Level percentage of payroll funding: Meaning, Criticisms & Real-World Uses

What Is Level Percentage of Payroll Funding?

Level percentage of payroll funding is an actuarial method used primarily in pension plan management, particularly for public sector defined benefit plans, to determine employer contributions as a stable proportion of covered payroll over time. This approach falls under the broader category of actuarial science and public finance, aiming to provide a predictable and consistent funding schedule for future benefit obligations. The core idea behind level percentage of payroll funding is to ensure that pension contributions rise or fall in tandem with the plan's total payroll, rather than as a fixed dollar amount, thereby adapting to changes in the wage base and providing intergenerational equity. It is a common objective for public pension plans to have employer contributions that, over time, are a level percentage of payroll.¹²

History and Origin

The concept of actuarial funding for pension plans evolved significantly in the 20th century as defined benefit arrangements became more common, particularly in the public sector. The need for stable and systematic funding methods led to the development of various actuarial cost methods, including those that aim for a level percentage of payroll. This methodology gained prominence as a way to manage the long-term financial health of pension systems, allowing contributions to adjust with economic growth and inflation, which naturally influences payroll. Actuaries and policymakers sought methods that would avoid steep, unpredictable contribution spikes and ensure that the cost of benefits for each generation of employees was funded equitably. Professional associations, such as the Council of Consulting Actuaries (CCA), have developed white papers providing guidance on actuarial funding policies for public pension plans, advocating for principles-based models like the Level Cost Allocation Model (LCAM) which are characterized by allocating costs as a level percentage of compensation.¹¹ Similarly, the American Academy of Actuaries has published objectives and principles for funding public sector pension plans, emphasizing the importance of clear and consistent funding policies to maintain an appropriate balance among objectives like benefit security, generational equity, and contribution stability.¹⁰

Key Takeaways

Level percentage of payroll funding aims to stabilize pension contributions as a consistent proportion of total employee payroll.
It is widely used in public sector defined benefit plans to manage long-term obligations.
This method helps to align contributions with the plan's ability to pay, as payroll often reflects the economic capacity of the employer.
It contributes to intergenerational equity by ensuring that the cost of benefits for active employees is spread consistently over their working careers.
The calculation involves complex actuarial assumptions and regular actuarial valuations.

Formula and Calculation

The objective of level percentage of payroll funding means that the annual contribution is calculated such that it represents a constant percentage of the projected future payroll. This involves determining the normal cost (the cost of benefits accrued in the current year) and amortizing any unfunded actuarial accrued liability (UAAL) as a level percentage of payroll over a specified amortization period.

While there isn't a single universal formula for "level percentage of payroll funding" itself, the underlying actuarial contribution calculation that achieves this objective typically involves:

\text{Required Contribution Rate} = \frac{\text{Normal Cost} + \text{Amortization Payment for UAAL}}{\text{Total Covered Payroll}}

Where:

Normal Cost: The portion of the present value of future benefits attributed to current service, expressed as a percentage of current payroll.
Amortization Payment for UAAL: The annual payment required to eliminate the UAAL over the amortization period, structured to be a level percentage of future projected payroll rather than a level dollar amount. This payment takes into account expected payroll growth.
Total Covered Payroll: The total compensation of all active participants in the pension plan.

Actuaries use various actuarial assumptions, including salary growth, inflation, investment returns, and demographic factors, to project future payroll and calculate the level percentage of payroll contribution.

Interpreting Level Percentage of Payroll Funding

Interpreting the level percentage of payroll funding involves understanding its implications for financial stability and equity. When a pension plan aims for a level percentage of payroll funding, it implies that the burden of funding the plan is expected to remain proportional to the employer's capacity (as measured by its payroll) over the long term. This approach recognizes that payroll typically grows with inflation and economic expansion, allowing contributions to increase naturally without requiring sudden, large dollar increases that could strain budgets. It provides a measure of predictability for employers and ensures that the cost of benefits earned by employees is recognized and funded consistently throughout their careers. A lower or stable level percentage of payroll funding indicates a well-managed and adequately funded plan, while a rising percentage could signal increasing costs or funding shortfalls. This is often contrasted with a level dollar amortization, where payments are fixed in nominal terms, which might become a smaller proportion of payroll over time, or a larger burden if payroll shrinks.⁹

Hypothetical Example

Consider a hypothetical municipal pension plan for city employees. The plan's actuary determines that, using the level percentage of payroll funding method, the total required annual contribution from the city (employer) for the upcoming fiscal year is 15% of the total payroll for all active employees.

Scenario:

Total Annual Payroll for Active Employees: $50,000,000
Normal Cost Rate (as a % of payroll): 10%
UAAL Amortization Rate (as a % of payroll): 5%
Total Required Employer Contribution Rate: 15% (10% + 5%)

Calculation:

The city's contribution for the year would be ( $50,000,000 \times 0.15 = $7,500,000 ).

