SAC 305:Pension Mathematics
Topic No.3
Course Lecturer: Johnstone k munywoki
TOPIC 3
Value of future contributions
There are two main ways of calculating contributions
(a)contributions are at rate of k% of salary.
(b)contributions are at a fixed rate of F per annum payable continuously
(a)the mean present value of the future contributions (of employee, employer
or both) at rate k% of salary for a member aged x with current salary rate of
SAL per annum is
Z 65−x
k SAL lx+t
× vx × × S̄x+t dt
100 S̄x 0 lx
This is usually approximated to
64−x
k SAL X 1 lx+t
× × v t+ 2 × × S̄x+t
100 S̄x t=0
lx
Introducing the commutation function Dx = v x lx by multiplying the numerator
and the denominator by v x we have the above approximation formula becoming
64−x
k SAL X 1 lx+t
× × v x+t+ 2 × x × Sx+t
100 S̄x t=0
v lx
64−x
k SAL X Dx+t
= × × × S̄x+t
100 S̄x t=0
Dx
64−x
k SAL X
s
= × × D̄x+t
100 S̄x t=0
k SAL s
= × × N̄x
100 S̄x
Note
[Link] SAL refers to past year, change S̄x to Sx−1 in the denominator.
[Link] SAL refers to the coming year change S̄x to Sx .
Example (a)Consider a life aged 35 with current salary of 10,000 who con-
tributes 5% of his salary to a pension [Link] pension fund tables, calcu-
late the mean present value of the employee’s future contributions.
Solution mpv of contributions is
5 10000
×
100 S̄D25
500 × 417, 224
≈ 1
2 [2.98 + 3.08] × 7232
= 9520
(b)Suppose contributions are independent of salary and that these are at a fixed
annual sum of F payable continuously. The mean present value of future con-
tributions is
Z 65−x
lx+t
F vt × dt
0 lx
64−x
X 1 lx+t+ 12
≈F v t+ 2 ×
t=0
lx
64−x
X Dx+t+ 12
=F
t=0
Dx
64−x
F X
= D̄x+t
Dx t=0
N̄x
=F
Dx
The Value of Pension Benefits
Pension benefits are usually of the following forms,—— (a)A fixed pension of P
per year of service.
(b)A fraction of the average salary per year of service.
(c)A fraction of the final salary per year of service.
Note
[Link] of service include fractions pro rata
[Link] benefits on the date of age retirement or ill-health retirement are valued
by multiplying the annual pension by an appropriate annuity function. For ex-
ample the benefit on age retirement at age 65 is
annual pension ×ār65
where r indicates age retirement mortality.
Similarly āix refers to a life at age x due to ill [Link]-health mortality is usu-
ally heavier than that of age retirement.
[Link] the symbol ār65 is usually used, the benefit may be payable in various
ways e.g monthly in advance and is possible subject to a guarantee that at least
5 years payments will be made. In this example
ār65 = ä(12) + 5|ä(12)
5 65
on a suitable mortality table.
2
Fixed Pension Schemes
Consider a fixed pension scheme of P per year of service, including fractions
pro rata, for a life now aged x with n years past [Link]-health and age re-
tirements will be considered seperately.
(a)Ill- Health Retirement
The mpv of the benefit is
64−x
X 1 ix+t 1
v t+ 2 × × (n + t + ) × P āix+t+ 1
t=0
lx 2 2
This can be divided into two.
1. The value of past service pension(P.S.P) where P is taken as nP .
[Link] value of Future service pension(F.S.P) where P is taken as (t + 21 )P if
retirement occurs due ti ill-health at age x + t + 21 .
