In our last post, we discussed how Social Security actuaries compare system assets with system liabilities on an annual basis to determine the system’s funded status (long-range actuarial balance). We noted that the process used for this purpose for Social Security is very similar to the process we recommend for developing a spending plan in retirement.
As previously noted, this process is also similar to the processes used by pension plan actuaries to determine funding requirements for defined benefit pension plans. A subset of these plans, that is very similar in nature to the Social Security system as well as personal household retirement systems, is “Fixed Rate Pension Plans”, a type of pension plan generally seen in the public plan sector, where the plan’s contributions are generally not determined actuarially. Recently, the American Academy of Actuaries (AAA) released a practice note on considerations involved in consulting on fixed rate plans. The practice note defines fixed rate funding as:
“… a situation in which contributions to a defined benefit plan are defined as a certain fixed percentage of pay, often without regard to the results of a current actuarial valuation, and in a way that is not subject to change by the plan’s governing body. For example, the contribution rate might be defined in a statute or ordinance. In that case, a change in the rate requires some type of direct action by a separate governing authority.”
Readers will note that, consistent with the definition above, the Social Security system is essentially a fixed rate pension plan. Similarly, because future retired household income streams (Social Security, annuities and pensions) are fixed to a significant degree, it can be argued that personal retirement plans are similar in concept to fixed rate pension plans.
The AAA practice note advocates consideration of the following items when an actuary consults with a fixed rate pension plan:
- Advise the client on the funding policy and the importance of achieving and maintaining full funding. Work with the client to establish a formal written funding policy if one does not already exist.
- Select actuarial assumptions and methods with due consideration to the potential need for a margin for adverse deviation. A margin for adverse deviation is arguably more important in fixed rate plans than in other plans because of the difficulty in increasing the contribution rate and the reluctance to decrease benefits.
- Develop an actuarial benchmark contribution/adequacy measure which in some cases could be the statutory measure.
- Maintain a history of the adequacy measure reflecting both market value and actuarial value of assets.
- Use projections, scenario testing, and stress testing to provide a leading indicator of the potential need for change.
- Work to establish procedures to evaluate and update the fixed rate and possibly benefits in a timely, systematic manner.
- Ensure that stakeholders are aware of the significant risks associated with pension funding— most notably investment risk—and that a combination of fixed benefits and contributions cannot persist indefinitely.
Consideration items 1-4 above all involve comparing system assets with system liabilities, where such amounts are based on conservative deterministic assumptions about the future (Item 2). Item 5 suggests risk assessment techniques to provide information relative to when assets or liabilities may need to be changed in the future, Item 6 suggests establishing procedures to determine when assets or liabilities should be adjusted, and Item 7 cautions system stakeholders that future changes to assets and/or liabilities are essentially inevitable in situations involving both fixed income and benefit streams.
While Item 7 appears to be obvious, it is important to acknowledge that future experience can be less favorable than assumed and, if so, that assets (or revenue) may either need to be increased or liabilities (or benefits or spending) may need to be decreased. This is a truism for fixed rate pension plans, Social Security and personal retirement plans.
