What is the 'Actuarial Cost Method'

Actuarial cost method is used by actuaries to calculate the amount a company must pay periodically to cover its pension expenses. The two main methods used are the cost approach and the benefit approach. These approaches take into consideration an employee's current salary, the number of years they have until they retire and start receiving benefits, the annual rate at which the employee's salary increases, the percentage of the final salary the employee will receive on a yearly basis when they retire, and the probable number of the years the individual will live to continue receiving those annual payments. Any cost of living adjustments (COLAs) are also built into the equation.

The cost approach calculates total final benefits based on several assumptions, including the rate of wage increases and when employees will retire. The amount of funding that will be needed to meet those future benefits is then determined. The benefit approach finds the present value of future benefits by discounting them.

Actuarial cost method is also known as the actuarial funding method.

BREAKING DOWN 'Actuarial Cost Method'

Actuarial cost method is an important part of pension consulting and pension funding. In order to know how much money is needed to fund a pension plan and to figure out the way in which it should be invested, it is necessary to know the likely lifetime cost of providing a pension for an employee. Actuaries are trained to make these calculations.

When a company funds its pension, it records the funding cost as an expense and the total future pension payments as a liability. When reviewing a company's financial statements, it is important to look closely at the accounting for pension liabilities. This is an area with a lot of assumptions that can be manipulated. The company must make assumptions regarding the rate at which to discount future pension costs, the future rate of return on pension-plan assets, at what age the average worker will retire and the rate of future salary raises. When reviewing these assumptions, investors should note whether the company is being aggressive or conservative.

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