Actuarial Valuation—An analysis of a pension plan’s current financial condition that includes liabilities, assets, and the future contribution rates needed to ensure long-term fiscal health. Estimated liabilities and contribution rates are based on assumptions about a plan’s future investment performance and demographic trends.
Actuarial Value of Assets—An approach to calculating a pension plan’s assets for funding and reporting purposes that smooths investment gains and losses over a specified period of time, generally five years. A plan’s Actuarial Value of Assets will lag behind its Market Value of Assets during periods of investment return volatility.
Amortization—The process of paying off a debt over a period of time according to a specified repayment schedule. In the context of pension plans, amortization refers to the process of paying off the unfunded actuarially accrued liability, or pension debt.
Annual Required Contribution (ARC) or Actuarially Determined Contribution (ADC)—The minimum payment a sponsoring government must make each year to its pension plan to ensure that the plan has sufficient assets to cover the retirement benefits earned by public workers. A government’s ARC/ADC is determined by the plan’s actuary and is calculated by adding (1) the cost of the benefits earned by current workers in that year and (2) the payment necessary to pay off the government’s accumulated unfunded liability, or pension debt. Plans frequently report the ARC/ADC as a percentage of payroll.
Annuity—Annual payments made to a retiree. Retirees often receive their annuities in monthly installments.
Assets—The current value of the resources that governments have set aside to pay for workers’ accrued benefits. Pension plans hold a range of assets including lower-risk assets such as cash and bonds, and assets that are considered to be higher-risk, such as publicly traded equities, private equity, hedge funds, and real estate.
Assumed Rate of Return—The profit, expressed as an average annual growth rate, that pension fund managers expect to earn on the plan’s investments over a period of time.
Cash Balance plan—A retirement savings plan in which workers and their employers contribute a fixed amount to a personal savings account each year. Governments pool workers’ accounts and invest their savings. Workers are promised a certain annual rate of return on the accumulated savings. Retirees’ benefits are based on the value of their accounts at retirement. Benefits are paid out to workers as an annuity or lump sum.
Final Average Salary Defined Benefit plan—A retirement savings plan in which workers and their employers make annual contributions to a pooled savings account. Workers earn an annuity that is payable once they reach the plan’s retirement eligibility thresholds. The annual payment a worker receives in retirement is based on a formula that includes years of service and final average salary, which is usually calculated using the salary he or she earned during his or her final three to five years on the job. Workers and their employers are expected to contribute enough to fully cover the cost of the benefits as they are earned. However, Defined Benefit plans require plan managers to make a number of predictions about demographic and market trends in order to determine the amount of money governments must save now to cover the cost of providing benefits to future retirees. If those predictions are wrong, the cost of providing promised benefits can rise substantially.
Defined Contribution Plan—A 401(k)-style retirement savings plan in which employees and employers contribute a fixed amount to personal savings accounts each year. Workers invest their accounts in diversified, professionally managed, low-fee funds, which are either selected by employees themselves or their employers. Retirees’ benefits are based on the value of their accounts at retirement. Workers are provided with a range of payout options including a full or partial lump sum and annuities that offer a lifetime income.
Discount Rate—The interest rate used to calculate the present value of benefits that workers have already earned, or a plan’s liabilities. The discount rate is a key determinant in the calculation of governments’ annual pension contributions (i.e., ARC/ADC). Using higher discount rates to calculate liabilities for pension funding results in lower current estimated values for benefit promises and lower annual contributions from government sponsors. Using higher discount rates to calculate pension liabilities increases the probability that annual contributions will not be sufficient to fully cover future benefit payments and that contributions will need to increase to make up the difference.
Funded Ratio—A pension plan’s total assets divided by the value of retirement benefits that workers have already earned, or a plan’s liabilities. In other words, if a pension plan is 75 percent funded, the plan has only 75 percent of the assets needed to pay for the retirement benefits owed to workers for past service. A fully funded plan has assets that are equal to or greater than its estimated liabilities.
Liabilities or Actuarially Accrued Liabilities—An estimate of the current value of the benefits workers have already earned. These benefits will be paid out to workers in the future when they retire.
Market Value of Assets—The current value of a pension plan’s assets.
Normal Cost—The value of the benefits that workers earned in a given year. A government’s annual payment to a pension plan should always cover the normal cost.
Risk-Free Rate—The return that an investor should expect to earn on assets that are considered to be very safe, such as U.S. Treasury securities. The difference between the risk-free rate and a pension plan’s assumed rate of return is a measure of the plan’s market and funding risk. Funds with assumed rates of return that are much higher than the risk-free rate are likely to experience greater asset volatility, which can make budgeting difficult and could leave governments on the hook to cover much lower-than-expected returns.
Unfunded Actuarially Accrued Liabilities or Pension Debt—The difference between the current value of the retirement benefits workers have already earned and the assets a plan has on hand to pay for those benefits.