Chapter 2 – Financial Management of

Pension Plans
As discussed in Chapter 1, a defined benefit (DB) pension plan promises to pay a pension benefit to an
employee based on a formula linked to the employee's length of service and salary, and other factors
such as inflation and spousal status at retirement. Sponsors of such plans, which may include
employers, employees or both, are effectively insurers with obligations to fund payouts with a present
value that will typically not equal the market value of the plan assets at any point in time. Annual
accruals of benefits will typically be different in value from the contributions made. Thus, DB plans
have balance sheets consisting of assets, liabilities and accumulative surpluses and deficits at different
points in time.

On the other hand, the benefits provided under a defined contribution (DC) pension plan are like
current compensation because an employer’s annual contribution fulfils its funding obligation for that
year. DC pension assets always equal liabilities: participants’ retirement incomes will come entirely
from contributions and investment income accumulated in their accounts. With DC plans, there are
no pension-related gains and losses, or outstanding assets and obligations, for a sponsor to report.

The purpose of this chapter is to give an overview of the financing issues related to DB pension plans
and to acquaint the students with the factors that affect the ultimate cost of a pension plan, apart
from the specific plan provisions. Particular reference is made to the actuarial assumptions and cost
methods that are used to estimate a plan's obligations and annual cost of benefits.

2.1 Pension Financing

The only way to determine the true cost of a pension plan would be to wait until the last retired
participant dies, add up all the benefit payments and administrative expenses that have been paid
since the inception of the plan, and subtract the investment earnings of the pension fund. However,
this ultimate cost is not known while the plan continues in operation.

Employers of ongoing pension plans are concerned with two financing issues, namely, funding and
accounting.

2.1.1 Funding
Funding of a pension plan is to estimate the periodic contributions that are required to meet the
benefit obligations under the plan. Generally, it involves the creation of a pension fund held by an
outside third party, such as a trust or insurance company. The fund receives the employer’s
contributions (and the employee contributions, if applicable), earns investment incomes, and pays
out the benefits promised by the plan as they become due.

Over time, contributions plus investment returns from the pension plan assets must be sufficient to
meet the benefits promised and the expenses paid under the pension plan. Actuaries estimate the

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cost of the plan using reasonable actuarial assumptions, arriving at a level of estimated plan
contributions to be paid over the life of the plan.

So how does the actuary make an estimate of the cost of a pension plan? The first step is to estimate
the various components of the cost, which are the expected benefits and expenses, and the expected
return from pension fund investment. The estimate of the benefits expected to be paid depends on
three things: the benefit provisions of the plan; the plan participants’ characteristics (i.e., age, gender,
salary, and length of service, etc.); and the actuarial assumptions used to project the amount and
timing of future benefit payments. The benefit provisions and characteristics of plan participants are
unique to a plan being valued, while the actuarial assumptions are typically selected by the actuary
who performs the valuation of a plan.

Once the expected cost of a plan is estimated, the next step is to determine the contributions that are
required to pay off the estimated cost in an orderly and rational manner. For this purpose, actuaries
have developed different actuarial cost methods to allocate the cost to various years of employees’
service. We will discuss some commonly used cost methods in later chapters.

2.1.2 Accounting
Accounting is to determine the annual pension expense to be recorded on the employer’s financial
statement. Accrued pension expenses (net of fund assets) are recognized as a liability on the
employer’s financial statement.

In the US, pension accounting is subject to the generally accepted accounting principles (GAAP)
established by its accounting professional body. Most countries including Canada have now adopted
the International Financial Reporting Standards (IFRS). Pension accounting rules require the cost
associated with a pension benefit to be recognized by the employer as that benefit is earned by an
employee.

The amount of funding contributions and pension expense may sometimes be referred to as the "cost"
of a pension plan but they represent two different concepts. The funding contributions represent a cash
outlay to be made by the employer, whereas the pension expense is an expense (or income) item which
decreases (or increases) the employer’s reported earnings. Both are calculated using actuarial
principles and assumptions, but the rules for calculation are very different.

2.2 Budgeting Pension Costs

As discussed in the preceding section, funding of a pension plan is concerned with determining the
amount and timing of contributions to be made by the employer (and employees if applicable) to meet
the benefits that are promised or targeted under the plan. There are three possible approaches to
funding a pension plan:

• Pay-as-you-go (PAYGO) funding - no assets are set aside and the benefits are paid for by the
employer as and when they fall due

• Terminal funding – an arrangement under which lump sum contributions are made to fully
pay the benefits to members upon their cessation of employment

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 • Advance funding (or pre-funding) – an arrangement where contributions are made to and
accumulated in a fund ahead of the payment of pension benefits

2.2.1 Pay-As-You-Go Funding

Under the pay-as-you-go (PAYGO) approach, the employer pays each retired employee's monthly
pension as each payment becomes due. There is no accumulation of funds in a trust or through a
contract with an insurance company.

