A PROBLEM-SOLVING

APPROACH

TO

PENSION FUNDING

AND

VALUATION

Second Edition

William H. Aitken, FSA, FCIA, EA

Professor Emeritus

University of Waterloo

ACTEX Publications

Winsted, Connecticut

Copyright <0 1994, 1996, by ACTEX Publications, Inc.

All rights reserved. No portion of this book may be
reproduced in any form or by any means without the
prior written permission ofthe copyright owner.
Requests for permission should be addressed to
ACTEX Publications
P.O. Box 974
Winsted, CT 06098

Manufactured in the United States of America

109876543
Cover Design by MUF
The ankh was the ancient Egyptian symbol for life.

Its use on the cover of this text symbolizes the payment of

pension income for life.

Library of Congress Cataloging. in-Publication Data

Aitken, William H., 19272000
A problem.solving approach to pension funding and valuation I
William H. Aitken.
p. cm.

Includes bibliographical references and index.

ISBN 156698-2006

1. PensionsCosts-Mathematics. 2. Pensions ValuationMathematics. 1.

Title.
HD7105.A37 1994
331.25'2'0151--dc20
94-9260
CIP

ISBN: 1-56698-200-6

Contents
vii

Preface
1

Pension Benefits
1.1
1.2

1.3

1.4
1.5
1.6

1.7

Increasing Cost Individual Cost Methods

2.1
2.2
2.3
2.4

19

Traditional Unit Credit.. .............................................................. 19

Benefits with a Salary Scale........................................................28

Projected Unit Credit.. ................................................................ 30

Exercises..................................................................................... 44

Level Cost Individual Cost Methods

3.1
3.2
3.3

Introduction... .... ............. ...... ..... ................. ............ .... ........... .... .... 1

Design of Pension Plans ................................................................ 2

1.2.1 Defined Benefits ............................................................... 3

1.2.2 Defined Contributions and Defined Benefits ................... 4

Plan Cost................... ................... ................... ........ ............ .......... 7

1.3.1 Replacement Ratio ........................................................... 7

1.3.2 The Effects of Age and Plan Design ................................ 8

1.3.3 Anticipating Inflation ....................................................... 9

1.3.4 Recognizing Inflation ..................................................... 10

1.3.5 Pension Payments ........................................................... 10

1.3.6 Surplus............................................................................ 10

Plan Documents and Funding.............. ....................................... 11

Actuarial Valuations.................. ............... .... .......... ............ ........ 13

Notation and Terminology .......................................................... 15

1.6.1 Dates and Ages ............................................................... 16

1.6.2 Definitions...................................................................... 17

1.6.3 Pension Notation Specific to This Text ......................... 17

Cost Methods...................... ........................................................ 18

49

Entry Age Normal (Level Dollar) ............................................... 49

Cost as a Level Percent ofSalary ................................................61

Entry Age Normal (Level Percent)............................................. 64

iv

Contents
3.4
3.5

3.6

Aggregate Cost Methods

111

4.1
4.2
4.3
4.4
4.5
4.6
4.7

III

116

133

141

150

155

158

Individual Aggregate .................................................................

Aggregate..................................................................................
Frozen Initial Liability (Entry Age Normal) .............................
Frozen Initial Liability (Attained Age Normal) ........................
Aggregate Entry Age NormaL.................................................
Review.......................................................................................
Exercises...................................................................................

Experience Gains and Losses

5.1

5.2
5.3
5.4

5.5

5.6
5.7
5.8

Individual Level Premium ........................................................... 81

Supplemental Cost. ......................................................................93

3.5.1 Amortization of Supplemental Liabilities ...................... 94

3.5.2 Pension Fund Balance Sheet... ....................................... 96

Exercises.......... ........... ............... ...................................... ......... 100

Changes and Ancillary Benefits

6.1
6.2
6.3
6.4
6.5

175

Unfunded Liabilities and Gains ................................................ 175

5.1.1 Relationships................................................................ 175

5.1.2 Explanations of the Relationships ................................ 177

5.1.3 Observations................................................................. 179

5.1.4 Experience Gain Summary ........................................... 182

Total Experience Gains ............................................................. 186

Investment Gains ....................................................................... 191

Retirement Gains ....................................................................... 204

5.4.1 Normal Retirement Gains ............................................. 204

5.4.2 Early Retirement Gains ................................................ 204

5.4.3 Postponed Retirement Gains ........................................ 206

Withdrawal Gains ...................................................................... 214