Under this level percentage of payroll funding approach, if the city's total payroll increases to $55,000,000 in the following year due to salary raises or new hires, the required contribution would automatically adjust to ( $55,000,000 \times 0.15 = $8,250,000 ), assuming the actuarially determined percentage remains the same. This contrasts with a fixed dollar contribution, where the amount would remain $7,500,000 regardless of payroll growth, potentially leading to underfunding in real terms or an increased relative burden if payroll decreases.

Practical Applications

Level percentage of payroll funding is predominantly applied in the context of public sector pension plans.

Public Sector Pension Management: State and local government pension systems frequently adopt this method to determine their annual employer contributions. It helps these governmental entities budget for pension costs as a predictable share of their employee compensation expenses.⁸,⁷
Financial Reporting and Compliance: This funding method aligns with accounting standards, particularly those set by the Governmental Accounting Standards Board (GASB), which provides guidance on financial reporting for public pension plans. GASB Statements No. 67 and 68 require specific disclosures regarding pension liabilities and contributions, often influenced by actuarial cost methods that target level contributions as a percentage of pay.⁶
Budgeting and Fiscal Planning: For government agencies, the stability offered by level percentage of payroll funding facilitates long-term fiscal planning. It allows them to factor pension costs into their budgets as a consistent proportion of their salary outlays, which can be easier to manage than volatile dollar amounts. The National Association of State Retirement Administrators (NASRA) highlights that public pensions are typically funded through employer and employee contributions, alongside investment earnings, with contributions often expressed as a percentage of payroll.⁵
Actuarial Valuations: Actuaries regularly perform actuarial valuations to determine the appropriate contribution rate. These valuations consider various economic assumptions like inflation and salary increases to project future payroll and ensure the level percentage objective is met.⁴

Limitations and Criticisms

While level percentage of payroll funding offers stability and predictability, it also has limitations and faces criticisms:

Sensitivity to Payroll Growth Assumptions: The effectiveness of this method heavily relies on accurate long-term projections of payroll growth. If actual payroll growth falls short of actuarial assumptions, the plan may become underfunded, requiring higher contributions in the future. Conversely, overestimated payroll growth could lead to overfunding.
Impact of Demographic Shifts: Significant changes in workforce demographics, such as an aging workforce with fewer new entrants or a decline in total employees, can strain the funding model. If the payroll base shrinks, maintaining a "level percentage" might still result in insufficient dollar contributions to cover growing retiree benefit payments.
Less Flexible for Surplus Management: Some argue that while it handles unfunded actuarial accrued liability (UAAL) well, it can be less flexible in managing significant surpluses. Policies may need to be in place to handle overfunded situations, potentially by amortizing the surplus over a period.³
Perceived Intergenerational Inequity: Critics sometimes argue that even with level percentage of payroll funding, certain generations might still bear a disproportionate burden if earlier contributions were insufficient or if economic downturns significantly impact asset values, requiring higher percentages from subsequent generations. However, proponents argue it is designed to promote intergenerational equity ².

Level Percentage of Payroll Funding vs. Level Dollar Amortization

The key distinction between level percentage of payroll funding and level dollar amortization lies in how actuarial liabilities, particularly the Unfunded Actuarial Accrued Liability (UAAL), are amortized.

Feature	Level Percentage of Payroll Funding	Level Dollar Amortization
Amortization Payment	Payments are calculated to be a constant percentage of future payroll.	Payments are a fixed dollar amount each year.
Annual Contribution	Increases as total payroll increases.	Remains constant in nominal dollar terms.
Impact of Inflation	Naturally adjusts with inflation, as payroll typically grows.	Payments become smaller in real terms over time with inflation.
Budget Predictability	Provides stable ratio to payroll, useful for budgeting.	Provides stable nominal dollar amount, also useful for budgeting.
Usage	Common for public sector pension plans.	Used in some private sector plans or for specific liabilities.
Intergenerational Equity	Aims for a more equitable spread of costs across generations.	Can shift a larger real burden to future generations if payroll grows.

Level percentage of payroll funding aims to keep the contribution burden consistent relative to the employer's wage base, providing a more stable long-term fiscal commitment in a growing economy. Level dollar amortization, while providing predictable nominal payments, may see these payments become a smaller portion of an increasing payroll over time, or a larger burden if payroll declines.

FAQs

What is the primary goal of level percentage of payroll funding?

The primary goal is to maintain a stable and predictable employer contribution rate for a pension plan as a consistent percentage of the total payroll, adapting to changes in the wage base over time.

Why is this method common in public pensions?

It is common in public pensions because it aligns contributions with the government's economic capacity, which is often tied to its payroll and tax revenues. This helps ensure long-term fiscal sustainability and generational equity ¹.

How do actuarial assumptions affect this funding method?

Actuarial assumptions, particularly those related to future payroll growth, inflation, and investment returns, are crucial. Inaccurate assumptions can lead to deviations from the targeted level percentage and potentially result in underfunding or overfunding.

Does this method guarantee a fully funded pension plan?

No, while it provides a systematic approach to funding, it does not guarantee a 100% funded ratio. The actual funded status depends on many factors, including actual investment returns, demographic experience, and whether the full actuarially determined contributions are consistently made.