Alternative Minimum Cost Method

  

A brief aside into music history before launching into a discussion of pension funding.

In the 1990s, a musical genre known as "alternative" became very popular. It was known as "alternative" because it was guitar-based rock-style music, but in approach and spirit, it set itself apart from the mainstream popular guitar-based rock music that dominated the charts, stuff like Guns N Roses and the pretty-boy hair bands of the day. By the end of the decade, though, the Guns N Roses types had faded from the scene and the only rock music left standing were the alternative bands, with groups like Pearl Jam and REM representing some of the most popular performers in the world. The music was still called alternative, even though it was actually just mainstream rock at that point.

Okay, on to pensions...

The alternative minimum cost method is a way to figure out how much money is needed to fund a pension plan. The name has "alternative" in it, but (like those popular alternative bands of the 1990s) the process actually represents the main proscribed way to make these calculations. In 1974, Congress passed a bill called the Employee Retirement Income Security Act, or ERISA. This put guidelines in place for how pension plans had to be funded. One of the results was that most companies started using the alternative minimum cost method for their calculations.

Basically, this technique uses demographic information to figure out how to fund the pension accounts of individual employees. There are two versions of the method and the pension fund can choose whichever one has the lower cost. Hence the name "alternative minimum cost method." The pension plan is selecting the method with the minimum cost among two alternatives.

The details of the two methods are things only an accountant could love. They involve complicated number crunching and the difference between them relates to the numbers being crunched. Just to give you the names of the two methods, though: there's the actuarial cost method and the accrued cost method.

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Finance: What is ERISA?7 Views

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finance a la shmoop what is ERISA ERISA

00:07

wasn't that the actress Milano or something from charmed and maybe not

00:12

well ERISA actually stands for Employee Retirement Income Security Act

00:17

yeah next name there which was lovingly created by yes the Nixon clan in 1974 [picture of President Nixon]

00:23

about a week after Watergate it essentially established minimum

00:27

standards or guidelines for pension plans in the United States and believe

00:31

it or not before this act companies essentially did not have to disclose to

00:36

their employees how well or poorly their pension investments had been doing all

00:40

along the way sort of a hidden set of numbers until well one day the [pension papers going into a filing cabinet]

00:44

beneficiary retired and was more or less cashed out well here's what you got good [older guy casting a fishing rod]

00:49

luck have fun in your two and a half years of expected lifetime after [$50 check passing hands]

00:52

retirement weirdly pension funds were actually

00:55

managed by the corporation that made whoopee cushions or whatever they made

00:59

because of course it assumed that if it was great at making whoopee cushions [whoopie cushions in a production line]

01:03

well then it would also be great at buying and selling stocks in the global [stock floating across world map]

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stock market marketplace yeah not so much

01:11

so specifically ERISA codified or structured the way in which pension

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funds are created and managed in the United States it made them voluntary

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that is you are no longer forced to save money in a structure in which the [money going into piggy bank]

01:25

company managed your retirement savings and by the same token it did away with

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the government's requirements formerly of the company having to have pension [gov't mandated pension plan paper getting ripped]

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funds in the first place like they didn't need them anymore wasn't a

01:37

requirement additionally the features benefits and the whole notion of

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fairness in terms of how the pension fund monies were earned retained vested

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into and then distributed well it all had to be written down yes that was like

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a new thing back then in a rational logical way so that employees would not [guy writing in binder]

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end up being screwed under the yoke of unscrupulous managers in a lousy company

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ERISA only exists for corporations that is it's not something that government

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uses nor religious organizations nor other structured health things like

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workers comp unemployment or disability insurance and all of this only works if

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you and your they are in the good ol US of A there is [US map with whoopie cushion business man]

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in fact a Somalian corporate retirement plan but we're pretty sure you wouldn't

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like it

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