What is an 'Alternative Minimum Cost Method'

An alternative minimum cost method is the type calculation used by a defined-benefit pension plan to ensure it has sufficient funds to pay participants in the future. Broadly speaking, these calculations use either the projected actuarial cost of benefits over time or a formula that applies a discount to current total benefits.

BREAKING DOWN 'Alternative Minimum Cost Method'

An employer uses an alternative minimum cost method to determine its funding formula for a pension plan. The calculation depends upon a complex set of actuarial assumptions, laws governing retirement plans and the costs incurred to fund the plan.

In any pension plan, an employer sets up an investment fund out of which it pays retirement benefits to employees. Employers offering pension plans agree to fund the plans on either a defined-contribution or defined-benefit basis. The accounting for defined-contribution plans is fairly straightforward, as employers simply invest a set percentage of an employee’s pay, with the benefit subject to gains and losses over the course of the investment. Defined-benefit plans create an accounting challenge, however. Employers must pay benefits as defined in the pension plan regardless of how the pension fund performs.

The Employee Retirement Income Security Act of 1974 (ERISA) set minimum standards employers must meet when offering retirement plans. For defined-benefit plans, the law stipulates that while employers can change the calculation for how employees accrue future benefits, employers may not adjust earned benefits. If a pension fund performs poorly, employers cannot simply reduce their employees’ earned benefits to close the financial gap. To help ensure sufficient funding, ERISA establishes minimum required contributions which employers must calculate and make each year. The specific calculation used to do this is known as the employer's alternative minimum cost method.

Acceptable Actuarial Cost Methods

Under ERISA, companies have two broad choices of strategy for establishing the actuarial cost method they use to determine minimum funding levels. The cost approach takes into account the cost of total benefits using actuarial assumptions to estimate wage levels and the timing of employee retirements over time. The benefit approach uses the current calculation for the present value of employee benefits and discounting them based upon expected retirement dates.

The U.S. Secretary of the Treasury determines the acceptability of individual actuarial cost methods used to determine annual funding requirements. Current regulations do not allow terminal cost methods, where employers promise to pay a lump sum to cover shortfalls at a later date, or pay-as-you-go methods. Acceptable methods generally require calculations that yield more level ongoing payments, such as the individual level premium cost method or the aggregate level cost method.

RELATED TERMS
  1. Actuarial Cost Method

    Actuarial cost method is used by actuaries to calculate the amount ...
  2. Unit Benefit Plan

    A unit benefit plan is an employer-sponsored pension plan with ...
  3. Actuarial Basis Of Accounting

    A method used in computing the periodic payments that a company ...
  4. Benefit Allocation Method

    The benefit allocation method is a means of funding a pension ...
  5. Advance Funded Pension Plan

    An advance funded pension plan is funded concurrently with the ...
  6. Cash Balance Pension Plan

    A cash balance pension plan is when an employer credits a participant's ...
Related Articles
  1. Retirement

    A Primer On Defined-Benefit Pension Plans

    Most of us will rely on a pension plan in the future, so it's best to know the details of the various plans before signing up.
  2. Retirement

    Chipping Away At The Pension Freeze Trend

    Learn five steps that'll put your retirement back into your own hands.
  3. Retirement

    More Pension Plans in the Deep Freeze

    A growing number of Fortune 500 companies have sent their defined-benefit pension plans to the deep freeze. What employees should do next.
  4. Retirement

    America's Frozen Pension Dilemma

    Unfortunately, there are several factors that have eroded the presence of pension plans in America, and workers need to be prepared to replace that expected income for their retirement years. ...
  5. Retirement

    3 Jobs With Good Retirement Benefits

    Jobs with retirement benefits are sought after by U.S. employees. Those retirement benefits can include pensions, 401(k) plans and other perks.
  6. Retirement

    The 401(k) and Other Qualified Plans Tutorial

    Learn about eligibility requirements, contributions and distribution rules for these retirement plans.
  7. Retirement

    How Safe Is Your Pension?

    A 2014 law permits some private pension plans to reduce benefits. How to figure out if your retirement income is endangered.
  8. Financial Advisor

    How Capital Gains Tax Works on Pension Funds

    Here's why capital gains tax does not affect the assets in pension funds.
  9. Retirement

    7 Signs Your Pension Fund Is In Trouble

    Even if you're lucky enough to have a pension plan, you can't assume it'll pay out.
RELATED FAQS
  1. How do pay-as-you-go pension plans work?

    Learn what a pay-as-you-go pension plan is and how it is different from fully funded pension plans. Understand how public ... Read Answer >>
  2. Which of the Following Accounts Does ERISA Cover?

    A—IRA, B—State employee pension plan, C—Corporate defined-benefit plan, D—Coverdell savings account. Read Answer >>
Trading Center