Pension

Review
Board

Understanding the Basics of

Actuarial Methods
April 2013
Research Paper No. 13-001

PensionReviewBoard
PaulA.Braden,Chair
J.RobertMassengale,ViceChair
AndrewW.Cable
LeslieGrecoPool
RobertM.May
RichardE.McElreath
WayneR.Roberts
RepresentativeWilliam"Bill"Callegari
SenatorJohnH.Whitmire

ChristopherHanson,ExecutiveDirector

ProjectStaff
DanielMoore,Actuary
SteveCrone,ResearchSpecialist

Reviewer
NormanW.Parrish

ThePensionReviewBoardwouldliketoacknowledgethemanyvaluablecontributionsandsuggestions
madebymembersoftheTexaspublicretirementandactuarialcommunitiesduringthewritingofthis
paper.SpecialthankstoJohnM.Crider,Jr.,ASA,EA,MAAAandMickeyG.McDaniel,FCA,FSA,MAAA,
EAforprovidingstaffwiththoroughandthoughtfulcommentsduringthepeerreviewprocess.
Materialinthispublicationisnotcopyrightedandmaybereproduced.ThePensionReviewBoardwould
appreciatecreditforanymaterialusedorcitedandacopyofthereprint.
AdditionalinformationaboutthisreportmaybeobtainedbycontactingthePensionReviewBoard,by
phoneat(512)4631736,byemailatprb@prb.state.tx.us,orbymailatP.O.Box13498Austin,Texas
787113498.

Understanding the Basics of Actuarial Methods

Introduction
Thispaperisdesignedtomakethetheoriesandlanguageofactuarialmethodsrelatedtopublic
pensionsintheStateofTexasmoreunderstandable.Presentconditionsinpublicfinanceonboththe
statewideandlocalgovernmentallevelsrequireamorecompleteunderstandingofhowpensionsare
structuredandhowactuariallanguagedescribesthatstructure.Publicpensiontrusteesand
administratorsdealwithactuarialinformationintheirdutiestomanagetheirpensionplansandcarry
outtheirfiduciaryduties.Governmentofficialsarechargedwithsettingpolicyforpublicpensions.Plan
membersmustunderstandtheimpactofchoicesbydecisionmakersontheirownretirements.
Taxpayersprovidetherevenueforgovernmentstocontributetopublicpensionsandareincreasingly
concernedaboutthestewardshipofpublicpensions.
Thispaperisstructuredtodistinguishbetweenplansthatuseactuarialconceptsinalimitedfashionand
thosethatrelyonactuarialconceptsmoreheavily.First,thepaperintroducesthefundamental
equationofpensionplanfinancingtoshowthesimilaritiesinpensiongoalsofalldifferenttypesof
plans.Next,thepaperexplainsthedifferenttypesofpensionplansandhowactuarialconceptsapply
moretocertaintypesofplans.Lastly,thispaperdescribesconceptsthatapplytoactuariallyfunded
definedbenefitplansandgivesexamplestohelpunderstandtheseactuarialconcepts.

Fundamental Equation of Pension Plan Financing

Tounderstandthebasicsofactuarialmethodsofvaluingpensionplanliabilities,considerthe
fundamentalequationofpensionplanfinancing:

C+I=B+E:
Contributions(C)+Income(I)=Benefits(B)+Expenses(E).

Contributions

Income

Benefits

Expenses

EmployersandEmployeescontributetoa

fundinregularintervals.Thefundinvests

thesecontributionsandearnsareturnon

Retirementplanspaybenefitstomembers
whohavemetplanrequirements.
Retirementplansalsopayexpensesfor
maintainingtheplan:administrative,
investment,auditing,etc.Benefitpayments
andexpensescombinetodecreasethe
amountinthefund.

thatinvestment.Returnfrominvestments

(fixedincome,equity,mutualfund,etc.)are
consideredincome.Contributionsand

Incomecombinetoaddtothefund.

Overtime,theinputstothefundarecontributionsandincome,whileoutputsfromthefundare
benefitsandexpenses.Therefore,overtime,contributionsandinterestmustequalbenefitsand
expenses.

Defined Benefit or Defined Contribution?

Thefundamentalequationholdstruewhetherthepensionplanisadefinedbenefitplan(DBplan)ora
definedcontributionplan(DCplan)

DefinedBenefitPlan:apensionplanwhereamonthlybenefit,payable

DBPlanExample

atacertainretirementage,isdefinedintheplan.Atraditionalpension
withpredeterminedmonthlyannuitypayments,payableuntildeath,is
anexampleofaDBplan.Actuarialmethodsareusedtocalculateand
predictbenefits,expensesandincomeintheequation.

RetirementBenefit:2.3%of
finalpaytimesyearsof
service

RetirementAge:65
InregardstotheequationC+I=B+E,adefinedbenefitplanisaffected
Levelmonthlypayment
inthefollowingways:First,actuarieswillcalculatetheamountrequired
afterretirement.
forfuturebenefits(B).Withthisinformation,thefundisableto
determinerequiredcontributions(C),whencombinedwithassumed
investmentincome(I).Ifbenefitsormarketconditionschange,adjustmentsmustbemadeto
contributions.Ifcontributionsorinvestmentincomefalls,thestabilityoftheplanmaybeaffectedand
benefitsmaybeadjusted.
2

DefinedContributionPlan:apensionplaninwhichspecified
contributionsaremadetoeachparticipantsaccount.The
contributionsandinterestearnedontheinvestmentsserveasthe
totalretirementamountfortheretiree.InaDCplan,the
contributionsandincomedeterminetheamountofbenefits
available,netofexpenses.InregardstotheequationC+I=B+E,
adefinedcontributionplanisaffectedinthefollowingways.
Benefits(B)ortheaccountbalanceatretirement,areequaltothe
contribution(C)andtheinvestmentincome(I)minusany
expenses(E)incurredformanagementofthefunds.Individual
RetirementAccounts(IRAs)and401(k)plansaretwoexamplesof
DCplans.

