Chapter 2

Financial Management of Pension Plans

1 Lecture 2
 DB Plan Cost
 “Cost” of a DB plan
Cost (amount required to pay promised benefits)
= Benefit payments plus expenses less investment income earned
on pension fund assets
 Until the last benefit is paid out, all parameters on the right-
hand side cannot be determined in advance with certainty
 “Cost” of an ongoing plan at a point in time can only be
estimated, using actuarial principles

2 Lecture 2
 Financing Issues
 Funding: estimate of periodic contributions required to meet
benefit obligations
 Accounting: determination of annual pension costs to be
expensed on employer’s financial statement

3 Lecture 2
 Pension Funding Problem
 Funding concerns with determining the amounts and timing
of contributions required to meet promised benefits
 Three possible funding approaches:
 Pay-as-you-go (PAYGO) funding
 Terminal funding
 Pre-funding or advance funding

4 Lecture 2
 PAYGO funding
(Illustration only)

 Contributions are made as benefits fall due

 Benefit payouts under a DB plan tend to trend upward over time from plan inception until
maturity

Benefit Stationary
Level membership

Closed
membership

Time

5 Lecture 2
 PAYGO Funding
 PAYGO problems
 Budgeting and expensing – costs are not recognized as benefits
are earned by members; inconsistent with accounting principles
 Benefit security – no funds are set aside for benefits; safety of
benefits depends upon the continued willingness and ability of
the employer to pay
 Not an acceptable funding approach

6 Lecture 2
 Terminal Funding
 Employer makes a lump sum contribution to fully pay the
lifetime benefit to each plan participant, as that participant
retires or terminates.
 No funds are set aside while the participants are in
employment and accruing benefits
 Employer’s cost will vary widely year to year – similar
budgeting problem as the PAYGO financing
 Not an acceptable funding approach

7 Lecture 2
 Prefunding/advance funding
 An arrangement where periodic contributions are made to
meet the benefits of plan participants as they are accruing
benefits under the plan

8 Lecture 2
 Example 1
Pension formula - US$50 per month per year of service
Form of pension - Life annuity, payable monthly in advance
Preretirement death/termination benefit - None
Normal retirement age - 65

Sole participant data

Sex Male
Age at hire 30

Actuarial assumptions used to calculate the cost of benefits

Interest rate 6% p.a.
Pre-retirement death or termination None
( )
Life annuity at age 65 𝑎̈ = 10, based on 6% interest

Demonstrate the funding patterns under the PAYGO, terminal funding and prefunding approaches.

In the case of prefunding, it is assumed that the plan adopts a funding method under which the employer
contributes an amount equal to the estimated cost of the pension benefit earned by the participant in each
year.

9 Lecture 2
 Example 1 answers
Number of years of service at age 65 = 65-30=35
Total amount of earned pension at age 65 = 50*35 = $1,750 per month ($21,000 per year)
PAYGO funding
 The employer pays a monthly pension of $1,750 to the participant from age 65 as long
as he is alive.
Terminal funding
 The employer pays a lump sum amount of , to fully settle
the pension benefit accrued by the participant when he retires at age 65.

10 Lecture 2
 Example 1 answers
Prefunding

 We set the contribution payable at the beginning of each year as the actuarial present value of the
pension earned in that year, based on a discount rate of 6%. For example, the amount to be
contributed at age 40 would be: 𝐴𝑃𝑉 = 50 ∗ 12 ∗ 10⁄1.06 = 1,398. (No pre-
retirement decrement is assumed, so 𝑝 = 1. )
 Contributions are made to a pension fund for investment in the financial markets. Assume the
pension fund earns a return of 6% p.a., verify that the pension fund would accumulate to an
amount of $210,000 when the participant reaches age 65.
Estimated cost of Fund balance
Age Annual pension
earned pension @ end of year
(𝑥) earned ( )
600 ∗ 𝑎̈ /1.06^(65 − 𝑥) (return of 6% p.a.)