5.5.1 Vesting......................................................................... 214

5.5.2 Gain.............................................................................. 215

Salary Gains .............................................................................. 218

Mortality Gains.................................................. ..... ....... ........... 222

Exercises................................................................................... 229

251

Change in Cost Method ............................................................. 251

Change in Retirement Benefit................................................... 253

Change in Retirement Age ........................................................ 269

Change in Interest Assumption ................................................. 272

Change in Salary Increase Assumption ..................................... 279

Contents

Changes in Decrement Assumptions ......................................... 284

6.6.1 Mortality Rates ............................................................. 284

6.6.2 Withdrawal Rates ......................................................... 284

6.6.3 Disability Rates ............................................................ 285

6.7 Ancillary Benefits ..................................................................... 291

6.8 Employee Contributions ............................................................ 293

6.8.1 Unit Credit with Employee Contributions ................... 295

6.8.2 Entry Age Normal. ....................................................... 296

6.8.3 Aggregate..................................................................... 298

6.9 Exercises...................................................................................... 303

6.6

Options and Assets

7.1

7.2
7.3

7.4

Observations
8.1

319

Retirement Options .................................................................... 3 19

7.1.1 Early Retirement Option ............................................... 320

7.1.2 Deferred Retirement Option ......................................... 324

Optional Forms of Benefit... ...................................................... 325

Assets......................................................................................... 335

7.3.1 Dollar-Weighted Rate ofReturn ................................... 339

7.3.2 Time-Weighted Rate of Return.................................... 341

7.3.3 Side Funds .................................................................... 343

Exercises................................................................................... 348

357

Comparison of Methods............................................................ 357

8.1.1 Traditional Unit Credit.. ............................................... 357

8.1.2 Projected Unit Credit.. ................................................. 359

8.1.3 Modified Unit Credit.. .................................................. 360

8.1.4 Entry Age Normal. ....................................................... 361

8.1.5 Individual Level Premium ............................................ 362

8.1.6 Individual Attained Age NormaL ............................... 362

8.1.7 Individual Aggregate .................................................... 363

8.1.8 Aggregate..................................................................... 363

8.1.9 Frozen Initial Liability................................................. 364

8.1.10 Plan Termination Cost Method .................................... 365

8.1.11 Aggregate Entry Age NormaL .................................... 366

8.1.12 Employee Contributions ............................................... 367

8.1.13 Employer Contributions............................................... 367

8.2 Alternatives................................................................................... 367

8.2.1 Choice of Method......................................................... 367

8.2.2 Actuarial Valuations .................................................... 368

Contents

vi

8.2.3 Alternative Liabilities .................................................. 368

8.2.4 Small and Large Plans .................................................. 369

8.2.5 Closed and Open Groups ............................................. 370

8.3 Concepts........................................................................................ 370

8.3.1 Pension Benefit............................................................ 370

8.3.2 Inflation........................................................................ 370

8.3.3 Final Average Salary .................................................... 371

8.3.4 Salary Scale.................................................................. 371

8.3.5
Percent of Salary......................................................... 371

8.3.6 Vesting......................................................................... 371

8.3.7 Assumptions................................................................. 372

8.3.8 Surplus.......................................................................... 373

8.3.9 Not Guaranteed ............................................................ 373

8.3.1 0 Projected Benefit.. ......................................................... 373

8.3.11 New Entrants ................................................................. 373

8.3.12 Active and Retired Participants ..................................... 374

8.3.13 Early Retirement. .......................................................... 374

8.3.14 Trusteed and Insured Plans ........................................... 374

8.3.15 Funding.......................................................................... 375

8.3.16 Cost Methods ................................................................ 375

8.3.17 Expensing vs. Funding .................................................. 376

8.3.18 Financial Reporting ....................................................... 376

8.4 Government Aspects .................................................................. 377

8.4.1 Social Pension Plans ..................................................... 377

8.4.2 Tax Assistance .............................................................. 379

8.4.3 Regulation and Protection .............................................384

8.4.4 Public Service Pension Plans ........................................ 386

Answers to the Text Exercises

389

Bibliography

395

Index of Notation

397

Subject Index

401

Chapter 2

Increasing Cost
Individual Cost Methods

In this chapter we learn how to calculate the cost each year of a piece of
pension benefit. Younger participants have low costs because we discount at
interest for many years. Older participants have higher costs because we
discount for fewer years. (In the following two chapters we calculate the
levelized annual cost ofthe expected pension.)