If benefit payments are monitored, the employer’s pension outlay begins with the retirement of the
first eligible employee (assuming there are no benefits payable before retirement). The outlay would
move upward with each new retirement and downward with the benefit ceasing upon the death of
each retiree. The outlay for a typical open group plan is very likely to show an increasing tendency
over time, for some or all of the following reasons:

• Number of pensioners is small in the early years of a plan’s existence but will increase as the
plan becomes more mature.
• Benefits under a pension plan may be improved over time.
• If pensions are related to earnings, earnings increases are likely to cause pensions to increase.
• A pension plan may provide inflationary adjustments to pensions in pay.

Difficulties

Pay-as-you-go is clearly the simplest and most straightforward financing method, but there are two
important difficulties:

Budgeting of employer pension costs

According to the accrual accounting principle generally followed in business practices,
expenses should be reflected on the employer’s books when those expenses are incurred.
Employer contributions made to a pension plan are closely linked to salaries and wages,
representing in the minds of many, a form of deferred compensation. Pensions should
therefore be charged over employees' periods of employment, rather than over the periods
after retirement.

Pay-as-you-go funding charges too little against the early years of a plan’s operation, and
hence too much against future years. There is a tendency for employer contributions to
increase over time, causing difficulties to employer’s budgeting for cash allocation between
funding pension benefits and funding other business activities in future times.

Security of benefits
The second difficulty with pay-as-you-go funding is the dependence of the payment of
benefits upon the continued willingness and ability of the employer to pay, since there is no
fund set aside to secure the benefits.

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2.2.2 Terminal Funding
Under this funding approach, the employer pays a lump-sum amount sufficient to provide the
promised benefit as each employee retires. Like the pay-as-you-go approach, it does not require the
employer to make any contributions on behalf of employees who are still in employment.

The retirees’ benefits can be funded through the purchase of single-premium annuities from insurance
companies, or the employer can transfer the estimated amount for the payment of benefits to a
separate trust. The cost to the employer will tend to vary widely year to year, since employees’
employment pattern is usually irregular and difficult to predict.

Both the pay-as-you-go approach and terminal approach are no longer permitted by pension
legislation for tax-qualified pension plans in the U.S. and Canada. However, a knowledge of them
should provide a better basis for understanding why advance funding is required by law, as discussed
below.

2.2.3 Advance Funding

Under the advance funding approach, the employer (and the employees in the case of a contributory
plan) would set aside funds on a systematic basis prior to employees' retirement. Periodic
contributions are made to a pension fund on behalf of the group of active employees during their
working years.

Advance funding is at least a partial solution to the PAYGO and terminal funding problems:

• To the extent employer’s contributions fit with the principles of good accounting, the budgeting
problem is addressed. Accounting principles require pension costs be recognized over the years
that the employees render their services, regardless of when the benefits are ultimately paid.
• Funding creates a pool of assets which is available to secure the promised benefits and which are
not subject to claims from the employer’s creditors in the event of employer bankruptcy. Advance
funding therefore increases the likelihood that the pension plan promise will be kept.
• If a pension plan is not pre-funded, the recognition of accounting costs will ultimately lead to a
large accrued pension expense (i.e., liability), with no offset from pension fund assets, in the
employer’s financial statements. This could potentially impair the employer’s credit rating and
affect its ability to secure financing for other business purposes. When the pension is pre-funded,
the accumulated funding contributions would offset this build-up of liability, either fully or
partially.

There are other reasons for prefunding a pension plan:

• Prefunding for pension plans may be required by law. Many countries have introduced regulations
requiring pension plans to hold a prescribed level of assets against their liabilities, usually as a part
of consumer protection legislation aimed at ensuring that a minimum level of security is afforded
to plan participants.
• The relatively even distribution of annual pension costs under some cost methods produces a
more stable allocation of the employer’s cash outlay over time. It provides the employer with a
means to managing its cash resources, and avoids the situation where the contribution
requirements spiral out of control as the plan matures.

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• To encourage citizens to save for their retirement and not relying on the government to look after
them in old age, many countries provide significant tax incentives to the employers (and/or
employees) for establishing and funding a pension plan. These tax incentives can apply to pension
contributions and/or benefits, or to qualified investments held within the pension plan.
• Pre-funding reduces or eliminates the transfer of costs between different generations of
employees, shareholders, taxpayers or other stakeholders, thereby enhancing intergenerational
equity.

Under advance funding the actuary uses a set of assumptions and an actuarial cost method to estimate
the annual cost of benefits provided under a pension plan. Annual contribution requirements are then
based on these estimated annual costs. There are several actuarial cost methods, each producing
different patterns of cost accruals for a plan. However, it should be noted that the choice of a
particular actuarial cost method will not affect the ultimate cost of the plan. One important exception
to this assertion is that if a chosen actuarial cost method produces higher initial contributions than
other methods, then the asset accumulation will be greater in the early years of a plan, with a potential
of greater investment incomes to be earned (assuming a positive rate of return to be earned over the
long term). An increase in investment earnings will reduce the ultimate cost that is required to be paid
by the employer.

