Assumptions in Pension Fund Accounting

Accounting for pension funds is considered to be much more complex than standard accounting. This is because a lot of the payments being made in the pension funds are to be done in the distant future. Hence, as an accountant, provisions have to be made to account for these expenses as well as incomes that will accrue in the distant future.

It is a known fact that as soon as assumptions start being made about the distant future, they become less and less accurate. As a result, pension funds are very sensitive to the assumptions that they make about the future.

In this article, we will have a look at the various types of assumptions that a pension fund has to make for its accounting as well as funding needs.

Who Makes These Accounting Assumptions?

The value of any pension fund, as well as its funded and unfunded liabilities, is significantly influenced by these assumptions. If the assumptions are tweaked even a little bit, then the accounted-for value can change quite significantly. Hence, there will always be an incentive for the pension fund sponsor to keep tweaking the assumptions in their favor.

In most parts of the world, changing assumptions are not allowed very easily. The assumptions based on which a pension fund operates have to be agreed upon between the sponsor and an actuary.

The actuary is a licensed professional who is bound by an oath to ensure the correctness of the data that they propose. Any changes to these assumptions are not allowed and are considered very carefully by the regulatory body.

Types of Accounting Assumptions for Pension Funds

An actuary is a person who analyses statistics from past data and uses them to determine the assets and liabilities of the future.

Actuaries are generally used by insurance companies. However, in the case of pension funds too, there is a huge element of prediction. Since all assumptions about the future are made based on data and patterns about the past, these assumptions are called actuarial assumptions.

Now, there are two broad categories of actuarial assumptions which have a huge impact on pension funds. These assumption categories have been mentioned below:

Economic Assumptions

Pension funds have to make certain assumptions about the larger economy. Some of the important macroeconomic factors which affect these funds are:

  • Interest Rate: The interest rate is the cost of capital that is applicable to the people contributing to pension funds. Hence, it is a very important assumption for the pension fund.

    In pension fund accounting, this interest rate is used as a discount rate. The discount rate is used to calculate the liabilities as well as assets of the fund on the measurement date i.e. the date at which accounting estimates are made. Even a minor change in the interest rate can have a huge impact on the pension fund valuation and accounting.

  • Rate of Return: When pension funds make an investment, they project a possible rate of return on these investments. This projection is generally made based on past data. This rate determines the expected return that the pension will earn and thereby has an impact on the expected benefit payments which the pension fund will be able to make.

  • Inflation: It is important for any pension fund to generate a real rate of return. Merely having a nominal rate of return is not good enough.

    The real rate of return must be greater than the inflation rate. Hence, while forecasting return, it is also vital that the inflation rate also be forecasted and compared with the nominal rate of return to make assumptions about the real rate of return which will be made by the fund.

  • Salary Scale: The salary scale i.e the quantum of wages that will be paid, the expected promotions, and other related factors is an important assumption for pension funds. People typically pay a percentage of their income to the pension fund. Hence, the total income has to be forecasted to make assumptions about the inflow of pensions.

Demographic Assumptions

Another category of assumptions called demographic assumptions also has a huge influence on the value of pension funds.

  • Mortality Assumptions: Pension funds generally promise to pay benefits to the investors and their spouses till they are alive. Hence, the mortality assumption is quite important for pension funds.

    If the average life span of people increases, then the present value of pension benefits payable also increases. This can be detrimental to a pension fund if not taken into account at the correct time.

  • Retirement Assumptions: Pension funds also have to make assumptions about the retirement age. This is because the retirement age is when the investors stop contributing to the pension funds and withdraw money from the fund.

    Different countries of the world have different retirement ages. In some countries, the age is sixty whereas, in some others, it is seventy. Also, this age is continuously changing. Pension funds need to have a proper estimate of this age.

  • Disability Assumptions: A percentage of the workers ends up being disabled and hence withdraw benefits earlier than expected. Pension funds need to understand the nature of work and make disability assumptions. For example, disability is more likely in jobs such as mining or construction as compared to desk jobs.

  • Withdrawal Assumptions: In some cases, people will be involuntarily terminated from service. Hence, they may withdraw money from their pension funds in order to make ends meet. The pension fund needs to take into account such withdrawals while making its cash flow projections.

The bottom line is that the accounting, funding as well as overall functioning of pension funds is heavily dependent upon certain kinds of assumptions. These assumptions need to be carefully made in order to ensure the smooth functioning of the fund.

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Pension Funds