Studies
Studies 

 

 

WHAT IS THE BEST FUNDING VALUATION METHOD?

 

From our observation, the following actuarial valuation methods are commonly used by actuaries in the country for funding purposes: (1) Projected Unit Credit Method (2) Aggregate Method and (3) Aggregate Entry Age Normal Method.

 

Which one is the best method to use then for funding purposes?

 

If actuarial valuations for funding purposes are done annually, there may not be significant advantages will one method have over another and it is really up to the retirement program sponsor how it prefers to fund the retirement program as a level percentage of payroll, or an increasing one, etc.

 

However, if valuations are done with intervals of say three (3) or more years, then the Aggregate Entry Age Normal becomes superior because the Normal Cost under this method is a fixed percentage (Normal Cost Rate) of payroll and the accrued liability is computed separately. Thus, for the years that no valuation is made, the Normal Cost Rate is simply multiplied to the current payroll to arrive at the Normal Cost. Funding would then simply be the Normal Cost plus the amortization of the Unfunded Accrued Liability. The method also handily accommodates new hires.

 

This is not true for the Projected Unit Credit Method because under this method the Normal Cost is not a fixed percentage of payroll. How then would the Normal Cost be determined during the years when no valuation is made? Applying the ratio of the Normal Cost to the Current Payroll is not appropriate and will normally cause additional unfunded liability. The other problem is that such ratio does not apply to the new hire.

 

The Aggregate Method, on the other hand, while it also expresses the Normal Cost as a fixed percentage of payroll, its Normal Cost is already inclusive of any funding deficiency in the past. Note that under this method, the accrued liability is always set equal to the fund value. As such the Normal Cost Rate can not be applied to new entrants as it would mean over-funding (new entrants have no funding deficiencies).

 

Below is an illustration of the Stream of Normal Cost for an individual participant under the different methods stated above:

 

 

Projected Unit Credit

Aggregate Method

 

Aggregate Entry-Age

Age

YOS

Salary

NC

% Salary

AL

NC

% Salary

AL

NC

% Salary

AL

50

1

 10,000

   8,663

7.22%

     9,182

 

 

 

   9,037

7.53%

     9,579

51

2

 10,500

   9,182

7.29%

   19,466

 

 

 

   9,489

7.53%

   20,211

52

3

 11,025

   9,733

7.36%

   30,952

 

 

 

   9,963

7.53%

   31,985

53

4

 11,576

 10,317

7.43%

   43,745

 

 

 

 10,461

7.53%

   44,993

54

5

 12,155

 10,936

7.50%

   57,962

 18,662

12.79%

   19,781

 10,984

7.53%

   59,335

55

6

 12,763

 11,592

7.57%

   73,728

 19,595

12.79%

   41,739

 11,533

7.53%

   75,121

56

7

 13,401

 12,288

7.64%

   91,177

 20,575

12.79%

   66,052

 12,110

7.53%

   92,465

57

8

 14,071

 13,025

7.71%

 110,454

 21,603

12.79%

   92,915

 12,716

7.53%

 111,491

58

9

 14,775

 13,807

7.79%

 131,717

 22,683

12.79%

 122,534

 13,351

7.53%

 132,333

59

10

 15,513

 14,635

7.86%

 155,133

 23,818

12.79%

 155,133

 14,019

7.53%

 155,133

Legend: NC Normal Cost, AL Accrued Liability

 

The benefit considered is one month salary per year of service upon retirement at Age 60. Salary is assumed to increase by 5% per annum while the interest rate assumed is 6.0% p.a. For simplification, the individual is assumed to stay with the company until retirement. Finally, it is assumed that the plan is implemented when the individual has served the company for four (4) years.   

 

The Aggregate Entry-Age Normal Method also has the advantage of being able to provide the average long-term cost of the plan which is very important when setting up or amending a plan. Another advantage is that it fits well in the common practice of companies monitoring their other benefit costs in terms of percentage of payroll.