Explain in general terms how defined benefit pension plans are funded.

Question

What will be an ideal response?

Answer 1

ANSWER:
When benefits of a defined benefit plan are based on salary, actuaries determine annual contribution levels. The principal of actuarial funding is to derive a time series of annual pension fund contributions that will accumulate to produce a projected pension fund balance sufficient to meet the cost of projected pension benefits. There are two broad types of actuarial funding methods: accumulated benefit and projected benefit. With the accumulated benefit method, the accumulation of benefits is measured using current salary levels and years of service to value current benefits. Future salary increases are not incorporated into the funding calculations.

Projected benefit funding methods represent alternative ways of spreading the cost of projected benefits over time. Some methods in this group develop individual contribution rates, which are then summed to derive the total contribution of the plan. Other methods, called aggregate methods, make funding calculations for the plan as a whole.

SFAS No. 87 requires that a projected benefit method, the benefits/years of service approach, be used for pension expense recognition. In general, the accumulated benefit method assigns more cost to later years of employment and a smaller amount to earlier years compared to projected benefit methods. In addition, there is more even distribution of contribution levels with projected benefit methods.