Actuarial back-loading is a complicated concept that can have a significant adverse impact on the funding of Kentucky's pension plans.
Every year, the actuaries recommend a minimum amount that employers should pay to the pension funds. This "actuarially required contribution" – the "ARC" – has two components:
- "Normal cost" and
- "Past service cost"
The normal cost is the amount that should be paid in today so that, when combined with investment earnings, there will be sufficient money to make future retirement payments. The normal cost is intended to fund the increase in future pension payments arising from services provided during the year. If the plans were fully funded, this would be the only payment made by employers.
Then there is the past service cost. This is the payment to cover any unfunded liability.
Based on various assumptions, the actuaries estimate the timing and amount of future pension payments. They determine the amount needed in the fund at the beginning of a year so that, when combined with future investment earnings, there is sufficient money to make the retirement payments. (This is future pension payments, discounted back to "present value" using the assumed investment return assumption.) If the amount needed today is less than what is in the fund, then the plan is "underfunded.") The past service cost component is intended to pay off the past service cost (underfunding) over 30 years.
Once the amount of underfunding is determined, a formula is used to determine how much should be paid each year to pay fully the underfunding over 30 years. The statutes require the "percentage of payroll" formula. This formula requires the annual payment of a fixed percentage of payroll. Additionally, the formula takes into account anticipated growth in future payroll costs. Recently, it has been assumed that payroll costs will increase at 4% per year. Because future payrolls are anticipated to increase, future payments will also increase. The result is lower payments in early years, increasing payments in future years.
We told you it was complicated!
Here is an analogy of how the percent of payroll method works and how it results in the "back-loading" of principal payments:
Suppose you borrow $100,000 to purchase that home you really want. Under a "standard" loan arrangement, the interest rate is 7.5%6 and monthly mortgage payment is about $700 per month (plus taxes and insurance). Under that arrangement, you will immediately start reducing the $100,000 balance, so that you pay off the loan in 30 years.
Unfortunately, due to other financial obligations, the monthly payment is more than you can afford right now. However, you expect your income to increase in the future so that dealing with larger payments in the future will be easier. Fortunately, your friendly banker agrees to payments equal to 5.6% of your annual income. This means that payments will increase as your income increases. Under this arrangement, your monthly payments start out at $460 instead of $700.
But all is not good.
While this is a certainly a very comfortable arrangement that allows you to afford the home you want, several not-so-good things are happening:
- In the first year, the interest charge is $7,500 (7.5% of $100,000) but your payments total only $5,500 ($465 per month). As a result, unlike the standard loan arrangement, the amount you owe to the bank actually increases by $2,000 – the additional interest that is not covered by your payments. This is "negative amortization."
- Your liability continues to increase through year 12. The amount you owe the bank does not fall below $100,000 until year 20. In year 20, your monthly payment has increased from $463 to $975. In year 30, the monthly payments are $1,400. These compare to a standard loan where the $700 monthly payment remains constant throughout all 30 years.
- Over 30 years, you pay $58,000 more interest than you would with the standard loan arrangement.
The percent of payroll method combined with a 4% growth assumption has resulted in negative amortization (back-loading) for all eight pf the pension plans. This has contributed to 25% of underfunding.
Source: PFM Group Consulting report, May 22, 2017. For more information about this topic, click here to see relevant portions of that report.
6 We use 7.5% because the plans have used 7.50% as the target rate of return for investments.