Superannuation Schemes III

METHODS OF COSTING PENSIONS

The method of costing means the rate of funding at which a fund is built
up to meet a liability when it emerges.There are two methods of costing
depending upon the circumstances of each employer. –
 a) SINGLE PREMIUM COSTING
 b) ANNUAL PREMIUM COSTING

SINGLE PREMIUM COSTING

Defined benefit schemes

 An employee earns certain pension rights for every year of service put in by him.
The cost of pension right acquired in a given year is fully paid for in that year by
payment of one single premium in that year
 The premium for benefit earned during the year depends on the age of the
member at the commencement of the policy year and his future service as the
age of the member increases, so does the cost for a unit of pension because of the
incidence of mortality and or interest.
 Every year the insurance company will contract to provide a stated amount of
pension payable from normal retirement age and will charge a single premium
therefore (payable in one sum or in instalments spread over the year) so that each
year's transaction is a complete contract in itself.
 In succeeding yeas, similar purchase is made by paying the required premium for
that year's pension and the sum total of the various years' pensions until the
normal retirement date will represent the final pension for the member under the
scheme.
 This method of costing is suitable only in schemes where the pension-benefit
accruing in a year is-predetermined as a fixed amount.
 The method is not suitable to cost pensions under final salary based schemes
under which the benefit for each year of service including the past service
increases as future salary increases

 Defined contribution schemes Each year's contribution is treated as a separate

premium which is utilised to purchase a fully paid-up pension payable from the
specified normal retirement date
 Single premium method of costing is very convenient
 The amount of pension will not in any way be affected by any future revision of
premium rates.
 when a revision takes place, the revised premium rates will be applicable to that
year's premium and the benefit of revision will be available to the premium
payments received from that year onwards.
 When a member retires on his normal retirement date, the aggregate of the
pensions purchased from year to year will represent the pension payable to him.
 Even if future contributions are discontinued, the pensions already purchased will
remain intact and the same will become payable from the stipulated normal
retirement date.
  This system is very popular in our country under insured schemes.

BALANCE TABLE
 In the case of contributory schemes where the benefits are predetermined, the
calculations are complicated because part of the cost is met by the employee's
contributions and the remaining cost is met by the employer's contributions.
 If the whole of the future service pension of a member is to be purchased under
the same type of annuity,the total cost for each year's pension can be worked out
according to the premium table and the employee's contribution can be deducted
there from to find out the employer's cost
The employee's and employer's contributions are applied under different
premium tables. To find out the employer's cost, ascertain the amount of pension
which will be purchased by the employee's contribution by applying the relevant
premium rate and deduct the resulting pension from the total pension to be
provided in that year, the balance being the amount of pension to be secured by
he employer's contribution.

 The cost to the employer is then ascertained by applying the appropriate premium
rate. Under large membership schemes where thousands of employees participate,
it will be very tedious to undertake individual calculations to arrive at the
employer's cost every year.
 To simplify , use is made of a specially prepared table known as 'balance table' in
which the results of the calculations in relation to one unit of pension and one unit
of employee's contribution are recorded for each age.
 The balance table showing the premium payable by employer to purchase a
pension of Rs. 200 p.a. from normal retirement date after deducting therefrom the
pension purchased by employee's contribution of Rs. 240 per annum is shown
below.
  The balance table can be applied only if the employee's contribution has a
fixed relationship with the amount of pension. For example,it is assumed that
for every pension of Rs. 200 p.a the employee's contribution will be Rs. 240 p.a.
The unit of pension can also vary with the salary class.
 Pension secured by the employee's contributions at younger ages is more than
the pensions required to be provided for that year , the employer does not have
to pay anything in that year because there is no balance of pension to be
purchased
 When the employee's contribution does not purchase the required amount of
pension, the excess pension purchased in the previous years will be drawn to
make up the shortfall, and this process will continue repeated in the succeeding
years until the total of excess pension purchased at younger ages is exhausted
The employer will start contributing from this point of time. The effect of this
operation is to defer the date on which the employer has to begin contributing
towards the pension.

ADVANTAGES OF SINGLE PREMIUM COSTING

 The cost is lowest in the early years of the scheme because the employer does not
contribute in the earlier years of the scheme.
 It makes it easier for an employer to install a pension scheme, when he has not
been setting aside any substantial sums out of his profits as reserve for pension.
 When the employer starts contributing the premiums will be directed towards
securing pensions to the older employees , the employer feel satisfied because
whatever money he is able to contribute towards the scheme is applied to a greater
advantage
 It is convenient to make any major alterations in the benefit structure of a scheme
which has been in force for a number of years, if the scheme is costed on single
premium basis.
 In this method of costing the wastage is reduced to the minimum possible in case
of surrenders & withdrawls during the early years of the scheme.

