Introduction

A pension plan can serve as a crucial pillar of financial security for retirees, providing them with a steady income during their post-employment years. Several key factors go into the success and sustainability of a pension plan, including assumptions used, funding policies, and financial stability. Experience studies are a tool used by actuaries to ensure assumptions used for pension plans are reasonable. They involve analyzing historical data to evaluate the actual experience of a pension plan against the assumptions used to calculate the plan’s liabilities and funded status. This article delves into the significance of experience studies for pension plans and their key components, including how they help manage gains and losses, and it explores the question: Is it time to do an experience study?

Understanding experience studies for pension plans

An experience study is a comprehensive analysis that looks at the historical experience of a pension plan over an extended period. It examines a wide range of factors, including investment returns, actuarial assumptions, and demographic changes, among other items. Experience studies compare what has actually happened in a pension plan in recent years to the expected results based on current assumptions.

In general, two different types of assumptions are examined during an experience study: demographic and economic. Demographic assumptions focus on the characteristics of the plan population. They include assumptions such as rates of termination of employment, retirement, disability, and mortality. Economic assumptions pertain to the financial landscape of the pension plan. They involve the rate of inflation, interest, or discount rates, and assumed future investment returns. Both demographic and economic assumptions play a key role in determining the financial health and sustainability of a pension plan. An experience study looks at these assumptions to make sure they reasonably project the experience of the plan in determining liabilities.

The primary objectives of experience studies are:

1. Evaluating assumption accuracy: Experience studies allow actuaries to examine how well the assumptions used in the plan's funding and accounting calculations align with actual experience. This assessment is crucial for understanding the accuracy of the plan's financial projections. Adjustments can then be made to the assumptions, where appropriate.
2. Risk management: By analyzing historical data, experience studies help actuaries identify potential risks that could impact the plan's future financial stability. This information enables plan sponsors to implement proactive risk management strategies.
3. Adapting funding and investment policies: Based on the results of the experience study, actuaries can recommend adjustments to the plan's funding and investment policies to verify it remains on track to meet its long-term objectives.
4. Plan design enhancements: Experience studies often reveal areas where the plan design can be improved. This can lead to changes in benefit structures or other plan features that can be advantageous for both participants and sponsors.

Components of pension experience studies

Experience studies for pension plans involve several key components:

1. Data collection: The foundation of any experience study lies in the collection of historical data related to the plan's participants, their contributions and benefits, investment returns, and other relevant variables. The accuracy of such information is important to confirm that the results of the experience study are reliable and correct.
2. Data analysis: Actuaries use statistical techniques and actuarial models to analyze the collected data. This analysis includes an in depth look at the assumptions used to calculate the plan’s liabilities, such as evaluating mortality rates, investment returns, salary growth, and other factors that affect the plan’s financial health. The study also reveals the key components that contribute to a positive (gain) or negative (loss) outcome. The gain/loss analysis shows whether there have been significant deviations between assumptions and results.
3. Reviewing benefit payments and participant behavior: Experience studies analyze the actual benefit payments made to retirees and beneficiaries and compares them to the expected patterns. Understanding participant behavior, such as the timing of termination and retirement, is crucial for predicting future plan costs accurately.
4. Recommending adjustments to the actuarial calculation of plan liabilities and costs: Using the results of data analysis, actuaries recommend updated assumptions, where appropriate, to calculate future costs and liabilities for the pension plan. These calculations are instrumental in determining the plan's funding requirements and contribution levels. However, when setting new assumptions, it is key to strike a balance between recent behavior and long term assumptions. Actuaries and plan sponsors should not overreact to recent market volatility or other significant changes in experience, but take a long term approach when setting actuarial assumptions by examining the historical trends in the plan’s history.

The importance of experience studies for pension plans

Experience studies hold particular importance for pension plans, serving as a tool to make informed strategic decisions and an opportunity to review the gains or losses that each assumption has on the plan’s liability. Here are the key reasons why experience studies are critical for pension plans:

1. Accurate assumptions: The calculation of a pension plan’s liabilities and costs relies on various assumptions, such as future investment returns and participant behavior. Experience studies help identify the gaps between assumptions and reality, ensuring that the actuarial calculations remain accurate. Experience studies often lead to adjustments in assumptions to align with actual experience more closely.
2. Risk identification: Analyzing historical data enables actuaries to identify potential risks that could impact the plan's ability to meet its obligations to retirees. By understanding these risks, plan sponsors can take proactive measures to mitigate them.
3. Informed decision-making: The insights gained from experience studies empower plan sponsors to make informed decisions regarding funding, investments, and plan design. This helps optimize the plan's performance and enhance the benefits provided to participants.
4. Regulatory compliance: Many jurisdictions have specific regulations governing pension plans. Experience studies help ensure that the plan complies with these regulations, avoiding potential legal and financial consequences.
5. Enhanced communication: Experience studies provide clear and transparent data about the plan's financial health. This allows plan sponsors to communicate effectively with participants, building trust and confidence in the plan.

How often should pension plans conduct experience studies?

The frequency of conducting experience studies for pension plans depends on various factors, including the size of the plan, the volatility of its participant base, and changes in external economic conditions. Generally, experience studies should be performed at regular intervals to check that the plan remains financially sound and aligns with its long-term objectives. Here are some considerations for determining the frequency of experience studies:

1. Regular intervals: For larger pension plans or those with significant fluctuations in participant demographics, conducting experience studies every three to five years might be appropriate. This allows for a comprehensive analysis of trends and patterns that emerge over a reasonably long period with credible data, so as not to overreact to recent short term fluctuations.
2. Trigger events: Experience studies should also be conducted with recent or upcoming significant plan changes, such as plan design amendments or shifts in investment strategies. Some events, like changes to retirement eligibility, may require an experience study to see how participant behavior impacts retirement rates. Other events can lead to changes to prior trends that should be captured with updated assumptions. These events can impact the plan's financial health, necessitating a timely evaluation of their effects.
3. Regulatory requirements: Some jurisdictions may mandate specific intervals for experience studies to confirm compliance with regulatory standards. Plan sponsors should be aware of these requirements and adhere to them accordingly.

Conclusion: Why pension plans should conduct experience studies

Experience studies for pension plans are vital tools in managing the financial well-being of retirement benefits. Pension plan experience studies are instrumental in evaluating the actual performance of retirement plans against actuarial assumptions. By analyzing historical data, assessing assumption accuracy, and making informed decisions based on real-world experience and anticipated trends, actuaries help ensure the accurate calculation of liabilities and costs for pension plans. These studies provide insights into participant behavior, investment performance, and mortality rates, allowing plan sponsors to navigate uncertainties effectively. Conducting experience studies at regular intervals helps pension plans adapt to changing conditions and remain on course to meet their objectives, ensuring a secure and prosperous retirement for plan participants. In today's dynamic financial landscape, experience studies are a powerful tool to secure the future of pension plans and the financial well-being of those they serve.