Originally published at Forbes.com on July 13, 2018.
How do employers fund and account for pensions? How should workers save for retirement? It occurs to me that going back 20 years to my first days, and first training sessions, as a trainee actuary, and revisiting the basics of pension funding methods, might provide a different way of thinking about these issues.
Back in the day, we learned that there were two general methods by which an employer could calculate their annual contribution, and their accrued liability, for a pension plan: level-cost methods and unit credit methods.
In the level cost method, or more specifically the Entry Age Normal or EAN method, the actuary calculates an employee’s projected future benefit at retirement, then calculates the amount needed to fund this benefit on a level basis throughout the employee’s career. If the benefit at retirement would be a flat dollar amount, then you’d calculate this as a level dollar amount throughout the employee’s career, kind of like paying off a mortgage. If (as in a traditional pension plan) this was based on the employee’s pay at retirement, you’d project the payout to retirement, and calculate the amount needed to fund the benefit as a level percent of pay throughout the employee’s career. For example, a worker starting at age 25, with a retirement age of 65, and a benefit accrual of 1.5% of pay per year would have accrued 40 x 1.5% = 60% of pay at retirement, so the actuary uses actuarial mathematics to determine a funding percent of pay for the employee’s working lifetime.
Sound familiar? This is the same sort of calculation, in general principles, as a retirement savings calculator would perform when you enter in your variables, such as “I want to retire at age 65 with enough savings to cover 70% of my future salary,” and ask for the recommended savings amount as a percent of pay — except that the actuary also has to reflect the likelihood that you’ll terminate before retirement (with or without a vested benefit), and your probabilities of dying before and after retirement.
In the Unit Credit method, the actuary’s calculation is different. To calculate the employer’s liability for any given employee, the actuary calculates the amount of benefit accrued up to the present point in time, then determines its value as a lump sum based on actuarial mathematics, considering the time-value of money as well as probabilities of termination and death. For a pay-based plan, this is called Projected Unit Credit (PUC) and, just as in the EAN method, pay is projected to retirement to determine the benefit accrual; in the above example, if the worker was age 45 at the time of the valuation, the liability would be based on 20 x 1.5% = 30% of projected pay, and the baseline amount for one year’s funding would be 1.5% of pay.
These hardly seem like two different methods, but there’s a very important difference: in the PUC method, as each year the employee ages and gets one year closer to retirement, the cost of that benefit increases, because the discounting for the interest rate (and the likelihood of terminating in the meantime) decreases. If the EAN method is similar to the idealized retirement-calculator method of saving for retirement, the PUC method more closely resembles the clunky way that Americans tend to save in practice, with the amount increasing from one year to the next as retirement grows nearer — except that in the latter case this is due to worry setting in and in the former case this is a consequence of the funding method.
What’s more, in my first paragraph, I referenced learning these funding methods as a trainee actuary. In practice, new pension funding regulations prescribe the PUC method, and pension accounting has always required this method — which makes sense, because, from an accounting point of view, the PUC method does reflect the true cost to the employer.
Incidentally, here’s another interesting tidbit: the method of providing Defined Contribution/401(k) benefits at the same level for everyone? There are two European countries which follow an entirely separate approach. In The Netherlands, because DC benefits were supposed to provide benefits equivalent at any given age to the traditional pension/Defined Benefit (DB) plans they replaced, employers’ contributions to their employees’ accounts also increase by age:
A typical individual DC scheme uses an age-related table in which contributions increase with age. Since the Dutch tax authorities have set up a maximum DC premium per age bracket (of five years), most companies use a system that corresponds to this.
KWPS provides two sample tables, based on the standard target equivalent defined benefit accrual and two different interest rates (their data, my reformatted table).
own table
And in Switzerland, where employers are required to provide a retirement plan, vaguely similar to a Defined Contribution system in the U.S., with employees contributing about 1/3 of the total contributions, contributions are also based on age, with a minimum total contribution of:
Age 25- 34, 7%
Age 35-44, 10%
Age 45-54, 15%
Age 55-65, 18%
So step back and imagine your employer contributing more to your 401(k) account the older you are. Hard to imagine, isn’t it? — Although in some of the earliest American cash balance/hybrid plans, the employer’s contribution schedule did that as well.
So far this all seems very abstract and not of much relevance to American retirement savings or retirement policy. But consider an article in yesterday’s Wall Street Journal, “Behind on Retirement Savings? It’s Not Too Late to Catch Up.” It’s paywalled, but much of its content is based off of a blog post by Michael Kitces, “Why The Empty Nest Transition Is Crucial For Retirement Success,” which proposes that, as an alternative to the goal of saving a level percent of your income throughout your working lifetime, you actively plan to cut your spending upon becoming an empty-nester, to the degree necessary to, in fact, fund your retirement, bearing in mind that this requires active efforts to keep your standard of living the same when kids have left the house, rather than boosting your spending to enjoy travel you’ve deferred or otherwise make up for an empty house with more (costly) activities.
Kitces writes:
for those who allow their total family consumption to fall (now that Mom and Dad are only supporting Mom and Dad, and not the kids), a significant uptick in savings can almost entirely make up the lack of savings during the child-rearing phase. In other words, if all the money that used to be spent to raise a family and send kids to college is now redirected into saving for retirement, a couple might find themselves suddenly leap from saving less than 5% of income to being able to save 25% or more.
Is this realistic? The WSJ article mentions research by the Center for Retirement Research that, on average, empty nesters don’t actually significantly increase their retirement savings when the kids leave home — whether because they’re still supporting those kids (college tuition, weddings, helping out in other ways) or for other reasons, and Kitces himself acknowledges that for who started their families late in life, there’s not much time to save after the kids are grown and before hitting retirement age — which means that, rather than providing a solution to the question of retirement savings, it really just provides a different perspective to take into consideration.
December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.