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.
Related or Semi-related Video
Finance: What is a Pension?31 Views
finance a la shmoop. what is a pension? well it rhymes with tension, and likely
for good reason. if you're a teachers pension or a fireman's pension or [person wearing dark glasses writes something down]
another state employees pension that's backed up by a state that's going
bankrupt. Hi, California, Hi Illinois. well we're looking at you. all right people
well a pension is another term for a retirement fund. but what's special about
a pension is that the employer essentially forces you to put away money
for your retirement and then they invested for you.
how nice. or at least be sure you invest it well on a salary of 75 grand a state [gambling table shown]
employed ditch-digger might get a contribution of say 10 grand a year into
her pension, and that's each year 10 grand of forced savings for as long as
she you know digs ditches for the state. and in some states where the unions are
strong in the governing financial knowledge is weak the government
guarantees a minimum financial return on the pension investment made on behalf of
the employees. that is in California for example the state guarantees a 10% per
year return on their invested pension savings. if the invested return like [equation]
investing it in Wall Street and stocks and bonds and private equity funds and
all that stuff well if that invested return is less than that number less
than that 10%, then the state rights to the pinch and a check to cover the
incremental difference. yeah it's a huge Delta and it's well pretty much why you
a Californian Illinois you're going bankrupt remember. Jesus Saves
but Moses invests. [ Moses, holding stone tablets glares and demands interest]
Up Next
What is ERISA? The Employee Retirement Income Security Act (ERISA) of 1974 essentially codifies all of the rules and laws that pertain to the manag...
What is a 401(k)? A 401(k) is a retirement plan that is offered by many employers (government entities, however, use a 403(b) plan). These plans us...