DCPlanExample:
Employercontribution:3%of
pay
Employeecontribution:3%of
pay
Retirementbenefitisaccount
balanceatretirement

Thestructuraldifferencesofdefinedbenefitanddefinedcontributionplansleadstoadifferentwayof
calculatingbenefitsasderivedfromtheequationC+I=B+E.Becausethereisadefiniteamountina
retireesaccountfromadefinedcontributionplan,astraightforwardB=C+IEresultsfromthe
operationoftheplan.Theretireeandplanknowthatthebenefitistheaccountbalance,whichthe
retireemustmanageoverhisretirementperiod.Conversely,adefinedbenefitplanisstructuredto
providelevelbenefitsatretirementoveravaryingamountoftime.Becauseofthecomplexityofthis
problem,actuarialprinciplesareappliedinordertocalculatethislevelbenefitoveravaryingtimeframe.
Anotherfundamentaldifferencebetweendefinedcontributionplansanddefinedbenefitplansisthatby
theirstructure(becausetheonlybenefitscomefromcontributionsactuallymadetoanindividuals
account),definedcontributionplansmustbefundedandneverhaveanunfundedactuarialaccrued
liability(UAAL).Indefinedbenefitplans,insufficientcontributionsorbadplanexperience,suchasa
marketdownturn,canincreasetheUAAL.

Defined Benefit Plans: Pre-funding vs. Pay-as-you-go

Prefundingallowsforassetstobebuiltuptofundfuturebenefits.Payasyougofunding,in
contrast,makescontributionsasbenefitsbecomedue.Payasyougoplansarenotactuariallyfunded,
asthereisnoattempttoleveltherequiredcontributions.Itispossible,however,toestimatethe
annuallyrequiredfuturecontributionstoapayasyougoplan.Allactuariallysoundplansarepre
funded.Withrespecttothefundamentalequationofpensionplanfinancing(C+I=B+E):
Payasyougomeansincome(I)equalszero,requiringgreatercontributions(C)tofundbenefitsand
expenses(B+E).Thefocusforapensionplanoritssponsoringentityisonbudgetingorprojectingthe
benefitpaymentswithouttheadvantageofinvestmentincome.Thesecontributionsarepassed
throughtopayforcurrentbenefits.JudicialRetirementSystemofTexasPlanOneisapayasyougo
plan.
Withprefunding,income(I)reducestheamountofcontributions(C)neededtofundbenefitsand
expenses(B+E).Apensionplanoritssponsoringentitymuststillconsiderbenefitpaymentswhen
makingcontributionstotheplan,butinvestmentincomeisalsoconsidered.

Also,whenaplanisprefunded,thecontributionstotheplanaremadeovertheworkingcareersofthe
employeesearningthebenefits.Thus,thetaxpayersbeingservedbythoseemployeesarebearingthe
costofthoseemployees'benefits.Withpayasyougofunding,thecostforanemployee'sbenefitis
bornebythesubsequentgenerationoftaxpayers.

Pre-Funding vs. Pay-as-you-go

Theoreticaldifferencesbetweenprefundingvs.payasyougocenterontwothings:
First,fromtheemployerside,prefundingisbasedonfuturepaymentswhilepayasyougo
fundingisapassthroughtopaycurrentbenefits.
Second,fromtheemployeecontributionsside,prefundingisseenascontributingtoyourown
pensionswhilepayasyougofundingcanbeseenaspayingforpresentdayretireepensions.

Actuarial Valuations of Pre-funded Defined Benefit Plans

Inprevioussections,wediscussedthedifferencebetweenadefinedbenefitplanandadefined
contributionplan.Asareminder,thedefinedcontributionplanonlyprovidesanamountoraccount
balanceuponretirement.Contributions(C)andincome(I)thatisearned,lessexpenses(E),become
thebenefit(B)oraccountbalancefortheretireeatretirement.
Prefundedpublicsectordefinedbenefitplansprovideagenerallylevelbenefittotheretireeafter
retirement.Anumberofvariables,beforeandafterretirement(salarylevel,lifespan,etc.),affectthe
calculationoffuturebenefitsforretirees.Mathematicalprinciplesareappliedtocalculatethecostof
futurebenefits.Retirementsystemstypicallybudgetpresentcontributionstomeetfuturebenefit
obligations.
Inordertocalculatethevalueoffuturebenefitsinadefinedbenefitplan,anactuarialvaluationis
performed.Generally,anactuarialvaluationisusedtoassessthefundedstatusandcalculatea
recommendedcontribution.TheequationC+I=B+Eholdstrueovertimeandanactuarialvaluationis
ameasuretakenorsnapshotatasinglemomentintime(i.e.,thevaluationdate).
Anactuarialvaluationincludesmanyfactorswhenmakingabasicdetermination.Thisincludes:

EmployerandEmployeeContributionswithcomparisontoexpectedcontributions
ReturnonInvestmentwithcomparisontoassumedinvestmentreturn
Benefitpaymentstobeneficiariesandfuturebenefitpaymentswithrespecttoretirementage
Rateofsalaryincrease,mortalityanddisabilityrates,inflationassumptions,anddiscountrate
Allassetsandliabilitiesfortheplan

Onemainpieceofanactuarialvaluationisthediscountrate.Actuaries,guidedbyplantrusteesand
investmentprofessionals,useadiscountratetodeterminethevalueoffuturebenefits.Publicplans
generallyusetheexpectedrateofreturnonplanassetsasthediscountratebecausepresentmoneyis
4

assumedtogrowovertimetopayforthebenefits.Thediscountrateistypicallybasedonalongtime
horizontomatchmemberlifespan.
Actuariesapplyadiscountratetofuturebenefitpaymentsinordertocalculateapresentvalueorvalue
intodaysdollars.Akeyfactaboutthediscountrateisthatthehigherthediscountrate,thelowerthe
presentvalue,andviceversa.
Thisfactisexplainedbythefollowingexample:
Discount Rate vs. Present Value

AssumeJohnhaspromisedtopaySusan$100,tobepaidfiveyearsfromnow.Whatisthe
presentvalueofthat$100payment?Inotherwords,Whatisthevalueintodaysdollarsof
$100infiveyears?ie:presentvalue.