A rational actuarial cost method (also known as a "funding" method) should enable the orderly
accumulation of assets over an employee’s career to match the liability at the date the employee
retires. It is helpful to keep in mind that the choice of a specific actuarial cost method may be
influenced by the degree of flexibility desired by the employer in annual contribution payments and
the cash flow requirements of the employer’s business.

2.3 Basic Actuarial Functions

The following three basic functions are essential elements of the pension cost models studied in later
chapters:

• The composite survival function

• The interest function
• The annuity function

2.3.1 Composite survival function

The composite survival function gives the probability that an active employee survives in active
employment for a given period, based on all of the decrements to which the employee is exposed. In
a single-decrement environment such as mortality, the probability of surviving one year is equal to 1
′(𝑑) ′(𝑑)
minus the rate of death, e.g., 𝑝𝑥 = 1 − 𝑞𝑥 . In a multiple-decrement environment, the probability
of surviving one year is equal to the product of such complements for each applicable rate of
decrement. For example, in a 3-decrement environment,

(𝑇) ′(𝑑) ′(𝑤) ′(𝑟) ′(𝑑) ′(𝑤) ′(𝑟)

𝑝𝑥 = (1 − 𝑞𝑥 ) (1 − 𝑞𝑥 ) (1 − 𝑞𝑥 ) = 𝑝𝑥 𝑝𝑥 𝑝𝑥 (1)

where the superscripts 𝑑, 𝑤 and 𝑟 represent death, withdrawal and retirement, respectively.

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Another expression for the probability of surviving one year in the multi-decrement case is:

(𝑇) (𝑑) (𝑤) (𝑟)

𝑝𝑥 = 1 − [𝑞𝑥 + 𝑞𝑥 +𝑞𝑥 ] (2)

(𝑑) (𝑤) (𝑟)

where the probabilities, 𝑞𝑥 , 𝑞𝑥 and 𝑞𝑥 , reflect competing decrements.

A typical assumption for transforming a rate of decrement into a probability of decrement in a

multiple-decrement environment is that all decrements occur on a uniform basis throughout the
′(𝑘) (𝑘)
year. If 𝑞𝑥 is the rate of decrement for cause 𝑘 and 𝑞𝑥 is the probability of the decrement, the
transformation of a rate into a probability in a three-decrement environment (𝑘 = 1, 2, 3) under
the uniform distribution of decrement (UDD) assumption is as follows (see Bowers et.al.1):

(1) ′(1) 1 ′(2) ′(3) 1 ′(2) ′(3)

𝑞𝑥 = 𝑞𝑥 [1 − [𝑞𝑥 + 𝑞𝑥 ] + [𝑞𝑥 𝑞𝑥 ]]
2 3

(2) (3)
Similar formulas hold for 𝑞𝑥 and 𝑞𝑥 .

(1)
The value of 𝑞𝑥 in the three-decrement environment can also be approximated by the following
formula:

(1) ′(1) 1 ′(2) 1 ′(3)

𝑞𝑥 ≈ 𝑞𝑥 [1 − 𝑞𝑥 ] [1 − 𝑞𝑥 ]
2 2
(1)
The error involved with the above approximation is relatively small, causing 𝑞𝑥 to be
1 ′(1) ′(2) ′(3)
understated by 12 𝑞𝑥 𝑞𝑥 𝑞𝑥 .

Similarly, in a four-decrement environment (𝑘 = 1,2,3,4), we have under the UDD assumption:

(1) ′(1) 1 ′(2) ′(3) ′(4) 1 ′(2) ′(3) ′(2) ′(4) ′(3) ′(4)
𝑞𝑥 = 𝑞𝑥 [1 − (𝑞𝑥 + 𝑞𝑥 + 𝑞𝑥 ) + (𝑞𝑥 𝑞𝑥 + 𝑞𝑥 𝑞𝑥 + 𝑞𝑥 𝑞𝑥 )
2 3
1 ′(2) ′(3) ′(4)
− (𝑞𝑥 𝑞𝑥 𝑞𝑥 )]
4

The corresponding approximation is:

(1) 1 1 1
𝑞𝑥 ≈ 𝑞𝑥′(1) [1 − 𝑞𝑥′(2) ] [1 − 𝑞𝑥′(3) ] [1 − 𝑞𝑥′(4) ]
2 2 2

′(1) 1 ′(2) ′(3) ′(4) 1 ′(2) ′(3) ′(2) ′(4) ′(3) ′(4) 1 ′(2) ′(3) ′(4)
= 𝑞𝑥 [1 − (𝑞𝑥 + 𝑞𝑥 + 𝑞𝑥 ) + (𝑞𝑥 𝑞𝑥 + 𝑞𝑥 𝑞𝑥 + 𝑞𝑥 𝑞𝑥 ) − (𝑞𝑥 𝑞𝑥 𝑞𝑥 )]
2 4 8

Again, the error involved with the approximation for the four-decrement case is relatively small:

