals: Does the sponsor prioritize contribution stability, lower near-term costs, or faster funding?
- Workforce demographics: A younger workforce favors spread methods; an older or shrinking workforce may make aggregate methods volatile.
- Accounting standards: The method used for financial reporting may differ from the method used for funding.
- Regulatory requirements: Applicable laws may mandate or restrict certain methods.
Regulatory Requirements
- In the U.S., ERISA sets minimum funding standards for private-sector plans, and the Pension Protection Act of 2006 further tightened these rules.
- U.S. governmental plans follow GASB standards (Statements 67 and 68), which require the use of the entry age normal method for financial reporting.
- Other countries have their own frameworks (e.g., the UK Pensions Regulator, Canadian federal and provincial pension legislation).
Funding Policy vs. Accounting Policy
These are distinct concepts that students often conflate:
- The funding policy governs actual cash contributions to the plan trust.
- The accounting policy governs how pension expense and liability appear on the sponsor's financial statements.
- They can use different actuarial cost methods, different assumptions, and different amortization periods. For example, a U.S. public plan might fund on an EAN basis but report accounting expense under GASB using the same method with a different discount rate.
Comparison of Actuarial Cost Methods
Impact on Contribution Levels
- Spread methods (EAN, aggregate) produce more stable contributions over time because costs are leveled across the employee's career.
- Unit credit methods (TUC, PUC) may produce lower contributions when the workforce is young but increasingly higher contributions as employees age.
- Contribution levels are also heavily influenced by the actuarial assumptions chosen, not just the method.
Sensitivity to Assumptions
Different methods respond differently to assumption changes:
- Unit credit methods are particularly sensitive to the discount rate because the accrued liability is a direct present value of earned benefits.
- EAN and aggregate methods are more sensitive to the salary scale assumption because projected salaries drive the total benefit being funded.
- Aggregate methods are also more sensitive to demographic shifts since they pool all participants together.
Intergenerational Equity
This concept asks: are the costs of pension benefits shared fairly across different generations of contributors (taxpayers, in the public sector)?
- Spread methods (EAN, aggregate) allocate costs more evenly over time, which tends to be more equitable across generations.
- Unit credit methods can shift costs toward later generations if contributions are back-loaded as the workforce ages.
- For public-sector plans, intergenerational equity is a significant policy concern because today's taxpayers shouldn't bear a disproportionate share of costs for benefits earned by past employees, and vice versa.