Thepresentvaluedependsontheinterestrateatwhichthe$100isdiscounted.SayJohnhas
afundwhichwillearn5%peryear.Howmuchwouldhehavetoputinthefundnowinorder
toaccumulate$100afterfiveyears?Theansweris$78.35,becausethisamount,if
accumulatedforfiveyearsat5%,willreach$100:
$78.35=$100/1.055

Instead,sayJohnsfundearns8%peryear.Nowhowmuchwouldhehavetoputinthefund?
Theansweris$68.05,becausethisamount,ifaccumulatedforfiveyearsat8%,willreach
$100:
$68.05=$100/1.085

Discountingadeferredpaymentwithahigher(lower)discountratewillproducealower
(higher)presentvalue,duetothehigher(lower)expectedinteresttobeaddedtoa
hypotheticalfundforthepayment.

Benefits or Pension Obligations

InourequationC+I=B+E,actuariescalculatepensionbenefits(B)usingtermsoutlinedintheplan
designsofeachplan.Eachyear,therearevaluesforpensionbenefitsalreadyaccruedfrompastyears,
benefitsaccruingfromthecurrentyear,andbenefitsprojectedforfutureyears.Thevalueofbenefits
accruedinpastyearsiscalledtheactuarialaccruedliabilityorAAL.Thevalueofbenefitsaccruingfor
thepresentyeariscalledtheNormalCost.Thevalueofbenefitsforpresentyearandallfutureyears
arecalledthepresentvalueoffuturenormalcostsorPVFNC(thisincludesNormalCost).Thetotal
amountofallbenefits(AAL+PVFNC)iscalledpresentvalueoffuturebenefitsorPVFB.
Theconcepthereistoprojectthebenefitsforanentiregroupofpeopleandgivethatprojectiona
numericalvalue.Itisasiftheprojectedbenefitcalculationforonememberofthegroupisrepeatedfor
theentiregroup.However,eachmemberisatadifferentage,numberofyearsworked,projected
retirementage,etc.
5

Thepresentvalueoffuturebenefits(PVFB)iscalculatedasoftheactuarialvaluationdate.PVFBisthe
presentvalueofallbenefitsexpectedtobepaidfromtheplantocurrentparticipants.Thisamount
considersfutureserviceandpayparticipantsareexpectedtoearn.
PVFBissplitintotwoparts:theactuarialaccruedliability(AAL)andthepresentvalueoffuturenormal
costs(PVFNC).
AAListheportionofPVFBattributedtopastservice.
PVFNCistheportionofPVFBthatwillbeattributedtopresentandfutureyearsofservice.

Actuarial
Accrued
Liability

PresentValue
ofFuture
NormalCosts

PresentValue
ofFuture
Benefits

AAL

PVFNC

PVFB

PastYears

PresentYearand
Forward

Total

NormalCost(NC)istheportionofPVFBthatrepresentsthecurrentyearsbenefitaccruals.Thecurrent
yearisthefirstyearofPVFNC.Typically,contributionsinagivenyearareenoughtocoverthatsame
yearsnormalcostwithadditionalcontributionsappliedtopastyearsobligations,ifnotfullyfunded.

Assets and Asset Smoothing

Inprefundeddefinedbenefitplans,assetsarecalculatedusingdifferentmethodologies.TheMarket
ValueofAssets(MVA)isthevalueatwhichassetscouldbetradedonthemarket.TheActuarialValueof
Assets(AVA)isthevalueofassetsusedfortheactuarialvaluation.TheAVAcanbeeitherthemarket
value(MVA)orasmoothedvalueofassets.Thesmoothedvaluephasesingainsandlossestoreduce
volatility.TheAVAisusedtocalculatetheUnfundedActuarialAccruedLiability(UAAL).
Trusteesoftheretirementplanareresponsiblefortheinvestmentoffundassets.Theincomefrom
theseinvestments,(I)inourequationC+I=B+E,isprojectedataratecomparabletothelifetimeof
theaverageretiree.Actuariesuseanassumedrateofreturntocalculatetheprojectedincomefrom
theseinvestments.Actuarialsmoothingofactualreturnsallowsformoremanageablebudgetingofplan
contributions.Onceassetsaresmoothed,theplanactuarycalculatestheprojectedincome(I)and
projectedbenefits(B)inordertofindtheappropriatecontributionlevel(C).
AVAsmoothingmethodsareusedtosmooththeeffectofshorttermvolatilityintheMVA.
SmoothingreducesthevolatilityoftheMVAandkeepscontributionsmorestable,andthusmore
predictable.Shorttermassetgainsandlossesarerecognizedoveraperiodofyears.Smoothedvalue
6

maybesubjecttoacorridoraroundthemarketvalue,suchasplusorminus20%oftheMVA.Sucha
corridorputsanupperlimitontheamountofdeferredgainsandlossesincludedintheAVA.(Thatis,
AVA=MVA+deferredlossesdeferredgains.)Themostfrequentmethodofsmoothingisthefiveyear
phaseinofgainsandlosses.
Thefollowingchartillustratestheeffectofassetsmoothing:

Value

Nosmoothing

Withsmoothing
MVA
AVA

Time

UAAL and Funded Ratio

TheAAListhetotalactuarialvaluedamountofliabilityforallpensionbenefitsearnedasofthe
valuationdate.TheAVAisthetotalactuariallyvaluedamountassetsheldbythefund.TheUnfunded
ActuarialAccruedLiability(UAAL)isthedifferencebetweentheAALandtheAVA.ThereforetheUAAL
istheamountthatisstillowedtothefundforpastobligations.

Actuarial
Accrued
Liability

Actuarial
Valueof
Assets

(AAL)

(AVA)

Unfunded
Actuarial
Accrued
Liability
(UAAL)

TheFundedRatioistheratioofactuarialvalueofassetstoactuarialaccruedliabilityoraratioofthe
planscurrentassetstothepresentvalueofearnedpensionobligation.Thefundedratioiscalculated
bydividingtheAVAbyAAL.

