Normal cost

Normal cost
See also

Normal cost is defined as the sum of actual direct materials cost, actual labour cost and other direct expense. They are called normal or regular cost and they arise in the normal conditions during the normal operations of the organization.

Normal cost is the term used to describe the annual cost of a pension or survivor plan. It is expressed as a percentage of payroll and represents the amount of money that should be set aside during employees' working years that, with investment earnings, will be sufficient to cover future benefit payments. It applies to future benefits being earned during current employment, not payments to current annuitants[1]

Actuarial Accrued Liability, Unfunded Actuarial Accrued Liability and Normal Cost

The three terms, (actuarial accrued liability, normal cost, and unfunded actuarial accrued liability) are central building blocks for actuarial analysis. The portion of the actuarial present value of future benefits that is allocated the year following each valuation is the plan's normal cost. The actuarial accrued liability is the value of the costs that have accrued to date, as determined at each actuarial valuation. The excess of the actuarial accrued liability over the plan's actuarial assets is the unfunded actuarial accrued liability, which represents the amount for which funds have not as yet been put aside to pay for promised benefits[2]

Normal Cost Methods

Actuaries are far more creative, however, than hand-held calculators. They can and perhaps sometimes do calculate normal cost on a level payment basis, but typically, they calculate payment size to vary over time in one of many possible shapes or patterns, each representing a different normal cost method[3]:

  • For most non-actuaries, payment patterns other than level payments are not often experienced, and so are unfamiliar. Level payments are the norm when financing a car, a house, and in fact in most business transactions. Exceptions in the non-actuarial world of finance are relatively rare, and maybe not fully parallel. As two examples of such exceptions, in a sale of a small business the payment amount is sometimes set at least partially as a function of profitability, and inflation-linked bonds pay out a fixed coupon plus the current inflation rate, a varying term.
  • But most of the normal cost methods in use by actuaries generate streams of notional payments that have no analogue whatsoever in conventional financing. The differences are in two dimensions, the first being that they sometimes aren't even calculated as if they were required to be present value equivalent to the present value of future benefit payments. The second is that the resulting shape of the periodic payment amounts over time is most often anything but level- there may be small payments with negative amortization in early years followed by larger payments in later years, as one very common example.
  • Three of the many commonly used normal cost allocation or payment methods are computed by looking at the benefit formulas to determine the accrued liability and then deriving the normal cost from it (not by computing the present value of the liability and then finding the payment stream that is equivalent to its value). These methods are said to be benefit prorated.

Footnotes

  1. M. T. Wrightson et al. 1998, p.5
  2. B. Barsook, Ch. E. Platten, C. A. Vendrillo 2019, p.98
  3. M. B. Waring 2011, p.82

References

Author: Katarzyna Siedlarczyk