′(1) 1 ′(2) ′(3) ′(2) ′(4) ′(3) ′(4) 1 ′(2) ′(3) ′(4)
Error= 𝑞𝑥 {12 [𝑞𝑥 𝑞𝑥 + 𝑞𝑥 𝑞𝑥 + 𝑞𝑥 𝑞𝑥 ] − 8 (𝑞𝑥 𝑞𝑥 𝑞𝑥 )}

1
Bowers, et.al. (1997). Actuarial Mathematics (Second Edition). Society of Actuaries

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The probability of surviving in active service for 𝑛 years is equal to the product of successive one-year
composite survival probabilities:
𝑛−1
(𝑇) (𝑇)
𝑛𝑝𝑥 = ∏ 𝑝𝑥+𝑡 (3)
𝑡=0

These probabilities can be readily obtained from a service table, which shows the number of
employees out of an original group who survive to each future attained age. The initial number of
employees is generally taken to be some large value, such as 1,000,000. The notation for the number
(𝑇)
of survivors at age 𝑥 is 𝑙𝑥 . Denote the total number of employees leaving service during the year as
(𝑇)
𝑑𝑥 . Then,

(𝑇) (𝑑) (𝑤) (𝑟) (𝑇) (𝑑) (𝑤) (𝑟)

𝑑𝑥 = 𝑑𝑥 + 𝑑𝑥 + 𝑑𝑥 = 𝑙𝑥 [𝑞𝑥 + 𝑞𝑥 +𝑞𝑥 ]
(4)
(𝑇) (𝑇) (𝑇)
𝑙𝑥+1 = 𝑙𝑥 − 𝑑𝑥

(𝒊) ′(𝒊) (𝑻) ′(𝒊)

In pension practice, 𝒒𝒙 is often set equal to 𝒒𝒙 , so that 𝒒𝒙 ≡ ∑𝒏𝒊=𝟏 𝒒𝒙 in an 𝒏-decrement
environment. The resultant inaccuracy is usually within acceptable tolerances.

Exercise 1

Using the rates of decrement provided, construct a service table consisting of:

(𝑇) (𝑑) (𝑤) (𝑟) (𝑇)

𝑙𝑥 , 𝑑𝑥 , 𝑑𝑥 , 𝑑𝑥 𝑎𝑛𝑑 𝑑𝑥 , 20 ≤ 𝑥 ≤ 65

Then calculate the probability of an entrant aged 20 surviving in active service to age 65.

2.3.2 Interest Function

The interest function is used to discount a future payment to the present time. It plays a crucial role
in determining pension costs.

If 𝑖𝑡 is the interest rate assumed for the 𝑡th year, the present value of 1 unit due in 𝑛 years is given by:

1
(1 + 𝑖1 )(1 + 𝑖2 ) … (1 + 𝑖𝑛 )

In a deterministic model of interest rates and if 𝑖1 = 𝑖2 = ⋯ = 𝑖𝑛 = 𝑖 , the above present value

1 1
reduces to . Set 𝑣 = . The interest discount function 𝑣 𝑛 represents the present value of 1
(1+𝑖)𝑛 (1+𝑖)
unit due in 𝑛 years at an annual compound rate of interest equal to 𝑖 .

The product of the interest discount function and survival probabilities is frequently encountered in
pension mathematics. It is used to discount pension benefits paid in the future.

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 Exercise 2

a) Compute the compound interest functions, 𝑣 𝑡 , for 𝑡 = 0, 1, … ,70 using interest rates 𝑖 =
5%, 6% and 7%.
b) Plot the survival and interest discount functions over the same age interval from age 𝑥 to age
65 for 𝑥 ≥ 30 based on an interest rate of 6% per annum and the service table developed in
Exercise 1.

2.3.3 Annuity Function

The annuity function calculates the actuarial present value of a pension payable to a retired member
under a pension plan.

Straight life annuity

When a member retires from a pension plan, he or she begins to receive a series of pension payments,
often at monthly intervals. In this section, we assume that they are paid annually in advance for
convenience. If payments cease upon the retiree’s death, the pension is a straight life annuity and its
actuarial present value, assuming an annual payment of one unit2, with the first payment due at the
beginning of age 𝑥, is given by:
∞

𝑎̈ 𝑥 = ∑ 𝑡𝑝𝑥 𝑣 𝑡 (5)
𝑡=0

The infinity sign is used as the upper limit of the summation for convenience since 𝑡𝑝𝑥 becomes zero
beyond some ultimate age 𝜔.

Life annuity with term certain

It is not uncommon to find a pension plan that offers an 𝑛-year term certain and life annuity. This type
of annuity is a combination of an 𝑛-year certain annuity plus an 𝑛-year deferred life annuity:
𝑛
𝑎̈ 𝑥:𝑛¬
̅̅̅̅̅̅̅ = 𝑎̈ 𝑛¬ + 𝑛𝑝𝑥 𝑣 𝑎̈ 𝑥+𝑛 (6)

Joint and survivor annuity

Another type of annuity is known as the joint and survivor annuity. The term “joint” means that the
payment amount is based on more than one status (usually husband and wife), and the term
“survivor” means that the annuity pays at least some amount until the last status fails. A 50% joint
and survivor annuity pays one dollar annually while both statuses are alive, and reduces to 50 cents
after the first death. Another version of this annuity is known as a contingent joint and survivor
annuity. Under this form, the annuity reduces to 50 cents only if the retired member (i.e., the primary
annuitant) is the first to die. This type of annuity is frequently found in pension plans. The survivor
benefit might be any proportion, with one-half, two-thirds, and three-fourths representing the choices
usually available.

