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