Backgrounder

Glossary of Pension Terminology

Understand what pension terms and phrases mean

This glossary of pension terms and phrases is organized alphabetically. Terms in this glossary include:

Structural Design of Retirement Systems

Pension Financial Terms

Unfunded Liabilities

 

Pension Glossary

Actuarial Accrued Liability (AAL) or Total Pension Liability (TPL): Accrued liabilities are the present value of promised pension benefits, or pension obligations. In any given year, the plan’s actuary calculates the total value of liabilities that have accrued, and this figure is used to determine the plan’s unfunded liability. At any given time the recognized value of accrued liabilities on the pension plan’s books is dependent on the rate used to discount the promised benefits to their net present value. Ultimately, the value of the obligations will be based on how long retirees live; the actuarial present day value of these benefits is based on the discount rate used to estimate those benefits. If a plan increases or decreases the discount rate, leading to a decrease or increase in the reported liabilities, this does not mean the actual promised benefits have changed, only the accounting value of them has changed.

Traditionally, liabilities have been formally known as ‘actuarial accrued liabilities,’ ‘accrued liabilities,’ or ‘actuarial liabilities’; recently, new terminology introduced by the Government Accounting Standards Board refers to liabilities as ‘total pension liabilities.’ For most purposes the terminology of AAL and TPL is similar. » return to top

Actuarial Assumptions: Estimates used to forecast uncertain future events affecting future benefits or costs associated with a pension fund. Examples of these assumptions are investment rate of return, inflation, payroll growth, mortality, retirement patterns, and other demographic data.

Actuarially Determined Employer Contribution (ADEC): The amount actuarially calculated each year that is required to be contributed by an employer to a pension plan’s pool of assets in order to ensure there will be enough funds to pay promised pension benefits. The contribution rate can be reported either in dollars or a percent of salary, Actuaries annually determine how much should be paid by employers in a given year in order to properly fund a pension plan. This amount is a combination of the employer’s share of normal cost plus the unfunded liability amortization payment. The actuarially determined amount is the “required” contribution, but employers are not necessarily legally bound to actually contribute this amount. The ability for employers to not pay 100% of their pension bill is one of the reasons unfunded liabilities can increase.

Prior to 2014, annual contributions to a plan were known as the ARC for “actuarially required contribution” or “annual required contribution.” The Government Accounting Standards Board changed its guidance for actuaries on calculating the ARC and moved to clarify the difference between its guidance for pension plan financial reporting and the funding policies determined by a pension board. For most purposes, the terminology of “ARC” and “ADEC” is similar. » return to top

Actuarial Value of Assets (AVA): The value of a plan’s total assets that accounts for investment gains and losses on a smoothed basis, as used by the actuary for the purpose of an actuarial valuation. For example, a plan using a five-year smoothing period will only recognize 20% of investment losses or gains for a given year’s returns when calculating the value of assets. Each year thereafter the plan will recognize another 20% of losses or gains until they are fully recognized in the actuarial value of the assets. Thus, at any given time, there are investment gains or losses up to four years in the past that are not accounted for when citing the actuarial value of assets.

Amortization Method, Closed: If an amortization schedule is “closed” that means the plan has a particular date it is targeting to eliminate unfunded liabilities. Each year the plan pays off a portion of the unfunded liabilities the schedule moves one year closer to its end date. If the plan experiences additional actuarial losses during the schedule that add to the unfunded liabilities that need to be paid down, then the plan could either create a separate amortization schedule for that new debt (known as an amortization ‘layer’) or simply add the new amounts owed to the existing debt and increase the payment in each year of the schedule without the number of years in the schedule increasing.

Amortization Method, Open: If an amortization schedule is “open” that means the amortization payments are reset each year, like refinancing a mortgage each year. This approach guarantees the pension debt will never be paid off and often can mean contributions towards unfunded liabilities each year don’t even cover the interest on the debt. » return to top

Amortization Method, Level-Dollar: Unfunded liabilities can be amortized over a fixed (closed) or open number of years such that the plan expects to pay the same dollar amount each year of the schedule.

Amortization Method, Level-Percent: Unfunded liabilities can be amortized over a fixed (closed) or open number of years such that the plan expects to pay the same percentage of payroll each year of the schedule.

Annual Required Contribution (ARC): See ‘Actuarially Determined Employer Contribution’

Annuitization: Conversion of a lump sum of money into a stream of future income payments.  » return to top

Asset Allocation: The allocation of invested pension assets between different types of investments. Asset allocation typically involves a mix of investments representing different levels of risk and return, and may behave differently over time. The pension plan’s board develops an investment strategy that apportions a plan’s assets according to a particular tolerance for risk and investment goals.

Asset Smoothing: The process of recognizing only part of an actuarial gain or loss to plan assets in any given year in order to calculate the actuarial value of assets (AVA). A pension plan might want to do this because amortization payments are based on the amount of unfunded liabilities, and smoothing in gains or losses to the plan’s assets means the recognized value of unfunded liabilities is unlikely to make a big jump from one year to the next. » return to top

Assumed Rate of Return: The rate of return adopted by the board as its assumption of what the plan will return on average in the long run. Actuaries use the assumed rate of return to determine how much should be contributed to the plan each year to ensure there is enough saved to pay out pension benefits to each employee upon retirement. This rate is typically determined based on the expected rate of return, and in practice the technically different terms are used interchangeably.