2
The standard approximation for the present value of an annuity payable m times a year is to subtract (𝑚 −
1)/2𝑚 from the annuity payable annually. Since pension benefits are normally paid monthly, 11/24 should be
subtracted from the above annuity to approximate a monthly payment of 1/12 of a dollar.

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Let 𝑥 denote the age of the retired member, 𝑦 the age of the spouse and 100𝑘 the percentage of the
annual pension continued in the event that the retired member predeceases the spouse. The 100𝑘
percent joint and survivor annuity may be represented mathematically as:
∞
𝑘 1
𝑎̈ 𝑥𝑦 = ∑ 𝑣 𝑡 [ 𝑡𝑝𝑥 𝑡𝑝𝑦 + 𝑡𝑝𝑥 (1 − 𝑡𝑝𝑦 ) + 𝑘 𝑡𝑝𝑦 (1 − 𝑡𝑝𝑥 )]
𝑡=0 (7)
∞
𝑡
= ∑ 𝑣 [ 𝑡𝑝𝑥 + 𝑘 𝑡𝑝𝑦 (1 − 𝑡𝑝𝑥 )],
𝑡=0

where 𝑘 ≤ 1 and the 1 above the 𝑥 subscript denotes that 𝑘 dollars are paid to 𝑦 if 𝑥 is the first to die.

Temporary annuities
The temporary annuity, as will be shown in later chapters, plays a central role in determining annual
pension costs. In this case we are dealing with an employment-based annuity, subject to multiple
decrements, rather than the typical retirement annuity which includes only a mortality decrement.
The mathematical expression of this annuity is as follows:
𝑛−1
(𝑇)
𝑎̈ 𝑥:𝑛¬ = ∑ 𝑡𝑝𝑥 𝑣𝑡 (8)
𝑡=0

Another important temporary annuity is denoted as 𝑠𝑎̈ 𝑥:𝑦−𝑥¬ , where the superscript s means that the
annuity is salary-based. More formally,
𝑦−1
𝑠
𝑠𝑧 (𝑇)
𝑎̈ 𝑥:𝑦−𝑥¬ = ∑ ( ) 𝑧−𝑥𝑝𝑥 𝑣 𝑧−𝑥 (9)
𝑠𝑥
𝑧=𝑥

This formula represents the present value of an employee’s future salary from age 𝑥 to age 𝑦, per unit
of salary at age 𝑥, where 𝑠𝑧 denotes a salary scale at age 𝑧.

2.4 Pension Cost Functions

In this section, we define the accrued (or actuarial) liability and supplemental liability associated with
the pension benefits under a pension plan and the related concepts of the plan’s normal cost and
supplemental cost. First, we introduce some notation.

Notation Description
A Set of actively working plan participants
T Set of terminated plan participants
R Set of retired participants
w Entry age from which pensionable service is calculated (e.g., date of hire)
u Age at plan inception
x Attained age at the valuation date
PVFB Present value of future benefits
F Pension fund balance
NC Normal cost
𝑺𝒙 Actual salary in the year of age 𝑥

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 𝒔𝒙 Salary scale at age 𝑥
AL Accrued or actuarial liability
SL Supplemental liability

2.4.1 Pension Plan liability measures

The actuary calculates the expected future benefit payments for each participant in the plan using the
participant’s data and plan provisions. These future benefit payments consider the individual’s service
and/or pay history, and when that individual might be expected to die, quit, become disabled or retire.
Each future payment is discounted from the expected date of payment to the valuation date using
actuarial assumptions. Actuaries call the total of these discounted amounts the present value of
future benefits (𝑃𝑉𝐹𝐵) and it represents the actuarial present value of benefits expected to be paid
from the plan to that participant.

The following benefits (if the plan includes these provisions) may be included in the calculation of the
𝑃𝑉𝐹𝐵:

• Retirement benefits
• Termination benefits
• Disability benefits
• Surviving spouse benefits/death benefits

Note that the 𝑃𝑉𝐹𝐵 for a participant includes the benefits pertaining to the participant's past service
(i.e., the service before the valuation date) as well as the service the participant is expected to accrue
in the future. Actuaries have developed different actuarial cost methods to divide the 𝑃𝑉𝐹𝐵 into the
following components:

• Accrued liability (𝐴𝐿) – The portion of the 𝑃𝑉𝐹𝐵 that is theoretically attributed to past
service.
• Normal cost (𝑁𝐶) – The portion of the 𝑃𝑉𝐹𝐵 that is attributable to the current year of service
(i.e., the year following the valuation date).
• Present value of future normal costs (𝑃𝑉𝐹𝑁𝐶) – The portion of the 𝑃𝑉𝐹𝐵 that is attributed
to all future years of service, which includes the normal cost as a part.

