Issue: July/August 2005
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:
Important objectives of the employer(s) in determining the required level of contributions include:
Important objectives of members in determining the required level of contributions include:
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:
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.