Actuarial
Valueof
Assets

Actuarial
Accrued
Liability

(AVA)

(AAL)

Funded
Ratio

Contributions
InourequationC+I=B+E,actuariescalculatebenefits(B)andprojectedandsmoothedincome(I)so
thatplanscanchoosetheappropriateamountofcontributions(C).Contributionsusuallycomefrom
twosources:theEmployerandtheEmployee.Inpublicpensionplans,theemployeristhegovernment
sponsoringentity.ThiscouldbeaslargeastheStateofTexasorassmallasalocalfiredepartment.
Plansvaryincontribution.Someplanshaveequalcontributionsbetweenemployerandemployee,
othersareunequal.Usually,bothemployerandemployeecontributeapercentageoftakehomepay.
Again,thesevarywidelywithsomecontributionsbeing0%.
Initially,contributionsarecreditedtothenormalcost.Afternormalcostispaid,theremainderis
creditedtowardtheUnfundedActuarialAccruedLiability(UAAL).Anothercalculationoccursatthis
point.Whencontributions(C)arecombinedwithincome(I)andbenefits(B)areprojectedandpaid,the
discountrateandrateofpayrollgrowthareusedtocalculatetheamortizationperiodfortheplan.The
amortizationperiodisthenumberofyearsrequiredtopayofftheunfundedactuarialaccruedliability.

Amortization Period
TheamortizationperiodistheexpectedperiodoftimeforUAALtobepaidinfull.UnderPRB
GuidelinesforActuarialSoundness,theamortizationperiodmustbe40yearsorlesstobeconsidered
actuariallysound(with1525yearsbeingthepreferabletarget).Publicplansuseoneofthree
amortizationperiodmethods:open,closedorrecalculated.

Openamortizationperiod:Aperiodthatbeginsagaineachtimeanewactuarialvaluationis
performed.Thisisanalogoustogettinganew30yearmortgageeveryyearfortheunpaid
balanceofthemortgagestartedthepreviousyear.

Closedamortizationperiod:Aspecificnumberofyearsthatiscountedfromonedateand
decreasesbyoneeachyear.Thisisanalogoustoa30yearmortgage(withnorefinancing).

Recalculatedamortizationperiod:Aperiodthatisrecalculatedeachtimeanewactuarial
valuationisperformed.Thistypeofamortizationcommonlyappliestoplanswithafixed
contributionrate(e.g.,setinstatute).
8

Amortization Methods
TheplansfundedratioistheratiooftheassetstotheplansActuarialAccruedLiability(AAL).Itcanbe
calculatedusingtheactuarialvalueofassets(AVA)orthemarketvalueofassets(MVA).Iftheplanis
lessthat100%funded,thereisaUAAL,andanamortizationmethodisneededtosystematicallypay
downtheUAAL.
ThetwomostcommonamortizationmethodsaretheLevelDollarandtheLevelPercentofPayroll.
TheLevelPercentofPayrollisthemostcommonamortizationmethodusedinTexas.TheLevelPercent
ofPayrollmethodmakesuseofanassumedannualrateofpayrollincrease(i.e.,boththepayrolland
theamortizationpaymentareprojectedtoincreaseannuallyatthisrate.)Theamortizationpaymentis
determined,whichisusedtopaytheUAAL.Thenormalcost(NC)plustheamortizationpayment
determinesthetotalcontributionamount.

Amortization Illustration: Fixed-rate mortgage

LevelDollarAmortizationissimilartoafixedratehomemortgage.

Sayyouareborrowing$100,000,tobepaidinmonthlypaymentsover30
years,witha7%interestrate.
Themonthlypaymentis$665.30.
Aftermakingmonthlypaymentsofthisamountfor30years,theloanwill
befullyrepaid.

LevelPercentofPayrollusesanannuallyincreasingpaymentamountinsteadofa
constantpaymentamount.

Asabove,saytheloanamountis$100,000,tobepaidmonthlyover30
years,witha7%interestrate.
Themonthlypayment,however,increasesby3%eachyear,ratherthan
remaininglevelfor30years.
Inthiscase,theinitialmonthlypaymentwouldbe$486.85.(Inthe30th
year,themonthlypaymentwouldbe$1,147.32).

Cost Methods
ActuarialcostmethodsdifferbythewaythattheAALandNCarecalculated.Thetwomostcommon
costmethodsinTexaspublicplansareEntryAgeNormalCostandProjectedUnitCredit.

EntryAgeNormal(EAN)mostcommoninTexas

TheAALisbasedonprojectedpayandcurrentservice

Themethoddefinesthenormalcostasalevelpercentofpayfromentryageuntil
retirement

GenerallyputsmoreoftheliabilityintotheAALandlessintoPVFNCthanothermethods

ProjectedUnitCredit(PUC)secondmostcommoninTexas

TheAALisbasedonprojectedpayandcurrentservice

Thenormalcostforeachmemberincreasesasapercentofpayasthemember
approachesretirementage

GenerallyputslessoftheliabilityintotheAALandmoreintothePVFNCthanEAN

ThistableshowsthePVFB,AALandNCforanemployeehiredatage35whoworks30yearsuntilhis
retirementatage65.Hehasannual3%payincreases,andanendingpayof$50,000:

Age

Service

PVFB

EANAAL

EANNC

PUCAAL

PUCNC

35

$43,464

$0

$2,385

$0

$1,449

45

10

$85,500

$39,769

$3,206

$28,500

$2,850

55

20

$168,191

$131,678

$4,308

$112,128

$5,606

64

29

$309,213

$303,591

$5,621

$298,906

$10,307

65

30

$330,858

$330,858

$0

$330,858

$0

Noticehowthepresentvalueoffuturebenefits(PVFB)growsovertheyearsuntiltheretirementageof
65.IntheEntryAgeNormal(EAN)costmethod,theAALishigherthantheAALundertheProjected
UnitCreditcostmethod(PUCAAL).Also,NormalCostintheEANmodel(EANNC)startsatahigherlevel
peryearbutdoesnotgrowasquicklyasthePUCNC.NormalCostinthePUCmodel(PUCNC)starts
lowerbutsurpassesthelevelofNormalCostintheEANmodelandisweightedtowardsthefinalyears
ofservice.BothEANandPUCarriveatthesamelevelinthefinalyearofservicebutthecostsare
allocateddifferentlyovertheyears.
10

Assumptions
Pensionfundingrequiresassumptionstobemadeaboutthefuture.Theseassumptionsarecalled
actuarialassumptions,whichalongwithcurrentplanparticipantdataandthebenefitformula,areused
toprojectfuturebenefitobligations.Theplansponsorselectstheactuarialassumptions,withguidance
fromtheactuary.
Actuarialassumptionsforpensionplanscanbebrokendownintotwocategories:Economicand
Demographic.

