Issue: June 2005

ABC OF FUNDING (First of two parts)

"Funding" refers to the manner in which capital is set aside to meet a retirement fundís future obligations to its members. In essence, it determines when contributions should be set aside to pay future benefits. Funding cannot be considered in isolation, as it interacts with other areas in the financial arena such as investments.

In this TT edition and the next we will introduce the key funding concepts.

Funding level

The funding level is referred to as the ratio of fund assets to fund liabilities at the valuation date. It is similar to the solvency ratio for a company, and indicates the ability of the fund to meet its liabilities. A ratio higher than 100 percent means that the fundís assets should be sufficient to meet its liabilities; conversely, a ratio of lower than 100 percent means that the fundís assets (according to the method adopted) are likely to be insufficient.

If the fundís funding level is less than 100 percent, the contributions may have to be increased (at least temporarily) to make up the deficiency. Conversely, if the funding ratio is above 100 percent it means that the contributions (in aggregate) may be temporarily reduced. Movements in the funding levels are dependent upon many factors such as contribution levels, investment strategy and market performance.

Even when the funding level suggests that the current contribution rate is adequate (fund is 100 percent funded), the future level of contributions should be considered. This is because the funding level/ratio could change in the future, owing to losses being experienced due to an aggressive investment strategy adopted by the fund; poor investment performance; prevailing market conditions, etc. For example, if the net investment return of the fund decreases, it may need to be compensated by an increase in the contributions level.

Funding method

The funding method adopted refers to the actuarial model used to determine the required contribution rate, based on the determined actuarial liability. The actuary determines the method of funding after giving careful consideration to the objectives of the employer as well as the fund demographics and outlook. Different methods have different characteristics and are generally used in different circumstances (for example, whether the fund is closed to new members or whether it is a new fund).

The basic difference between the main methods of funding is whether a stable contribution rate is targeted, or a certain level of funding is targeted. Whichever method of targeting (funding level or contribution rate) is chosen, the other will fluctuate more. In other words, if a stable contribution rate is required, then the funding level will fluctuate more, and vice versa.

The most important long-term consideration in determining the funding method is the level and incidence of benefit payments. Various methods are possible. Their appropriateness depends on the type of employer involved, the regulatory framework and accounting principles applicable. Possible funding methods include:

  • Pay-as-you-go funding

    The employer(s) make(s) the necessary contributions into the fund only when physical payment of a memberís benefit takes place. Thus the employer(s) make(s) no monthly contributions into the fund.

    The main risk associated with this approach is that reserves are not built up in the fund to finance future benefits, resulting in the fund being entirely dependent on the employer(s) to fund these benefits. This could negatively impact the fund and the member (active or pensioner) especially if, for example, the employer experiences liquidity problems and fails to meet its debts. Thus both the active member and the pensioner have a sense of insecurity with regard to the future payment of their benefits.

  • Terminal funding

    Similar to the "pay-as-you-go" approach, the employer also does not contribute to the fund on a monthly basis but makes its contributions at the time that the full benefit accrues to the member.

    The same risk associated with the "pay-as-you-go" approach applies. However, here the pensioner is more secure in being paid his monthly pension as the employer contributes his "full" benefit into the fund when the pensioner retires. This makes reserves available in the fund to pay the future monthly pension due to the pensioner. No such funding is available for the active member.

  • Regular funding

    This is generally used by most funds. The employer makes monthly contributions into the fund, and reserves build up in the fund to finance membersí benefits when they become payable. It requires actuarial input to ensure that the contribution rate is sufficient to meet all future fund liabilities. In terms of this approach, more security is offered to both the active member and the pensioner in respect of benefit payments.

    Risks will depend on whether the fund has been established as a defined contribution (DC) defined contribution (DC) fund.

  • Advance funding

    Essentially, it means that lump-sum capital payments are made into the fund. Together with investment returns, these capital payments are able substantially or partially to meet the future benefits payable to members. Thus the payment of a benefit is not wholly dependent on the receipt of monthly contributions from the employer. This type of funding approach is generally rare in practice.

Both over- and under-funding could have a negative impact on the fund and the employer. Therefore the following should be taken into account when deciding upon the most suitable funding method:

  • Needs and objectives of all interested parties (fund and employer or employers);
  • Respective advantages and disadvantages of each method;
  • Potential consequences and legality of each method.

The needs and objectives of interested parties will be discussed in the next TT edition.