The relationship of these components can be depicted graphically as follows.

Valuation
Date
𝑷𝑽𝑭𝑩

𝑨𝑳
𝑷𝑽𝑭𝑵𝑪

𝑵𝑪

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2.5.2 Mathematical Formulation
In this subsection, we develop the mathematical formulas for 𝑃𝑉𝐹𝐵, 𝐴𝐿 and 𝑁𝐶 under an individual
actuarial cost method (discussed in later chapters). For instruction purposes, we only define the
formulas related to a retirement benefit but the same concepts apply to other benefits as well.

Present value of future benefits

The present value of future benefits (𝑃𝑉𝐹𝐵) for a participant currently age 𝑥, having entered the plan
at age 𝑤 and retiring at age 𝑦 is given by:

(12)
𝑃𝑉𝐹𝐵𝑥 = 𝐵(𝑦) ∙ 𝑦−𝑥𝑝𝑥 ∙ 𝑣 𝑦−𝑥 ∙ 𝑎̈ 𝑦 (10)
where

𝐵(𝑦) = the pension benefit payable at retirement for the participant

𝑦−𝑥𝑝𝑥 = the probability that the participant survives in employment to age 𝑦

𝑣 𝑦−𝑥 = the interest discount from age 𝑦 to 𝑥

(12)
𝑎̈ 𝑦 = the actuarial present value, at age 𝑦, of a life annuity due in the annual amount of 1
payable monthly in advance

(12)
After the participant retires, this function is reduced to: 𝑃𝑉𝐹𝐵𝑥 = 𝐵(𝑦)𝑎̈ 𝑥 , 𝑥 ≥ 𝑦.

The 𝑃𝑉𝐹𝐵 for the plan as a whole is the sum of the 𝑃𝑉𝐹𝐵𝑠 for all participants in the plan.

The 𝑃𝑉𝐹𝐵 function for each active participant increases with age from entry age 𝑤 to retirement age
𝑦, since both 𝑦−𝑥𝑝𝑥 and 𝑣 𝑦−𝑥 increase with age 𝑥 and approach 1 as 𝑥 approaches 𝑦. Beyond age 𝑦,
(12)
however, the 𝑃𝑉𝐹𝐵 function decreases since 𝑎̈ 𝑥 is a decreasing function of age 𝑥. The 𝑃𝑉𝐹𝐵 takes
on its largest value for active participants at retirement age 𝑦 and for retired participants at the
beginning of their age-𝑦 life expectancy period.

A change in the interest rate has its largest effect on the magnitude of 𝑃𝑉𝐹𝐵 for participants at the
youngest age, with the effect of such changes diminishing as the participant's age approaches the end
of his or her life span.

Normal cost
In general, the normal cost (𝑁𝐶) is designed to amortize the 𝑃𝑉𝐹𝐵 over the participant’s working
years, with the pattern of amortization payments being specified by the actuarial cost method. Thus,
prospectively, the present value of a participant’s future normal costs at entry age 𝑤 is equal to his
𝑃𝑉𝐹𝐵 at that age, i.e., 𝑃𝑉𝐹𝑁𝐶𝑤 = 𝑃𝑉𝐹𝐵𝑤 . Retrospectively, the normal cost will accumulate by age
𝑦 to the 𝑃𝑉𝐹𝐵 of the participant at that age.

Accrued liability
The accrued liability (𝐴𝐿) associated with a given active participant age 𝑥 is equal to the portion of the
𝑃𝑉𝐹𝐵 theoretically amortized by age 𝑥, exclusive of the normal cost then due.

Retrospective definition of 𝐴𝐿

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Retrospectively, the accrued liability for a participant aged 𝑥 is equal to the accumulated value of the
participant’s past normal costs (𝐴𝑉𝑃𝑁𝐶𝑥 ):
𝑥−1
1
𝐴𝐿𝑥 = 𝐴𝑉𝑃𝑁𝐶𝑥 = ∑ 𝑁𝐶𝑧 (1 + 𝑖)𝑥−𝑧 ( ) (11)
𝑥−𝑧𝑝𝑧
𝑧=𝑤

The third factor on the right increases the normal cost at each age according to the benefit of
𝑙𝑥
survivorship in employment. To see what this means, we write 𝑥−𝑧𝑝𝑧 as 𝑙𝑧
. Then

𝑥−1
𝑙𝑧
𝐴𝐿𝑥 = ∑ 𝑁𝐶𝑧 (1 + 𝑖)𝑥−𝑧 ( )
𝑙𝑥
𝑧=𝑤

In this form, we see that for each age 𝑧 < 𝑥, a normal cost 𝑁𝐶𝑧 is generated on behalf of each
hypothetical participant at this age (there are 𝑙𝑧 of them), yet the total accumulation with interest at
age 𝑥 is shared only by the smaller number (𝑙𝑥 ) of those who survive in service to age 𝑥. This benefit
of survivorship increases the accrued liability for the participant at age 𝑥.