2.1 Traditional Unit Credit

Traditional Unit Credit (TUC) is the first actuarial cost method we will
study. The TUe actuarial liability is the value, at the valuation date, of the
pension benefit accrued from the date of entry into the plan to the date of
valuation. This method is also called the Unit Credit Cost Method by
ERISA and by Anderson [2], and the Accrued Benefit Cost Method by
McGill and Grubbs [7]. A salary scale assumption for salaries in all future
years is not made with this method; with other methods, a salary scale
assumption is often made.
If a participant is to retire at age r with an expected annual pension of
Bn with one-twelfth of Br payable at the beginning of each month, then
Br . a~12) is sufficient to fund this pension at age r. Br denotes the benefit
accrued (or earned) during the participant's active years of service, from age
e to age r.

20

Chapter 2: Increasing Cost Individual Cost Methods

Let us consider a pension fund valuation at time 0 for a participant who

is age x at time O. The annual pension benefit which has accrued from age e
to age x is usually a certain number of dollars per month for each year of
service. The annual benefit that has accrued to age x is denoted by Bx. For
example, if the pension benefit is $30 per month for each of 20 years of
service, then Bx = 30 x 12 x 20 = $7200. The actuarial liability at age x
is the value of the pension benefit accrued from age e to age x. It is given by
ALx

where D~7)/D~7) is computed from a service table. The calculation includes

interest and decrements such as mortality, withdrawal, disability, and dis
charge. Under the Unit Credit method, we obtain the total actuarial liability
(TAL) at time 0 for all active participants in a pension plan by summing the
individual liabilities for each active participant, obtaining

The liability for each participant increases with age. It follows that, if no
participants leave the group and no new participants enter the group, the
total liability will increase with time.
The TUC cost method is most often used with pension plans that
provide a flat pension benefit, such as $30 per month for each year of
service. If the entry age is 35 and the retirement age is 65, the annual pen
sion benefit commencing at retirement will be 30 x 30 x 12 = $10,800. At
age 45, after ten years of service, the accrued pension benefit will be B45 =
30 x 10 x 12 = $3600.
bx denotes the piece of the total pension benefit that is earned in the
year following age x. The simplest case is the one in which the same benefit
is earned each year, so that

r-e
This case will be assumed to apply unless otherwise stated. Therefore in our
example of a benefit of $30 per month for each year of service, we have bx
= 30 x 12 = $360.

21

Section 2.1: Traditional Unit Credit

The normal cost at the beginning of each year is the cost of the pension
benefit that is earned (accrues) in that year. It is given by

The normal cost for younger participants is lower due to the greater effect of
discounting in the D~T) / D1T) term. The total normal cost for the plan each
year is the sum of the normal costs for all participants receiving benefit
accruals. The total normal cost in future years will be affected by aging, the
size of the unit benefit, withdrawals, retirements, deaths, and new entrants.
In single-decrement situations, we will often use the simple variations
}/J2)
r

= bx' Dx

x'

t
V

.. (12)

tPx' ar ,

where t = r - x, and
ALx = NCx(x-e).

I DISCUSSION QUESTIONS I
2-1

Write an expression for NC44 , where the benefit is $35 per month for
each year of service.

2-2

Write an expression for the total actuarial liability for all active,
terminated, and retired participants.

2-3

What is the normal cost for a retired or terminated participant?

I EXAMPLE 2.1 I
Plan effective date: 111184
Normal retirement benefit: $30 per month for each year of service
All employees were hired at age 25.
Retired or terminated vested participants: None
Preretirement terminations other than by death: None
Selected annuity value: a~~2) = 10
Census data on 111194, and commutation functions:

Chapter 2: Increasing Cost Individual Cost Methods

22

What is the

Age x

Participants

Dx!

25
35
45
55
65

8
0
2
0
0

16
8 I
4'
21
1 I

ruc actuarial liability and normal cost as of 1I1194?

I SOIJITION I Let 111/94 be time O. The participants who are age 25 have
just been hired, so B25 = 0 since no benefit has yet accrued. For each of the
two participants who are attained age 45, we have a benefit accrual of B45
= 30 x 12 x 20 = 7200. Then
18,000
and the total liability is

TALo

2 AL45

$36,000.

The normal cost for the plan is the sum of the several NCx , so
'T'IHC
1. lV' 0

where bx

'"

L.J

b Dr ..(12)
x' Dx . a r ,

= 30 x 12 = 360. Thus we have

TNCo

= 8 [360. D65 . ii~~2)] + 2 [360 . D65 . ii~~2)]

D25

D45

- 360ii~~2) [8(1/16) + 2(1/4)] = $3600.

