Actuarial accrued liability (AAL): Total amount of promised pension benefits, counting up all expected pension checks for active members and retirees, and then reporting those in today’s dollars.
Also see: Pension obligations, Total pension liability
Actuarial assumptions: Estimates used to forecast uncertain future events affecting future benefits or costs associated with a pension fund. Examples of these assumptions include investment rate of return, inflation, payroll growth, mortality, retirement patterns, and other demographic data.
Actuarially determined contribution (ADC): Annual amount actuarially necessary to cover the normal cost and amortization payment, after accounting for any employee contributions.
Similar terminology: Actuarially required contribution (ARC)
Actuary: A financial expert who specializes in analyzing risk and mathematical analysis. Pension plans hire actuaries to measure the value of benefits, and determine contribution rates.
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Annuity, annuitization: A permanent, fixed stream of future income payments. Pension payments are a form of annuity. Contracts between individuals and financial companies, where individuals make a payment to a company in exchange for a certain amount of lifetime income, are another form of annuity. All or a portion of the accumulated balance of an individual retirement account (such as a guaranteed return plan or defined contribution plan) can be converted into guaranteed lifetime income through a process called annuitization. To read up more on the various kinds of annuities and how they work, check out Investopedia for details.
Assets: Money held by the retirement system to be invested and used to pay out benefits to retirees who have contributed to the system.
Assets, actuarial value (AVA): A “smoothed” value of assets, typically used for the purposes of determining contribution rates and measuring unfunded liabilities. Actuaries “smooth” any gains and losses of a particular number of years to minimize year-to-year changes in the value of the AVA. For example, actuaries typically smooth investment gains and losses over a five-year period, only recognizing 20% of the market valued return each year for the purposes of determining the AVA.
Similar terminology: Actuarial value of assets
Assets, market value (MVA): The real value of the plan’s total assets, measured by the price that would be received to sell an asset in an orderly transaction between market participants at that date.
Also see: Fiduciary net position
Similar terminology: Market value of assets
Asset smoothing: The process of recognizing only part of an actuarial gain or loss to plan assets in any given year in order to calculate the actuarial value of assets. A pension plan might want to do this because amortization payments are based on the amount of unfunded liabilities, and smoothing in gains or losses to the plan’s assets means the recognized value of unfunded liabilities is unlikely to make a big jump from one year to the next.
Amortization: The process of setting a payment schedule for paying off unfunded liabilities. This is similar to a series of mortgage payments. When a pension fund has a shortfall—i.e. pension debt or unfunded liabilities—contributions are necessary to catch up on the appropriate amount of funding. These contributions are known as amortization payments.
Amortization method: The process of determining whether amortization payments will be made over a fixed period of time, annually refinanced, or paid off in stages. Amortization payments are typically made with either equal dollar payments each year in a schedule, or with dollar payments as a fixed percentage of payroll.
Amortization method, closed: If an amortization schedule is “closed,” it has a particular number of years within which the unfunded liabilities will be paid off. Each year the pension plan pays off a portion of the amortization schedule and moves one year closer to its end date. If the pension plan experiences actuarial losses during the schedule that add to unfunded liabilities, the pension board could either create a separate amortization schedule for that new debt (known as an amortization “layer”) or simply add the new amounts owed to the existing debt and increase the payment in each year of the schedule without the number of years in the schedule increasing.
Amortization method, open: If an amortization schedule is “open” the payments are reset each year, like refinancing a mortgage. This approach virtually guarantees the pension debt will never be paid off and often can mean contributions towards unfunded liabilities each year don’t even cover the interest on the debt.
Amortization payments, level-dollar: Unfunded liabilities can be amortized over a fixed (closed) or open number of years such that the plan expects to pay the same dollar amount each year of the schedule.
Amortization payments, level-percent of pay: Unfunded liabilities can be amortized such that the plan expects to pay the same percentage of payroll each year of the schedule. Because most retirement systems anticipate payroll will grow over time, this method means that the dollar amount of amortization payments will be expected to grow too.
Assumed rate of return (ARR): The investment return on assets that the pension fund expects to earn over a long-term period of time. This is the most important actuarial assumption that pension boards determine. To determine the amount of contributions required, a pension fund and its actuaries make educated guesses about how much they think they can earn by investing those contributions. That educated guess is called the assumed rate of return. A simple way to think about this assumption is as the minimum amount that a pension fund needs to earn to avoid accumulating pension debt.
Beneficiary: A person designated by the terms of the pension plan that is, or may become, entitled to a benefit under the plan. Typically, these benefits are spousal benefits and survivorship benefits for minor children.
