STAT3956

Pension Funds and Pension Mathematics

Department of Statistics and Actuarial Science
Lecturer: George Ma, PhD, FSA, FCIA
 Course Plan
 Topics covered:
 First two weeks – basic pension plan design and financing
concepts
 Next 8 or 9 weeks – pension valuation techniques
 Last 2 or 3 weeks – practical application of actuarial principles
to financial management of pension plans
 If time permits – retiree health care coverage
 Text books used:
 McGill, D.M., et.al.: Fundamentals of Private Pensions
 Arthur W. Anderson: Pension Mathematics for Actuaries
 William H. Aitken: Pension Funding and Valuation

2 Lecture 1
 Pension Plan Basics
Chapter1

3 Lecture 1
 Pension and Pension Plan
 Pension - a fixed sum to be paid regularly to a person over
the person’s remaining lifetime after retirement
 Pension plan – an arrangement set up by a legal entity (e.g.,
government, corporation, etc.) to deliver the pension benefit

4 Lecture 1
 Economic Problems of Old Age
Old age economic challenges:
 Maintaining standard of living during retirement
 Limited employment opportunities for elderly
 Inadequate savings for retirement
 Increasing longevity
 Erosion of purchasing power due to inflation

Means to address old-age economic insecurity:

 Social security programs
 Employer-provided pensions
 Personal savings before retirement
 Family support

5 Lecture 1
 Pension Systems
 Pension programs consist of social security and employment-based
pensions
 Social security
 Universal old age pensions (Zero Pillar*)
 State pensions that require contributions by workers and employers (First
Pillar*)
 Employment-based (occupational) pensions
 Pensions provided by employers for their employees
 Require regular employer’s contributions (and/or employees’ contributions)
 Operate as a tax deferred savings vehicle in some countries
 Mandatory or voluntary (Second & Third Pillar*)
 Other special government support, owned homes, family support etc.
(Fourth Pillar*)

*World Bank’s Five-Pillar pension framework

6 Lecture 1
 Hong Kong Retirement Protection System
 Zero Pillar - Old age allowance
 Normal old age allowance – means-tested, available to seniors
between age 65 and age 69
 Higher old age allowance – for all seniors aged 70 and above
 First Pillar – No income-related pensions provided by the
government
 Second Pillar – Employment-based pensions provided through
Mandatory Provident Fund (MPF) schemes
 Third Pillar – ORSO* schemes and/or personal savings

* Occupational Retirement Schemes Ordinance (ORSO) schemes were set up voluntarily by employers to provide
retirement benefits for their employees, prior to the MPF system that came into effect on December 1, 2000.

7 Lecture 1
 Discussion Question
 In US and Canada, it is not mandatory for employers to set
up a pension plan for their employees.
 Why should an employer establish a pension plan for its
employees, if it is not required to do so?

FOR
or
AGAINST

8 Lecture 1
 Should an employer establish
a pension plan for its employees?
For:
 Recruitment and retention of employees
 Meeting competitive industry standards
 Optimizing tax benefits
 A human resource management tool
 Alignment with company’s interests
 Social responsibility
Against:
 Better return to invest in company’s own business
 High administrative costs
 Legal risk (fiduciary obligation)
 Individuals’ responsibility

9 Lecture 1
 Employment-based Pension Plans
 Three broad types:
 Defined benefit (DB) pension plans;
 Defined contribution (DC) pension plans; and
 Hybrid pension plans

10 Lecture 1
 DB Pension Plans
 Pension amount is determined according to a specified
formula, typically based on employee’s pay, years of
employment, etc.
 DB plan types
 flat benefit plan (FB plan)
 Pension calculated as a fixed amount per year of employment
 final (or best) average earnings plan (FAE plan)
 Pension calculated based on the employee’s salaries in the last few years of
employment and the number of years of employment
 career average earnings plan (CAE plan)
 Pension calculated based on total earnings over the employee’s working
career

11 Lecture 1
 Example 1 – DB Plan Types
a) Flat Benefit Plan US$50 per month per year of service
b) Final Earnings Plan 1.5% of final-year earnings for each year of service
c) Career Average Earnings Plan 1.5% of earnings over the entire period of employee’s career
Participant Data
Age at plan entry 30
Starting annual salary $40,000
Assumptions
Salary increase rate 3% per annum
Retirement age 65

Calculate the expected pension benefit payable to the participant at age 65 under each
of the three plan formulas.

