There are two types of pension assumptions that a sponsor makes with input from their actuaries:
- Economic assumptions describe how market forces affect the amount of expected future benefits to be paid to plan recipients.
- Demographic assumptions describe the impact of plan-participant behaviours on the timing and probabilities of benefits being paid to them.
In (consolidated) financial statements the following key actuarial assumptions that the company/ sponsor used to estimate its portion of benefit obligation and pension expense under the pension plan.
The economic assumptions relate to:
- discount rate;
- expected rate of return on plan assets; Key assumptions in a Pension plan
- salary escalation rate; and Key assumptions in a Pension plan
- inflation rate. Key assumptions in a Pension plan
The demographic assumptions relate to the expected average remaining years of service (service life) of employees and mortality rates. These key actuarial assumptions are described in more detail below.
Discount rate—Under accounting standards, the company has the choice of setting this rate with reference to expected pension-plan asset returns or the company’s cost of borrowing (i.e., its long-term bond rate). The company has chosen to set the discount rate equal to long-term plan asset returns. This economic assumption is usually the most significant one that a sponsor determines. The discount rate is critical to calculations that determine a sponsor’s pension obligation and pension expense.
Expected rate of return on plan assets—This assumption represents the sponsor’s expectation of the long-term investment returns that the pension fund’s assets will earn each year. In the company’s accounting for pension plans, the expected rate of return on plan assets and the discount-rate assumptions are the same.
Salary escalation rate—Part of the estimate of an employee’s future defined benefits at retirement involves the rate at which their salary rises over the course of their working life. The salary escalation rate reflects factors that can affect an individual’s wages over time, including expected inflation, productivity, seniority, and promotion.
Inflation—This assumption helps determine other economic assumptions. General inflation is a fundamental starting point for setting each of the three economic assumptions above, because nominal interest rates, investment returns and salaries tend to rise and fall with changes in inflation. Key assumptions in a Pension plan
Expected average remaining service life of employees—This figure represents the average remaining years of service for active employees in a plan. In accounting, this is the period over which unamortized net actuarial gains and losses are amortized into pension expense. This figure changes with the average age of the current employee group (i.e., an older workforce has a shorter expected average remaining service life) and the demographic assumptions that affect expected years of service. Key assumptions in a Pension plan
Actuaries use probabilities to model the uncertainty of behaviors that affect a participant’s expected years of service and years in retirement.
For example, an employee’s years of service and years in retirement are both affected by the employee’s decision about when to retire—before, at, or after age 65. Many current employees will only make this decision well into the future. In the meantime, for the purposes of their calculations, an actuary will assign probabilities to the various ages at which employees will choose to retire.
Years of service are also affected by assumptions that predict the proportion of current employees that will stop working for the plan sponsor before they retire because, for example, they leave voluntarily, are terminated, or become disabled.
Mortality rates—The length of time that a retiree will collect pension benefits depends on how long they live beyond retirement. Therefore, actuaries use mortality assumptions to estimate how long a pension plan will pay out defined benefits to a retired individual based on their demographic.