30 600 781 827

… … … …
40 600 1,398 16,301
… … … …
50 600 2,504 55,730
… … … …
64 600 5,660 210,000

11 Lecture 2
 Example 1 (cont’d)
Follow-up questions:
 Of the fund balance of $210,000 at age 65, what proportion
is from employer contributions and what proportion is from
investment earnings?
 If the actual returns were 4% p.a., what would the fund
balance be when the participant reaches age 65? Who has to
make up the funding shortfall?

12 Lecture 2
 Mathematical solution
Under the funding method, the contribution payable as of age 𝑥 < 65 , 𝐶 , is set as the 𝐴𝑃𝑉 of the
pension earned by the participant in the year of age 𝑥.

𝐶 = 50 ∗ 12 ∗ 𝑎̈ ∗ 𝑝 ∗𝑣
Let 𝑟 be the annual rate of return on the pension fund. The accumulated value of fund at age 65 is:

1+𝑟
𝐹= 𝐶 1+𝑟 = 600 𝑎̈ 𝑝
1+𝑖
Based on the valuation assumptions, we have: 𝑎̈ = 10, 𝑝 = 1 and 𝑖 = 6%.
If 𝑟 = 𝑖, then

𝐹= 600 10 = 600 ∗ 10 ∗ 35 = 210,000

If 𝑟 = 4%, then

1.04
1.04 1.04 −1
1.06
𝐹= 600 10 = 6000 = 151,817
1.06 1.06 1.04
−1
1.06

13 Lecture 2
 Why prefunding?
 Overcomes PAYGO & terminal funding problems
 Solving the budgeting and expensing problem
 Build-up of funds to secure future benefit payments
 Any other reasons?
 Required by law
 Spreading pension costs over time
 Tax incentives
 Achieving inter-generational fairness – reducing cost transfers
between generations of members
 Rational funding enables the orderly accumulation of assets over
an employee’s career to match the liability at the date the
employee retires

14 Lecture 2
 Basic Actuarial Functions
 Three basic functions used in pension mathematics:
 Composite survival function
 Interest function
 Annuity function
 The actuarial present value at age x of an annual pension of $1
starting at retirement age y is calculated as:
The product of (i) a survival function, (ii) an interest function, and (iii) an
annuity function

15 Lecture 2
 Composite survival function
In a multiple-decrement environment, the probability of surviving one year is equal to the product of such complements for each applicable rate
of decrement, e.g., a 3-decrement environment

(𝑇) ′(𝑑) ′ (𝑤) ′ (𝑟) ′ (𝑑) ′ (𝑤) ′ (𝑟)

𝑝𝑥 = 1 − 𝑞𝑥 1 − 𝑞𝑥 1 − 𝑞𝑥 = 𝑝𝑥 𝑝𝑥 𝑝𝑥 (1)

Alternatively, we can express the probability of surviving one year in terms of the probabilities that reflect competing decrements as follows:

(𝑇) (𝑑) (𝑤) (𝑟)

𝑝𝑥 = 1 − 𝑞𝑥 + 𝑞𝑥 +𝑞𝑥

We can estimate the probability of death from the rates of decrements using the following approximation:

(𝑑) ′ (𝑑) 1 ′ (𝑤) 1 ′ (𝑟)

𝑞𝑥 ≈ 𝑞𝑥 1 − 𝑞𝑥 1 − 𝑞𝑥
2 2

Other decrement probabilities can be similarly estimated.

The probability of surviving in active service for 𝑛 years is equal to the product of successive one-year composite survival probabilities:

(𝑇) (𝑇)
𝑛 𝑝𝑥 = ∏𝑛−1
𝑡=0 𝑝𝑥+𝑡 (2)

Note that discounting for the various decrements before retirement reduces pension cost estimates with respect to members.

