Actuarial cost method definition
/What is the Actuarial Cost Method?
The actuarial cost method is used by actuaries to determine the amount of periodic payments that an employer must make into a pension plan. The outcome of using this method is a payment figure that, when combined with the return on investment on funds already invested, offsets the amount of payments made from the plan. The goal of the actuarial cost method can be achieved by using either of the approaches noted below.
Cost Approach
The cost approach calculates the estimated total benefit to be paid out and then works backwards to determine the total periodic cost required to meet the projected benefit.
Benefit Approach
The benefit approach calculates the amount of benefit associated with employees’ service to date and uses a discount factor to reduce this benefit to its present value.
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Accounting for Retirement Benefits
Actuarial Assumptions
When determining the amount of payments to be made, an actuary needs to use a number of estimates, including the future rate of return on invested plan assets, the rate at which employee compensation will increase in the future, the average retirement age, and the rate at which future pension costs will be discounted. These assumptions may be aggressive, which means that the calculated payment amounts may be too low. If so, the amount that must eventually be paid into a pension plan may need to be increased - and possibly by quite a large amount.
An investor who is reviewing the financial disclosures of a business with pension obligations should review these estimates for reasonableness. If the estimates are not reasonable, this can lead to a conclusion to disinvest in the business, on the grounds that its pension-related expenses are likely to increase in the future.