What it means
A pension promise stretches decades into the future, but accounts and budgets are set every year. The actuarial cost method slices the lifetime promise into annual amounts.
It answers the question of how much of the eventual cost belongs to this year. Methods fall into two broad families.
Accrued benefit methods, such as unit credit and projected unit credit, charge each year with the value of the benefit employees earned that year. Level cost methods, such as entry age normal and aggregate, aim to spread the cost evenly, often as a level percentage of pay, from an employee's start to retirement.
Every method rests on assumptions about the discount rate, expected return on assets, salary growth, retirement age and mortality. These assumptions can be chosen boldly or prudently, which is why pension footnotes reward suspicion.
A richer expected return or lower salary growth makes the annual expense shrink with no change in the real promise. The annual result has two main parts.
The normal cost is the value of benefits earned in the current year, and the accrued liability is the portion of the total promise attributed to past service. Any gap between that liability and the plan's assets is the unfunded liability, which is normally paid down over a set period.
The profession polices the practice. In the United States, Actuarial Standard of Practice number 4 sets the standard for measuring pension obligations and determining plan costs or contributions, and other countries have equivalent standards for their actuaries.
The choice of method is not cosmetic. Two companies with identical promises can report different annual expenses under different accepted methods, and the cost method also guides funding policy, meaning how much cash the sponsor puts in.
For a manager the method matters twice: when reading your own accounts and when sizing up an acquisition.
In practice
Real-world examples.
Example
An actuary values a mid-career engineer's promised pension. Under the projected unit credit method, this year's service adds a specific normal cost, which finance books as part of employee benefit expense. The following year the same calculation is repeated with updated salary and service data.
Example
Reviewing a target company's accounts before an acquisition, an analyst notices the plan uses an 8% asset return assumption. She asks the target's actuary to re-run the cost on a more cautious return, and the higher annual charge becomes part of the price discussion.
Example
A public school district uses the entry age normal method so that its contribution stays a roughly level share of payroll each year. This avoids sudden budget spikes as the workforce ages. Trustees can then plan staffing budgets years ahead with confidence.
Formula
Calculation
Normal cost (projected unit credit) = [accrual rate x projected final salary x annuity factor] / (1 + discount rate)^years to retirement. Suppose a plan pays 1.5% of final salary for each year of service, the employee's projected final salary is $80,000, and the annuity factor at retirement is 12. The benefit earned this year is 1.5% of $80,000, which is $1,200 a year of pension, worth $1,200 x 12 = $14,400 at retirement. With 15 years to retirement and a 5% discount rate, 1.05^15 is about 2.0789, so the normal cost is $14,400 / 2.0789, which rounds to $6,927.Case study
Seen in the real world.
Northgate Freight is a fictional logistics firm used for this illustrative case study. It inherits a defined benefit plan in a merger and asks its actuaries to revalue the plan using the cost method it has chosen for its own reporting.
The revaluation shows a liability 15% above the seller's books, mainly because the seller had assumed slower salary growth than the workforce actually delivered. The buyer renegotiates the price and adopts a prudent set of assumptions for its own reporting going forward.
A year later the firm reports the plan's normal cost and unfunded liability separately to its board. Directors can then see how much of the cost relates to this year's service and how much to the past.
Watch out
Common mistakes.
- Reading the pension expense without checking the assumptions; the same workforce can carry very different annual costs under different discount and return rates.
- Confusing the accounting expense with the cash contribution; the cost method informs both, but funding policy and tax rules set the actual cash call.
- Treating the accrued liability as fixed; every re-estimate of salaries, returns or retirement age rewrites it.
Questions
People also ask.
What are the two main families of actuarial cost method?
Accrued benefit methods charge each year with the benefit earned that year, while level cost methods spread the total expected cost evenly across an employee's working life.
Why do investors watch pension assumptions so closely?
Because the annual expense and the balance-sheet liability both move with assumptions about returns, discount rates, salaries and retirement age, and aggressive choices flatter current results.
Who sets the standards for these calculations?
National actuarial bodies do. In the United States, Actuarial Standard of Practice number 4 governs how pension obligations are measured and how plan costs and contributions are determined.
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