The closer that people listen, the more likely it is that they will realize that the pension debate is happening in a language other than English. In other words, pension gurus and policy wonks have a way of speaking about immensely complicated matters in such a way that makes it sound even more complicated.
PublicCEO has produced a brief dictionary of a few of the key terms most often used in the pension debate. It is our hope that we can shed some additional light on such an important topic. And, if you don’t see a word on here you’d like defined, just send me an email and I’ll do my best.
401(k) Plan –A 401(k) is the most common form of defined contribution pension plan. Under this type of plan, employees contribute an amount of their salary to an account that will be invested for their eventual retirement. This system allows for the employers to contribute matching funds or even enter into profit-sharing agreements.
Actuarially required contribution rate – This is the rate that is necessary to ensure that the pension’s portfolio adequately funded to meet future obligations, based upon the actuary’s report and risk assessments.
Actuary – A pension fund’s actuary is someone who quantifies risk. This person’s job is to look at all of the positive revenues and holdings of a pension and weigh their potential against the real and potential future costs (and future losses) of a portfolio. Included in a very complicated equation are factors such as expected lifespan of retirees, number of workers paying into a system versus those drawing benefits, and healthcare costs.
This work involves a great deal of math, finance, and budgeting.
Contribution rate – The contribution rate, whether paid by the employee or employer, is usually a percentage of the employee’s salary that is put in to the pension fund. Some funds use a flat percentage for all employees, but more commonly in the public sector the percentage varies by job.
Defined benefit (DB) plan – CalPERS and CalSTRS are defined benefit plans. This means that an employer sets (or defines) the amount that will be paid to retirees. It usually includes a fixed equation: Salary times a set percentage for each year of service equals the monthly or yearly payment. This type of plan provides a predictable benefit to the retiree, but also is relatively inflexible for the pension fund itself..
Defined contribution (DC) plan – A defined contribution plan is most similar to the common private industry pension programs. An employer determines how much it will contribute to an employee’s private retirement account. Usually, it is an amount up to a set amount of the employee’s total salary. Some of these plans have matching funds options, where the employer will match a certain amount of each dollar the employee contributes to his or her own retirement fund.
Discount Rate – (Also known as the Assumption Rate)The amount that a pension’s investments are expected to grow is a discount rate. The accuracy of the amount of growth is fundamental to determining the health of a pension’s funded ratio.
Most pensions are managed on a 30-year outlook, much like mortgages in reverse. The people who oversee the pensions need to determine how much money they need to have today to be able to pay a certain value over the course of the next 30 years.
If a pension fund’s 30-year payment obligations equal $1,000 and the fund is operating with a 5% discount rate, then the plan administrators can calculate that they need to have $231 today. Basically, if $231 is amortized over 30 years, the result is $1,000.
However, if the fund assumes a 10% discount rate, the fund would only need $57 to cover the funding obligation.
The danger of having a high discount rate is clear. If the fund invested its $57 today and with a expected 10% discount rate, but only earned 7%, the pension fund would only have $433 to cover $1,000 in obligations, leaving the fund 56% unfunded.
Fiduciary – This is a blanket term for anyone involved with the handling, investing, or control of a pension fund’s assets, including consultants or those with discretionary authority. Generally, this includes pension fund trustees, the employer, or its investment managers or advisors.
Funded Ratio – In comparing the current or future fund obligations to its expected assets, one can determine its funded ratio. That’s the simpler way of stating its formal definition (read at your own risk): “The funded ratio equals the actuarial value of assets divided by the actuarial accrued liability calculated under the Projected Unit Credit cost method.”
For an example of this, see Unfunded Liability.
Plan Administrator -A plan administrator (either person, committee, or company) has the responsibility for operating the business side of the pension program. They oversee the day-to-day operations of the fund, and advise the trustees with how to best manage the portfolio.
Projected Benefit Obligation– One of the jobs of an actuary is determining the cost of a retiree’s future benefits. By combing the expected number of years that a retiree will receive his or her benefits and multiplying that by the annual cost, the total value of obligated expenses can be determined.
Trustees – Public Pension funds are often overseen by a board of trustees. These boards are often made up of a combination of people from member agencies, retirees, and the public. For instance, the CalSTRS Board of Trustees includes two K-12 teachers, a retired representative, a community college instructor, a school board representative, and a public representative. It also includes ex-officio members of California State Government.
Because of the lay background of the trustees, they are often given advice from professional staff and consultants.
A perfect trustee would act (by definition) “without favor of any individual and take collective responsibility for the decisions they take.”
Unfunded Liability – Unfunded liability is the result of an equation. It takes the value of the currently held assets, changes that (up or down) by their expected returns and compares that result to the expected cost of providing retirement benefits to a pension plan’s enrollees.
To simplify this concept, if an actuary determines that a pension fund’s future assets will be $100 and it will have to pay $100 to cover all of its future expenses, then there is no unfunded liability. If an actuary determines that the pension’s future assets will be worth $60, but that its future payment obligations will be $100, then the pension would have a 40% unfunded liability.
Most healthy pension funds carry a nominal unfunded liability.
See also Funded Ratio.
For more, and more technical definitions of these and other pension related terms, please visit this website.