ANNUAL PREMIUM COSTING

 The entire cost of providing the total pension is spread over the future service of
the member.
 The total pension is paid for by equal level annual premiums payable during the
future service of the member
 The amount of annual premium does not vary unless there is a change, in the
benefit payable to the members
 If the premium is discontinued at a future date, the pension secured will be
determined by calculating the paid-up pension
 The annual premium costing leads to an increased pace of funding in the earlier
years as compared to the single premium costing method.
.
ADVANTAGES OF ANNUAL PREMIUM COSTING
 Since the premiums are leveled the budgeting for annual contribution is easier for
employer
 A pension scheme is usually launched when the business is in a prosperous
condition. In such a situation, the employer put aside as much money as he can
into the pension scheme while favourable conditions last. The employer would
then be able to take advantage of valuable income-tax relief particularly at a time
when higher profits attract taxation at higher rates
 If the employer has to terminate the scheme at some future date, there will be
higher paid-up pensions available for the existing members with annual premium
basis than with single premium basis.
 In case of small groups of employees where there is likely to be a very little turn-
over of staff and where it is probably more difficult for the employer to pay for
the rising cost, the annual premium is generally considered more satisfactory.

CASH ACCUMULATION SYSTEM

 When the trustees pay the contributions to the insurance company, the amount
will not be applied as premiums under deferred annuities but will be credited to a
running account to be maintained in favour of the trustees under a Master Policy
to be issued to them.
 The premiums to be received in the subsequent years will likewise be credited to
this account.
 This account always belong to the trustees from which monies will be utilised
from time to time for securing pensions when the contingencies arise by way of
retirements, deaths or withdrawals
 Under defined benefit schemes, the insurer will undertake an actuarial valuation
of the liability taking into consideration the estimated progression in salaries,
expected number of exits by retirements, withdrawals and deaths and the likely
interest to be earned over the future years
 The trustees will be advised of the rate of contribution payable under the policy.
This rate will be expressed as a percentage of the salaries of the employees and
once determined, it can hold good for a period of three to five years
 At the end of this period, the contribution rate will be reviewed taking into
consideration the actual experience under the scheme, that is, the changes that
may have occured to the group of members with regard to their salaries, 'on' and
'off movements and interest additions made to the premiums already received. If
the employees also contribute to the scheme, details of the contributions received
and interest allowed in respect of each member will be preserved separately.
 In case of defined contribution schemes, the contribution rate would have already
been fixed and there is no need of making any valuation. The monies received
from year to year will be straightaway credited to the running account
 ADVANTAGES OF CASH ACCUMLATION
 Annuities will be effected on the date on which they become payable on
retirement or other contingencies, hence annuities can be paid in case of early
retirement ,early death & there is no question of surrendering an annuity in any
contingencies
 Higher interest rates can be given because they do not hold long term guarantee
as any other premium and annuity
 This system makes the returns on contributions attractive enough so that the
employer would not prefer to go for self-administration by the trustees
 The rate of interest will depend upon the net yield earned by the insurance
company on its investments of the the Superannuation und.
 Administrative expenses of the insurance company are met by a specific deduction
from the contributions or indirectly through a margin in the accumulation rate
 The insurance companies guarantee the interest rate at a particular level and also
allow a bonus interest rate every year, which will fluctuate depending on the yield on its
superannuation schemes fund from year to year. It will be seen that if the investment
conditions are favourable, the superannuation schemes will earn attractive interest rates.
The guaranteed interest rate is generally fixed at a lower level since the insurers follow a
conservative policy in fixing rates. The guaranteed rate will apply for a period of five
years.

COSTING OF PAST SERVICE PENSIONS

 SINGLE PREMIUM
 ANNUAL PREMIUM
 DEFINITE FUNDING METHOD
 INDEFINITE FUNDING METHOD
 CONTROLLED FUNDING

SINGLE PREMIUM
 Employer could pay a lump sum initial contribution, for purchasing full past
service pension but the employer may find it inconvenient to put down a large
initial payment at one point of time without straining his working capital.
 Employer will get income tax exemption as admissible expenses only 80% of the
initial contributions, and it will be spread over five years commencing from the
year of payment.
 In our country-no restrictions as to the period during which such initial
contribution could be spread over. But every payment made for securing the past
service pension will qualify for tax relief only to the extent of 80% with the relief
allowed in the following five assessment years by way of deduction of one-fifth
of the contribution in each of the five years
  various methods of spreading the cost over a period of time -ANNUAL
PREMIUM, DEFINITE FUNDING METHOD,INDEFINITE FUNDING
METHOD, CONTROLLED FUNDING