Prospective definition of 𝐴𝐿

Prospectively, the accrued liability for an active participant at age 𝑥 is equal to the present value of
future benefits at that age less the present value of future normal costs yet to be made:

𝐴𝐿𝑥 = 𝑃𝑉𝐹𝐵𝑥 − 𝑃𝑉𝐹𝑁𝐶𝑥 (12)

where,
𝑦−1

𝑃𝑉𝐹𝑁𝐶𝑥 = ∑( 𝑧−𝑥𝑝𝑥 𝑣 𝑧−𝑥 ) ∙ 𝑁𝐶𝑧 (13)

𝑧=𝑥

The accrued liability for a retired participant aged 𝑥 is equal to the 𝑃𝑉𝐹𝐵 for that participant, i.e.,
(12)
𝐴𝐿𝑥 = 𝑃𝑉𝐹𝐵𝑥 = 𝐵 𝑗 (𝑦)𝑎̈ 𝑥 , 𝑥 ≥ 𝑦.

The accrued liability for the plan as a whole is equal to the sum of the accrued liabilities for all active
and retired participants in the plan.

Example:

Plan provisions
Pension formula US$50 per month per year of service
Form of pension Straight life annuity
Termination and pre-retirement death benefits None
Normal retirement age 65

Sole participant data at date of valuation

Sex Male
Attained age 40
Years of service 10

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 Actuarial assumptions
Interest rate 6%
Pre-retirement death or termination None
(12)
Life annuity at age 𝑎̈ 65 =10, based on 6% interest and some mortality table

Projected pension benefit at age 65

Projected years of service 10+(65-40) = 35
Projected annual pension benefit 50 x 12 x 35 = 21,000

Application of an actuarial cost method - Unit Credit cost method

a) Allocate the projected retirement benefit to past service and the year following the valuation date.
b) Then calculate 𝐴𝐿 and 𝑁𝐶, respectively, as the actuarial present values of the allocated benefits.
c) Calculate the present value of future normal costs (𝑃𝑉𝐹𝑁𝐶).
d) Verify that 𝐴𝐿 = 𝑃𝑉𝐹𝐵 − 𝑃𝑉𝐹𝑁𝐶

Prospectively determined accrued liability vs. retrospectively determined accrued liability

At a valuation date, the retrospective and prospective approaches to determining a participant’s

accrued liability will be equal, provided that several rigid conditions are met. In a more typical
situation, one or more of these conditions will be violated, and in turn, there will be a discrepancy
between these two calculations of accrued liability. This discrepancy could be due to factors such as
benefit improvements or changes in actuarial assumptions.

For example, if a plan is amended to improve existing retirement benefits, there will be an additional
liability for the benefit improvement created and the 𝑃𝑉𝐹𝐵 will be increased by the same amount.
Depending on the actuarial cost method used, the additional 𝑃𝑉𝐹𝐵 might be:

1. Allocated entirely to past service: This would increase the prospectively determined 𝐴𝐿.
2. Allocated entirely to future service: This would increase future normal costs but would not
increase the prospectively determined 𝐴𝐿.
3. Allocated partly to past service and partly to future service: This would increase the
prospectively determined 𝐴𝐿 and 𝑃𝑉𝐹𝑁𝐶.

We will see these different treatments of benefit improvements as we discuss various actuarial cost
methods.

Additional liability from benefit improvements

(Allocated to past or future service with different effects on 𝐴𝐿 and 𝑃𝑉𝐹𝑁𝐶)

𝑨𝑳(Retrospective) 𝑷𝑽𝑭𝑵𝑪

However, the retrospectively determined 𝐴𝐿, which is the accumulated value of past normal costs to
the date of valuation, would not be affected by the benefit improvement.

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For a given participant, to the extent that the prospectively determined 𝐴𝐿 is greater than the
retrospectively determined 𝐴𝐿, a supplemental liability (𝑆𝐿) is said to create for the participant:

𝑆𝐿𝑥 = 𝑃𝑟𝑜𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝐿𝑥 − 𝑅𝑒𝑡𝑟𝑜𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝐿𝑥

(14)
= [𝑃𝑉𝐹𝐵𝑥 − 𝑃𝑉𝐹𝑁𝐶𝑥 ] − 𝐴𝑉𝑃𝑁𝐶𝑥

The supplemental liability for the plan as a whole is equal to the sum of each plan participant’s
supplemental liability.

The supplemental liability for the plan that is not covered by the surplus assets in the plan (i.e., the
excess of plan assets over the retrospectively determined 𝐴𝐿) must be funded by the employer, either
in a lump sum, or paid over a number of years. The payment made to fund the supplemental liability
is referred to as supplemental cost. This can be shown graphically as follows.

