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# Chapter 1: Pensions

## Tak Kuen (Ken) Siu

Department of Actuarial Mathematics and
Statistics
School of Mathematical and Computer
Sciences
Heriot-Watt University
Term III, 2006/07

## A pension is an income paid to someone from

the time he/she ceases full time employment
for the rest of his/her life. The pension can
be paid by an insurance company, the worker's
employer and the government. In this chapter,
I will provide an introduction to the concept
of pension funds and the mathematics of pension funds. You will learn the basic underlying
mechanisms of various pension funds and how
to perform simple calculations involving pension benets. More advanced topics and practical details about pension funds will be covered in the fourth year pensions module and
professional examinations. The outline of this
chapter is listed as follows:

Outline of Chapter 1

## Section 1.1: An orientation to pension funds

and their variants
Section 1.2: Valuation of the liabilities
Section 1.3: Valuation by commutation functions
Reference: Part III Pension Funds by M. R
Hardy and M Willder

## Section 1.1: An orientation to

pension funds and their variants

## Question: What is a pension?

A Pension is an income paid to someone
from the time he/she ceases full time employment for the rest of his/her life
Question: Why are pensions important?
 About 40% actuaries work in pensions
 Pension funds account for signicant per-

## Question: Who pays the pension?

 Insurance company: Premiums (e.g. Per-

sonal pensions)

OPS

Pension (BSP))

## Occupational Pension Scheme (OPS):

 Both the employer and the employee

 Deferred pay

## Question: What is the amount of pension

 Same as salary?
 Half of salary?
 A xed amount to employee per annum,

## The size or amount of the pension is related to salary (S). Why?

 Higher wages can aord higher contri-

retirement

## Pensions are typically lower than pre-retirement

wages

Explanations:
 Living costs are lower in retirement (e.g.

o)

## The size of the pension is also related to

years of service (N). How?
 The longer an employee's years of ser-

retirement

NS
= 60

at

## Most occuptional pension scheme (OPS)

targets on two-third of salary

N = 40

years

tirement

40 S = 2 S
= 60
3

at re-

## Question: What are the main benets from

an OPS?
 Age Retirement => Immediate Pension
+

Lump Sum

+

Spouse's Pension

=>

##  Withdrawal from Service

Lump Sum

Deferred
Pension or Return of Contributions
=>

Remarks:
 Pensions are not only paid on age re-

tirement

## Dened Benet Schemes (DBS)

 DBS is an OPS where the benets are

##  Example 1: Pension = 10, 000 per an-

num

N Average Salary
 Example 2: Pension = 80

Current Salary

= 4

## not be known in advance (i.e. random),

but we know how to evaluate it from a
formula

## since the benets are often evaluated

based on salary at retirement

## Dened Contribution Schemes

 Varying benets depending on the value

##  Contributions are xed

 Another name: Money Purchase

Pensionable Salary
 Salary used to calculate the contributions and benets
 Example: Pension salary = Basic salary

##  Final Pensionable Salary: The average

salary received in the three years prior

to retirement

## Section 1.2: Valuation of the

liabilities

Objectives:
 Calculate the amount of money we need

(i.e. reserve)

## need to pay in the future to honor our

promise on the benets (i.e. premiums
or contributions)

 Active (a)

 Active (a)

## Ill-health retirment (i)

 Active (a)

Dealth (d)

 Active (a)

Withdrawal (w)

Service Table
 A multiple decrement table with the decre-

##  Contruct the table for lx,

and
wx, where l is the radix of the table
associated with the entry age

rx, ix, dx

Notation:
 Dier from standard multiple decrement

notation

x

x+t
aa
aa
tpx = lx = tpx

##  Pr( A member retires

| In service at age
r

x+tx+t+1
ar
x) = tpaa
x 1 px+t

= x+t
lx

##  Pr( A member retires through ill-health

x + t x + t + 1 | In
ix+t
ai
= tpaa

p
=
1 x+t
x
lx

service at age x)