12 Lecture 1
 Example 1 Answers
Years of service at age 65 = 35
Projected earnings in the year before age 65 =

 Flat benefit plan

 Final earnings plan

 Career average earnings plan

13 Lecture 1
 DB Benefits & Costs
 Costs required to fund promised benefits are not known in
advance
 Pension benefit is relatively certain but with significant cost
uncertainty to employer
 More valuable than DC plans for career employees because of
the guaranteed nature of benefit and the back-loading
characteristic (age-bias effect)
 A unit of benefit earned in the later career of an employee would be
worth more than that earned when the employee was young

14 Lecture 1
 Example 2
Pension formula US$50 per month per year of service
Form of pension Life annuity, payable monthly in advance
Normal retirement age 65

Participant data at date of valuation

Sex Male
Age at hire 30
Years of service 10

Actuarial assumptions
Interest rate 6%
Pre-retirement death or termination Selected rates
( )
Life annuity at age 65 𝑎̈ = 10, based on 6% interest
Selected probabilities 𝑝 = 0.4318, 𝑝 = 0.7359, 𝑝 = 0.9051

a) Calculate the actuarial present values (APVs) of annual pension accruals* at ages 30, 40 & 50.
b) Comment on the pattern of APVs

* Annual pension accrual means the annual pension earned for a year of service, which is equal to 50*12=600.

15 Lecture 1
NM1

Example 2 Answers
The APV of the annual pension accrual at any age 𝑥 is equal to:
𝐴𝑃𝑉 = 𝑣 𝑝 (600 𝑎̈ )

Age (𝑥) 𝑨𝑷𝑽𝒙

30 337
40 1,029*
50 2,266

*𝐴𝑃𝑉 = 1.06 ∗ 0.7359 ∗ 600 ∗ 10 = 1029

Implications:
 APV is dependent on the interest and demographic (notably mortality) assumptions used:
o Lower interest  higher value
o Lower mortality (i.e., longer life expectancy)  higher value
 Age-bias effect – A unit of pension earned in the later career of an employee is worth more than the same unit
earned while the employee was young. This is due to:
o Shortening period for interest discounting as the employee is close to retirement,
o Less discount for pre-retirement decrements - decreasing likelihood of leaving the pension plan as the
employee is close to retirement.

16 Lecture 1
Slide 16

NM1 Nancy Ma, 9/3/2021

 DB Plan Drawbacks
From sponsor’s/employer’s perspective:
 Age bias effect – cost back-loading
 Open-ended cost risk
 Expensive to set up and administer a DB plan
From employees’ perspective:
 Pension not portable - less transferrable
 No control over retirement assets
 Paternalistic – not compatible with mobile workforce
characteristics

17 Lecture 1
 DC Pension Plans
 Contributions are determined by a fixed formula and paid into
individual member accounts
 Investment earnings are credited to a member’s account, with expenses
deducted
 Balance of a member’s account is paid to the member as retirement benefit
when the member retires
Advantages and disadvantages:
 Cost certainty for employer
 Funding cost is fixed by the plan’s contribution formula
 No actuarial calculation is required
 Less expensive to run than DB plans
 Employees bear both investment and longevity risks in managing their
retirement assets, unless they use the assets to purchase annuities (but
they still bear interest risk associated with annuity pricing at time of
annuity purchase)

18 Lecture 1
 Comparison - DB vs. DC
Attributes DB Plan DC Plan
Who bear investment and •Sponsor/employer •Employees
demographic risks? •Risks are pooled •No pooling of risks among
participants
Cost to fund pension •Cost not known in advance •Contributions readily calculated
•Cost more for older employees than using predefined formula
for younger ones (“age bias”) • No age bias effect

