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Using this method, the NCPs are adjusted each year based on actual numbers and incorporate changed assumptions and benefits. Gains and losses arising from retention rates therefore are clearly under DoD control, while interest rates are not.

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One can argue that gains and losses arising from factors outside DoD control be assigned to Treasury. These issues are discussed further in Hix and Taylor, However, adjustments are likely to be larger for more recent cohorts, so the effective amortization period is probably longer. This adjustment period partially protects the accrual contribution from undue volatility. The second method for adjusting the payment stream is to establish a DoD side-amortization account--similar to the current Treasury account--that receives the DoD portion of gains or losses.

In this case, the amortization period can be set by assumption, and the new NCP is calculated as in the first method but eliminates that portion of the gain or loss being amortized. If the data vary little over the years, the two techniques will produce similar accrual contributions. However, if retention, COLAs, pay growth, and interest rates vary significantly, then the typical cohort method is likely to generate substantial annual gains and losses.

In situations with greater levels of variance, cohort accounting has an advantage in terms of providing incentives. Research has established that cohort retention rates can differ substantially depending on the demographic composition of the cohort, its size, the retirement benefits available, and its particular retention and promotion history. Using such information could reduce the gains and losses encountered each year.

Creating incentives to incorporate retirement costs is more important in manpower systems that exhibit large variance in key parameters. These changes can imply rapid changes in manpower costs that require policy intervention to keep those costs at appropriate levels. The cohort method has strong advantages here also. In addition, planners can be provided with easily run algorithms that can produce accurate estimates of the effect of different personnel plans on accrual contributions.

Thus, budget planners probably will include the accrual calculations because they will change year to year in response to policy; this is possible because the methods use straightforward computations. However, large differences in service-specific liabilities result both from differing probabilities of enlisted and officer cohorts reaching retirement and different mixes of officer and enlisted personnel.

For instance, Figure 3. Somewhat smaller--but still significant-- differences exist for officers across services. NCPs and therefore accrual contributions are extremely sensitive to both categories of assumptions. Figure 4. Interest and COLA assumptions also show strong effects, albeit less than that of pay growth. If these parameters had been historically constant, then the sensitivity would not be an important issue. However, each of the economic assumptions, as well as retention rates, displays substantial variance over the past 20 years, and it is not unreasonable to assume they will continue to do so.

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Assumptions involve two distinct time periods--near and long term. For some parameters, long term projections extend for 40—50 years. The distinction between the periods is important for two reasons.

The Accrual Method for Funding Military Retirement

First, near-term values are easier to predict than long-term values, and different methods should be used to generate them. Second, accrual contributions are more sensitive to changes in a near-term annual value in a given year. For instance, a 5-percent pay raise tomorrow affects contributions more than does a similar raise five years from now. The history of assumptions has shown significant differences between actual values and assumptions, as Figures 3.

For an actuarial system designed only to ensure payments, the emphasis is not on whether individual parameters are in error so much as whether the net effect of the assumptions produces significant misfunding.

The Accrual Method for Funding Military Retirement: Assessment and Recommended Changes (2001)

Errors in individual assumptions may not be serious because they can be changed gradually to restore sound funding. In these types of systems, assumptions are seen as the control mechanisms to guide the fund to avoid substantial misfunding. But in an accrual system where annual accuracy is necessary to reflect true costs and provide incentives, accurate projections of each parameter are important.

If prospective policies were automatically included in near-term retention estimates, then planners could institute policies for the explicit purpose of reducing near-term contributions at the expense of raising long-term contributions. Judgments therefore must be made by an independent and impartial group regarding whether prospective policies are likely enough to be implemented that including calculations regarding them would improve the accuracy of near-term estimates.

Those making these judgments should consider whether the policies are part of a broader policy framework extending beyond specific services, as well as the track record of individual services in carrying out previous policies. Drawdown, for instance, is a clear congressional and administration policy addressing the apparent collapse of the Warsaw Pact threat.

While the specific details and retention effects of the policy may not be predictable with great accuracy, recognizing some part of the drawdown would provide more-accurate projections than would ignoring it. These judgements are better made by labor economists with expertise in military-personnel labor markets than by actuarial scientists.

