Definition of "amortization" in a multi-employer defined ben

[Guest nlipton]

Does anyone have a ready source that defines "amortization" in a DB plan context? I understand it to be how quicKly the unfunded vested liability is paid off, i.e., funded. Has anyone got a more detailed definition on this?

[MGB]

Amortization is a generic term meaning to pay something off with scheduled payments in the future. A mortgage is an amortization to pay for your house. The payments in the future may be structured in one of many different ways -- they may be level, increasing, decreasing, or variable (e.g., based on the then-current interest rates).

Most of the time the term is used with adjustments for interest. However, there are instances where the term amortization has been used without interest (e.g., financial accounting under SFAS 87), although this is a twisting of the term from what it is supposed to mean. A level amortization with interest adjustments at a fixed rate is the same as a level mortgage payment with a fixed rate of interest.

In the multi-employer context, it could be used in many different ways:

1. If you are talking about the minimum required contribution that the IRS requires the fund to receive each year, then the amortizations are level amortizations at a fixed rate of interest for a fixed number of years specified in the law (section 412 of the Code). Each change in liability is amortized from the date established for differing lengths of time depending on where the new liability originated from (e.g., plan amendment, experience gains and losses, etc.). Although this sets the minimum required to be contributed, the actual contributions may be more than this, which is then tracked as a "credit balance" against future minimum contribution requirements based on the given amortization schedules.

2. If you are talking about the maximum deductible contribution, the amortization periods are all 10 years from the date established, but may be combined together and/or "restarted" and reamortized at any time over a new 10 year period.

3. The plan may have a funding policy that falls between the minimum and maximum and may be defining its own amortization approach, but constrained between the minimum and maximum amounts required by law.

4. They may use the term in a generic sense: "The unfunded liability will be fully amortized in 8 years given the current rate of contributions."

[david rigby]

As usual, MGB's explanation is a good one.

A minor addition: amortization most often refers to the gradual repayment of a fixed dollar amount, a mortgage or the discussion in Item 1 being good examples.

Imagine a simple example, where a plan sponsor creates a new DB plan, and recognizes prior service. Immediately, the plan has created a liability, but has zero offseting assets. This fixed "Unfunded Liability" must be amortized. Most actuarial funding methods will amortize this fixed amount explicitly. Some methods will use an implicit amortization. Future adjustments to this, thru investment experience for example, will usually be amortized separately.

[Guest Keith N]

Both MGB & PAX offered good responses. I just wanted to add that in the multi-employer world a lot of actuaries calculate the number of years needed to "pay off" the current unfunded liability assuming the current contribution rate does not change. It helps the trustees understand the relationship between the expected contributions and the expected benefits. If the amortization period is rising from year to year, than the expected contributions may not be able to support the expected benefits. It's just a number to monitor (like the ongoing funding ratio) and as far as I know has no regulatory significance.

Typically you calculate how many years it will take for the expected contributions minus normal cost to amortize the UAL, assuming the valuation interest rate.