600 Chapter 16 pension plans work by investing enough money while employees are working so that the money in vested, plus the investment income it earns over the years, will be sufficient to pay the workers their retirement incomes once they have retired There are many complicated assumptions estimates, and calculations needed to determine how much money a state should invest in its pension fund each year. One of the most important assump tions is the rate of return the plan's investments will earn in the future. As you have seen in this chapter. the higher the rate of return used to calculate the present value of future cash flows, the lower the pres ent value will be. To determine a pension plan's funded status, actuaries (1) estimate the future cash puyments expected to be made to employees. (2) calculate the present value of those cash flows using an assumed rate of return this present value is the gross liability of the fund), and (3) subtract the amount of money that has been invested from the gross liability calculated in step 2 (this amount is the funded status of the pension plan), Essentially, this is the same as calculating the net present value of an investment. If the plan has less money in its investments than the present value of its estimated future cash nows, it has a net liability and is considered to be underfunded by that amount Many states' pension plans have assumed they will earn 8 percent or more on their investments, even though many experts think a more appropriate assumption would be 6.5 percent. As an example, Virginia used un assumed rate of return of 7.5 percent in 2009 but reduced the rate to 70 percent in 2010. In 2014. Actual investment returns can vary widely. In 2016, Virginia's actual return on its pension assets was only 1.9 percent, but in 2017 it was 12.1 percent Virginia paid out approximately $4.5 billion in benefits to retirees in 2017, Required Assume Virginia's annual payments will continue to be $4.5 billion, and the retirees will receive benefits for 20 years on average. Using an assumed rate of return of 8 percenticulate the liability of the state's pension plan. The liability is the present value of the future cuinaments. (Be aware that the real world calculation for a state's pension plan liability involves more assumptions than just these two.) b. Assume the annual payments will continue to be 54.5 billion, and that retire all receive benefits for 20 years on average. Using an assumed rate of return of 6 percent calculate the liability of the state's pension plan c. Reviewing your answers from Requirements a and b, provide an explanation as to why states muy wish to assume a higher rate of return on their pension plan's investments than actuaries might recommend vestment decision ANALYZE, THINK, COMMUNICATE ATC 16-1 Business Application Case Pension planning in state governments In recent years, there has been a lot of media coverage about the funding status of pension plans for state employees. In many states, the amount of money invested in employee pension plans is far less than the amount estimated to pay employees the retirement benefits they have been promised. Basically 600 Chapter 16 retirement incomes once they have retired. vested, plus the investment income it earns over the years, will be sufficient to pay the workers the pension plans work by investing enough money while enployees are working so that the money There are many complicated assumptions, estimates, and calculations needed to determine how much money a state should invest in its pension fund each year. One of the most important awum tions is the rate of return the plan's investments will earn in the future. As you have seen in this chapter the higher the rate of retum used to calculate the present value of future cash flows, the lower the pres ent value will be. To determine a pension plan's funded status, actuaries (1) estimate the future cu payments expected to be made to employees, (2) calculate the present value of those cash flows amount of money that has been invested from the gross liability calculated in step 2 (this amount is the amousumed rate of return (this present value the the cross liay diary of the funds) , and (3) subtraction funded status of the pension plun). Essentially, this is the same as calculating the net present value an investment. If the plan has less money in its investments than the present value of its estimated future cash flows, it has a not liability and is considered to be underfunded by that amount Many states pension plans have assumed they will earn 8 percent or more on their investment even though many experts think a more appropriate assumption would be 6.5 percent. As an example, Virginia used an assumed rate of return of 7.5 percent in 2009 but reduced the rate to 70 percent 2010. In 2014, Actual investment returns can vary widely. In 2016, Virginia's actual return on its pension assets was only 19 percent, but in 2017 it was 12.1 percent. Virginia paid out approximately $4.5 billion in benefits to retirees in 2017. Required 2. Assume Virginia's annual payments will continue to be $4.5 billion, and that retirees will receive benefits for 20 years on average. Using an assumed rate of return of 8 percent, calculate the liabiliny of the state's pension plan. The liability is the present value of the future cash payments. (Be aware that the real-world calculation for a state's pension plan liability involves many more assumption than just these two.) b. Assume the annual payments will continue to be $4.5 billion, and that retirees will receive benefits for 20 years on average. Using an assumed rate of return of 6 percent, calculate the liability of the state's pension plan e. Reviewing your answers from Requirements a and b, provide an explanation as to why states may wis to assume a higher rate of return on their pension plan's investments than actuaries might recommend