Benefit certainty •Benefit is calculated from a •Benefit depends upon account

predefined formula; it is relatively balance at retirement
certain •Risk of outliving one’s accumulated
•Guaranteed to a certain extent by assets unless they are used to
government insurance schemes in purchase a life annuity
some countries, e.g., US and UK
Investment decisions •Controlled by sponsor/employer •Participants typically are able to
select investments

Portability •Some plans provide portability •Easily portable

before retirement
•Pensions in pay are not portable
19 Lecture 1
 Retirement Income Adequacy
 Income replacement ratio is a person’s gross income after
retirement divided by his or her gross income before
retirement
 An income replacement ratio of 50% to 80% is typically
required to maintain a person’s pre-retirement standard of
living
 Read study note DA_123_13:
 Replacement Ratio Study by Aon Consulting

20 Lecture 1
 Example 3
Level of contributions under Hong Kong’s MPF schemes – 5% from employer and 5% from employees
Do you think the MPF schemes would provide an adequate retirement income?

To answer this question, let’s calculate the retirement income replacement ratio at age 65 for two
sample employees with the following data:
Employee A Employee B
Age at hire 30 years 50 years
Annual salary at hire US$50,000 US$50.000
Assumptions:
 Salary scale – 3% per annum
 Return on DC fund – 6% per annum
 Age 65 annuity factor – 11.25
 Contributions are made at the end of each year

What will the income replacement ratios be if the return on DC fund is 4% per annum?

21 Lecture 1
 Example 3 Answers
Employee A Employee B
Age at hire 30 50
Annual salary at hire $50,000 $50,000
Projected annual salary prior to
50000 × 1.03 = 136595 50000 × 1.03 = 75629
retirement at age 65 (1)
Accumulated contributions with 0.1 × 50000 × 1.03
0.1 × 50000 × 1.03
interest (ACWI) at age 65 (2)
1.06
−1 1.06
1.03 −1
× = 812037 1.03
1.06 × = 139765
−1 1.06
1.03 −1
1.03
See Note below.
Conversion of account balance into
812037 139765
an annual pension (3) = 72181 = 12424
11.25 11.25
Income replacement ratio 𝟕𝟐𝟏𝟖𝟏 𝟏𝟐𝟒𝟐𝟑
(3)/(1) = 𝟓𝟐. 𝟖% = 𝟏𝟔. 𝟒%
𝟏𝟑𝟔𝟓𝟗𝟓 𝟕𝟓𝟔𝟐𝟗

Note: ACWI at 65 = 10% ∗ 50000 ∗ 1.06 + 1.03 ∗ 1.06 + … + 1.03 = 10% ∗ 50000 ∗ 1.03 ∗
.
. . . .
1+ .
+ .
+ …+ .
= 10% ∗ 50000 ∗ 1.03 ∗ .
.

IRR if 4% return 36.8% 14.3%

22 Lecture 1
 Example 4
A DB plan provides a pension benefit equal to 1.5% of final average earnings times years of
service, where final average earnings is the average annual earnings during the 36 months
immediately before termination of employment

Calculate the retirement income replacement ratio at age 65 for two sample employees with
the following data, assuming salary increases at 3% per annum:

Employee A Employee B
Age at hire 30 50
Annual salary at hire $50,000 $50,000

What will be the lump sum amount required at age 65 to fund the projected pension benefit
( )
for each employee, if the life annuity factor equals 11.25?

