Actuarial Basis of Accounting: What It is, How It Works

What Is the Actuarial Basis of Accounting?

The actuarial basis of accounting is a method often used in computing the periodic payments that a company must make to fund its employee pension benefits. The actuarial basis stipulates that total contributions from the company plus investment returns on pension assets must match the required annual contribution from the pension fund.

Understanding the Actuarial Basis of Accounting

The actuarial basis of accounting follows the basic premise of any actuarial process in that costs and benefits must be equal. Accounting for pensions involves assumptions on both sides of the equation.

Assumptions must be made for the following factors:

• The estimated number of years that employees are likely to work.
• The rate at which salaries are expected to increase in the future.
• The rate of return on plan assets.
• The discount rate used for future benefits.

When reviewing a company's financial statements, investors should note whether the company is being aggressive or conservative in these assumptions.

For example, if a company uses a very high rate of return on its plan assets, this will reduce the current costs to fund its pension plan. Information on pension contributions and assets can be found in the company's quarterly and annual reports to the Securities and Exchange Commission (SEC).

The actuarial basis of accounting method is carried out by actuarial accountants; statisticians who use formulas that are applied to statistical information in accordance with generally accepted accounting principles (GAAP) to determine the likelihood of a specific event risk occurring during a given period of time.

These accountants gather and assess data, including financial and lifestyle information, and then provide guidance that allows the company to make investment decisions that will ideally keep the account well funded and the company in good financial standing.

Example of the Actuarial Basis of Accounting

Examples of the actuarial basis of accounting method put to work in a fund might include a trust fund, set up for a public employee retirement system, or a pension fund.

When making suggestions for these funds, actuaries need to assess the four factors identified above:

• Years an employee is likely to work.
• What they are likely to earn.
• The rate of return on plan assets.
• The discount rate for future benefits.

To carry out these steps, an accountant would look at the current ages of the plan participants and the estimates for how many years they might work until retirement, allowing for participants who take early retirement and those that defer cashing out benefits in favor of retiring later.

The actuaries would also look at the projected final salary for each employee, considering potential merit raises, bonuses, and other kinds of compensation, as well as at the plan funding, market conditions, economic conditions, and other factors that may impact the rate of return for the plan assets.

Finally, the accountant would look at the impact of the discount rate for benefits down the line. Based on this information, the accountant can estimate how much needs to be funded for the employees to receive an equal retirement distribution each year that they are entitled to, and then make recommendations to the company for achieving this amount.

The company would then determine the contribution amounts it needs to make to the account as well as the rate of return it must achieve on its investments to ensure that the pension account is fully funded. The account is fully funded when it can meet payment requirements to both current and prospective pensioners.