Economicassumptionsincludeinterestrates,salaryincreases,andinflation.

Demographicassumptionsincluderatesofretirement,turnoverorwithdrawalrates,ratesof
disability,andmortalityrates.

Economic Assumptions
Keyeconomicassumptionsusedforpensionactuarialvaluations,inroughlydecreasingorderof
importance,are:

EconomicAssumption
Rateofreturnonplan
assets

WhyItsImportant
Thisisthediscountrate
usedforcalculatingthe
PVFB,theAALandthe
NC.

Description
Basedoninvestedplan
assetcategoriesand
theirhistoricalratesof
return.

HigherAssumption
Causes:
Lowerliabilityandcost

Salaryincreases

Thisassumptionaffects
theNCandtheAALfor
activeemployees;thus
alsothePVFB.

Theexpectedrateof
futuresalaryincreases
foremployeesat
variousstagesoftheir
careers.

Higherliabilityandcost

Inflation

Acomponentofbothrate
ofreturnonplanassets
andsalaryincreases.Also
usedforplanshavingan
indexedCOLA.

Therateatwhichprice
levelsarerising,and
purchasingpoweris
falling.

Forplanswithan
indexedCOLA,higher
liabilityandcost

Payrollgrowth

Usedonlyforcalculating
theamortizationofthe
UAAL.

Theprojectedoverall
annualrateofincrease
incoveredpayroll.

Lowerinitialcost,
higherultimatecost

11

Demographic Assumptions
Keydemographicassumptionsusedforpensionactuarialvaluations,inroughlydecreasingorderof
importance,are:

Demographic
Assumption

WhyItsImportant

Description

CostImpact:

Expectedretirementage, Thisassumptionaffects
orratesofretirementby theNCandtheAALfor
ageorservice
activeemployees;thus
alsothePVFB.

Theage(orages)when
employeesare
expectedtoretire.

Earlierassumed
retirementusually
increasescost.

Turnover(rateof
withdrawali.e.,pre
retirementtermination
ofemployment)

Thisassumptionaffects
theNCandtheAALfor
activeemployees;thus
alsothePVFB.

Theannualrateof
employment
terminationof
employeesatvarious
stagesoftheircareers.

Greaterassumed
turnoverdecreases
liabilityandcost.

Mortality

Thisassumptionaffects
theNCandtheAALfor
activeemployees;thus
alsothePVFB.

Theprobabilityofdying
withinoneyearateach
age.

Lowermortality
increasesliabilityand
cost.

Disability

Thisassumptionaffects
theNCandtheAALfor
activeemployees;thus
alsothePVFB.

Theprobabilityof
disablementfromactive
employmentwithinone
yearateachage.

Withahighdisability
benefit,ahighassumed
rateofdisabilitycan
increaseliabilityand
cost.

PercentMarried,Spouse
AgeDifference,and
OptionalFormofBenefit
Elected

Affectscostsinplans
wherespousalsurvivor
benefitsaresubsidized.

Assumptionsregarding
thepaymentofa
subsidizedformof
benefit

Correctlyapplied,these
assumptionsaccount
forthecostof
subsidizedbenefits

12

Experience Studies and Reasonable Assumptions

Howdoplansponsorsassesswhethertheassumptionsusedfortheactuarialvaluationsarereasonable
(i.e.,realisticovertheprojectedcareersandlifetimesofcurrentmembers)?
ActuariesareguidedbythefollowingActuarialStandardsofPractice(ASOPs),issuedbytheActuarial
StandardsBoardoftheAmericanAcademyofActuaries:

ASOP#4MeasuringPensionObligationsandDeterminingPensionPlanCostsofContributions;
ASOP#27SelectionofEconomicAssumptionsforMeasuringPensionObligations

Pensionplanactuariescanalsoconductexperiencestudies,measuringtheactualincidenceofevents
coveredbyactuarialassumptions(e.g.,retirementage,turnover,salaryincreases,anddisability).
Experiencestudiesprovidepensiontrusteeswithinformationtocomparetheirplansactualexperiences
withtheassumptionsusedintheplansactuarialvaluations.Thisallowstrusteestomakechangesto
assumptionswhenplanexperienceturnsoutdifferentfromtheassumptions.

Summary

DefinedBenefitandDefinedContributionPlansarebothsubjecttothefundamentalequationof
pensionplanfinancing:Contributions(C)+Income(I)=Benefits(B)+Expenses(E).

DefinedContributionPlansandPayasyougoDefinedBenefitPlansusethefundamental
equationinastraightforwardway;whereasPrefundedDefinedBenefitPlansrequireaperiodic
ActuarialValuationtodeterminetherecommendedcontributionamount.

CostmethodssplitthetotalliabilityorPresentValueofFutureBenefits(PVFB)betweenthe
ActuarialAccruedLiability(AAL)andthePresentValueofFutureNormalCosts(PVFNC).

Thecostmethodshouldincludeallliabilitiesandreflectprojectedpay.

SmoothingmethodscanbeusedtodeterminetheActuarialValueofAssets(AVA).

Theassetsshouldbewithinareasonablerangearoundmarketvaluerecognizinggainsand
lossesinatimeperiod.