16 Lecture 2
 Take-home exercise
In a 3-decrement environment (death, withdrawal & retirement), assume that all
decrements occur uniformly in each year of age (UDD assumption). Show that the
probability of death can be expressed in terms of the multiple rates of decrements as
follows:

( ) ( ) ( ) ( ) ( ) ( )

Please submit your solution to Howard Chan in the next tutorial session.

17 Lecture 2
 Service table
 A service table shows the number of employees out of an original group who survive in service to
each future age.
( ) ( )
 Denote 𝑙 as number of survivors at age 𝑥 and 𝑑 is as total number of employees leaving
service during the year. The superscript 𝑇 indicates that survivors are exposed to multiple
decrements. The initial number is usually set equal to some large number such as 1,000,000.
 In a 3-decrement (death, withdrawal and retirement) environment, we have the following recursive
relationship for the construction of a service table:
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
𝑑 =𝑑 +𝑑 +𝑑 =𝑙 𝑞 +𝑞 +𝑞
( ) ( ) ( )
𝑙 =𝑙 −𝑑
 Once a service table is constructed, the probability of a life aged 𝑥 surviving in service after 𝑛 years
can be easily calculated as:
( )
( ) 𝑙
𝑝 = ( )
𝑙
𝒊 (𝒊)
 In pension practice, we often set 𝒒𝒙 equal to 𝒒𝒙 to simplify calculations, so that
(𝑻) (𝒊)
𝒒𝒙 ≡ ∑𝒏𝒊 𝟏 𝒒𝒙 in an n-decrement environment. The resultant inaccuracy is usually
within acceptable tolerances.

18 Lecture 2
 Example 2

Given Use the rates of decrement provided

and set equal to , construct a service table consisting of:
(𝑇) (𝑑) (𝑤) (𝑟) (𝑇)
𝑙𝑥 , 𝑑𝑥 , 𝑑𝑥 , 𝑑𝑥 𝑎𝑛𝑑 𝑑𝑥 , 20 ≤ 𝑥 ≤ 65

Then calculate the probabilities of employees with hire ages of

20, 30, 40 and 50 surviving in service to age 65.
(Ans: 0.1363, 0.4318, 0.7359, 0.9051)
Decrement rates.xlsx

19 Lecture 2
 Exact calculation
We can use the following exact formulas to calculate the survival
probabilities:
( ) ( ) ( ) ( ) ( ) ( ) ( )

( ) ( )

The corresponding results are: 0.1365, 0.4321, 0.7361, 0.9051.

They are close to the results generated from the crude
approximation: 0.1363, 0.4318, 0.7359, 0.9051.

20 Lecture 2
 Interest Function

Interest function

The interest function is used to discount a future payment to the present time. It plays a crucial role in
determining pension costs, and like the survival function, a positive discount rate reduces the pension costs.

If 𝑖𝑡 is the interest rate assumed for the 𝑡 𝑡ℎ year in a deterministic economic environment, the present value
of $1 due in 𝑛 years is given by:
1
(1 + 𝑖1 )(1 + 𝑖2 ) … (1 + 𝑖𝑛 )
1
If 𝑖1 = 𝑖2 = ⋯ = 𝑖𝑛 = 𝑖, it reduces to .
(1+𝑖)𝑛

1
Set 𝑣 = . Thus 𝑣 𝑛 represents the present value of $1 due in 𝑛 years at an annual compound rate of
(1+𝑖)
interest equal 𝑖 .

21 Lecture 2
 Annuity Function
 Life annuity due
∞

𝑎̈ 𝑥 = 𝑡 𝑝𝑥 𝑣𝑡
𝑡=0

 Life annuity due with -year term certain

𝑎̈ 𝑥:𝑛¬ = 𝑎̈ 𝑛¬ + 𝑛 𝑝𝑥 𝑣 𝑛 𝑎̈ 𝑥+𝑛

 Joint and survivor annuity due

∞ ∞
𝑘 1 𝑡
𝑎̈ 𝑥𝑦 = 𝑣 [ 𝑡 𝑝𝑥 𝑡 𝑝𝑦 + 𝑡 𝑝𝑥 1 − 𝑡 𝑝𝑦 + 𝑘 𝑡 𝑝𝑦 (1 − 𝑡 𝑝𝑥 )] = 𝑣 𝑡 [ 𝑡 𝑝𝑥 + 𝑘 𝑡 𝑝𝑦 (1 − 𝑡 𝑝𝑥 )]
𝑡=0 𝑡=0

22 Lecture 2
 Annuity function (cont’d)
 Temporary annuity due

 Salary-based temporary annuity due:

The superscript s denotes that the annuity is dependent on a salary scale 𝑠 , 𝑧 = 𝑥 … 𝑦 .

23 Lecture 2
 Cost of future benefits
General procedure to calculate the cost of future benefits under a pension plan at a
valuation date:
 For each plan participant,
1. Calculate the future benefits expected to be payable under the plan when the participant is
expected to die, quit, become disabled, or retire.

2. Each future benefit is discounted from the expected date of payment to the valuation date,
using interest rate assumption and decrement probabilities (e.g., death, termination, disability
or retirement).

3. The total of these discounted amounts is the cost of future benefits for the participant.

 The cost of future benefits provided under a plan is the sum of the cost of future
benefits for all participants in the plan.

24 Lecture 2
 Example 3
Pension formula US$50 per month per year of service
Form of pension Life annuity, payable monthly in advance
Termination & death benefits None
Normal retirement age 65

Sole participant data at date of valuation 1.1.2021

Sex Male
Age at hire 30
Years of service 10

Actuarial assumptions
Interest rate 6%
Pre-retirement death or termination Selected rates (see Example 2)
( )
Life annuity at age 65 = 10, based on 6% interest

Calculate the cost of future pension benefit as at 1.1.2021.

25 Lecture 2
 Example 3 answer
(1) Calculate annual pension B expected to be paid at age 65:

𝐵 = 50x12x35 = 21000

(2) Amount required to fully settle the pension benefit B at age 65:

𝐵 / ( )
/ 𝑝 𝑣 = 𝐵𝑎̈ = 21000 × 10 = 210000
12

(3) Determine the probability that the participant would remain in the plan until age 65 (from Example 2):

( )
( ) 𝑙 136301
𝑝 = ( )
= = 0.73588
𝑙 185222

(4) Calculate interest discount factor from age 40 to age 65: 𝑣 = = 0.2330
.

Cost of future pension benefit = (2) x (3) x (4) = 210000 x 0.73588 x 0.2330 = 36006

In pension mathematics, we call this the present value of future benefits or 𝑃𝑉𝐹𝐵 for the participant.

26 Lecture 2
 Pension Cost Functions
 At a valuation date, actuaries use an actuarial cost method to divide the PVFB of
a pension plan into different components:
 Accrued or actuarial liability (AL) –The portion of the PVFB that is theoretically
attributed to participants’ service prior to valuation date
 Normal cost (NC) – The portion of the PVFB that is attributed to the current year of
service (i.e., the year immediately following the valuation date)
 Present value of future normal costs (PVFNC) – The portion of the PVFB that is
attributed to expected future years of service. NC is a part of PVFNC.
 For the plan as a whole, the following relationship must hold at any date of
valuation:
PVFB = AL + PVFNC

