Module 7: Optimizing Plan Funding and Financial Reporting Flashcards
Explain how the terms “funding” and “advance funding” are used in the context of DB pension plans and compare them to the approach called “pay-as-you-go.”
These terms are typically used to refer to the creation of a fund held by an outside third party, such as a trust or insurance company. The fund receives employer and, if applicable, employee contributions to the pension plan, earns investment income and pays out the benefits promised by the plan.
“Pay-as-you-go” involves the transfer of assets to the retiree or their survivors only as benefits are paid, and there is no pension fund accumulated. This method of paying pension benefits is prohibited under provincial and federal pension standards legislation. However, two public retirement programs, Old Age Security and the Guaranteed Income Supplement, operate on a pay-as-you-go basis.
Identify the reasons for advance funding a DB pension plan.
(a) The significant tax advantages provided under the Income Tax Act require that the pension plan be registered with Canada Revenue Agency. To be registered, it is necessary that the plan sponsor create a pension fund.
(b) Pension standards legislation in provincial and federal jurisdictions require advance funding to increase benefit security of registered pension plans (RPPs).
(c) The accumulated pension fund provides security that employees will receive the promised benefits, regardless of the plan sponsor’s financial status in the future.
(d) Funding provides the employer with an orderly method of managing cash resources and avoids the situation where contribution requirements rise out of control as the plan matures (i.e., as a plan matures, benefits accumulate and the plan population ages, the plan’s obligations become large relative to its source of contributions). Funding can also help insulate the employer from dealing with high pension payments during a period of economic distress.
(e) Generally accepted accounting principles require the allocation of pension costs over the years that employees perform their services, regardless of when benefits are ultimately paid. In the absence of advance funding, the recognition of accounting costs will ultimately lead to a large pension liability in the employer’s financial statements. This could impair the employer’s ability to raise additional financing. When the pension promise is funded, the funding contributions offset this buildup of liability.
(f) Advance funding at an appropriate level can reduce or eliminate transfers of cost among generations of employees, shareholders, taxpayers or other stakeholders.
Discuss arguments made against the use of advance funding.
In the private sector, the most common reason put forward for not funding a pension plan in advance is that the employer can achieve a higher after-tax rate of return by retaining the assets in the business until they are needed to pay pension obligations than what would be possible if those assets are retained in an invested fund. In that situation, advance funding would increase pension costs.
In the public sector, it has been argued that because of the perpetual nature of governments, combined with their ability to tax and borrow, benefit security and cash management are not matters of great concern. There is also a concern that large injections of money from public sector pension plans into private capital markets are neither socially desirable nor financially advantageous and can create opportunities for politically motivated interference in the investment process of assets intended to be used to pay pension obligations.
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Identify possible consequences of overfunding of a DB pension plan.
Overfunding (i.e., accumulating more assets than are needed to provide current and future pension obligations) may be seen as a more favourable outcome as the benefits are more secure and the plan sponsor can enjoy reduced future costs. However, overfunding may also mean that:
(a) Past generations of plan members have received lesser benefits than they might have otherwise enjoyed.
(b) There may be pressure from plan members for benefit improvements when a plan is overfunded.
(c) If surplus funds are used to improve benefits, when financial markets experience the next downturn, the funds will not be available to offset investment losses, and the plan could become underfunded.
(d) The ongoing debate over surplus ownership, the requirement for plan sponsors to deal with surplus distribution in the event of partial wind-up and the limit on the amount of surplus that can be recognized under the accounting standards have caused some plan sponsors to view an underfunded plan as a preferred approach.
Describe the purpose of a funding policy for a pension plan and the usual components of such a policy.
The purpose of a funding policy is generally to support the plan reaching its funding goals by documenting:
(a) The level and timing of contributions that the plan sponsor is willing to commit to
(b) The strategies that may be employed as corrective actions to address overfunding and underfunding situations based on defined requirements under the plan’s founding documents.
Generally, a funding policy will describe the following items:
(a) Purpose of the pension plan and funding policy
(b) Benefit objectives
(c) Desired degree of stability of contributions
(d) Risk management processes
(e) Actions contemplated when either an underfunded or overfunded position exists
(f) Margin in actuarial assumptions
(g) Requirements for an annual review.
Identify the reasons why actuarial valuations are performed in respect of a DB pension plan.
Actuarial valuations are performed for a variety of reasons, including:
(a) To satisfy requirements of provincial and federal pension regulators (often referred to as the “triennial valuation”) that require actuarial certification of the contributions needed to fund the pension plan. These valuations must be performed on a triennial schedule (often referred to as the “triennial valuation”), but if the plan’s funding level is below prescribed thresholds, the valuation will be required annually.
(b) When a pension plan is wound up, either partially or fully. This valuation is called a “wind-up valuation.” (Note that some jurisdictions, most notably Ontario, will no longer consider that a pension plan is being partially wound up.)
(c) When the plan sponsor wants to estimate the financial position of the plan on full or partial wind-up. This valuation is called a “hypothetical wind-up valuation.”
(d) To provide information to be used in the plan sponsor’s financial statements under Canadian accounting standards. This valuation is called an “accounting valuation.”
Discuss the two actuarial bases included in a triennial valuation completed for a DB pension plan to meet ongoing regulatory requirements.
A triennial actuarial valuation performed to satisfy ongoing regulatory requirements will report on the funded position of the plan on two actuarial bases: a going concern basis and a solvency basis.
