Guideline 4. Valuation methodology

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The valuation methodology is consistent with the social security scheme financing approach and enables the actuarial assessment of its sustainability measures or indicators. The actuary provides an opinion on the appropriateness of the methodology.

The choice of the methodology used to evaluate the situation of a social security scheme is often the responsibility of social security institutions. Legislation may specify at least some elements of the methodology to be used. Actuaries should advise the social security institution and, ultimately, policy-makers on the choice of valuation methodology and appropriate measures of financial soundness (the latter is discussed in more detail in Guidelines 42 and 43). Specific considerations in assessing the financial situation of new schemes as well as reformed schemes are covered in Guidelines 40, 41, 43 and 46.

Guideline code

ACT_00500

Mechanism

The social security institution should define funding objectives for the scheme and/or develop sustainability measures. This should be undertaken taking into account the content of Guideline 42 on funding and financing considerations, and Guideline 58 of the ISSA Guidelines on Good Governance.
The actuary should ensure that the valuation methodology properly reflects all sources of financing of the social security scheme, e.g. employers, employees and/or state contributions, earmarked general tax revenues, investment earnings, etc.
The actuary should determine the appropriate length of the projection period. While increasing the length of the projection period may lead to more relevant, accurate and appropriate results, the longer the period, the more uncertainty exists surrounding the projections of cash flows.
The actuary should make a decision whether open or closed group methodology should be used. Partially funded and pay-as-you-go (PAYG) schemes represent social contracts where, in any given year, current contributors allow the use of their contributions to pay benefits to current beneficiaries. As a result, such social contracts create claims for current and past contributors to contributions of future contributors. The proper assessment of the financial sustainability of a social security PAYG or partially funded system by different means (including through its balance sheet) should take into account these claims. The open group methodology considers contributions and benefits of current as well as future scheme participants and is considered to be most appropriate for PAYG and partially funded social security schemes. It can also be used for schemes whose objective is to fully fund benefits. The closed group methodology considers only current scheme participants and is appropriate only for schemes whose objective is to fully fund benefits.
In the case of actuarial valuations of schemes that are based on contingencies (e.g. defined benefit pension schemes, disability programmes, health systems, etc.), the valuation methodology should be based on cohort-wide cash flow projections that take into account the evolution of the age-gender structure of the scheme’s members and beneficiaries, as well as benefit provisions of the scheme.
The actuary responsible for the analysis should comply with national and/or international actuarial standards of practice and/or other relevant guidance, including IAA ISAP 2, that describe the methodologies to be used for actuarial valuations.

Parent

A. Valuation of Social Security Schemes

Structure

Principles

The social security institution should assess different valuation methodologies to determine their:

Appropriateness for actuarial assessment of the sustainability of the social security scheme and of actuarial measures;
Appropriateness for other goals of actuarial assessment such as, for example, analysis of adequacy and affordability of benefits;
Consistency with the scheme’s financing approach and funding policy;
Ability to assess whether the scheme’s funding objectives (e.g. stability of contribution rate, benefit security, contributions or benefits levels) are achievable.

The projection methodology should be flexible in order to be able to respond to potential changes in the system’s design (e.g. changes in benefits provisions, indexation methods, eligibility requirements, combination of different benefits, preferred service providers, etc.).
The social security institution should delegate the responsibility of assessing the appropriateness of valuation methodologies to actuaries or at least require formal actuarial advice on appropriateness of methodologies.
In the case of a legislated valuation methodology, the social security institution, with the assistance of actuaries, should review on a regular basis its appropriateness.
If the legislated methodology or any of its elements are found to be inappropriate, the social security institution should initiate the process of legislative amendments.

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