What is an Actuarial Valuation?

An actuarial valuation is a financial document comparing the actual performance of a pension plan with the assumptions made in setting it up. The actuarial valuation is normally used in company pension plans where the company itself is responsible for providing the final pension. The valuation may reveal a serious shortfall that can affect both the future of the plan and the financial position of the company.

There are two main types of pension plan that can be run by a company for its employees. The precise terms vary from location to location, but "defined contribution" and "defined benefit" are the most common. In a defined contribution plan, the company agrees on the amount of money it will invest on behalf of employees. Their final pensions depend on how well these investments perform and the cost of pension products when they retire.

A defined benefit plan, however, guarantees that the employee will get a pension based on an agreed calculation method, rather than simply depending on how much money is available. A common example is the final salary plan where, for example, a retiring employee may get a pension equal to two-thirds of the salary he was earning upon retirement. In defined benefit plans, the company is responsible for making sure it has enough money in the plan to provide these pensions.

When calculating the finances of a defined benefit plan, the company must make two sets of assumptions. One is how much money it will need to provide in the future, which takes account of when people will retire and how long they will live. The other is how successful the company will be in investing money to produce enough return to fund these pensions.

As the sums of money involved are so large, the company cannot simply hope for the best and worry about any shortfalls only when employees retire. If predictions have proved incorrect, the shortfall may become a crippling financial problem for the company. To avoid such nasty surprises, a company can carry out an actuarial variation. This involves an actuary, a financial specialist in statistical analysis on issues such as population demographics and life expectancy, checking the original expectations and comparing them with the latest available information about the actual performance of the investments and the pattern of retirement and life expectancy.

Under United States law, a pension plan must have an actuarial valuation at least once every three years. Many companies will carry out a valuation more often, for example once a year. Although this is more costly, it can highlight problems earlier, and it is often cheaper to increase the level of investment at that time in order to reduce the likelihood of a shortfall later. A valuation may also reveal that the company is investing more money in the pension plan than it is truly likely to need to meet its obligations.