Cost-of-living adjustment (COLA): An annual change to a pension benefit for retirees, usually pegged to some measure of the rate of inflation. Some COLA benefits have minimum adjustments, such as 1% or 2%. Some COLA benefits have maximum adjustments. Some are intended to match inflation, while others are based in part on inflation and in part on some other metric, such as investment returns.
Similar terminology: Inflation protection
Cash balance plan: A kind of defined benefit retirement plan that provides income through an individual account with investments managed by the state and returns guaranteed at a minimum level.
Also see: Guaranteed return plan.
Deferred retirement option plan (DROP): A supplemental retirement benefit provided by some pension plans that allow you to start receiving retirement checks during the final few years you work. A typical DROP will require you to commit to retire within one to five years, during which time your retirement plan will start putting pension payments into an individual account. Upon completing the DROP period, you would receive a lump sum of those payments, usually with some minimum rate of return on those assets. The rules for DROPs can vary considerably, changing how risky they are to plan sponsors.
Defined benefit plan (DB Plan): A retirement plan that determines benefits by a formula in advance of your retirement. This term is often used to refer to pensions, but technically it can refer to a range of retirement plan designs.
Also see: Guaranteed income plan, Guaranteed return plan
Defined contribution plan (DC Plan): In a defined contribution plan, you and your employer each contribute a specified amount to your individual account, which is then invested in one of several professionally designed and managed funds. These accounts allow you to choose whether to convert retirement savings from your working years into a lump-sum, a guaranteed monthly pension check (called an annuity), or a combination of both. The IRS typically refers DC plans as 401(a), 403(b), or 457 depending on when the retirement plan was established and whether or not it is supplemental to some other retirement benefit.
Discount rate: A tool in the process of estimating the value of promised pension benefits. Actuaries need to use an interest rate to “discount” the value of future pension payments back into today’s dollars for the purposes of determining accrued liabilities or determining the value of pension benefits earned in a given year. This rate theoretically should reflect expectations about the future value of money. Most plans use the assumed rate of return for the discount rate, leading to some interchangeable terminology.
Expected rate of return: This term is often used interchangeably with “assumed rate of return.” Technically, the expected rate of return refers to the middle of the possible investment returns for a given pension fund’s portfolio. Investment advisors forecast what the probability is for different rates of return based on a given portfolio (such as the mix of stocks and bonds). The 50th percentile—or 50% probability—in that forecast is formally known as the expected rate of return. Pension board trustees do not always choose the expected rate of return as the assumed rate of return, but they do use it as a guidepost.
Also See: Assumed rate of return
Fiduciary net position: A technical definition from the Governmental Accounting Standards Board for the market value of assets. All retirement systems that want to comply with GASB reporting requirements are required to measure the real value of their assets, instead of the actuarial value.
Also see: Assets, market value
Final average salary: a measure of compensation that your benefit will be based on. Most states use your final average salary is the average of the last five years of work, or the last three years. Other states use the three or five highest years of salary, rather than the years at the end of your career. Some states allow for sick days and unused leave to be calculated into the value of compensation. Some states use the three to five highest years of salary during your career, rather than the years at the end of your career.
Similar terminology: Highest average salary
Funded ratio: The funded ratio measures the ratio of dollars in the pension fund compared to the value of promised lifetime income benefits. A funded ratio above 100% means the plan has more than enough assets to cover the benefits it has promised to pay. A funded ratio below 100% means the plan has not saved enough. Funded ratios can be measured using assets reported on either an actuarial basis (AVA) or market basis (MVA).
Funding period: The anticipated number of years remaining until the pension fund reaches 100% funded. This term is typically used by pension funds where the legislature has assigned fixed contribution rates instead of paying actuarially determined contribution rates. Actuaries analyze how long, given the prescribed contributions, it will take for any unfunded liabilities to be amortized—as opposed to starting with a desired amortization method and determining the contributions necessary to meet that objective.
Governmental Accounting Standards Board (GASB): A private organization that recommends standards for governments to use in accounting and financial reporting. No state or local government is required by any federal law to follow GASB recommendations, though it is often best practice to treat GASB standards as a minimum for accounting and operational purposes.
Guaranteed income plan (GIP): A guaranteed income plan provides a fixed, guaranteed monthly income based on two factors: years worked and average salary during final working years. In guaranteed income plans, you make contributions at a level determined by your state government, which the pension fund invests alongside contributions from your employer. GIPs are traditionally known as pensions or defined benefit plans.
Guaranteed return plan (GRP): In a guaranteed return plan, you and your employer both make contributions to a fund managed on your behalf. The retirement system invests the money for you and guarantees that you’ll earn at least a certain return. During your working years you accumulate contributions, the minimum investment return on your savings, plus some share of any investment returns above that minimum. When you reach retirement, you can convert the accumulated savings into income that is guaranteed for life — which turns your guaranteed return plan into a pension. Guaranteed return plans are sometimes called “money purchase” or “cash balance” plans.
