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 Summer 2000

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 plan’s beneficiaries at certain times in the future, often the very distant future.

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 actuary’s 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 plan’s 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 fund’s 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 plan’s 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 plan’s 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.

SUMMER 2000: Introduction to Retirement Income | Pension Plans: The Nuts and Bolts | Show Me the Money | The Effects of Inflation on Pension Benefits |Sample Pension Statement

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