##  Pr( A member dies x + t x + t + 1 | In

service at age x) = tpaa

p
1 x+t
x
lx

##  Pr( A member withdraws x+t x+t+1

| In service at age x) =

wx+t
lx

aa
aw
tpx 1 px+t

## Example: Yellow Tables (Page 142); Green

Tables (Page 90)
Remarks:
 Lecture notes and tutorials: Yellow Tables
 Past examination papers: Green Tables
 Examination: Yellow Tables
 In real situations, every scheme is dif-

## Service Table (Yellow Tables, Page 142;

Green Tables, Page 90): Qualitative Analysis
 Withdrawal: Probability is initially high,

## but is very low

Age retirement
 Normal retirement age (NRA) = 65
 Everyone must retire
 Normally retire by age 65
 Early retirement: Allowed from 60 to 65

Salary Scale
 OPS benets are related to salary
 Salaries increase over time due to

1. Ination
2. Promotion
3. Merit
4. Experience
 A promotional salary scale,

sx

is set up

sx+t
sx

Salary Earned x + t x + t + 1
Salary Earned x x + 1
provided that the employee is in service
in the entire period
= E

## 18 and 19 is 18,000. Based on the

salary scale in the Yellow Tables, calculate the expected salary earned between
1. 19 and 20
2. 40 and 41

 Solution:
s18 =
s19 =
s40 =

## 1. The expected salary between 19 and

20 =
2. The expected salary between 40 and
41 =

## Relationship between salary earned and salary

rate
 Salary Earned: The amount paid over a

time interval

payment

and x + t
Z t
0

(Salary

x+1

x and
x + 1/2

##  Example: Suppose the salary rate at

age 30 is 20,000 and salary rate increases by 4,000 at age 30.75. Calculate the salary earned between ages 30
and 31.

 Solution:

=

## Final Pensionable Salary (FPS)

 The scheme rules will specify the pen-

or past salaries

sx2 + sx1)



y = Age

at retirement



x = Current

n=3

x1x

age

 Then,
=

Expected FPS
!
sy1
sy2
sy3
1
SAL
+ SAL
+ SAL

SAL

sx1

zy

sx1

sx1

sx1

## Section 1.3: Valuation by

commutation functions

## A quick review of commutation functions

 Invented in the 18th century
 Simplify the calculation of numerical val-

##  Popular tool for premium calculations in

a deterministic model

## velopment of powerful computers and

insurance models based on probability
theory

 Life annuities
Dx = v xlx

survivors

= Discounted number of

Nx = Dx + Dx+1 + Dx+2 . . .

## Recall that ax = DNxx

Sx = Dx + 2Dx+1 + 3Dx+2 = Nx +
Nx+1 + Nt+2 + . . .

## Recall that (Ia)x = DSxx

 Life insurance
Cx = v x+1dx

deaths

= Discounted number of

Mx = Cx + Cx+1 + Cx+2 + . . .
Rx = Cx +2Cx+1 +3Cx+2 + = Mx +
Mx+1 + Mx+2 + . . .

x
Recall that Ax = M
Dx and that (IA)x =

Rx
Dx

## Valuation of past and future service

 Accruals basis: Account for the benets

paid

## 1. Past service accrual

2. Future service accrual
 Example: An OPS provides a pension of

FPS for each year of service. Suppose a member joined this scheme aged
x and he is now aged y . Assume the
NRA is 65. What is the member's
1. past service pension ?
1
60

## 2. future service pension ?

 Solution:

Past Service = y x
The member has already earned a pension of yx
60 FPS, which is payable
from age 65
Suppose the future service is F
Then, the member will earn a pension
F FPS, where y + F is the age
of 60
when the member leaves the service
or scheme
Note that F

[0, 65 y]

## Final Average Salary Schemes: Age Retirement

 FPS is the average salary earned in the

## 1 (i.e. Benets of 1 FPS

 Accrual = 60
60
is earned each year for each year of ser-

vice)

 Member
x =
n =

SAL
NRA

Current age
Past service
Salary earned

= 65

 General rule:

## The expected present value (EPV) of

past service benets paid in year t t+

1 (t < 65 x)
Discount

= Amount Probability

##  Suppose exits occur half-way through

the year

n SAL zx+t+0.5
 Past service pension = 60
sx1

## service pension arx+t+0.5

 Probability

= x+t
lx

 Discount factor

x+t+0.5
= v t+0.5 = v v x

 Therefore,
!