The ‘assumed rate of return’ is not the same as the ‘discount rate,’ though the two are often mistakenly equated. Most public sector pension plans use the same rate for the assumed rate of return (which should reflect the risk of the plan assets) as for the discount rate (which should reflect the risk of the plan liabilities), even though this is not a best practice. For all purposes the terminology should not be equated.

Beneficiary: A person designated by the terms of the pension plan that is, or may become, entitled to a benefit under the plan. Typically these benefits are spousal benefits and survivorship benefits for minor children. » return to top

Cost-of-living adjustment (COLA): An annual change to a pension benefit for retirees, usually pegged to some measure of the rate of inflation. Some COLA benefits have minimum adjustments, such as 1% or 2%. Some COLA benefits have maximum adjustments. Some COLA benefits are intended to match inflation. Some COLA benefits are based in part on inflation and in part on some other metric (such as returns).

Deferred Retirement Option Plan (DROP): A benefit design offered by some defined benefit pension plans that allows an employee to continue their employment after applying for retirement. Usually DROPs involve an employee’s regular retirement checks being put into a dedicated account while the employee continues to work for one to five years. After completing work during the DROP period, the employee receives a lump sum of the deferred pension checks, plus some rate of return. Different DROP designs offer rates of return that are some variant of the plan’s actual rate of return during the DROP period, but almost always they offer a minimum rate of return. For example, a DROP design might offer a minimum of 4% return on deferred pension checks and a maximum 8% return. The advantage for the plan is that they get to keep any returns on the deferred pension checks above 8%. The advantage for the employee is that they get to keep working while receiving pension checks, and they get some guaranteed return on the assets. However, if the asset returns are lower than the guaranteed minimum, the plan will wind up with losses because of the DROP rather than gains. In this way, the DROP design has similar risks and rewards as defined benefit plans. » return to top

Defined Benefit Plan: A plan that provides specified retirement benefits that are guaranteed by their employer. The monthly retirement benefit is typically based on the employee’s final average salary, years of work, and age. A defined benefit plan is designed to be pre-funded such that when an employee retires, the plan has sufficient funds to pay for all promised retirement benefits (i.e. pension checks). A typical defined benefit plan has an eligibility age and/or year of service minimum in order to qualify for retirement.

Defined Contribution Plan: A plan that provides retirement benefits for employees via regular deposits into a personal retirement account. The accumulated savings and investment income are used to fund the employee’s retirement. The liability of employers is only to make the regular contributions to these accounts, which for public sector employees are similar to a 401(k) for private sector employees. Typical public sector defined contribution plans can take the form of 401(a), 403(b), or 457 IRS qualified plans. » return to top

Discount Rate: A rate used to determine the net present value of promised pension benefits (or liabilities of the plan). Discount rates are supposed to reflect the risks of the liabilities— i.e. the risk that the plan sponsor will not be able to pay the promised pensions. As such, a discount rate represents the combination of a so-called “risk-free interest rate” plus a risk premium associated with the employer(s) responsible for a particular plan. Theoretically the higher the discount rate, the higher the implicit risk associated with the plan. In practice, the discount rate is often selected in a political context with an eye on minimizing near-term contributions.

The ‘assumed rate of return’ is not the same as the ‘discount rate,’ though the two are often mistakenly equated. Most public sector pension plans use the same rate for the assumed rate of return (which should reflect the risk of the plan assets) as for the discount rate (which should reflect the risk of the plan liabilities), even though this is not a best practice. For all purposes the terminology should not be equated.

Expected Rate of Return: A rate of return that a pension plan expects to earn on average over a particular period of time from its investments. The expectation is derived from a historic analysis of the plan’s investments and based on its forward-looking investment strategy for the plan’s assets. Generally, pension boards adopt the “expected rate of return” on their assets as the “assumed rate of return” used for determining contribution rates; the terms “expected rate of return” and “assumed rate of return” are technically different, though often used interchangeably. » return to top

Funded Ratio: The ratio of the plan’s assets to its liabilities. This could be measured on a market value or actuarial value of assets. It is simply the MVA or AVA divided by the AAL. A funded ratio above 100% means the plan has more assets than liabilities; a funded ratio below 100% means the plan has not saved enough relative to the estimated value of the benefits it has promised.

Market Value of Assets (MVA): The real value of the plan’s total assets, measured by the price that would be received to sell an asset in an orderly transaction between market participants at that date. » return to top

Multiplier: A typical defined benefit plan offers benefits as a percentage of the employee’s final average salary. The percentage is usually a function of the employee’s years of service times a ‘multiplier’ percentage, such as 1% or 2.5%. For an employee who retires with a final average salary of $100,000 and 30 years of service, their benefit might be: 2.5% x 30 x $100,000 = $75,000. In principle, the higher the multiplier the greater the pension benefits offered. Some pension plans offer a higher multiplier the more years the employee works. The multiplier percentage is sometimes called a ‘service credit’ or ‘accrual rate.’