TheAALminustheAVAistheUnfundedActuarialAccruedLiability(UAAL)

ThecontributionistheNCplustheamortizationoftheUAALplusinterest.

TheUAALisamortizedoveraperiodoftimeasdeterminedbytheactuary.

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Pension Review Board Guidelines for Actuarial Soundness

(revised September 2011):
1.Thefundingofapensionplanshouldreflectallplanobligationsandassets.
2.Theallocationofthenormalcostportionofthecontributionsshouldbelevelordecliningasapercent
ofpayrolloverallgenerationsoftaxpayers,andshouldbecalculatedunderapplicableactuarial
standards.
3.Fundingoftheunfundedactuarialaccruedliabilityshouldbelevelordecliningasapercentofpayroll
overtheamortizationperiod.
4.Fundingshouldbeadequatetoamortizetheunfundedactuarialaccruedliabilityoveraperiodnotto
exceed40years,with1525yearsbeingamorepreferabletarget.Benefitincreasesshouldnotbe
adoptedifallplanchangesbeingconsideredcauseamaterialincreaseintheamortizationperiodandif
theresultingamortizationperiodexceeds25years.
5.Thechoiceofassumptionsshouldbereasonable,andshouldcomplywithapplicableactuarial
standards.

Pension Terminology
ActuarialAccruedLiability
Computeddifferentlyunderdifferentfundingmethods,theactuarialaccruedliabilitygenerally
representstheportionofthePresentValueofFutureProjectedBenefitsattributabletoservicecredit
earned(oraccrued)asofthevaluationdate.
ActuarialAssumptions
Factorswhichactuariesuseinestimatingthecostoffundingadefinedbenefitpensionplan.Examples
include:therateofreturnonplaninvestments;mortalityrates;andtheratesatwhichplanparticipants
areexpectedtoleavethesystembecauseofretirement,disability,termination,etc.
ActuarialCostMethods
Anactuarialmethodwhichdefinestheallocationofpensioncosts(andcontributions)overamember's
workingcareer.Allstandardactuarialcostmethodsarecomprisedoftwocomponents:normalcostand
theactuarialaccruedliability.Anactuarialcostmethoddeterminestheincidenceofpensioncosts,not
theultimatecostofapensionplan;thatcostisdeterminedbytheactualbenefitspaidlesstheactual
investmentincome.
ActuarialEquivalent
Abenefithavingthesamepresentvalueasthebenefititreplaces.Also,theamountofannuitythatcan
beprovidedatthesamepresentvaluecostasaspecifiedannuityofadifferenttypeoraspecified
annuitypayablefromadifferentage.
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ActuarialGainorLoss
Experienceoftheplan,fromoneyeartothenextwhichdiffersfromthatassumedresultsinanactuarial
gainorloss.Forexample,anactuarialgainwouldoccurifassetsearned10percentforagivenyear
sincetheassumedinterestrateinthevaluationis8percent.
ActuarialPresentValue
Thevalueofanamountorseriesofamountspayableorreceivableatvarioustimes,determinedasofa
givendatebytheapplicationofaparticularsetofactuarialassumptions(i.e.interestrate,rateofsalary
increases,mortality,etc).
ActuarialValueofAssets
Thevalueofpensionplaninvestmentsandotherpropertyusedbytheactuaryforthepurposeofan
actuarialvaluation(sometimesreferredtoasvaluationassets).Actuariesoftenselectanassetvaluation
methodthatsmoothestheeffectsofshorttermvolatilityinthemarketvalueofassets.
ActuariallyReduced
Themethodofadjustingabenefitreceivedatanearlydatesothattheexpectedtotalcosttothe
retirementsystemisequivalenttothecostifthebenefitdidnotbeginuntillater.
Actuary
Abusinessprofessionalwhoanalyzesthefinancialconsequencesofrisk.Actuariesusemathematics,
statisticsandfinancialtheorytostudythecostoffutureevents,especiallythoseofconcerntoinsurance
andpensionprograms.Theyevaluatethelikelihoodofthoseevents,designcreativewaystoreducethe
likelihoodanddecreasetheimpactofadverseeventsthatactuallydooccur.
Age(Retirement)
Normalretirementdependentuponattainmentofaspecifiedage.
AggregateFundingMethod
Theaggregatefundingmethodisastandardactuarialfundingmethod.Theannualcostofbenefits
undertheaggregatemethodisequaltothenormalcost.Themethoddoesnotproduceanunfunded
liability.Thenormalcostisdeterminedfortheentiregroupratherthanonanindividualbasis.
Amortization
Payingoffaninterestbearingliabilitybygradualreductionthroughaseriesofinstallments,asopposed
topayingitoffbyonelumpsumpayment.
Annuitant
Onewhoreceivesperiodicpaymentsfromtheretirementsystem.Thistermincludesserviceand
disabilityretirees,andtheirsurvivors.
Annuity
Aseriesofperiodicpayments,usuallyforlife,payablemonthlyoratotherspecifiedintervals.Theterm
isfrequentlyusedtodescribethepartofaretirementallowancederivedfromaparticipant's
contributions.Comparewith"pension".
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Beneficiary
Thepersondesignatedtoreceivebenefitsunderanemployeebenefitplanintheeventofthedeathof
thepersoncoveredbytheplan.
CashOut
Alumpsumpaymentofthemember'scontributionspriortoretirement.
CreditedService
Aperiodofemploymentwhichisrecognizedasserviceforpurposesofdeterminingeligibilitytoreceive
pensionpaymentsand/ordeterminingtheamountofsuchpayments.
DeathBenefit
Abenefitpayablebyreasonofamember'sdeath.Thebenefitcanbeintheformofalumpsum,an
annuityorarefundofthemember'scontributions.
DeferredAnnuity
Anannuityforwhichpaymentsdonotcommenceuntiladesignatedtimeinthefuture.
DeferredCompensation
Considerationsforemploymentthatarenotpayableuntilaftertheregularpayperiod.Themost
commonformofdeferredcompensationarepensionplans,butprivateemployersmayalsooffer
bonuses,incentiveclauses,etc.
DefinedBenefitPlan(DB)
Apensionplanprovidingadefinitebenefitformulaforcalculatingbenefitamountssuchasaflat
amountperyearofservice;apercentageofsalary;orapercentageofsalary,timesyearsofservice.
DefinedContributionPlan(DC)
Apensionplaninwhichthecontributionsaremadetoanindividualaccountforeachemployee.The
retirementbenefitisdependentupontheaccountbalanceatretirement.Thebalancedependsupon
amountscontributedduringtheemployee'sparticipationintheplanandtheinvestmentexperienceon
thosecontributions.
DisabilityRetirement
Aterminationofemploymentinvolvingthepaymentofaretirementallowanceasaresultofanaccident
orsicknessoccurringbeforeaparticipantiseligiblefornormalretirement.
EarlyRetirement
Aterminationofemploymentinvolvingthepaymentofaretirementallowancebeforeaparticipantis
eligiblefornormalretirement.Theretirementallowancepayableintheeventofearlyretirementis
oftenlowerthantheaccruedportionofthenormalretirementallowance.

