The Financing and Costing of Government Superannuation Schemes
APPENDIX - DESCRIPTION OF COMMON FUNDING METHODS
Most funding methods involve two concepts - the standard contribution rate, which is the rate required to be paid if the scheme is neither overfunded nor underfunded, and the standard fund which is the amount of assets required for the scheme to be in balance so that it is neither underfunded nor overfunded. The difference between the actual assets and the standard fund is the surplus or deficit, which is normally amortised over a period by an adjustment to the future contribution rate.
Individual Entry Age
A standard contribution rate is determined for each member based on age at entry as a level percentage of earnings over their anticipated membership. It is calculated as the value at the time of entry of all future benefits which may become payable to that member divided by the value at the time of entry of all future earnings of the member.
The standard fund is determined as the total of the standard funds for each existing member of the scheme. The standard fund for each member is determined as the difference between the present value of all benefits payable to the member and the present value of future contributions at the standard rate for that member.
Since there are major practical difficulties in having different contribution rates for each individual member this method is rarely used in practice. The Entry Age Normal method is generally a good practical approximation to the Individual Entry Age method.
Entry Age Normal
The standard contribution rate is determined as a level percentage of earnings for a new member entering at the assumed normal entry age for the scheme. It is calculated as the present value of all future benefits which may be payable to such a member divided by the present value of all future earnings of the member.
The standard fund is determined as the difference between the present value of all benefits payable to existing members and the present value of future contributions at the standard contribution rate for these members. This method only gives the standard fund as an aggregate for the whole membership - if it needs to be broken down to individuals then the Individual Entry Age will give the most satisfactory division consistent with the principles of the method.
Aggregate
This method does not require a standard contribution rate or a standard fund. A single contribution rate is determined which is the contribution rate required to fund the total benefits for existing employees, allowing for the assets actually held, but ignoring new entrants. It is calculated as the present value of all benefits payable to existing members, less the value of the assets held, divided by the present value of all future earnings of the existing members.
This method cannot be used in a wholly or partially unfunded scheme. In a funded scheme it can be regarded as a variant of the Entry Age Normal method, as it produces the same contribution rate as under Entry Age Normal if any surplus or deficiency under Entry Age Normal is spread over the future working lifetime of existing members.
Attained Age Normal
This method involves a division of benefits for existing members between those that have accrued prior to the valuation date and those that will accrue after the valuation date. The division is normally done on the basis of the accrual rates specified in the scheme design. (The method is not normally used where benefits are not defined in terms of an accrual rate.)
The standard contribution rate is determined as the level percentage of earnings required to fund the future service benefits of existing employees, ignoring new entrants. It is calculated as the present value of the future service component of all future benefits which may be payable to existing members divided by the present value of all future earnings of these members.
The standard fund is calculated as the present value of the past service component of all future benefits which may be payable to existing members.
A peculiarity of this method is that the standard contribution rate and the standard fund are not calculated on a consistent basis; if the assumptions are met in practice then payment of the standard contribution rate will lead to a surplus of assets over the standard fund.
Projected Unit Credit
This method involves a determination of the proportion of each eventual benefit which is deemed to accrue in each year of membership. The conceptually simplest determination is to allow for each benefit to accrue uniformly over membership - ie each year of membership accrues an equal proportion of the ultimate benefit. However other approaches can be taken, particularly in respect of benefits which are not directly related to membership completed (such as death benefits).
The standard contribution is the present value of the benefits that will accrue in the next year; this can be expressed as a contribution rate by dividing by the present value of earnings in the next year.
The standard fund is the present value of the benefits that have accrued in respect of membership prior to the valuation date. This is the same standard fund as for the Attained Age Normal method, but the standard contribution rate for the Projected Unit Credit method is consistent with this standard fund.
Current Unit Credit
This method starts with the standard fund and derives the standard contribution rate from it.
The standard fund is determined as for the Projected Unit Credit method, but ignoring future increases in earnings.
The standard contribution rate is determined as the rate required to maintain the scheme at this level of funding. It is therefore calculated as two components - the increase in the accrued liability over the next year arising from the increase in earnings, plus the actual accrual of liability in the next year.
Funding Periods
The standard contribution rate under both the Projected and Current Unit Credit methods is determined as the cost of the next year's accrual of benefits. This may be liable to short term fluctuations and these can be evened out by averaging the contribution rate over the period between valuations (generally three years). If the period is extended beyond one year then it is necessary to allow for the effect of new entrants during the funding period.
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