0
Note that because there are no decrements other than death, we can use an
appropriate single-decrement table (mortality only). This explains the use of
Dx rather than DiT )
1 EXAMPLE 2.21
Normal retirement benefit: $10 per month for each year of service
Actuarial cost method: Unit Credit
Actuarial assumptions:

Section 2.1: Traditional Unit Credit

23

Interest: 6%

Preretirement terminations other than deaths: None

Retirement age: 65

Participants as of 111193: 100 active employees, all age 60

Normal cost for 1993 as of 111/93: $100,000
Selected mortality value: Q60 = .04
Calculate the normal cost for 1994 as of 111194 (a) per survivor, (b) for the
total group if 92 participants are alive at 1/1/94, (c) if 96 participants are
alive, and (d) if all participants are alive.

ISOLUTION I The normal cost per participant at age 60 is

(lOx 12)vs SP60 a~;2),

NC60

and the normal cost per survivor at age 61 is

NC61

(10

12)v4 4P61 a~;2).

NC60
Note that NC61 = Vp60. Then we have the following results.

NC60
VP60

100,000/100
.96/1.06

(a)

NC61

(b)

TNC6J

(c)

TNC61 = 96( 1060)

.96

(d)

TNC61

92( 1060)
.96

1060
.96

$1104.17.

$101,583.

1060)
100 ( T6

$106,000.

$110,417.

Note that in (a) the normal cost per survivor does not depend on the actual
mortality experience; in (b) more than expected die so there is a gain from
mortality (see Chapter 5); in (c) the expected mortality is exactly realized, so
the TNC at 1/1/94 is 100,000(1 +i); in (d) there is a loss from mortality.

If Fo is the amount of the pension fund at time 0 and TALo represents

the plan's total actuarial liability for all active, retired and terminated vested
participants at time 0, then the surplus at that time is Fo - TAL o.

24

Chapter 2: Increasing Cost Individual Cost Methods

Traditionally, most plans had, and many plans still have, a negative sur-plus,
called the unfunded actuarial liability, where

UALo = TALo - Fo.

The disposition of an unfunded actuarial liability is an important actuarial

matter; it is discussed in Section 3.6.

I EXAMPLE 2.3 I

Refer to the data given in Example 2.1. Under the Unit Credit cost method,

what is the unfunded actuarial liability as of 111/94 if the plan assets amount

to $5000 at that time?

I SOLUTION I We need the total actuarial liability for the plan since the

unfunded liability at time 0 is

UALo

= TALo - Fo.

From Example 2.1 we have TALo = $36,000, so

UALo

36,000

5,000

$31,000.

The fund balance at the beginning of the year (BOY), which we have
denoted by Fo, will increase during the year by actual investment income
and contributions to the fund. It will be diminished by amounts withdrawn
from the fund as benefits. At time 0, we can calculate what we expect the
unfunded actuarial liability to be at time I as
exp UAL, = (UALo +NCo)(I+i) - iC,
where iC is the contribution plus the interest earned during the year on the
contribution using the actuarial interest assumption. If the contribution is
made at the end of the year (EOY), then iC = C, and if it is made at BOY,
then iC = C(l+i}. A total experience gain, tote, will result if the actual
unfunded actuarial liability (act UAL) is less than exp UAL. In other words

A negative gain is called a loss. The relationship between UALo and UALI is
developed, and the subject of gains and losses is discussed, in Chapter 5.

Section 2.1: Traditional Unit Credit

25

I EXAMPLE 2.41
Actuarial cost method: Unit Credit
Assumed interest rate: 6%
Valuation results as of 111193:
Actuarial liability
Actuarial value of assets
Normal cost as of 12/31193
Valuation results as of 111/94:
Actuarial liability
Actuarial value of assets
Contributions:
$13,910 at 12/31193
$15,587 at 12/31194

$100,000
50,000
10,000
$115,000
70,000

What is the experience gain for 1993?

I SOI.lJTION I Let 111193 be time 0 and 111/94 be time 1. There is a gain
when the actual unfunded liability turns out to be less than the expected.
Since the normal cost is at 12/31/93 and iC = C, then the expected unfunded
liability at time I is

eXPUAL I

UAL o(1+i)

+ NC

= (100,000-50,000)(1.06) + 10,000 - 13,910

49,090.

