Alternative Minimum Cost Method - Explained
What is the Alternative Minimum Cost Method?
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What is the Alternative Minimum Cost Method?
The form of measure used by a defined benefit pension plan, ensuring that it has enough funds for future payments to its participants is an alternative minimum cost method. The alternative minimum cost method is a system of funding pension plans that have been approved by ERISA (Employee Retirement Income Security Act). The alternative minimum cost approach is a way of figuring out how much money is needed to finance a pension plan. The name of the method has the term "alternative" in it, but the process is actually the main forbidden way to make those calculations. Generally, these estimates use either the estimated operating cost of the benefits over time or a discount formula for current overall benefits.
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How the Alternative Minimum Cost Method Works.
A way of finding out how much money is needed to support a pension scheme is an alternative minimum cost. A bill called the Employee Retirement Income Security Act (ERISA) was passed in 1974 by Congress. It laid down guidelines for the funding of pension plans. One result was that most firms started to use the alternative method of calculation of the minimum costs. In fact, this approach is based on demographic data to determine how to finance individual workers ' pension plans. The method consists of two variants and the pension fund will choose which one has the lowest cost. The pension plan chooses the option with the minimum cost from two alternatives. Hence the name "alternative minimum cost method"
A defined benefit pension plan is a type of pension plan in which an employer/sponsor offered a fixed pension contribution, lump sum, or combination of pensions, based on the employee's salary, service duration and age ratio, rather than on a direct dependence on individual returns on the investment. A retirement benefit program is a form of a pension plan. In the sense that the benefit formula is specified and is understood beforehand, a defined benefits package is said to be "defined." Moreover, the formula for determining the employer's and employee's contributions is specified and known in advance for a "defined contribution retirement saving program," but the profit to be paid is not known in advance. Most government and public agencies, as well as many companies historically, have offered defined benefit plans, sometimes to reward employees rather than to increase their pay.
The Employee Retirement Income Security Act of 1974 (ERISA)
This is a US federal tax and labor law that sets minimum standards for private industry pension plans. It contains rules regarding the federal tax effects of transactions related to employee benefit plans. ERISA was enacted to protect the interests of participants in the employee benefit plan and its beneficiaries by:
- Requiring transparency of the plan, by notifying the beneficiaries of every information relating to the plan
- Establishing standards of conduct for plan fiduciaries
- Providing sufficient solutions and access to federal courts.
ERISA does not require employers to draw up pension schemes. Equally, it does not mandate, as a general rule, that programs provide a minimum level of benefits. Rather it governs the operation of a pension plan once it is formed.
Acceptable Actuarial Cost Methods
Organizations have two specific strategic choices for the calculation of the minimum level of funding using the actuarial cost approach based on the less expensive method. The choices include: Actuarial Cost Method: The pension fee plus return of the investment must equal or exceed the sum paid to pensioners for the purpose of remaining solvent. In order to calculate premiums on this assumption, the pension management company uses an actuarial process. Accrued Benefits Cost Method: This approach measures the benefits which an employee receives by participating in a retirement plan each year. By considering the life expectancy of the employee, one then measures the present value of the benefits and applies this value to the year the employee receives those benefits. The acceptability of the individual actuarial cost methods which are used by organizations to arrive at the requirements of the annual fundings is largely dependent on the Secretary of Treasury of the United States. Terminal cost methods which give room for employers in various organizations to pledge the payment of a lump sum to their employees in order to make up for shortcomings at a later date, or by using "pay-as-you-go method", are discouraged in current regulations. Measures that produce higher current payment levels are a usual requirement by acceptable methods. Examples of such high current payments level generating measures include individual level premium cost method or the aggregate level cost method.
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