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.