As part of the budget process, prospective policies are often provided in detail over the following six years. For instance, end strengths, pay levels, and personnel force structures are routine parts of budget submissions.

Automatic incorporation of these policy effects into accrual assumptions may not be warranted. However, ignoring these effects will probably lead to more inaccuracy than their incorporation would. These effects have been thoroughly researched, and more- accurate projections can result from incorporation of the results.

Again, the expertise to make these judgments lies in the economic rather than actuarial community. Improved Economic Models Near-term projections of economic parameters might be improved through incorporation of information and predictions arising from macroeconomic models, or estimation through time-series analysis of separate relationships between these parameters and other, more easily predicted parameters.

The longer-term projections of these parameters might also be improved, although accurate longer-term projections from econometric models are more problematic.

Finally, the models and assumptions used to produce future projections should be internally consistent. For instance, falling or rising interest rates usually occur in conjunction with particular phases of the economic cycle. Economic cycles markedly affect retention and likely would affect pay raises and COLAs.

Projections of each of these parameters should show an internal consistency that flows from a common future economic scenario. The governing body for the accrual method should include members from wider disciplinary backgrounds with its actuaries. Actuarially sound funding methods are still required for the system, but improvement in accuracy of estimates and management incentives requires the participation of those possessing the above skills. The reconstituted governing board should maintain an independence from the DoD, as the present board has.

This independence is preserved by long terms of service, appointment by the President, and accountability to Congress. The interpretation selected accrued all gains and losses to the Treasury. No provision was made for a side-amortization account or other procedure to assign gains or losses to DoD. In the long term, the absence of a DoD side account or equivalent procedure is inconsistent with the goal of having DoD assume full responsibility for all retirement liabilities after 60 years. Such an account would have to be created.

Creating it now makes sense, because it strengthens incentives for improved management. Without such an account or procedure, policy changes that are not prospectively anticipated in accrual calculations will not affect DoD contributions. It means, for instance, that the total change in liabilities for an unanticipated drawdown or force buildup would fall to Treasury. Such a procedure actually produces perverse incentives within DoD to produce losses that get assigned to Treasury.

For these reasons, we believe the method of amortizing gains and losses to the system in the absence of moving to a cohort method should be changed to include a DoD amortization account or equivalent procedure that reflects changes due to service after October 1, The cohort- specific entry-age normal method provides a way to incorporate gains and - 55 - losses into future NCPs, and a side account would be unnecessary.

If a side account is set up, the amortization period for this account should probably be set much lower than the Treasury amortization account, to provide more-rapid feedback and strengthened incentives for efficient management of manpower. These subsidies reduce the incentives for the Air Force to restrain seniority. However, the services experience considerable uncertainty whether future gains will be recaptured, because such depends on the fiscal environment and negotiations between DoD, OMB, and Congress.

Moreover, historical precendent indicates that previous major gains were considered to revert to OSD rather than to the services. The length of the amortization period is critical to establishing management incentives.

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  5. The current year period used for amortization of Treasury payments would provide virtually no incentive if used for DoD gains. The Board has suggested both a method of recapturing DoD gains for service after and a method for amortizing those gains. Alternative methods have also been suggested Hix and Taylor, The only way to make accrual gains and losses fungible at the service level is to create an advance-funding system.

    This would increase the deficit or decrease the budget surplus in the short run, but would have several benefits in the longer term. First, it would probably cover part of its costs through more-efficient personnel management. Second, it would remove the intergenerational transfers implicit in the current method. These transfers can place future retirement payments at more risk because of their dependence on future generations to pay the obligations.

    Burdened with social security obligations, future generations may opt to reduce benefits through lower COLAs rather than pay the full implicit benefit.

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    Advance funding when budget surpluses are possible would protect future benefits from such risks. Presumably, this movement is fueled by concerns for efficiency and the risk of large, uncertain future obligations. This will make the military retirement system increasingly visible, probably increasing the future political risk associated with retirement benefits.

    Advance funding would ease the transition to such defined contribution systems. Fourth, military-compensation research suggests that a more costeffective mix of personnel could be produced by higher retention of those with years of service and reduced retention of those with Asch and Warner, a. Alternative military retirement systems have been proposed to achieve this Asch and Warner, b.