Net Pension Liability (NPL): See ‘Unfunded Actuarial Accrued Liability’. » return to top

Normal Cost: Employees earn new pension benefits each year. The annual actuarially calculated contribution necessary to provide these benefits is known as the normal cost. In technical terms, the normal cost represents a single valuation year’s portion of the value of actuarial liabilities.

Payroll: The total amount of salary paid to all active employees of a pension plan. The costs and contribution rates of a pension plan are often expressed as a percentage of the total plan payroll. » return to top

Pension System, Plan, and/or Tier: The terminology for retirement benefit design structures can vary from state to state. Usually ‘system’ refers to an overarching benefit structure (such as “Michigan State Employee Retirement System”). Within a pension system, there are often defined benefit ‘plans’ or ‘tiers.’ Some ‘plans’ may have multiple ‘tiers’ that represent subsets of benefits, such as employees with different retirement eligibility based on hire date. Other systems provide a subset of benefits through different ‘plans’ within a ‘system’. Still other states will have one ‘system’ and multiple ‘tiers’. Ultimately, the terminology is interchangeable and pension system specific.

Service Credit: See ‘Multiplier’.

Unfunded Actuarial Accrued Liability (UAAL) or Net Pension Liability (NPL): Unfunded liabilities are the amount of liabilities (or promised benefits) that are greater than assets of a pension plan. In most cases it is measured as the amount of actuarially accrued liabilities (AAL) greater than the actuarially valued assets (AVA) of a plan, or simply the AAL minus the AVA. Colloquially, the phrase “unfunded liabilities” is interchangeable with “unfunded actuarially accrued liabilities” (UAAL), “unfunded actuarial liability” (UAL), or “net pension liability” (NPL).

If a plan’s assets were to be greater than the liabilities of the fund, the plan would be considered “overfunded” and in some cases the plan’s actuary would report a “negative” unfunded liability.

Unfunded liabilities can also be reported as the difference between actuarially accrued liabilities and the market value of assets (MVA). Again, this is calculated as AAL minus MVA. Since unfunded liability typically refers to the measurement on an AVA basis, reporting unfunded liabilities on a market basis should always be clearly stated.

Traditionally, unfunded liabilities have been formally known as ‘unfunded actuarial accrued liabilities’; recently, new terminology introduced by the Government Accounting Standards Board refers to liabilities as ‘net pension liabilities,’ i.e. the total pension liability minus the market value of assets. Technically, the actuarial calculation of UAL and NPL can be different, but for most purposes the terminology of UAL and NPL is similar. » return to top

Unfunded Liability Amortization Payments: Pension plans are required to make regular payments to reduce any actuarially accrued unfunded liability, which is effectively pension debt. Amortization payments are regular contributions to reduce the unfunded liability and are on a set schedule, similar to paying off a student loan, or a mortgage that allows for negative amortization payments. The pension plan’s board determines how many years it wants to take to pay off the pension debt, and then directs the plan actuary to use a particular method for determining what should be paid each year of the amortization schedule in order to eliminate unfunded liabilities.

Valuation: An analysis of the financial condition of a pension plan on a regular basis. The valuation determines the financial position of the plan and the future contribution rates needed to ensure its long-term funding. The pension plan’s actuary determines how much money the plan needs to pay pension benefits by using various assumptions concerning future events and behaviors. Pension information can also be found in a Comprehensive Annual Financial Report for a particular pension system or pension plan. » return to top

Anthony Randazzo

Anthony Randazzo is director of economic research for Reason Foundation, a nonprofit think tank advancing free minds and free markets. His research portfolio is regularly evolving, and he maintains a wide interest in economic policy at both a domestic and international level.

Randazzo is also managing director of the Pension Integrity Project, which provides technical assistance to public sector retirement system stakeholders who are seeking to prevent pension plan insolvency. His research focus on the national public sector pension crisis has a dual focus of identifying the systemic factors that cause public officials to underfund pension obligations as well as studying the processes by which meaningful pension reform can be accomplished. Within the Project he leads the analytics team that develops independent, third party actuarial analysis to stakeholders considering changes to public sector retirement systems.

In addition, Randazzo writes about the moral foundations of economic theory, and is currently developing research on the ways that the moral intuitions of economists influence their substantive findings on topics like income inequality, immigration, or labor policy.

Randazzo's work has been featured in The Wall Street Journal, Forbes, Barron's, Bloomberg View, The Washington Times, The Detroit News, Chicago Sun-Times, Orange-County Register, RealClearMarkets, Reason magazine and various other online and print publications.

During his tenure at Reason he has published substantive research on housing finance, financial services regulation, and various other aspects of economic policy at the federal level. And he has written regularly on labor economics, tax policy, privatization, and Turkish-U.S. political and economic issues.

Randazzo has also testified before numerous state and local legislative bodies on pension policy matters, as well as before the House Financial Services Committee on topics related to housing policy and government-sponsored enterprises.

He holds a multidisciplinary M.A. in behavioral political economy from New York University.

Follow Anthony Randazzo on Twitter @anthonyrandazzo