Creating Good "Funding Policy"
The standard practice for most pension boards is to create policy that will guide decision making about determining contribution rates. This is formally called “funding policy.”
The overarching goals of any pension funding policy are to:
- Ensure there is enough money to pay promised benefits
- Establish stable contributions into the fund
- Distribute the cost equitably across generations
The first goal is simple to understand: Benefit security means adequate funding. The second goal is about government finances: Managing budgets is easier if the contributions paid from year to year are relatively stable. The third goal gets at the important question of who pays for the benefits: How much should be paid by today’s taxpayers and how much by future taxpayers?
A pension board uses funding policies to establish a recommended contribution rate for the government. This rate is only as good as the assumptions and methods used to create it.
Gold standard funding policies will ensure that contribution rates are also designed to ensure a pension funded ratio is at least 100%, and some of the best funding policies target a 120% funded ratio to ensure a cushion against a market downturn. So the pension board’s recommended contribution rate in actuality represents the bare minimum for government employers. The best funding policies also aim to get unfunded liabilities paid off in 20 years or less, and have automatic adjustments to contribution rates in the case of poor actuarial performance.