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Target Cost

The parameters of the Target Cost dialog box pertain to the target cost methodology of Forecast Analysis.   Target cost analysis involves defining a funding target and a contribution pattern, selecting a period in which to reach the target and, in a Stochastic Forecast, selecting a level of conservatism (aka a confidence level).   The target cost is the percentage of pay required to achieve a prescribed funded status at the end of a given time interval (aka the funding horizon).  This calculation is separate from determination of actual (experience) employer contributions for the forecast period.  Essentially, target cost output facilitates obtaining the percentage of pay required to reach a funded ratio for each year in the projection period without running a separate forecast for each year.    

For purposes of the target cost calculation, a "simplified" scenario is presumed with respect to parameters that affect employer contribution amounts and cash flow (and thus asset values at each valuation date in the forecast period).  Overrides and settings for constraints on the employer contribution are ignored, it is assumed that no expenses are paid from plan funds and, in the U.S. qualified mode, no IRC section 420 asset transfers occur.  For the most part, these "simplifications" are necessary to avoid circular logic.  For example, if an expense is a function of assets (e.g., administrative expenses set to a fraction of assets) and the asset value changes because of a different contribution level, the expense would also change, changing the asset value, which would then require a different level of contributions to meet the target, and so on.  To take account of these items, or for greater precision in the results, separate Deterministic Forecasts could be run for each year, but the approach is not viable stochastically.

To check the target cost results (for a level contribution pattern), run a forecast using the target cost percentage output in a "Percentage of Payroll" Contribution Policy.  In a Deterministic Forecast, the target cost is "correct" if the funded ratio target is met in the year the target cost rate was calculated (i.e.,  at the funding horizon).  In a Stochastic Forecast, the target cost is "correct" if, at the chosen funding horizon, the desired funded ratio is greater than all funded ratios below the selected confidence level.  While the existence in the forecast of, for example, asset-related expenses may cause the target cost to not exactly meet this "correct" criterion, the relative target cost of alternative scenarios (e.g., asset mixes) is still a valid risk/reward indicator.        

The target is expressed as a funded ratio: the market value of assets divided by a liability value. Select the desired Liability type, which can be any of the following funding liabilities:

or any of the following accounting liabilities:

Select the desired Target liability funded ratio (enter as a percentage, not a decimal fraction – e.g., 100, not 1, for 100%). The target cost will be calculated such that if the target cost percentage of total payroll (which percentage is displayed in the forecast output under the “target cost” variable) indicated by the contribution pattern is contributed through the forecast year for which it is displayed, the market value of assets will grow to meet (by the valuation date in that year) the desired liability funded ratio, based on the specified type of liability.

Choose the desired Contribution pattern, either a level or a variable percentage of payroll. For a variable pattern, also enter the desired annual Relative Contribution as a multiple of the target cost percentage of payroll and enter, in the From and To columns, the years to which they apply. For example, suppose the (baseline) valuation date of the forecast is 1/1/2018 and you enter the following:

From To Relative Contribution
-- 2019 0
2020 2023 1
2024 -- 2

With these parameter settings, ProVal will solve for the level percentage of total payroll (i.e., of the value displayed for the forecast output variable “total salary”) to fund the chosen liability over the time horizon – but with no contributions during 2018 and 2019 and contributions in 2024 and later years at a rate that is twice the contribution rate (as a percentage of payroll) of years 2020 through 2023.

Because percentile results are available from a Stochastic Forecast, a confidence level can be introduced. For example, consider the following case. Suppose the employer would like to be 70% confident that the plan will be 100% funded at the end of ten years. First we need to decide which liability type to use and to find out what contribution pattern the employer wants. Assuming that ABO is used as the measure of the liability and that level funding is desired, we could then calculate the target cost level as follows:

  1. Set the target Liability type as ABO and the Target liability funded ratio at 100%; select a level contribution pattern.

  2. Run the Stochastic Forecast and view the 10th year, 70th percentile, value of the target cost.  This is the level contribution for the ten-year period (expressed as a percentage of payroll) that gives the plan a 70% chance of being at least 100% funded on an ABO basis by the end of 10 years.

Employers might use target cost analysis for any number of reasons, including to: