Actuarially determined contribution

Definition

An actuarially determined contribution is the amount of money that a pension plan sponsor is required to contribute to the plan, calculated using actuarial methods to ensure the plan remains adequately funded. This contribution takes into account various factors such as the plan's liabilities, the expected investment returns, and demographic factors like employee mortality and turnover rates. It is critical for maintaining the long-term sustainability of retirement plans and ensuring that future obligations can be met.

5 Must Know Facts For Your Next Test

1. The actuarially determined contribution is often calculated annually as part of the actuarial valuation process to ensure that the pension plan can meet its future obligations.
2. This contribution can vary significantly based on changes in assumptions such as investment returns, mortality rates, and employee demographics.
3. Pension plans may use different actuarial cost methods (like Projected Unit Credit or Entry Age Normal) which affect how the contributions are determined.
4. Regulatory requirements often mandate that plans make contributions at least equal to the actuarially determined amount to avoid underfunding issues.
5. Failure to make the actuarially determined contributions can lead to significant long-term financial challenges for pension plans, including potential insolvency.

Review Questions

• How does an actuarially determined contribution affect a pension plan's funding strategy?
  • An actuarially determined contribution is essential for a pension plan's funding strategy because it sets the required amount that must be contributed to meet future obligations. By accurately estimating liabilities through actuarial valuations, the sponsor can ensure that contributions align with both current assets and projected future payouts. If contributions are insufficient, it can lead to underfunding and jeopardize the plan's ability to pay benefits.
• Discuss how different actuarial cost methods impact the calculation of an actuarially determined contribution.
  • Different actuarial cost methods, such as Projected Unit Credit or Entry Age Normal, have significant implications on how an actuarially determined contribution is calculated. Each method assesses liabilities differently, which can result in varying contribution levels required to adequately fund the pension plan. For example, Projected Unit Credit focuses on benefits accrued based on projected salaries, while Entry Age Normal spreads costs more evenly over an employee's career, affecting short-term versus long-term funding needs.
• Evaluate the implications of failing to adhere to actuarially determined contributions on both employees and employers in a defined benefit plan.
  • Failing to adhere to actuarially determined contributions can have severe implications for both employees and employers in a defined benefit plan. For employees, this could mean reduced retirement benefits or increased uncertainty regarding their financial future. For employers, not making required contributions could result in legal penalties and higher future costs due to accumulating liabilities. Additionally, if underfunded plans become insolvent, it could lead to greater financial burdens on state insurance programs or even bankruptcy for companies reliant on their pension plans.

Related terms

Actuarial Valuation: A quantitative assessment performed by actuaries to determine the financial status of a pension plan, including its assets, liabilities, and funding levels.

Funding Ratio: A measure used to evaluate the financial health of a pension plan, calculated as the ratio of its assets to its liabilities.

Defined Benefit Plan: A type of retirement plan where the employer guarantees a specific retirement benefit amount based on factors such as salary history and duration of employment.