The actual unfunded liability at time 1 is the difference between ALI and F 1,
so
actUAL I = 115,000 70,000 = 45,000.
Then

49,090

45,000

= $4,090.

Note that the normal cost is usually at BOY but occasionally, as in Example
2.4, it is at EOY; the contribution is usually at EOY but occasionally it is at
BOY or mid-year.

Chapter 2: Increasing Cost Individual Cost Methods

26

I EXAMPLE 2.5 I
Which of the following statements concerning the Unit Credit cost method
are true?
I.

Under this method, the assumption must be made that each parti
cipant will remain in the plan until retirement or prior death.

II.

If the benefit accrual in each year is constant for any given partici
pant, the normal cost for that participant will also remain constant,
provided actual experience is in accordance with actuarial assump
tions.

III.

The actuarial liability of a newly established plan is equal to the

present value of the benefits attributable to credited service prior to
the effective date of the plan.

I SOLUTION I
I.

Not true. We could use other decrements such as withdrawal or dis

ability.

II.

Not true. The effect of mortality and interest discount is reducing with
age.

III.

True.

I EXAMPLE 2.6 I
Normal retirement benefit: $10 per month for each year of service
Vesting eligibility: 100% after 5 years of service
Preretirement death benefit: None
Actuarial cost method: Unit Credit
Actuarial assumptions:
Interest rate: 7% per year
Preretirement terminations other than deaths: EOY
q~d) = q~(d)
q~T) = q~d) + qiw)

Retirement age: 65
Selected annuity value: a~~2)
Data for sole participant:

= 8.736

Section 2.1: Traditional Unit Credit

Date of birth
Date of hire
Status as of 111194
Selected probabilities:

27

111131

111189

Active

x
63
64
65

qf:)

qidj

.069
.081
.023

.019
.021
.023

What is the nonnal cost for 1994 as of 1I1194?

I SOI,lJTION I The participant is 63 years old on 111194. Then

120 x 8.736 x v2 2P~;)

NC63

1048.32 x v2(1-.019)(1-.021) = $879.38.

In this defined benefit plan with no participant contributions,

100% vesting means that the participant is entitled to 100%
of the retirement benefit accrued to the date of withdrawal.
If withdrawal occurs before five years of service, no retire
ment benefit is payable because there is no vesting. 60%
vesting, for example, would mean that the participant is
entitled to 60% of the accrued benefit.
Since deaths occur at EOY, qid) = q~(d), and we discount for
mortality because the death benefit is zero. If, alternatively,
the tenninal reserve were paid out on death, we would not
discount for mortality. Similarly, we do not discount for
withdrawal because vesting is 100%, and the unit credit
liability is not released. The student may wish to review
these important aspects of contingency theory. (See, for
example, Chapter 9 of Bowers, et al. [5].)
0
Plan experience and changes in plan benefits will affect plan liabilities
and costs. These are discussed in Section 3.6 and Chapters 5 and 6. If death

28

Chapter 2: Increasing Cost Individual Cost Methods

and withdrawal benefits are not stated, they are assumed to be zero; they are
discussed in more detail in Chapter S.

2.2 Benefits with a Salary Scale

The benefit formulas in Section 2.1 did not make use of projected future
salary, but those of Se.ction 2.3 will. This section will introduce the idea of
salary scales themselves.
If a salary scale is not being used in the benefit projection, it would
appear that the actuary is assuming that salaries are not expected to increase.
The effect of such an assumption is normally to shift a portion of the costs
from the present to the future. This is often not appropriate.
If the actuary does use a salary scale, it may be a scale independent of
age, such as S% per year, or it may be a more sophisticated scale that
depends on age. In any event, it will make due allowance for inflation, actual
past salaries, and expected future salaries which are also discussed in
Sections 3.2 and 3.3.
We will illustrate the use of a S% scale by calculating the pension
benefits for (a) a 2% final salary plan, (b) a 2% final three-year average plan,
and (c) a 2% career average plan.
(a) For a person currently age x with a salary of Sx, the expected (or
projected) final salary, at age r - 1, is

Sr-J

(l.OSy-l-x Sx,

and the pension benefit accrued to age x is

Bx

.02(l.OSy-l-x Sx . (x-e).

(b) The expected final three-year average salary is

FAS

1
3 [Sr-3

+ Sr-2 + Sr- tl

3"1 [(l.OSy-3-x + (1.0Sy-2-x + (1.0Sy--l-x]Sx

1
r-J-x
..
3 (LOS)
Sx . 1jj .05 '

and the accrued pension benefit is