Bacs 323: Introduction to Pension Mathematics
Funding methods
Introduction
Whether designing benefits or monitoring the financing of benefits, models may be used to help
with decisions relating to the level and timing of contributions. The valuation of the liabilities (ie
the benefits promised to the members) involves estimating the amount and timing of future
benefit payments and then discounting these to the present time. It is not essential to hold
sufficient assets to cover the full expectation of future benefit payments (ie benefits relating to
both past and future service) to all current members. Instead, a common approach is to pay
regular contributions that are expected to accumulate to cover the benefit payments by the time
they begin to be paid.
Where a regular funding method is used, such models may be used in an attempt to produce a
generally stable contribution or a contribution that varies to meet other funding objectives.
Terms used
Funding methods can be used that attempt to replicate an “ideal” plan for meeting the expected
cost of running a pension scheme. Under each of these methods, there is
i) The Actuarial Liability: - an “ideal” amount of fund or to cover the benefits earned
to date. It is the value, using actuarial methods and assumptions, placed on the
obligations of a pension fund for outgoings, including expenses expected to fall on the
fund after the date to which the calculations relate. The Actuarial Liability (AL) is
sometimes referred to as the Standard Fund.
ii) Standard Contribution Rate (SCR): - a corresponding “ideal” contribution rate or
to cover the cost of future benefit accrual.
What is meant by “future benefit accrual” in describing the Standard Contribution Rate
(SCR), and by “benefits earned to date” in describing the Actuarial Liability (AL) will
depend on the method being used.
“Future benefit accrual” might, for example, be the benefits accruing in the next year, all future
years, or some other period. Similarly, “benefits earned to date” might allow for future salary
growth, no future increases to the benefits, or some other level of benefit projection, e.g. early
leaver revaluation. To further complicate matters, “future benefit accrual” will also depend on
how we define those “benefits earned to date”.
It is important to note that funding methods normally determine only the timing of meeting the
cost rather than its fundamental long-term amount. Funding methods are essentially about when
you pay, not what you pay. In a similar way, the valuation assumptions normally affect only the
pace of funding and not the actual cost of the scheme.
Main funding methods used
The following methods are commonly used to set the contributions for funded final salary
pension schemes that are funded in advance by regular contributions:
● Attained Age funding method (AAM)
● Entry Age funding method (EAM)
● Projected Unit funding method (PUM)
● Current Unit funding method. (CUM)
These methods fall into two distinct categories:
● prospective methods, which target a stable contribution rate
● accrued benefits methods, which target the Actuarial Liability.
Prospective methods
The Attained Age and Entry Age methods use models that target a stable level of contribution
(commonly expressed as a percentage of earnings and called a Standard Contribution Rate)
which can then be adjusted as appropriate when experience does not follow the model or its
parameter values.
For both of these methods the Actuarial Liability is the difference between the discounted value
of the total expected benefits for the members and the discounted value of the future expected
contributions.
1. Attained Age method
For the Attained Age method, the Standard Contribution Rate (AASCR) is determined as the
stable rate of contribution that, if paid over the expected future membership of a beneficiary, will
accumulate (with investment returns) to the value required to provide the benefits that are
expected to accrue over that future period of membership.
The AASCR, expressed as a percentage of earnings, is:
the present value of all benefits that will accrue to present members after the valuation date, by
reference to service after that date and projected final earnings
divided by
the present value of total projected earnings for all members throughout their expected future
membership
The AAAL is:
the present value of total benefits based on projected final earnings for members in service
minus
the value of the SCR multiplied by the present value of total projected earnings for all members
throughout their expected future membership
The AAAL can also be expressed as:
the present value of all benefits accrued at the valuation date, based on projected final earnings
for members in service
2. Entry Age method
For the Entry Age method, the SCR is determined in a similar manner except the contributions
and benefits are equated over the full expected period of membership for the member. This
includes any past service accrued at the time when the calculations are performed. Again, where
there is more than one member the calculations are combined. The full expected period of
membership will be based on a single assumed entry age for all of the members.
The EASCR, expressed as a percentage of earnings, is:
the present value of all future benefits for a member joining at the assumed entry age, by
reference to projected final earnings
divided by
the present value of total projected earnings for the member throughout his/her expected
membership
The EAAL is:
the present value of total benefits, based on projected final earnings for members in service
minus
the SCR multiplied by the present value of total projected earnings for all members throughout
their expected future membership
Accrued benefits methods
The Projected Unit and Current Unit methods use models that target a standard level of funding
with the Standard Contribution Rate being set to maintain this target from year to year and which
can then be adjusted as appropriate when experience does not follow the model or its parameter
values.
1. Projected Unit method
For the Projected Unit method, the Actuarial Liability is the discounted value of the benefits that
have accrued over the past period of membership of the beneficiaries. In determining this value
allowance is made for any future expected inflationary growth of the on-going benefits up to
retirement age.
The PUAL is:
the present value of all benefits accrued at the valuation date, based on projected final
earnings for members in service
The PUSCR, expressed as a percentage of earnings, is then:
the present value of all benefits that will accrue in the year following the valuation date, by
reference to service in that year and projected final earnings
divided by
the present value of all members’ earnings in that year
2. Current Unit method
For the Current Unit method, the target level of funding is determined in a similar manner except
that no allowance is made for any inflationary growth, e.g. earnings growth, that will apply to the
benefits between the date at which the target fund should be held and the date payment starts.
The CUAL is:
the present value of all benefits accrued at the valuation date, based on current earnings
for members in service
The CUSCR, expressed as a percentage of earnings, is:
the present value of all benefits that will accrue in the year following the valuation date, by
reference to service in that year and projected earnings at the end of that year
plus
the present value of all benefits accrued at the valuation date in respect of members in service,
multiplied by the projected percentage increase in earnings over the next year
all divided by
the present value of all members’ earnings in that year
NB: The definitions of the PUM and CUM standard contribution rates given above have been
based on a one-year time horizon. A control period is defined as “the period over which the
Standard Contribution Rate has been calculated to remain constant, assuming that the Funding
Ratio at the beginning and end of the period is 100%”.