Highest average salary: See final average salary.
Hybrid retirement plan (HYP): In a hybrid retirement plan, your employer provides access to two compatible retirement benefit structures at the same time. A typical hybrid plan combines a small guaranteed income plan with a defined contribution plan. Employer contributions to the DC portion of the hybrid will likely be smaller than if the DC plan were offered on its own. Some states provide hybrid plans where the employer finances the pension portion, and the employee finances the DC portion. Hawaii has paired a guaranteed return plan with a guaranteed income plan.
Interest credit: For those who have guaranteed return plans, this is the amount of interest that gets added to your accumulated balance of contributions. When individuals leave a pension fund and request a refund of their contributions, some pension funds also provide small interest credits on that balance of assets.
Interest rates: A percentage increase, typically the amount a lender charges for a loan. U.S. Treasury bonds are sometimes a proxy for risk-free interest rates because the yield is the amount the government is paying to borrow money, and there is virtually no risk that the government would default on its loan.
Multiplier: A number that is multiplied by your years of service and final average salary, creating the amount you’ll receive as a benefit when you retire. The higher the multiplier, the larger the benefit. Multipliers are sometimes called “accrual rate,” “crediting rate,” or another term that basically means “percentage to multiply the years of service.”
Net pension liability (NPL): A technical definition from the Governmental Accounting Standards Board for pension funding shortfalls. All retirement systems that want to comply with GASB reporting requirements are required to measure their obligations as total pension liabilities, and their assets using a market value called fiduciary net position. The difference between these two accounting metrics is the net pension liability. For practical purposes, the NPL is the same as pension debt.
Also see: Unfunded liability
Normal cost: The contribution necessary to pay for benefits earned each year. This amount gets invested, and the combined total is intended to pay all promised benefits. The normal cost “prefunds” or “pays in advance” for promised pension benefits.
Payroll: The total amount paid to employees that are participating in a retirement system. The costs and contribution rates of a pension plan are often expressed as a percentage of the total plan payroll.
Pension debt: A non-technical way to think about “unfunded liabilities,” which is the difference between the value of promised benefits and the assets available to pay those benefits. Pension debt isn’t like typical government debt. Money isn’t be borrowed and put into the pension fund. Instead, it is money the pension fund needs to make up for past contributions that weren’t enough to appropriately pre-pay for benefits.
Also see: Net pension liability, Unfunded liabilities
Pension Obligations: Total amount of promised pension benefits, counting up all expected pension checks for active members and retirees, and then reporting those in today’s dollars.
Also see: Actuarial accrued liability, Total pension liability
Pension system: An umbrella administrative organization that ensures benefits are paid, records kept, contributions collected, and investments managed. The terminology for retirement systems can vary from state to state, with different words and phrases often holding the same meaning. The term “system” typically refers to an overarching management structure, within which there might be several pension “plans” or “divisions.” Sometimes multiple retirement systems are managed by an umbrella system or association. Within a specific pension plan there might be various “tiers” of benefits that provide different formulas and qualifications based on starting date or job classification. The various labels are all important for making distinctions within a specific state, but often the terminology is interchangeable from state to state.
Similar terminology: Pension plan, Pension Tier
Service credit: A term for measuring qualifying time served towards earning a pension benefit.
Also see: Multiplier, Years of service
Total pension liability: A technical definition from the Governmental Accounting Standards Board for the value of promised benefits. All retirement systems that want to comply with GASB reporting requirements are required to measure their pension obligations in a particular way that sometimes can be slightly different from AAL.
Also see: Actuarial accrued liabilities
Unfunded liabilities: The difference between the value of promised benefits and assets available to pay those benefits. This is the shortfall in assets that should be in the pension fund and invested so that all promised benefits can be paid. An easy way to think about unfunded liabilities is as pension debt.
Also see: Net pension liability
Similar terminology: Unfunded actuarial accrued liability, unfunded accrued liability
Unfunded liability amortization payments: See amortization payments.
Valuation: An analysis of the financial condition of a pension plan on a regular basis. The valuation determines the financial position of the plan and the future contribution rates needed to ensure its long-term funding. The pension plan’s actuaries determine how much money the plan needs to pay pension benefits by using various assumptions concerning future events and behaviors.
Vesting: Vesting is the amount of time teachers must work and contribute to their pension systems before gaining the right to pension contributions from their employer.
Years of service: how many qualifying years you’ve worked for your employer within the pension plan.