What Is Normal Cost?
Normal cost, in the context of pension plans, represents the portion of the total actuarial present value of future benefits that is attributed to employee service during the current plan year. It is a fundamental concept in pension fund management and actuarial science, reflecting the cost of new benefits earned by plan participants each year. Actuaries determine the normal cost to ensure that adequate funds are set aside to cover these newly accruing benefit obligations, distinguishing them from costs related to past service. The calculation of normal cost is a critical component of a pension plan's overall funding policy and contributes to the long-term solvency of defined benefit plans.
History and Origin
The concept of normal cost evolved as actuarial science developed to address the complexities of long-term financial obligations, particularly in the realm of pension and insurance schemes. Early attempts to quantify risk and compensation date back to ancient civilizations, with more formal methods for assessing longevity and deaths emerging in the 17th century through figures like John Graunt and Edmond Halley, who created early life tables13. The recognition that pension benefits represented a form of deferred compensation, requiring pre-funding rather than simple pay-as-you-go systems, spurred the development of actuarial cost methods.
By the early 20th century, actuaries began to formalize techniques for analyzing pension costs. A significant milestone in the U.S. came with the 1945 publication of the Bulletin on Section 23(p)(1)(A) and (B) of the Internal Revenue Code, which outlined various methods for calculating and amortizing pension liabilities. These methods underpin modern actuarial valuations, wherein normal cost is a key element in allocating the present value of future benefits to specific periods12. The systematic determination of normal cost helps ensure that the cost of benefits is recognized as it is earned, promoting intergenerational equity in pension funding11.
Key Takeaways
- Normal cost is the annual expense representing the value of pension benefits earned by plan participants for their service in the current year.
- It is a forward-looking calculation, designed to pre-fund future pension obligations as they accrue.
- Calculated by actuaries using various actuarial cost methods and assumptions.
- Normal cost forms a core part of the total contribution rates required from employers and sometimes employees for a pension plan.
- Unlike unfunded liabilities, normal cost relates solely to benefits accrued in the current period, not to past service shortfalls.
Formula and Calculation
Normal cost is not represented by a single universal formula but is rather a component derived through an actuarial valuation using a chosen actuarial cost method. These methods allocate the actuarial present value of projected benefits over the working lifetimes of plan participants.
For a given plan year, the normal cost is typically calculated as:
This calculation involves numerous actuarial assumptions, such as:
- Mortality rates: The expected lifespan of participants.
- Turnover rates: The likelihood of employees leaving the plan before retirement.
- Salary growth: Projected increases in employee compensation over time.
- Investment returns: The assumed rate of return on plan assets.
- Discount rate: Used to bring future benefit payments to their present value.
Different actuarial cost methods will allocate costs differently over time, resulting in varying patterns of normal cost even for the same benefit structure. The goal remains to systematically recognize the cost of benefits as they are earned10.
Interpreting the Normal Cost
Interpreting the normal cost provides insight into the ongoing, annual cost of maintaining a defined benefit plan. It represents the theoretical contribution needed to fully fund the benefits earned by employees in a given year, assuming all actuarial assumptions hold true and there are no past unfunded liabilities.
A stable or predictable normal cost, often expressed as a percentage of payroll, indicates a consistent cost for newly accrued benefits. Changes in a plan's normal cost can arise from adjustments to actuarial assumptions, changes in plan design (e.g., richer benefits), or shifts in the demographic profile of the workforce (e.g., an aging workforce). For plan sponsors, understanding the normal cost helps in budgeting for future contribution rates and assessing the sustainability of their pension promises. It is distinct from covering a plan's actuarial liability from past service.
Hypothetical Example
Consider "Company Alpha," which sponsors a defined benefit plan for its employees. An actuary performs an annual actuarial valuation for the plan.
In 2025, the actuary determines that the total present value of benefits expected to be earned by all active employees for their service during that year is $5 million. This $5 million is the normal cost for Company Alpha's pension plan for 2025.
