As it pertains to public pensions, actuarial science is the application of statistics, finance, and economic and demographic assumptions for the purpose of assessing and projecting a pension plan’s condition and cost. Actuaries serve either as employees of a public retirement system, or, more commonly, as consultants hired by public retirement systems.
Actuarial assumptions are projections of future events that affect the cost and funding condition of a pension plan. Such assumptions fall into one of two broad categories: demographic, economic, and other.
- Demographic assumptions are those associated with the behavior of participants in the pension plan, such as their rate of retirement and mortality, frequency of turnover, age at which they join the plan, etc.
- Economic assumptions include rates of inflation, wage growth, and investment return on the plan’s assets.
- Other assumptions include administrative expenses, marriage and divorce, hours worked, and other, miscellaneous factors.
Policies and practices governing contracts for actuarial services
Public retirement system policies and practices governing contracts for actuarial services vary widely from one state to another. A listing of many such policies and practices is accessible on the Actuarial services policies and practices page.
Additionally there is some variation in the way actuarial insurance is administered. A description of the issues and listing of some examples by state can be found on the Actuarial Insurance page.
Use of in-house actuaries
Some systems choose to employ professional actuaries on staff to provide the services described above.
NASRA Survey on Retirement Systems’ Use of In-House Actuaries
Annual Required Contributions
According to GASB 25 retirement plans should submit
a schedule of employer contributions that provides information about the annual required contributions of the employer(s) (ARC) and the percentage of the ARC recognized by the plan as contributed
The ARC is comprised of the Employer Normal Cost and the required amortization payments as determined by an actuary.
Investment return assumption
Over time, earnings from public pension fund investments account for a majority of revenues for most public pension plans. Pension plan actuaries calculate the cost of a public pension plan on the basis of many assumptions about future events, such as the rate of return the fund’s investments will earn, rates of salary growth, how long retirees will live, etc. Because investment earnings account for such a large portion of a fund’s revenues, plan costs are highly sensitive to changes in the investment return assumption.
This assumption is sometimes referred to as the liability discount rate assumption. This is the rate of return that must be earned on all present and future system assets in order to fund the present and future liabilities at a given contribution rate. The lower the assumed liability discount rate, the higher the liabilities and, consequently, the higher the contribution rate necessary to finance those liabilities. (Another way of looking at this is that the system has two sources of future revenue to cover the expected benefit payout. Those sources are contributions from the state and return on invested assets. The more that comes from investment return the less that is needed from the state and vice versa.)
The predominant investment return assumption used by public pension plans is 8.0 percent, and ranges from 7.0 percent to 8.5 percent.
Actuarial Standards of Practice No. 27, “Selection of Economic Assumptions for Measuring Pension Obligations,” directs professional actuaries, in setting the investment return assumption, to consider various criteria, which may include the following:
- current yields to maturity of fixed income securities such as government securities and corporate bonds;
- forecasts of inflation and of total returns for each asset class;
- historical investment data, including real risk-free returns, the inflation component of the return, and the real return or risk premium for each asset class; and
- historical plan performance.
The actuary may also consider historical statistical data showing standard deviations, correlations, and other statistical measures related to historical returns of each asset class and to inflation.
ASOP No. 27 also recommends that other factors be considered in determining the investment return assumption. These factors include:
- Purpose of the measurement- is the purpose to calculate a termination amount or is the plan operating on an ongoing basis?
- The plan’s investment policy – the fund’s asset allocation, risk tolerance, target allocations, etc.
- Volatility of investments
- Performance of managers investing the assets
- Investment expenses
- Projected timing and volatility of cash flows
In a nutshell, the question of what the investment return assumption should be is not, “What will this portfolio return?” but rather, “How much can this portfolio reasonably be expected to return, considering the plan’s expected cash flows, past and future rates of inflation, the asset allocation, historic and projected returns for each asset class, and the plan sponsor’s tolerance for volatility and risk?”
Although investment return assumptions used by public pensions are intended to reflect long-term considerations, they are not static, and they do change. Until the 1980s, a majority of public pension assets were invested in bonds and other asset classes that yielded a lower return than a diversified portfolio of stocks, bonds, real estate, etc. Investment return assumptions were commensurately lower, at four or five percent. As public pension funds diversified into domestic equities, foreign equities, real estate, private equities, hedge funds, and other asset classes, investment return assumptions rose to reflect the higher expected returns.