Issue: July/August 2005
Edutorials
KPMG

ABC OF FUNDING (Second of two parts)

In last month’s TTedition we discussed the definition of “funding” as well as key concepts such as the funding level and different types of funding-calculation methods. Here we explain what drives the funding decision as well as the cost of funding. Funding is different between defined contribution (DC) and defined benefit (DB) funds.

Meeting the needs and objectives of interested parties Interested parties can be divided into two broad categories:

  • Employer(s); and
  • Members.
  • The employer(s)

Important objectives of the employer(s) in determining the required level of contributions include:

  • Stability in contribution levels, i.e. that they do not change drastically from period to period;
  • Providing the employer’s staff members with the necessary assurance that their benefits will be paid as they fall due, irrespective of prevailing circumstances;
  • Budgeting for future contributions, thereby ensuring that capital will be available when needed;
  • Contribution rate should fairly reflect the cost of the accrual of retirement benefits over a given financial period;
  • Meeting the realistic expectations of members;
  • Flexibility in future contribution levels for the employer to make appropriate business decisions when wishing to invest surplus cash in the various types of investments, including a retirement fund; and
  • The ability of the funding method to provide stability in changing conditions.

THE MEMBERS

Important objectives of members in determining the required level of contributions include:

  • Being given the security that their benefits will be paid when they fall due; and
  • Maintaining their present standard of living into retirement.

COST OF FUNDING

The funding method decided upon does not affect the cost of a DB fund. The cost of providing defined benefits is, amongst other things, ultimately dependent on the actual movement in member-exits, i.e. by way of withdrawal, death, retirements, etc. (The movements and exits may increase over time due, for example, to the increasing impact of HIV/Aids.)

However, in a DC fund the contributions received determine future benefits. Thus the contribution rate or funding decision determines the cost of funding. Trustees should aim at all times to meet the realistic expectations of members.

USES OF ASSET/LIABILITY MODELLING TECHNIQUES IN THE FUNDING DECISION

In deciding upon the most appropriate method of funding, actuaries often use asset/liability modelling techniques to develop an understanding of the type and level of benefit payments likely to be paid in future. These techniques can illuminate various important aspects of the funding method, including cash flow requirements and the likelihood of persistent under-funding into the future.

By understanding the impact of changes in the environment, including demographic and economic changes, a fund can plan ahead with a combination of both historical information and future predictions.

FUNDING WITHIN A DB ENVIRONMENT

The major constraint on DB funds is they must keep a formulated and transparent long-term promise. How this promise is kept relates directly to the funding philosophy. The cornerstone of funding is the level and incidence of contributions paid into the fund. However, the funding philosophy also links to other areas of the fund, such as the investment strategy.

Within a DB environment, the risk of not meeting the future obligations to members rests with the employer. Thus the fund is dependent upon the employer meeting its debts.

FUNDING WITHIN A DC ENVIRONMENT

There are no regulatory requirements on measuring a DC fund’s ability to honour its commitments to its members because the commitments are less clearly defined.

DC funds have the same objectives as DB funds, i.e. to ensure that post-retirement income is adequate to meet the realistic expectations of members. But the risk of whether these objectives will be met rests with the members.

Members’ expectations will naturally entail maintaining their living standards, and therefore the “funding” decision remains important. This implies that, as opposed to a DB fund where funding is regularly considered, the major funding considerations for a DC fund are to determine the contribution rate at the outset of the fund and to monitor it as circumstances change.

The following factors, amongsts, should be considered by the employer when determining the level and type of contributions:

  • Future benefit levels for certain groupings of employees;
  • Employee profiles such as lifestyle and demographics;
  • Anticipated effects of individual investment choice.

Trustees of a DC fund must realise that the comparative simplicity of their DC fund does not mean that their responsibility to members is much different. Ultimately, members have similar expectations. Trustees should strive to use the fund’s resources to ensure that these expectations are realistic and that the fund lives up to them.