If the company's total covered payroll for active employees in 2025 is $50 million, the normal cost can also be expressed as a percentage of payroll:
This means that, in theory, 10% of the active payroll needs to be contributed to cover the benefits earned in 2025 alone. This figure helps Company Alpha budget for its pension contributions, alongside any amounts needed to address past shortfalls.
Practical Applications
Normal cost is a crucial metric in several areas of pension management and financial planning. For corporate and public pension plan sponsors, it is a primary driver of the annual required contribution to their pension plans. Employers budget for this ongoing cost, which reflects the current value of future benefits being earned by their workforce. The accurate calculation of normal cost is essential for transparent financial reporting and compliance with regulatory standards.
Regulatory bodies, such as the Pension Benefit Guaranty Corporation (PBGC) in the United States, monitor the funding status of defined benefit plans and rely on actuarial calculations, including normal cost, to assess plan health. The PBGC, established by the Employee Retirement Income Security Act (ERISA) of 1974, insures private sector defined benefit pensions9. The Internal Revenue Service (IRS) also provides guidance on pension taxation and contributions, where normal cost plays a role in determining deductible contributions and the taxability of pension payments8. Pension actuaries often conduct "experience studies" to review past data and emerging trends, helping to ensure that the assumptions used in normal cost calculations remain reasonable and forward-looking7.
Limitations and Criticisms
While normal cost is a foundational concept in pension funding, its calculation and interpretation are subject to certain limitations and criticisms, primarily stemming from the reliance on actuarial assumptions. Since normal cost projects future events like mortality, salary increases, and investment returns, any deviation of actual experience from these assumptions can impact the accuracy of the calculated cost.
Critics argue that the selection of key assumptions, particularly the discount rate used to value future liabilities, can significantly influence the reported normal cost and overall actuarial liability6. An overly optimistic assumption about investment returns, for instance, could lead to a lower reported normal cost and lower required contribution rates, potentially understating the true cost of benefits being earned5. Conversely, overly conservative assumptions might lead to overfunding. The process of setting these assumptions involves professional judgment, which, if not exercised prudently, can lead to financial imbalances or controversies4. The Governmental Accountability Office (GAO) has also noted that the reliability of actuarial valuations can be questionable if based on incomplete or inaccurate participant data3.
Normal Cost vs. Unfunded Actuarial Accrued Liability
Normal cost and Unfunded Actuarial Accrued Liability (UAAL) are two distinct but related components of a pension plan's financial health, both determined through actuarial valuations. Normal cost refers to the cost of benefits earned by plan participants during the current year of service. It is the ongoing, fresh accrual of pension obligations.
In contrast, the Unfunded Actuarial Accrued Liability (UAAL), also known as pension debt, represents the shortfall between a plan's actuarial liability (the value of benefits earned to date for past service) and the plan's assets. The UAAL arises from past events, such as insufficient contributions, investment losses, or changes in actuarial assumptions or plan benefits that apply retroactively. While normal cost is about pre-funding new benefits, the UAAL is a measure of the existing deficit that needs to be paid off, typically over an amortization period1, 2. A plan can have a positive normal cost even if it has a large UAAL, as they address different aspects of funding.
FAQs
What does "normal cost" mean in simple terms?
Normal cost is the estimated cost of the retirement benefits employees earn in the current year. Think of it as the "fresh" cost of adding another year of future pension benefit for all active employees.
How is normal cost different from total pension contributions?
Total pension contributions often include both the normal cost (for current year's benefits) and a payment towards any existing Unfunded Actuarial Accrued Liability (UAAL) from past shortfalls. Normal cost is just the portion covering newly earned benefits.
Why does normal cost matter for a company or government?
For companies and governments sponsoring defined benefit plans, normal cost is a key part of their annual budget for employee benefits. It helps them understand the recurring cost of their pension promises and is reflected in their financial statements.
Can normal cost change over time?
Yes, normal cost can change due to several factors, including updates to actuarial assumptions (like expected lifespan or salary increases), changes in the pension plan's benefit formula, or shifts in the demographics of the employee group.