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EntryAgeNormalCostMethod(EANC)
TheEANCmethodisastandardactuarialfundingmethod.TheannualcostofbenefitsunderEANCis
comprisedoftwocomponents:

Normalcost
Amortizationoftheunfundedliability

Thenormalcostisdeterminedonanindividualbasis,fromamembersageatplanentry,andis
designedtobealevelpercentageofpaythroughoutamemberscareer.
Equities
Ownershipofacompany(asopposedtodebt).Examplesincludestocks,venturecapital,andleveraged
buyouts.
ERISA
EmployeeRetirementIncomeSecurityActacronym.Thisfederallegislationsetsminimumstandardsfor
pensiondesigntoincreasethesecurityofprivatesectoremployees'benefits.Mostpublicplansare
subjecttoasmallportionofERISA.
401(k),403(b),and457Plans
Thesedefinedcontributionplansallowemployeestosaveforretirementonataxdeferredbasis.401(k)
plansarefoundintheprivatesectorandthepublicsectorinsomestates.403(b)plansarefor
employeesofpubliceducationalinstitutionsandcertainnonprofittaxexemptorganization.457plans
(alsoknownasdeferredcompensationplans)areforgovernmentalemployeesandnonchurch
controlledtaxexemptorganizations.
Fiduciary
(1)Indicatestherelationshipoftrustandconfidencewhereoneperson(thefiduciary)holdsorcontrols
propertyforthebenefitofanotherperson;(2)anyonewhoexercisespowerandcontrol,management
ordispositionwithregardtoafund'sassets,orwhohasauthoritytodosoorwhohasauthorityor
responsibilityintheplan'sadministration.Fiduciariesmustdischargetheirdutiessolelyintheinterest
oftheparticipantsandtheirbeneficiaries,andareaccountableforanyactionswhichmaybeconstrued
bythecourtsasbreachingthattrust.
FundedRatio
Theratioofaplanscurrentassetstotheactuarialaccruedliability(AAL).Thereareseveralacceptable
methodsofmeasuringaplansassetsandAAL.Infinancialreportingofpublicpensionplans,funded
statusisreportedusingconsistentmeasuresbyallgovernmentalentities.Accordingtothe
GovernmentalAccountingStandardsBoard(GASB),thefundedratioequalstheactuarialvalueofassets
dividedbytheactuarialaccruedliabilitycalculatedundertheplansactuarialcostmethod.
GovernmentalAccountingStandardsBoard(GASB)
Thisgovernmentalagencysetstheaccountingstandardsforstateandlocalgovernmentfinancial
reporting.
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IndividualRetirementAccount(IRA)
Aretirementaccounttowhichanindividualcanmakeannualtaxdeductiblecontributionsaccordingto
annuallimitsthatarespecifiedbytheInternalRevenueService.
JointandSurvivorAnnuity
Aprovisionthatenablesaplanparticipanttotakeannuitypaymentswithcontinuingpaymentsofallor
partofthebenefitsafterhisorherdeathgoingtoadesignatedbeneficiary.Thesurvivorannuitywill
automaticallybeprovidedtoamarriedparticipantifheorshedoesnotchooseagainstit.Theannual
pensionbenefitsoftheparticipantelectingtohavesuchasurvivorannuityaregenerallyreducedto
provideforthesurvivor.
LifeAnnuity
Amonthlybenefitpayableaslongastheannuitantisalive.Therearenoresidualpaymentstosurvivors.
LifeExpectancy
Theaveragenumberofyearsapersonofagivenagemightbeexpectedtolive.
LumpSumDistribution
Paymentwithinonetaxableyearoftheentirebalancepayabletotheparticipantfromaqualified
pensionoremployeeannuityplan.
MoneyPurchasePlan
Atypeofpensionplanwheretheemployeragreestomakeafixedcontributioneachyearforeach
eligibleemployee.Thecontributionistypicallyexpressedasapercentageoftheemployee'spayand
thecontributionconstitutesanondiscretionarycommitmentonthepartoftheemployer.The
contributionmustbemadeeachyear,regardlessofemployerprofits,andcanonlybevariedbyplan
amendment.Althoughtreateddifferentlyunderfederaltaxlaw,moneypurchaseplansare
fundamentallydefinedcontributionplans.
NonContributoryPlan
Aretirementsysteminwhichnocontributionsarerequiredofitsmemberstoaidinitsfinancing.
NormalCost
Computeddifferentlyunderdifferentfundingmethods,thenormalcostgenerallyrepresentsthe
portionofthecostofprojectedbenefitsallocatedtothecurrentplanyear.Theemployernormalcost
equalsthetotalnormalcostoftheplanreducedbyemployeecontributions.
NormalRetirementAge
Theage,asestablishedbyaplan,whenunreducedbenefitscanbereceived.
OffsetPlan
Apensionplaninwhichtheemployer'sparticipationinSocialSecurityisusedas"credit"against
members'benefits.