Assets Liabilities

Prospective AL

𝑆𝐿

𝐹
Retrospective 𝐴𝐿

2.6 Commutation Functions

With advances in computing technology, commutation functions are no longer needed to simplify
the calculation of actuarial present values of contingent payments. However, it is still a convenient
way to use them to illustrate the concepts of pension mathematics. This section describes some
commutation functions that will be used in later chapters for illustrative purposes.

For a given survival function based on a deterministic model, we define 𝑙𝑥 as the number of lives out
of some initial population of newborns, that survive to age 𝑥. It follows that 𝑝𝑥 = 𝑙𝑥+1 /𝑙𝑥 and
𝑛𝑝𝑥 = 𝑙𝑥+𝑛 /𝑙𝑥 . With a constant interest rate 𝑖, the actuarial present value of an 𝑛-year pure
endowment is 𝑣 𝑛 𝑛𝑝𝑥 .

The basic commutation function is 𝐷𝑥 ≡ 𝑣 𝑥 𝑙𝑥 . Dividing 𝐷𝑥+𝑛 by 𝐷𝑥 gives the actuarial present value
of an 𝑛-year pure endowment:

1 𝐷𝑥+𝑛 𝑣 𝑥+𝑛 𝑙𝑥+𝑛

𝑛𝐸𝑥 = 𝐴𝑥:𝑛̅| = = = 𝑣 𝑛 𝑛𝑝𝑥
𝐷𝑥 𝑣 𝑥 𝑙𝑥

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For annuities of repeated level payments contingent on survival, we introduce the commutation
function 𝑁𝑥 ≡ ∑𝜔−𝑥−1
𝑡=0 𝐷𝑥+𝑡 , where 𝜔 represents the terminal age in a life table. When dividing 𝑁𝑥
𝑁𝑥 ∑𝜔−𝑥−1 𝐷𝑥+𝑡
by 𝐷𝑥 , we obtain a life-annuity due: 𝑎̈ 𝑥 = = 𝑡=0
= ∑𝜔−𝑥−1
𝑡=0 𝑣 𝑡 𝑡𝑝𝑥 .
𝐷𝑥 𝐷𝑥

(𝑚)
For payments occurring more frequently than annually, we make use of the approximation 𝑎̈ 𝑥 ≈
𝑚−1
𝑎̈ 𝑥 − 2𝑚
. The commutation function created for use in approximating the actuarial present value
(𝑚) 𝑚−1
of 𝑚 payments per year, contingent on survival, is 𝑁𝑥 = 𝑁𝑥 − 𝐷𝑥 ∙ 2𝑚
. The value of this annuity
can be calculated as follows:

(𝑚) 𝑚−1
(𝑚) 𝑁𝑥 𝑁𝑥 − 𝐷𝑥 ∙ 2𝑚 𝑚−1
𝑎̈ 𝑥 = = = 𝑎̈ 𝑥 −
𝐷𝑥 𝐷𝑥 2𝑚

In the valuation of a pension plan, we often calculate a temporary annuity based on a survival
function constructed from multiple decrements which may include mortality, early withdrawal or
disability3:

𝑦−𝑥−1 𝑦−𝑥−1 𝑣 𝑥+𝑡 𝑙𝑥+𝑡 𝑦−𝑥−1 𝐷𝑥+𝑡 𝑁𝑥 −𝑁𝑦

̅̅̅̅̅̅| = ∑𝑡=0
𝑎̈ 𝑥:𝑦−𝑥 𝑣 𝑡 𝑡𝑝𝑥 = ∑𝑡=0 = ∑𝑡=0 = ,
𝑣 𝑥 𝑙𝑥 𝐷𝑥 𝐷𝑥

where 𝑦 is the normal retirement age under the pension plan and 𝑥 ≤ 𝑦.

Where a pension plan provides a pension benefit based on the participants' future salaries, we apply
the salary-related commutation functions, 𝑠𝐷𝑥 and 𝑠𝑁𝑥 , to calculate the salary-related temporary
annuity:
𝑠
𝐷𝑥 ≡ 𝑠𝑥 𝐷𝑥 ; 𝑠
𝑁𝑥 ≡ ∑𝜔−𝑥−1
𝑡=0
𝑠
𝐷𝑥+𝑡 ,

where {𝑠𝑥 } represents a salary scale indexed by age 𝑥.

𝑦−𝑥−1 𝑦−𝑥−1 𝑦−𝑥−1
𝑠
𝑠𝑥+𝑡 𝑡 𝑠𝑥+𝑡 𝑣 𝑥+𝑡 𝑙𝑥+𝑡 𝑠
𝐷𝑥+𝑡 𝑠𝑁𝑥 − 𝑠𝑁𝑦
𝑎̈ 𝑥:𝑦−𝑥|
̅̅̅̅̅̅̅ = ∑ 𝑣 𝑡𝑝𝑥 = ∑ = ∑ =
𝑠𝑥 𝑠𝑥 𝑣 𝑥 𝑙𝑥 𝑠𝐷
𝑥
𝑠𝐷
𝑥
𝑡=0 𝑡=0 𝑡=0

3
A table of such survival functions is called a service table.

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