An actuarial valuation of a pension plan is the process used by actuaries for determining the amounts an employer is to contribute (pay, fund) under a pension plan (except where an insured arrangement calls for payment of specified premiums). A valuation is made as of a specific date, which need not coincide with the end of the period for which a payment based on the valuation will be made. Indeed, it is uncommon for such a coincidence of dates to exist. Among other factors, a time lag is necessary in order to compile the data and to permit the actuary to make the necessary calculations. Although annual valuations are, perhaps, the rule, some employers have valuations made at less frequent intervals, in some cases as infrequently as every five years. The calculations are made for a closed group - ordinarily, employees presently covered by the plan, former employees having vested rights and retired employees currently receiving benefits.

An initial step in making a valuation is to determine the present value on the valuation date of benefits to be paid over varying periods of time in the future to employees after retirement (plus any other benefits under the plan). An actuarial cost method (see description in a later section of this Appendix) is then applied to this present value to determine the contributions to be made by the employer.

The resulting determinations are estimates, since in making a valuation a number of significant uncertainties concerning future events must be resolved by making several actuarial assumptions.

Actuarial Assumptions

The uncertainties in estimating the cost of a pension plan relate to (1) interest (return on funds invested), (2) expenses NOTE: For further discussion see Appendix C of Accounting Research Study No. 8, Accounting for the Cost of Pension Plans by Ernest L. Hicks, CPA, published by the American Institute of Certified Public Accountants in 1965.

00

90

Opinions of the Accounting Principles Board

of administration and (3) the amounts and timing of benefits to be paid with respect to presently retired employees, former employees whose benefits have vested and present employees.

Interest (return on funds invested)

The rate of interest used in an actuarial valuation is an expression of the average rate of earnings that can be expected on the funds invested or to be invested to provide for the future benefits. Since in most instances the investments include equity securities as well as debt securities, the earnings include dividends as well as interest; gains and losses on investments are also a factor. For simplicity, however, the rate is ordinarily called the interest rate.

Expenses of administration

In many instances the expenses of administering a pension plan - for example, fees of attorneys, actuaries and trustees, and the cost of keeping pension records - are borne directly by the employer. In other cases, such expenses, or some of them, are paid by a trust or insurance company from funds contributed by the employer. In the latter cases, expenses to be incurred in the future must be estimated in computing the employer's pension cost.

Benefits

Several assumptions must be made as to the amounts and timing of the future benefits whose present value is used in expressing the cost of a pension plan. The principal assumptions are as follows:

a. Future compensation levels. Benefits under some pension plans depend in part on future compensation levels. Under plans of this type, an estimate is ordinarily made of normal increases expected from the progression of employees through the various earnings-rate categories, based on the employer's experience. General earnings-level increases, such as those which may result from inflation, are usually excluded from this actuarial assumption.

Accounting for the Cost of Pension Plans

91

b. Cost-of-living. To protect the purchasing power of retirement benefits, some plans provide that the benefits otherwise determined will be adjusted from time to time to reflect variations in a specific index, such as the Consumer Price Index of the United States Bureau of Labor Statistics. In estimating the cost of such a plan, expected future changes in the cost-ofliving index may be included in the actuarial assumptions.

c. Mortality. The length of time an employee covered by a pension plan will live is an important factor in estimating the cost of the benefit payments he will receive. If an employee dies before he becomes eligible for pension benefits, he receives no payments, although in some plans his beneficiaries receive lumpsum or periodic benefits. The total amount of pension benefits for employees who reach retirement is determined in large part by how long they live thereafter. Estimates regarding mortality are based on mortality tables.

d. Retirement age. Most plans provide a normal retirement age, but many plans permit employees to work thereafter under certain conditions. Some plans provide for retirement in advance of the normal age in case of disability, and most plans permit early retirement at the employee's option under certain conditions. When there are such provisions, an estimate is made of their effect on the amount and timing of the benefits which will ultimately be paid.

e. Turnover. In many plans, some employees who leave employment with the employer before completing vesting requirements forfeit their rights to receive benefits. In estimating the amount of future benefits, an allowance for the effect of turnover may be made.

of

f. Vesting. Many plans provide that after a stated number years of service an employee becomes entitled to receive benefits (commencing at his normal retirement age and usually varying in amount with his number of years of service) even though he leaves the company for a reason other than retirement. This is taken into consideration in estimating the effect of turnover.

92

Opinions of the Accounting Principles Board

g. Social security benefits. For plans providing for a reduction of pensions by all or part of social security benefits, it is necessary in estimating future pension benefits to estimate the effect of future social security benefits. Ordinarily, this estimate is based on the assumption that such benefits will remain at the level in effect at the time the valuation is being made.

Actuarial gains and losses

The likelihood that actual events will coincide with each of the assumptions used is so remote as to constitute an impossibility. As a result, the actuarial assumptions used may be changed from time to time as experience and judgment dictate. In addition, whether or not the assumptions as to events in the future are changed, it is often necessary to recognize in the calculations the effect of differences between actual prior experience and the assumptions used in the past.

Actuarial Cost Methods

Actuarial cost methods have been developed by actuaries as funding techniques to be used in actuarial valuations. As indicated in Paragraph 19 of the accompanying Opinion, many of the actuarial cost methods are also useful for accounting purposes. The following discussion of the principal methods describes them as funding techniques (to simplify the discussion, references to prior service cost arising on amendment of a plan have been omitted; such cost would ordinarily be treated in a manner consistent with that described for past service cost). Their application for accounting purposes is described in the accompanying Opinion.

Accrued benefit cost method-unit credit method

Under the unit credit method, future service benefits (pension benefits based on service after the inception of a plan) are funded as they accrue - that is, as each employee works out the service period involved. Thus, the normal cost under this method for a particular year is the present value of the units of future benefit credited to employees for service in that year (hence unit credit). For example, if a plan provides benefits of