EP V

zx+t+0.5
n
SAL
=
60
sx1
!
r

arx+t+0.5 x+t
lx
!
v x+t+0.5
vx
z C ra !
n
x+t
=
SAL
,
60
sx1Dx

## where z Cyra = zy+0.5 ary+0.5 ry vy+0.5

and Dx = vxlx by the convention of
commutation functions

## Summary: EPV of past service benets

paid on retirement at age x + t
 When

x + t < 65,
!

EP V

 When

z
n
SAL x+t+0.5
60
sx1
!
rx+t
r

ax+t+0.5
lx
!
x+t+0.5
v
vx
z C ra !
n
x+t
=
SAL
60
sx1Dx

x + t = 65,
!

n
z65
EP V = =
SAL

ar65
60
sx1
!
!
65
r
v
65
lx
vx
!
z
ra
C65
n
=
SAL
,
60
sx1Dx

ra = z
where z C65
ar65 r65 v 65
65

Remarks:
 Retirement at age 65 is at the exact age
 Retirement before age 65 occurs at age
x + t + 0.5

## EPV of past service benets paid on retirement at ANY future time

 Equal to past service liability

P

65x z ra !
Cx+t
t=0

n
SAL
60
sx1Dx
!
z
ra
Mx
n
=
SAL
,
60
sx1Dx

## z C ra by the conwhere z Mxra = P65x

t=0
x+t
vention of commutation functions

## age x, namely SAL , is given. What is

the formula for the past service liability?

 Solution:

## Past service liability

=

Future service
 Retirement can occur at any age y, where
x < y 65

1,
x+ 2

year's benet

1
2

one

 Then,
=

## EPV of one "year's accrual

!
z
64
1
X
y+ 2
1

ar 1
SAL
y+
60

y=x
y+ 1 !

sx1
!
z
1
1 x+

ry
v 2
r
2

a
1
x+ 2
lx
vx
2 sx1
!
!
!
1
z65
rx
r65
r
2
v +

a65
lx
sx1
lx
#

v 65x
=

SAL

where

P64 z ra
1 z C ra + z C ra !
C

y=x
y
x
65
2

60
s
Dx
!
! x1
!
1
1
z Mxra z Cxra

60
sx1Dx
2
z M ra = P65 z C ra
x
y=x
y

SAL

 Write

zM
xra = z Mxra 1 z Cxra
2

 Then,
=

! accrual
1
SAL
ra

zM
60

sx1Dx

## (i.e. Age x, x + 1, . . . , 64)

 Hence,

FSL

64x
X
SAL
1
zM
ra
x+t
=

60
sx1Dx
t=0
!
1
SAL z Rra ,
=

x
60
sx1Dx

zM
ra
where z Rxra = P64x
t=0
x+t

## is the sum of Mx, Mx+1, . . . , M64 since

the nal year of accrual is the year from
age 64 to 65

Rx

## Example: Suppose x = 40; SAL = 30, 000;

n = 10. Calculate the past service liability
(PSL) and the future service liability (FSL)
for age retirement using the Yellow Tables
with 4% rate of interest
Solution:
PSL =
FSL =

Ill-health retirement
 The EPV of past service benets paid

in year t t + 1
!

z
n
SAL x+t+0.5
aix+t+0.5
60
sx1
!
ix+t
v t+0.5

lx
!
z C ia !
n
x+t
=
SAL
60
sx1Dx

## where aiy = EPV of ill-health pension of

1 per annum from age y
 Then,
!

P64x z ia !
Cx+t
t=0

n
SAL
60
sx1Dx
!
!
z
ia
n
Mx
=
SAL
,
60
sx1Dx
where i65 = 0
P SL =

 Also,
F SL
z M ia 1 z C ia !
64x
X
1
x+t
x+t
2
SAL
=
60
sx1Dx
t=0
P64x z ia !

