Show Me the Money!
WHEN A SPONSOR INSTITUTES A pension plan
with a defined benefit formula it is promising its members that it will make certain
payments to the plans beneficiaries at certain times in the future, often the very
In order to demonstrate that it can keep
its promise, the sponsor will set aside funds in a separate pension fund and an actuary
will be hired to determine the pace at which such a fund should be built up.
The actuarys job is to calculate a
funding target which represents his estimate (termed assumption) of how much money will
eventually be needed to meet the promised payouts given the benefit formuIa set out in the
pension plans bylaws, the age-distribution of current and potential future
beneficiaries, the returns to be realized on future investments, etc.
Because the future cannot be foretold, the
actuary will likely build in a margin of safety into his calculations. This is quite
acceptable to the sponsor who does not want any surprises down the road when he is
informed that the funding target has been underestimated and there is a shortfall that has
to be made up.
Consider the following example:
Suppose an actuary estimates that a pension plan is likely to payout $7,500,000 in
benefits over its existence but that a funding target of $12,000,000 would allow a cushion
that would virtually guarantee that any unforeseen adverse situation could be covered with
ease, The assets of the plan stand at $10,000,000.
The actuary, when asked to report on the
pension plan, could point out that the fund is $2,000,000 short of its funding target. He
could term this amount to be an "unfunded liability" and recommend that the
sponsor accelerate his contributions to cover this shortfall.
The plan sponsor, on the other hand, could
argue that since the actuary himself estimates that $7,500,000 should be sufficient to
cover any and all payouts required by the plan; the funds asset base of $10,000,000
is more than adequate and represents a hidden surplus of $2,500,000 in the fund.
Thus an actuarial report could disclose an
unfunded liability when a surplus actually exists - all because the funding target
may be so very much higher than the plans actual obligations. The large cushion that
has been built into the plan represents the difference between the "best guess"
liability as determined by the actuary and the funding target of $12,000,000 that he would
like to see accumulate in the plan to cover any and all unforeseen contingencies.
This raises the question of just who is
entitled to the surplus, if any, that may exist within a pension plan.
One school of thought believes that the
sponsor, when setting up the pension plan, does so as a form of deferred compensation for
the employees whom he wishes to employ. Adherents of this idea feel that when an employee
agrees to work with a company, he does so at least in part because of the entire
compensation package that he will be receiving. At the beginning, he will receive his pay
in the form of a current salary and benefit package. But, down the road, he will also be
entitled to contribute into a pension plan that will provide additional income throughout
his retirement years.
If, by virtue of a better than anticipated
growth of pension assets, or some other stroke of good fortune, the plan experiences a
surplus, then it surely belongs to the membership as a whole, to be shared among them all
in the form of improved benefits; Others would argue that the surplus should revert to the
plan sponsor, and this is the way most pension plans have been designed. This reasoning is
predicated on the concept that should the situation be reversed and the plan actually
experience a shortfall in its funding, then the sponsor would be obligated by law to meet
the plans obligations out of its current operations.
The reasoning is clear If the sponsor must live with the
risk that the plan might not be able to meet its liabilities and be prepared to make good
on the plan's obligations as they become due, then it is only right and proper that they
should stand to benefit it fortunes are reversed and there are more than sufficient assets
to cover anticipated requirements.