A “going concern” valuation focuses on the ability of the plan to meet its obligations, assuming that it continues to operate indefinitely. That is, the valuation is completed assuming that current plan members will continue to accrue benefits in accordance with the plan terms and assumptions used in the valuation (e.g., plan members will continue to receive pay increases). The going concern valuation attempts to show whether the funding of the plan is on course to provide all future benefits as they are expected to fall due. The plan actuary uses a set of actuarial assumptions that are considered appropriate for each specific plan given the Canadian Institute of Actuaries Standards of Practice applicable for pension plans.
A “solvency valuation” is a valuation required by pension standards legislation that incorporates many elements of a wind-up valuation and, as such, is a special kind of hypothetical wind-up valuation. Most similar is the requirement that member benefits are considered to be frozen at the valuation date as if the pension plan’s operation stopped at the valuation date. Actuarial assumptions to be used in a solvency valuation are generally prescribed by the applicable pension standards legislation, and certain “grow-in” benefits, again prescribed by some pension standards legislation, must be included.
Solvency liabilities of a pension plan will be different from the liabilities calculated on a going concern basis, given the differences in benefit levels considered and actuarial assumptions used in the valuation process.
Compare “fully funded on a wind-up basis” with “fully funded on a going concern basis.”
A plan is “fully funded on a wind-up basis” if there are sufficient existing assets in the fund to provide for all the benefits that have been accumulated for service to date, determined on the assumption that the pension plan was being discontinued or wound up immediately. A plan is “fully funded on a going concern basis” if the existing assets plus the normal rate of contributions in the future are sufficient to enable all benefits, in respect of future service as well as past service, to be paid as they fall due.
It is possible for a pension plan to be fully funded on one of these bases (wind-up or going concern) and have a significant unfunded liability on the other basis. For example, a plan that bases benefits on end-of-career earnings might be able to meet all of its obligations if it were discontinued today but not have sufficient assets to provide benefits that are based on significantly higher earnings levels expected in the future—at least not without significant increases in future rates of contribution.
Alternatively, some plans may call for special benefits (such as grow-in benefits) that would not normally arise in the normal operation of the plan to be provided in the event of plan discontinuance. In these situations, a plan could be fully funded on a going concern basis but underfunded on a wind-up basis.
Funding calculation methods and actuarial assumptions used under the different bases also add to the difference in funded situations.
Define “funding method” as it relates to advance funding and the actuarial valuation report of a DB pension plan.
The Canadian Institute of Actuaries (CIA) defines a funding method as “any particular orderly and rational allocation of contributions among time periods.” The CIA states that the advance funding of a pension plan has objectives that include security of benefits, orderly and rational allocation of contributions among time periods, and/or intergenerational equity.
In practical terms, the choice of “funding method” determines the characteristics of the contribution schedule put in place for the advance funding of a DB pension plan. The actuarial valuation report describes required contributions and the plan’s funded status based on the funding method and set of actuarial assumptions chosen by the actuary.
Identify the two most common funding methods used by actuaries for DB pension plans. Describe one essential characteristic of each and outline their greatest similarity.
Benefit allocation methods are used for approximately two-thirds of all pension plans. Cost allocation methods are used in the majority of the remaining cases.
One essential characteristic of cost allocation methods is that the cost of the plan for the current group of members is designed to remain stable over the future working lifetime of the current group of members.
One essential characteristic of benefit allocation methods is that when applied to a closed group of plan members, the cost associated with future years tends to increase steadily.
Both funding methods assess the funding adequacy of a pension plan at a single point in time based only on the current membership population (i.e., they do not consider future membership changes).
Identify how the funding method chosen by the actuary for a DB pension plan is related to the ultimate cost of that pension plan.
The ultimate cost of a pension plan is not determined by the funding method selected by the plan actuary. When a DB plan member retires, the amount of funds needed to finance their pension is independent of the funding method selected by the actuary. The chosen funding method simply sets up a schedule for funding the member’s pension through contributions made to the pension fund over their period of membership.
Illustrate the basic difference between the pattern of current service costs for a pension plan determined by a “cost allocation” funding method compared to the pattern determined by a “benefit allocation” funding method.
Under a “benefit allocation” funding method, the current service cost for any individual member will increase each year as the member approaches retirement. Under a “cost allocation” funding method based on age at entry, the current service cost for any individual member will be stable.
Describe how the plan actuary for a DB pension plan determines the total required funding for the plan through an actuarial valuation.
When performing the actuarial valuation, the plan actuary will apply the chosen funding method to calculate the cost for each plan member and then aggregate those costs for the entire plan. The result is the “current service cost” for the year of the valuation.
To identify the plan’s funded status at the valuation date, the actuary compares going concern plan liabilities determined using the chosen funding method to plan assets. A comparison of liabilities and assets determined on a solvency basis will also be made. When going concern and/or solvency liabilities exceed assets, the actuary will identify a schedule of payments needed to eliminate the unfunded liability and/or solvency deficiency in accordance with pension standards legislation. These payments are typically referred to as special payments.
The current service cost plus any special payments needed to eliminate an unfunded liability and/or solvency deficiency form the total required funding for the pension plan for the year.
Describe how forecast funding methods differ from cost and benefit allocation funding methods. Identify the insights that forecast methods can provide to the plan sponsor.
Unlike cost and benefit allocation methods, which assess the funding adequacy of a pension plan at a single point in time based only on the current membership population, forecast funding methods are designed to assess funding levels over a lengthy period into the future and typically involve consideration of new entrants to the plan. They allow for development of a funding approach that satisfies a broad range of criteria.
Forecast methods can provide valuable insight into how the funding of a pension plan under the more traditional cost and benefit allocation methods is likely to proceed, assisting the plan sponsor in developing funding policy or managing funding decisions that must be made from valuation to valuation.