27 Lecture 2
 Graphical Representation
Valuation Date

Accrued Liability Normal

Cost

Total Cost of Plan

(PVFB)
28 Lecture 2
 Mathematical Formulation
Suppose a pension plan provides only a retirement benefit at age y.
 For a participant aged at the valuation date, the present value of benefits expected to
be paid to that participant, denoted as , is
𝑗 (12)
𝑃𝑉𝐹𝐵𝑥 = 𝐵 𝑗 (𝑦) ∙ 𝑦−𝑥 𝑝𝑥 ∙ 𝑣 𝑦−𝑥 ∙ 𝑎̈ 𝑦
 Normal cost is the annual cost designed to amortize over participant ’s
working career. Denote the normal cost payable as of age as .
 Accrued liability ( ) is the portion of theoretically funded by normal costs at
age , exclusive of the normal cost then due.
 Retrospectively, the accrued liability for participant at age is the accumulated value of
past normal costs before age ( is the age at hire). The superscript j is suppressed hereafter.
1
𝐴𝐿 = 𝐴𝑉𝑃𝑁𝐶 = 𝑁𝐶 1 + 𝑖
𝑝

Accumulation reflects both interest and benefit of survivorship from age 𝑧 to age 𝑥, where 𝑧
ranges from age 𝑤 to age 𝑥 − 1.

29 Lecture 2
 Mathematical Formulation
Explanation of “Benefit of survivorship”
 For a normal cost is generated for participant at age This
normal cost represents the “liability” created for participant ’s service in
the year of age . The liability accumulates with interest to an amount of
at age .
 According to the service table, there are a hypothetical number of active
participants at age .
 The total accumulated value of liabilities at age for the participants
equals .
 But at age , there are only remaining active participants. The liability
carried by each active participant at age is therefore equal to
.
 The last bracketed term has a value since . It is
interpreted as the “benefit of survivorship”.

30 Lecture 2
 Mathematical Formulation
 Prospectively, the accrued liability for participant can be
defined as the present value of future benefits less the present
value of future normal costs

31 Lecture 2
 Overview of Actuarial Valuation
Date of Valuation

Backward looking Forward looking

• Accrued liability for service to- • Future normal cost - Money set
date versus assets held in aside in each future period to
pension fund meet liability for future service
• Actual experience relative to
assumptions previously made

32 Lecture 2
 Unit Credit Cost Method
Normal cost is the central concept of an actuarial cost method. Once the normal
cost is defined, the accrued liability can be derived from it using either the retrospective
definition or prospective definition.
Under the Unit Credit cost method, the normal cost for a participant as of age is defined
as the actuarial present value of the benefit allocated to the year of age (denoted as ):
( )
𝑁𝐶 = ∆𝐵 𝑎̈ 𝑝 𝑣
Using the retrospective definition, we can derive as the accumulated value of past
normal costs (from age at hire to age ):
1
𝐴𝐿 = ∆𝐵 𝑎̈ 𝑝 𝑣 1+𝑖
𝑝

=∑ ∆𝐵 𝑎̈ 𝑝 𝑣 = ∑ ∆𝐵 𝑎̈ 𝑝 𝑣

The summation term is the benefit allocated to service before the valuation
date; we denote it as . Thus, the accrued liability can be determined as the actuarial
present value of the benefit allocated to past service.
( )

33 Lecture 2
 Example 4
Given the participant data, actuarial assumptions and plan scenario described in Example 3,
use the Unit Credit cost method to calculate the accrued liability and normal cost as of the
valuation date.

Unit credit cost method

Steps:
1. Calculate the projected retirement benefit for the sole participant at age 65.
2. Allocate the projected benefit to past service and current service.
3. Calculate AL and NC as the actuarial present values of the allocated benefits, respectively.

Note: Under the particular plan, it is natural to base allocation on how the retirement
benefit is accrued according to the benefit formula. Thus, the benefit allocated to past
service is the benefit accrued to the valuation date (which is 50*12*10=6,000 p.a.), and the
benefit allocated to current service is the benefit accrued in the current year (which is
50*12=600 p.a.).

34 Lecture 2
 Supplemental Liability
 The retrospective for a participant may differ from the
prospective due to changes in plan benefits or actuarial
assumptions
 We call the difference between Prospective and
Retrospective the supplemental liability
𝑥 𝑥 𝑥

35 Lecture 2