ANNUAL PREMIUM
1. The cost is spread over future service up to normal retirement date
2. An additional annual contribution is paid along with the ordinary annual
contribution
3. The past service liability is not liquidated until the youngest member entitled to
the past service pension reaches his normal retirement date

SINGLE PREMIUM Vs ANNUAL PREMIUM

Single Premium Costing Annual Premium Costing

The employer starts contributing towards The employer starts contributing at an
the pension at a deferred date, as the earlier date as compared to single premium
amount of pension purchased by the costing
employees contribution is in excess of the
pension required
The excess pension purchased by the The incidence of excess pension is very
employees contribution during earlier years less
is utilized to provide purchase pension
when the employees contribution does it
purchase the required amount of pension
the employers starts contributing when
excess pension is exhausted
The premium to purchase a unit of pension The total premium is purchased by
increases with age of the member payment of equated amount premium
payable during the future service of
member
Trend of cost Trend of Cost
If there are more lower age group to the I. The cost will remain same as long as the
employer will be negligible in early years member remain in the same salary class
II. When the average of members increases II. When the member moves to higher
the cost will go up salary class and entitling him to an increase
III. If there are new entries in the group pension the cost will go up
who will replace the exit by retirement the III. The additional premium will be
cost will remain more or less the same year determined on the basis of the age of the
after year member in the year in which he moves to
IV. if there are no or few new entrance as the higher salary class and also on the
compared to exst the cost to the employer additional pension to which he will be
will increase the trend of the cost will entitled
depend on the present age distribution of IV. The cost will very for change in
the member, addition of new entrance and benefits withdrawal and new entrants
deletion by exits and death while in Service V. The methods leads to an increase pace
V. The age distribution of employees of funding in the earlier years
comprising the group is very important in
determination of premium
DEFINITE FUNDING COSTING
1. lump sum cost is divided in equal annual payments for a fixed term
2. In case of death before normal retirement date, withdrawal from service, early
retirement on pension if the past service pension premium payment is not
completed, the employer should continue to pay the premium till the end of the
agreed term
3. If employer discontinues the payment for the fixed term difficulty will a rise

INDEFINITE FUNDING

1. The lump sum cost is taken as a guide to decide the annual payment spread for
appropriate number of years
2. The employees are arranged on roster in order of normal retirement date
3. First premium payment is used as a single premium for purchasing full past
service pension of the oldest employee and this process will continues every year
4. Each purchase is made at single premium rate corresponding to the attend age at
the date of purchased
5. In case of death and early withdrawal the concerned member are remove from the
roster as no purchase has been made for them and there is no reallocation of the
premium ones utilized in the purchase of pension
6. If employers discontinue the premium the past service pension for those who have
already retire or about to retire would have been purchase but no provision will
have been made for young employees

CONTROLLED FUNDING
1. Accrued pension rights are purchased when a member becomes eligible for
receiving the pension i.e. just before his retirement.
2. The premium received each year is utilized to secure the total to expected benefits
of the oldest employees at the normal retirement date.
3. The employer and the insurance company should agree upon the level of funding
which is desired over,a period of years
4. The employer and insurer agree upon certain level of funding keeping in view the
pension rights which have already been accrued and the funding should be such
that a pension of a member who is about to reach the normal pension date is
finally purchased before the due date of payment.
5. The insurer calculate the cost of achieving this level as percentage of pensionable
salary. This "percentage will be applied to calculate the premium required from
the employer. The premiums will be allocated each year to the employees nearest
to the normal pension date to secure all their pension entitlements and the
subsequent premiums may also be allocated in part to the same employees as their
salaries and pension entitlements increase
6. No distinction made between past service liability & future service liability.
7. No attempt is made to purchase a specific amount of pension each year.
8. No pension is purchased for younger members so if an employee leaves the
service or dies before his pension has been secured; there is no loss to the
employer.
9. The method can be called as unallocated method of funding as there is no relation
between the outlay of the employer & the past service & future sevice pension of
employees.
10. After assessing the level of funding the insurer will determine the cost as
percentage of pensionable salary, which will be applied to calculate the premium
from the employer.
11. The calculation will take into consideration assumed date of bonus under with
profit plan and will also make allowance for withdrawal from service.
12. The rates are reassessed by insurer and 3-5 years in view of changes due to
membership age and salary.
13. In case of early retirement on pension full pension of an employee may not have
been purchased at the date of leaving service and this cost has to be met from the
current year’s premium secured by reallocation of the premium already allotted to
other members.
14. There is no loss to employer in case of early death or employee leaving service.
15. Cost expressed as percentage of salary bill tends to remain stable.
16. It is a more flexible scheme and is comparable to the trustee administered scheme.