How The Actuarial Cost Method Works

There are two essential methods within the actuarial cost method, also known as the Actuarial Funding Method.

  • The Benefit Approach: determines the present value (the sum of money today is more valuable than the same quantity in a subsequent time) of posterior benefits (such as annual salary increases and salary paid after retirement) by discounting them. It shows the benefits an employee has received from the company during the length of their employment.
  • The Cost Approach: calculates the entire amount of benefits to be paid in the future based on a wide range of assumptions. These could be expected retirement age, salary increases, among others. After considering these assumptions, it's reached an agreement on the total sum of a funding pension necessary to meet these future benefits.

Both methods consider the following factors:

  • Up-to-date payroll
  • Annual salary increases
  • Years until retirement
  • Percentage of salary paid to the employee when retired
  • The life expectancy of the employee after retirement and receiving payment

Example of The Actuarial Cost Method

To better understand the Actuarial Cost Method, it is important to consider the Fundamental Equation of Pension Plan Financing, since the Actuarial Cost Method values the pension plan liabilities and is deeply related to this equation, which is the following: C (Contributions) + I (Income) = B (Benefits) + E (Expenses).

The first part of the equation is compound by the following items:

  • Contributions (C): This first part of the equation means that contributions are made by both employers and employees to a fund periodically. This fund, then, invests these contributions and in return, earns a certain amount on this investment.
  • Income (I): The income is therefore the return received from the investments made, that can be equities, mutual funds, fixed income, among others.

Combined, both the Contributions (C) and the Income (I), add to the pension fund. The second part is compound by two items:

  • Benefits (B): Benefits are paid to members of the pension fund who meet the Pension Plan requirements, such as the retirement age of 65.
  • Expenses (E): The Pension Plan also covers expenses generated for the preservation of the plan. These expenses can be from investments, auditing, administrative, and other sources.

In connection, these Benefits (B) paid and Expenses (E) generated a decline in the sum of the pension fund.

Significance of The Actuarial Cost Method

The Actuarial Cost Method is essential to pension funding and pension consulting, as it brings into light how much is necessary to create a pension plan. It helps determine the best way this pension plan should be invested, as well as to know approximately the lifetime cost investment of supplying an employee with a pension.

The Actuarial Cost Method is a type of method used by trained actuaries — a person who manages and assesses probable risky ventures, as in the case of insurance policies or financial investments. Actuaries stipulate how much money an employer/company must pay regularly to a fund to cover its pension costs. As a result, this method is an essential component of a company’s pension funding and consulting.

In addition, when an employer or a company creates a pension fund, this funding cost is considered an expense. The absolute number of future pension payments is labeled as an accrued liability (an expense that the company oremployer brought to themselves but hasn’t been paid yet). It can be a short-term expense, such as payroll taxes, or a long-term expense, as in the case of pension payments that are only paid when the employee retires.