Explanation of Basic Pension Accounting and Funding Terms: Chicago Context

Pension funding and accounting is notoriously complex. This blog post will break down commonly used terms and demonstrate what said terms are used for within the context of the City of Chicago’s four pension funds.

There are three different funding sources for pension funds. The first is the employee cost, which is the percentage of money pulled from an employee’s paycheck to fund the pension benefit. The second is the employer cost, which is the designated percentage of an employee’s salary that the employer will contribute to the retirement benefit of the employee. The third funding source is investment returns on the employee and employer payments, after the payments are invested.

Actuaries use a variety of terms to refer to specific costs associated with pensions. Definitions for the most common of these terms are listed below.

Glossary

Normal Cost: The term “normal cost” refers to the cost of the new benefits earned each year by the pension plan’s active participants, or the amount of benefits that need to be paid out that year.[1]

Actuarial Liability: The term “actuarial liability” refers to the value of benefits already earned by plan participants, including both active and retired participants. Actuaries compare a plan’s actuarial liability to its available assets to gauge the plan’s ability to pay its benefits.[2]

Unfunded Liability: The term “unfunded liability” refers to the amount by which an actuarial liability exceeds assets. Employers amortize unfunded liability, meaning they pay it off through regularly scheduled contributions, like a mortgage. For that reason, unfunded liabilities increase cost.[3] [4]

Asset Surplus: The term “asset surplus” refers to when a plan’s assets exceed its actuarial liabilities.[5]

Funded Ratio: The term “funded ratio” refers to the ratio of available assets to liabilities. It is represented as a percent and can be used to gauge a plan’s ability to pay its benefits.[6]

Accrued Liability: The term “accrued liability” refers to the amount of money needed to pay earned and not-yet-earned benefits for plan members. Actuaries use accrued liability when recommending how to the employer should amortize contributions to be able pay future benefits.[7]

Actuarial Assumptions: To calculate normal cost, actuarial liability, and accrued liability, actuaries make certain assumptions about how future economic and demographic conditions will affect the pension. These assumptions are called “actuarial assumptions.” Regulatory bodies determine how these assumptions are chosen.[8]

Assumptions

Actuarial assumptions play an important role in calculating indicators of pension health. Actuarial assumptions are lumped into two main categories: 1) economic assumptions and 2) demographic assumptions.

1) Economic assumptions are made regarding interest rates, future salary increases, inflation, and future market performance. Economic assumptions serve as estimates for how much benefits will increase in the future, how future benefit rates should be discounted, and how heavily the employer will be able to rely on plan assets to pay benefits.[9] For instance, if actuaries assume that the economy will perform well in the immediate future, then some of the plan’s investment assets will likely earn more, therefore reducing the amount the employer may have to contribute to meet actuarial liabilities during a certain period.

2) Demographic assumptions, on the other hand, estimate how long plan participants will work, at what age they will retire, and how long participants and their spouses will live after retirement.[10] For instance, if actuaries assume that plan beneficiaries born between the years 1960 and 1970 will live to be 85 years old on average, then the actuarial liability will be much higher than if those same beneficiaries only live to be 75 years old because actuaries anticipate that the plan will have to pay an extra ten years of benefits to a certain number of beneficiaries. Often, actuaries use probabilities to model and account for varying demographic trends.[11]

Differences in Funding Recommendations

When examining the yearly contributions made by the City of Chicago to the various pension plans, it is important to keep in mind the differences that exist between actuarially recommended contributions (“ARC”) and statutory contributions.

Each year, the actuaries hired by the City evaluate the overall health of each of the four funds, and recommend a dollar amount contribution. They base this level of contribution on their expectations for the fund’s future economic performance combined with their yearly assessment of the fund’s current health, as represented by its actuarial liability, normal cost, and other indicators. As such, the ARC represents the amount best suited to increase the overall health of any annuity fund for any given year.

The statutory contribution, on the other hand, represents the amount that the City must contribute in a given year by law. Statutory contributions are dictated according to Public Acts passed by the Illinois General Assembly. Currently, statutory contribution levels are dictated by P.A. 99–0506 and P.A. 100–0023, which aim to raise the funded level of each annuity and benefit fund to 90% by the mid 2050s.[12] To accomplish this, P.A. 99–0506 and P.A. 100–0023 impose a mixture of pre-determined annual contributions and annual contributions that will vary depending on actuarial calculations. For instance, P.A. 99–0506 mandates an aggregate statutory contribution of $792 million for the Policemen’s and Firemen’s plans for fiscal year 2019, however, for years 2021–2055, P.A. 99–0506 mandates annual statutory contributions equal to the amount actuarily determined to be sufficient to produce a funding ratio of 90 percent for the Policemen’s and Firemen’s plans by the end of 2055.[13] Because P.A. 99–0506 and P.A. 100–0023 mandate a mixture of pre-determined, static contributions and contributions designed to achieve a certain benchmark years in the future, these statutory contributions are less reflective of the overall health of each annuity fund than the actuarily determined contribution for any given year.

In fact, for each of the City of Chicago Annuity and Benefit Funds, the actuarially determined contribution almost uniformly exceeds the statutory contribution for any given year.[14] Typically, since P.A. 99–0506 and P.A. 100–0023 were enacted, the City will contribute an amount equal to or in excess to the statutory contribution, but far below the actuarially recommended contribution.[15] Given the City’s relative success meeting its statutory contribution requirements, it is tempting to say that the City is responding adequately to existing unfunded liability. However, actuaries consistently determine that the City should contribute more than the statutory contribution to reduce unfunded liability maximally given the extremely low funded ratio of 23 percent across Chicago’s four funds.[16]

[1] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans” (American Academy of Actuaries, July 2004), https://www.actuary.org/sites/default/files/pdf/pension/fundamentals_0704.pdf.

[2] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[3] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[4] “Understanding Public Pension Plan’s Unfunded Liability” (Florida Public Pension Trustees Association, November 7, 2011), https://www.houstontx.gov/finance/11_07_2011_FPPTA_%20UAL_%20Report.pdf.

[5] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[6] “The 80% Pension Funding Myth | American Academy of Actuaries,” accessed August 8, 2023, https://www.actuary.org/node/13461.

[7] “Understanding Public Pension Plan’s Unfunded Liability.”

[8] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[9] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[10] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[11] “Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans.”

[12] “ACFR — Annual Comprehensive Financial Reports Financial Statements Overview,” accessed August 7, 2023, https://www.chicago.gov/content/city/en/depts/fin/supp_info/comprehensive_annualfinancialstatements.html.

[13] “ACFR — Annual Comprehensive Financial Reports Financial Statements Overview.”

[14] “ACFR — Annual Comprehensive Financial Reports Financial Statements Overview.”

[15] “ACFR — Annual Comprehensive Financial Reports Financial Statements Overview.”

[16] “ACFR — Annual Comprehensive Financial Reports Financial Statements Overview.”