So mpv is
64−x 64−x
X 1 ix+t X 1 ix+t 1
nP v t+ 2 × × āix+t+ 1 + P v t+ 2 × × (t + )āix+t+ 1
t=0
lx 2
t=0
l x 2 2
Define the following commutation functions
1
Cxia = v x+ 2 × ix × āix+ 1
2
64−x
X
Mxia = ia
Cx+t
t=0
1
M̄xia = Mxia − × Cxia
2
and
64−x
X
R̄xia = ia
M̄x+t
t=0
3
It follows that
X 1 ia
R̄xia = (t + )Cx+t
2
Proof
R̄xia = M̄xia + M̄x+1
ia ia
+ ... + M̄64
1 1 ia 1 ia
= ( Cxia + Cx+1
ia ia
+ ... + C64 ) + ( Cx+1 ia
+ Cx+2 ia
+ ... + C64 ) + ... + C64
2 2 2
1 3 ia 1 ia
= Cxia + Cx+1 + ... + (64 − x + )C64
2 2 2
64−x
X 1 ia
= (t + )Cx+t
t=0
2
Therefore P.S.P is
64−x 1
X v x+t+ 2
nP ix+t āix+t+ 1
t=0
v x lx 2
64−x
nP X ia
= C
Dx t=0 x+t
ia
Mx
= nP
Dx
and F.S.P is
64−x 1
X v x+t+ 2 1
P ix+t (t + )āix+t+ 1
t=0
v x lx 2 2
64−x
P X 1
= (t + )āix+t+ 1
Dx t=0 2 2
64−x
P X ia
= C
Dx t=0 x+t
ia
R̄x
=P
Dx
(b)Age Retirements
The value of benefits caused by age retirements is very similar to that of ill-health
retirements, but with final term corresponding to age retirement at exact age
65. The m.p.v of age retirement benefit is
64−x
X 1 rx+t 1 r65
v t+ 2 (n + t + )P ārx+t+ 1 + v 65−x (n + 65 − x)P ār65
t=0
lx 2 2 lx
4
Again this may be separated intio P.S.P and the F.S.P terms.
Define the commutation functions
x+ 1
ra v 2 rx āx+ 21 , x < 65
Cx = 65
v r65 ā65 , x = 65
65−x
X
Mxra = ra
Cx+t
t=0
(not the summation is up to 65 − x)
1
M̄xra = Mxra − Cxra
2
and
64−x
X
R̄xra = ra
M̄x+t
t=0
64−x
X 1 ra ra
= (t + )Cx+t + (65 − x)C65
t=0
2
Then P.S.P is "64−x #
nP X
x+t+ 12
v rx+t ārx+t+ 1 + v 65 r65 ār65
Dx t=0
2
Mxra
= nP
Dx
The value of F.S.P is
"64−x #
P X x+t+ 1 r 65 r
v 2r
x+t āx+t+ 1 + (65 − x)v r65 ā65
Dx t=0 2
"64−x #
P X 1 1
= (t + )v x+t+ 2 rx+t ārx+t+ 1 + v 65 r65 ār65
Dx t=0
2 2
"64−x #
P X 1 ra ra
= (t + )Cx+t + (65 − x)C65
Dx t=0 2
ra
R̄x
=P
Dx
Hence the value of all age retirement pension benefit is
nMxra + R̄xra
P
Dx
5
Defined Benefit(DB) vs Defined Contribution Pen-
sion(DC)
Defined Benefit Pension(DB)
Advantages
• Retirement income is independent of market performance and usually ad-
justed for inflation
• Retirement income is relatively high (up to 70%) for the amount of con-
tribution the employee makes
• The higher income years prior to retirement really works to the employees
advantage
Disadvantages
• Defined benefit pensions are extremely expensive on the employer which is
why most companies are or have switched, to a defined contribution plan
instead. The biggest risk with having anon-government funded defined
benefit plan is that there is a possibility of the pension not being funded
properly.
• another disadvantage is that some plans only allow a portion to be trans-
fered to a spouse if the beneficiary passes away.
Defined Contribution Pension(DC)
Advantages
• Watch your money/portfolio grow,what you see is what you get
• Control over your money and investments within the plan
Disadvantages
• Retirement income is entirely dependent on how the portfolio/market per-
form over the vested period