Understanding and Managing Pension Costs

Actuarial Perspective Monday, May 21, 2007

Overview
Understanding pension costs:
Basic actuarial concepts Common sense approach Chapter 112 perspective GASB 25/27 perspective

Managing pension costs:

Avoiding the contribution roller coaster Advance contributions vs. excess contributions Benefit increase alternatives Managing costs responsibly

Understanding pension costs: Basic actuarial concepts

Present value of future benefits (PVB) = amount of money needed today to completely fund the pension plan, including future benefit accruals Actuarial cost method = splits the PVB into two pieces:
 

past service liability (a.k.a. the accrued liability) future service liability (a.k.a. future normal cost) amortization payment towards the portion of the accrued liability that is not yet funded by the pension assets (unfunded liability payment) PLUS normal cost (liability for benefits being earned during the current year)

Annual cost of the plan =



Amortization period is up to 30 years (Chapter 112 & GASB 25/27) Different cost methods split the PVB in different ways Seven acceptable cost methods; most common for governmental plans are: (1) aggregate; (2) entry age normal; and (3) frozen entry age (a.k.a. frozen initial liability)

Understanding pension costs: Basic actuarial concepts

Liabilities are determined by the assumptions used Most important assumptions are typically the:
  

interest (or discount) rate; mortality table; and salary increase assumption

Other assumptions may include withdrawal or employment termination rates, disability rates & whether disability is service-connected, serviceretirement rates, marital status, spousal age, expense loading

Understanding pension costs: Common sense approach

Common sense: The actuary does NOT change the ultimate cost of the plan.
  

Assumptions try to predict the future Cost is guaranteed to be greater or smaller than predicted Cost method is simply a way of allocating the pension cost to a particular year

Common sense: If participants receive bigger benefits in the aggregate, then pension costs will be higher.


Corollary: If some participants receive bigger benefits and pension costs do not increase, then other participants will receive smaller benefits.

Common sense: If participants are allowed to retire earlier, pension costs will almost always be higher because pensions will be provided to more individuals (i.e. the original employees plus their replacements).

Understanding pension costs: Chapter 112 perspective

Chapter 112, Florida Statutes = requires the sponsoring employer to make a minimum cash contribution each year Minimum contribution = Up to a 30-year amortization payment 30towards the unfunded accrued liability PLUS normal cost Minimum contribution should be made at least quarterly Also requires an actuarial impact statement for any and every change to the plan, even if the change does not impact the cost of the plan Actuarial valuation reports and impact statements must be filed with the State Actuarial valuation reports and impact statements are reviewed by an actuary in the Division of Retirement to determine State acceptance Actuarial valuations are required at least once every THREE years

Understanding pension costs: GASB 25/27 perspective

Governmental Accounting Standards Board Statements Nos. 25 and 27 (GASB 25/27) = determines the accounting cost of the pension plan (known as the annual pension cost or APC) Defines the annual required contribution or ARC APC and ARC may be different than the cash cost under Chapter 112 Cash contributions above or below the APC are accumulated in the net pension obligation or NPO ARC includes an amortization payment (or credit) towards the NPO; APC includes an interest charge for the NPO instead of an amortization payment GASB 25/27 also requires disclosure of:


 

the portion of the APC and ARC that was actually contributed on a cash basis each year; the funded status of the plan; and basic assumptions and methods used

Actuarial valuations are required at least once every TWO years

Managing pension costs:

Avoiding the contribution roller coaster
Without planning, the minimum cash contribution can vary dramatically from year to year under Chapter 112 To build a contribution cushion = ask the actuary to provide a level contribution amount (or level percentage of pay contribution) that is based on a shorter amortization period than the Chapter 112 minimum Having the discipline to make a larger contribution when the minimum is low can give you the flexibility to make a lower contribution when the minimum is high:
 

EXAMPLE 2007 minimum is $25,000; 2008 minimum is $450,000; 2009 minimum is $275,000 Make level contributions of $250,000 each year (without interest adjustment) to avoid the contribution roller coaster

LESSON: Work with the actuary to level the contributions and avoid the contribution roller coaster.

Managing pension costs:

Advance contributions vs. excess contributions
Advance contribution = additional contribution above the minimum that is NOT reflected until a later year Excess contribution = additional contribution above the minimum that is reflected IMMEDIATELY
ADVANCE CONTRIBUTION: Provides a dollar for dollar credit towards future minimum contribution Does NOT increase the funded percentage Useful for leveling future contributions Example: Minimum is $100,000 for 2007 and $450,000 for 2008; cash contribution for 2007 is $250,000, with $150,000 treated as an advance contribution for 2008; reduces 2008 contribution to $300,000 EXCESS CONTRIBUTION: Reduction in future minimum contribution is an amortization of the excess contribution Immediately increases the funded percentage of the plan Example (assuming 30-year amortization and 8% interest rate): Minimum is $100,000 for 2007 and $450,000 for 2008; cash contribution for 2007 is $250,000, with $150,000 treated as an excess contribution for 2007; reduces 2008 contribution to $437,663

Managing pension costs: Benefit increase alternatives

Instead of:
A permanent cost-of-living cost-ofadjustment (COLA) An immediate COLA upon retirement A Deferred Retirement Option Plan (DROP) An increased benefit formula multiplier for all A lower normal retirement age A pay-based benefit increase payA benefit increase funded entirely by the employer

Consider:
A one-time ad-hoc COLA oneadA COLA that is delayed for three or five years after retirement A partial lump-sum cash-out lumpcashoption An increased benefit formula multiplier that only applies to those with a long period of service An increased early retirement benefit A pension supplement based solely on service An increased employee contribution

Managing pension costs: Managing costs responsibly

A responsible individual: Recognizes that providing increased benefits or earlier payment of benefits will require increased contributions Doesnt try to hide increased costs by using actuarial tricks such as alternative assumptions or cost methods Doesnt spread the cost of the pension plan beyond the working lifetime of the active employees (there are rare exceptions to this rule) Doesnt act based on selfish interests, but tries to balance the competing interests of employees and taxpayers in designing and funding the pension plan