23 Lecture 1
 Example 4 Answers
Employee A Employee B
Age at hire 30 50
Annual salary at hire $50,000 $50,000
Projected annual salary prior
50000 × 1.03 = 136595 50000 × 1.03 = 75629
to retirement at age 65 (1)
Projected service at age 65 35 years 15 years
Projected FAE3 at age 65 50000 50000
(1.03 + 1.03 + 1.03 ) (1.03 + 1.03 + 1.03 )
× ×
3 3
= 132655 = 73448
Projected annual pension @65
.015 × 132655 × 35 = 69644 .015 × 73448 × 15 = 16526
(2)
Income replacement ratio 69644 16526
(2)/(1) = 51.0% = 21.9%
136595 75629
Lump sum amount required at
age 65 to fund the projected
pension benefit 69644 × 11.25 = 783496 16526 × 11.25 = 185915
( )
((2)x 𝑎̈ )

24 Lecture 1
 Hybrid Plans
 Combine certain features of DB & DC plans
 Cash balance plan
 Participants’ accounts are credited with notional interest; employer
bears investment risk on the pension fund
 Balance at retirement is converted to a pension at specified rates
 More common in the US than in other countries
 Target benefit (TB) plan/Collective Defined Contribution (CDC)
Plan
 Designed to provide DB-like benefits with predefined (or fixed)
employer contributions
 Benefits may be adjusted upwards or downwards relative to target
retirement income, based on plan experience
 A widely discussed plan design in the Netherland, UK and Canada

25 Lecture 1
 Establishing Pension Plans
 Primary purpose of a pension plan is to provide retirement benefit
in the form of a life annuity
 A formal pension plan has two main features:
 A plan text document setting out the terms and conditions for the
payment of benefits
 A funding vehicle to provide the needed funds to pay benefits
 In North America, the funding vehicle of most employment-based
pension plans is established as a trust, rather than an insurance
contract
 Assets in a trust are kept separate and apart from the employer
 A pension trust must comply with the pension standards legislation
and the local tax law

26 Lecture 1
 Typical Pension Plan Provisions
 Eligibility for membership
 Benefit formula/contribution formula
 Pensionable or credited service
 Employee contributions, if applicable
 Retirement age (normal, early and late)
 Normal and optional forms of pension
 Death benefits before retirement
 Termination benefits
 Disability benefits
 Inflation protection

27 Lecture 1
 Sample Plan A
 FAE DB plan
Eligibility Immediate
Vesting 100% after 2 years of service
Employee contributions None
Normal retirement age 65
Early retirement age 55 with 2 years of service
Final average earnings Average annual earnings during 36 months immediately
before termination of employment

Earnings exclude overtime and bonuses

Normal retirement benefit 1.5% of final average earnings times years of service
Early retirement benefit Accrued benefit reduced by 0.5% per month that early
retirement precedes age 65
Form of benefit If married, 50% joint & survivor annuity, without reduction
If not married, single life annuity
Optional forms of benefit Actuarially equivalent
Termination benefit Lump sum equal to actuarial present value of accrued
benefit
Pre-retirement death benefit Lump sum equal to actuarial present value of accrued
benefit payable to designated beneficiary

28 Lecture 1
 Sample Plan B
 DC plan

Eligibility Immediate
Vesting Immediate
Employee contributions None required
Employer contributions 10% of pay, made at the end of each month
Normal retirement age 65
Plan fund investment options The employer invests in funds elected by member
Account balance Contributions are accumulated in member's individual account,
earning a rate of return based on investments elected by the
member
Loans/withdrawal Not permitted
Benefit on termination or Account balance is payable to member upon termination or
retirement retirement. Member has the option to leave the balance in the
fund or withdraw the entire balance immediately upon
termination or retirement
Benefit on death Account balance is payable to designated beneficiary

29 Lecture 1
 Pension Challenges
 Longer retirements – paying lifetime pensions is more
expensive when retirees live longer
 Low interest rates – the pension plan needs to set aside more
money to fund future pensions when interest rates are low
 Matured pension systems
 Less cash to invest for future – the plan pays more in benefits
than it receives in contributions as it becomes more mature
 Low investment risk tolerance – the plan cannot afford to take
as much investment risk as before because the proportion of
contributing members has become smaller

30 Lecture 1
 A Documentary on Pension Challenges

Pension Plan Evolution – A New Financial Reality

 https://youtu.be/mvF3Ar9B_rs

31 Lecture 1