The last two days we've discussed the time value of money, and mortality. Both of these concepts are key to developing the annual contribution that the sponsor of a DB LOSAP must make each year. They are also used to determine the present value of all of the promised benefits, which is a key component in determining the funded ratio of the LOSAP.
The funded ratio of the LOSAP a percentage where the assets of the program is the numerator, and the present value of accrued benefits is the denominator. Essentially, the funded ratio is a snapshot of how the sponsor is doing in saving money to pay for the promised benefits. Typically, the cash or market value of the assets are used for this purpose, however this can get tricky when certain annuity products with surrender charges are used to fund a program.
Ideally, the funded ratio would improve each year. Let's look at a simple example.
Going back to our 4/18/2019 post, we used an example of a $100,000 payment owed five years from now. Assuming we will earn 2.5% interest on our assets, the present value of that $100,000 is $88,385 as of today.
If we have $80,000 in the bank, the funded ratio is roughly 90.5%. In other words, as of today, we are projecting to be about 9.5% short of meeting our $100,000 goal in five years. As a result, there is a gap we need to make up over the next five years if we want our $100,000. If the 2.5% interest assumption is realistic - meaning, we think we will average that rate of return over the next five years - we'll be about $9,500 short of our $100,000 goal. If we contribute about $1,800 each year for the next 5 years, that should be enough to get us to $100,000.
Assuming we make that $1,800 contribution on January 1st each year, and that we earn our 2.5% investment return each year, our funded ratio will slowly grow over the next 5 years:
Year 0: $80,000 ÷ $88,385 = 90.5%
Year 1: $83,845 ÷ $90,595 = 92.5%
Year 2: $87,786 ÷ $92,860 = 94.5%
Year 3: $91,826 ÷ $95,182 = 96.5%
Year 4: $95,967 ÷ $97,562 = 98.4%
Year 5: $100,211 ÷ $100,000 = 100.2%
What if one of our assumptions doesn't work out the way we planned? We'll consider that in future posts.
Sharing my thoughts and insights on LOSAP, and occasionally other topics.