In respect of the financing of a social security scheme, the social security institution establishes a formal written funding policy which takes into account factors relevant to the scheme as well as the socio-economic context of the country. An actuary takes into account the funding policy while preparing any actuarial valuation of the social security scheme.
The purpose of a funding policy is to establish a framework for funding a social security scheme by taking into account factors relevant to the scheme. These factors include: benefit security and adequacy, stability and/or affordability of contributions, the evolution of demographic characteristics of the scheme’s members, the financial situation of the scheme, the legal provisions of the scheme, and any substantive commitments such as benefit indexation.
The funding policy provides guidance to the actuary in the selection of valuation methodologies and assumptions in accordance with actuarial standards of practice and respecting the scheme’s risk tolerance. The consideration of the funding policy by the actuary is essential to ensure that the funding objectives are met with respect to securing benefit levels and payments in line with the rules, and stability and sustainability of the contribution level.
- The social security institution must inform the actuary conducting the actuarial valuation of the scheme about its funding policy.
- In performing an actuarial valuation, the actuary should follow the formal funding policy. It is recommended that the actuary should clearly state in the report the funding policy that he or she has adopted in the actuarial assessment.
- In the absence of a funding policy for the scheme or in the case when there is only an informal funding policy, the actuary should clearly indicate in his or her report what funding policy he or she has assumed and his or her reasoning and judgement of why he or she has assumed such a policy.
- The desired level of pre-funding should be chosen with attention to the following considerations:
- A higher funding level is generally more suitable in situations where the expected future real rate of return on investments is higher than the expected real growth of wages, expressed as the sum of the employment growth and the real average individual salary growth. However, higher funding levels are only appropriate in situations where long-term and stable investment opportunities and investment management expertise exist;
- A high level of pre-funding is not suitable in countries with unstable macroeconomic conditions and/or limited investment opportunities. It is also not recommended to have a high funding level where there exist significant risks associated with high inflation, limited investment opportunities and insufficient investment management expertise, lack of investment governance resources and/or possible abuses of scheme funds;
- A lower funding level is more suitable in countries where the expected future real growth of wages is higher than the expected future real rate of return on investments.
- The level of pre-funding should be monitored and adjusted as the economic and demographic environment of countries evolves.
- The desired level of pre-funding is likely to vary according to the type of the social security scheme. For example, for a scheme providing post-retirement health benefits, the level of pre-funding depends on the contribution structure after retirement.
- Social security schemes often establish a ceiling of administrative expenses as a percentage of income or a percentage of investment income. In such cases, the level of funding automatically leads to an increased ceiling on the administrative expenses which might be viewed as unreasonable. The social security institution should be aware of this issue so that supplementary resources could be used for more pressing needs such as benefit improvements and/or enhancing financial sustainability of the scheme, and not on unjustified increases of administration expenses.
- The actuary should be involved in the development of the funding policy. In particular, the actuary should render assistance in assessing risks faced by the social security scheme (Guideline 33), degree of pre-funding of the scheme (asset liability management, Guidelines 21 and 22), affordability of contributions (Guideline 43), and adequacy of benefits and coverage (Guidelines 44 and 45).
- A funding policy should be a formal written document and be publicly available.
- The funding policy should define the scheme’s funding objectives, describe key risks faced by the scheme and identify funding volatility factors.
- The social security institution should seek an actuary’s input in any funding policy development and improvement.
- The desired funding level should take into account the demographic and economic environment of the country.
- It is necessary to consider affordability of contributions and benefit adequacy under the socio-economic status of the specific country.
- The funding policy should be established by striking the right balance between benefit adequacy, contribution affordability and sustainability over a long-term horizon.