M
t=0
x+t

1
=
SAL
60
sx1Dx
!
z
ia
x
R
1
SAL
=
60
sx1Dx

## Non-Salary Related Schemes: Ill-health Retirement

 Pension of P per year of service per

annum

tt+1

ix+t
i
= nP
ax+t+0.5
lx
ia !
Cx+t
= nP
Dx

v t+0.5

P SL = n P
= nP

ia !
64x
X Cx+t
t=0 Dx
!
ia
Mx

Dx

F SL = P
= P

ia 1 C ia
Mx+t
2 x+t

64x
X
t=0
!
ia
x
R

Dx

Dx

## Lump Sum of L per year of service



Cyi = iy v y+0.5

Mxi
P SL = n L ( Dx )

xi
R
F SL = L ( Dx )

(Why?)

(Why?)

Age retirement
 If

y < 65 Cyra = v y+ 2 ry
ar 1
y+ 2

 If

ra = v 65 r
y = 65, C65
ar65
65

P SL = n
= n

65x
X

ra + LC r
P Cx+t
x+t

Dx
t=0
!
ra
r
P Mx + LMx
Dx

F SL =
=

64x
X

ra + LM
r
PM
x+t
x+t

Dx
t=0
xra + LR
xr
PR
Dx

## Pension per annum

1
=
Total Salaries in Service
60
1
=
Career Average Salary Service
60

x0 =

P SAL =

P SL =

## P SAL Mxia + Mxra

60

Future Service:
 Ill-health
 Age retirement

Dx

Ill-health
 EPV of future service benets accrued
in ANY future year
X SAL
1 64x
=
sx + sx+1 + +
60 t=0 sx1
!

ix+t
1
i
ax+t+0.5
sx+t1 + sx+t
2
lx
v t+0.5
=

SAL

64x
X

60sx1Dx t=0

ia
Cx+t
sx + sx+1 +

1
+ sx+t1 + sx+t
2

 Summation
!

1 ia
ia + + C ia
= sx Cx + Cx+1
64
2
!
1 ia
ia + + C ia
+ Cx+2
+ sx+1 Cx+1
64
2
!
1 ia
+ + s64 C64
2
=
=

64x
X
t=0
64x
X

ia
x+t
sx+tM
sM
ia = s R
x+t
xia

t=0

 Hence,

SAL
F SL =
60

sR
xia

sx1Dx

##  Similarly for age retirement

Age retirement:

SAL
F SL =
60

sR
xra

sx1Dx

Contributions:
 The employer (and often the employee)

## will pay contributions (or premiums) to

the pension fund

 Salary-Related Contributions:
k = Contribution

as a percentage of salary

##  EPV of future contributions

64x
X

sx+t
k
SAL
100
t=0 sx1
!
!
x+t+0.5
lx+t+0.5
v

lx
vx
!

k
SAL
100
!

=
=

P64x
t=0 sx+tDx+t+0.5
sx1Dx
P64x
x+t
sx+tD
t=0

sx1Dx
P64x s
x+t
D
t=0

sx1Dx
sN
x

k
SAL
100
!

k
SAL
100
!
k
SAL
100
sx1Dx

Fixed Contributions
F = Contribution payable continuously (
per annum)

= F

64x
X
t=0 !

lx+t+0.5
lx

v x+t+0.5

vx

x
N
= F
Dx

## can be found from Yellow Tables, Page

143

x
N

Return of Contributions
 On death or withdrawal, a return of employee contributions accumulated with

P SL =

k
ASAL
100

j M w +j M d
x
x
(1 + j)xDx

##  Future Service Liability:

F SL =

k
SAL
100

sj R
xw + sj R
xd
(1 + j)xDx

 Check Yellow Tables, Pages 148 149, Page 148 for death and Page
149 for withdrawal, accumulated in-

## terest rate j = 2% p.a. and discount

interest rate i = 4% p.a.

i = 4%

p.a.

## Class Work: Suppose x0 is the entry age;

x is the current age; PSAL is the salary
earned from x0 to x; RATE is the salary
rate at x. Derive suitable commutation
functions to value an ill-health pension of
1 average salary over member's career,
60
per year of service

Hints:
 Construct a service table
 Dene a promotional salary scale
 Evaluate the EPV of past service bene-

End of Chapter 1