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PayAsYouGo
Amethodofrecognizingthecostsofaretirementsystemonlyasbenefitsarepaid.Alsoknownasthe
currentdisbursementcostmethod.
Pension
Aseriesofperiodicpayments,usuallyforlife,payablemonthlyoratotherspecifiedintervals.Theterm
isfrequentlyusedtodescribethepartofaretirementallowancefinancedbyemployercontributions.
Comparewith"annuity".
Portability
Theabilityofanemployeewhochangesjobsandjoinsadifferentretirementsystemtobecomeadual
member,maintainingmembershipinbothsystems.Dualmembersmaycombineserviceforbenefit
eligibility.Theymayalsousetheirhighestsalaryfromeithersystemforbenefitcalculation.
PreFunding
Toaccumulateareservefundinadvanceofpayingbenefits.Thisistheoppositeof"payasyougo."
PresentValue
Thecurrentworthofanamountorseriesofamountspayableinthefuture,afterdiscountingeach
amountatanassumedrateofinterestandadjustingfortheprobabilityofitspaymentorreceipt.
PresentValueofFutureProjectedBenefits(PVFB)
Computedbyprojectingthetotalfuturebenefitpaymentsfromtheplan,usingactuarialassumptions
(i.e.probabilityofdeathorretirement,salaryincrease,etc.),anddiscountingthepaymentstothe
valuationdateusingthevaluationinterestratetodeterminethepresentvalue(todaysvalue).
ProjectedBenefits
Pensionbenefitamountswhichareexpectedtobepaidinthefuturetakingintoaccountsuchitemsas
theeffectofadvancementinageaswellaspastandanticipatedfuturecompensationandservice
credits.
ProjectedUnitCredit(PUC)FundingMethod
ThePUCfundingmethodisastandardactuarialfundingmethod.TheannualcostofbenefitsunderPUC
iscomprisedoftwocomponents:
Normalcost
Amortizationoftheunfundedactuarialaccruedliability
ThePUCnormalcostequalsthedifferencebetweentheaccruedliabilityatthebeginningandendofthe
year.
ProjectedUnitCredit(PUC)Liability
TheportionoftheActuarialPresentValueoffuturebenefitsattributabletoservicecreditthathasbeen
earnedtodate(pastservice).

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PrudentManRule
ArequirementimposedbytheEmployeeRetirementIncomeSecurityAct(ERISA)thatplanfiduciaries
carryouttheirdutieswiththecare,skillprudenceanddiligencewhichaprudentman,actinginalike
capacityandfamiliarwithsuchmatters,woulduseunderconditionsprevailingatthetime.
QualifiedPlan
AnemployeebenefitplanapprovedbytheInternalRevenueService,meetingrequirementssetforthin
IRSCodeSection401.Contributionstosuchplansaresubjecttofavorabletaxtreatment.
ReplacementRatio
Acalculationofthedegreetowhichretirementincomesupplantsapreretirementmember's"take
home"pay,lessworkingexpenses.Todeterminethisratio,severalfactorsmustbetakenintoaccount:
aretiree'spreretirementearnings;changesintaxliabilitiesafterretirement;changesinSocialSecurity
taxliability;theeliminationofworkrelatedexpensesincludingcontributionstotheretirementsystem;
andsavings.
Reserve
Acollectionofassetssetasidetomeetfutureliabilities.
RothIRA
Aretirementaccountwhichanindividualcanmakeaftertaxcontributionsaccordingtoannuallimits
thatarespecifiedbytheIRS.
ServiceRetirement
Retirementdependentuponcompletionofaspecifiedperiodofservice.Insomeusages,thetermhas
thesamemeaningas"normalretirement".
SupplementalCost
Aseparateelementofactuarialcostwhichresultsfromfuturenormalcostshavingapresentvalueless
thanthepresentvalueofthetotalprospectivebenefitsofthesystem.Suchsupplementalcostis
generallytheresultofassumingactuarialcostsaccruedbeforetheestablishmentoftheretirement
system.Asupplementalcostmayalsoariseafterinceptionofthesystembecauseofbenefitchanges,
changesinactuarialassumptions,actuariallosses,orfailuretofundorotherwiserecognizenormalcost
accrualsorinterest.
ThirteenthCheck
Anannualsupplementalretirementpaymentarisingfromearningsoninvestmentsofthesystemin
excessofthosedeterminedasneeded.
UltimateEntryAgeNormalCostMethod(UltimateEANC)
TheUltimateEANCmethodisavariationofEANC,wherethenormalcostiscalculatedforeachactive
memberbasedontheplanprovisionsapplicabletoaneworrecententranttotheplan.Foraplanthat
hasalowercosttierforneworrecententrants,useoftheUltimateEANCmethodlowersthenormal
costandincreasestheactuarialaccruedliability,ascomparedtoEANC.
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UnfundedActuarialAccruedLiability(UAAL)
Theexcess,ifany,oftheActuarialAccruedLiabilityovertheActuarialValueofAssets.Inotherwords,
thepresentvalueofbenefitsearnedtodatethatarenotcoveredbycurrentplanassets.
UnfundedLiabilityorUnfundedPBO
Theexcess,ifany,ofthepensionbenefitobligationoverthevaluationassets.Thisistheportionofall
benefitsearnedtodatethatarenotcoveredbyplanassets.
VariableAnnuity
Abenefitwhosepaymentsvaryfromyeartoyeardependinguponthevalueofaportfolioofsecurities
(usuallycommonstocks).
Vesting
Therightofanemployeetothebenefitsheorshehasaccrued,orsomeportionofthem,evenif
employmentundertheplanisterminated.Anemployeewhohasmetthevestingrequirementsofa
pensionplanissaidtohaveavestedright.Voluntaryandmandatoryemployeecontributionsarealways
fullyvested.
Withdrawal
Theterminationofemploymentpriortobecomingeligibleforanybenefits.Thetermsometimesrefers
tosubsequentterminationofmembershipinasystembywithdrawaloftheemployee'saccumulated
contributionsfromthesystem.

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