the accrued liability and the normal cost
/ AAL = "A-A-L" /
Imagine you run a defined-benefit pension and you ask two natural questions. First: of all the pension we have promised so far, how much should we already be holding today? Second: how much new promise is each member earning this year that we should set aside for? These two questions are answered by the accrued liability and the normal cost — the backbone numbers of pension funding.
The accrued liability (actuarial accrued liability, AAL) is the present value today of the benefits members have already earned through past service. The normal cost (also called service cost) is the present value of the benefits being earned in the current year alone. Roughly, the present value of all future benefits is split into a part attributed to the past (the accrued liability, which should ideally be matched by assets) and a part for the future (funded year by year through normal cost plus interest). For example, if a member's total promised pension has a present value of 200,000 and they are halfway through their career, the accrued liability for that member might be about 100,000, with this year's slice being the normal cost.
These two numbers drive everything in DB funding. The accrued liability compared with the plan's assets tells you the funded status; the normal cost tells the employer the ongoing yearly contribution for benefits being earned. Exactly how the total is divided between past and future depends on the actuarial cost method chosen. The honest caveat: the accrued liability is not a fact but an estimate — it depends heavily on the discount rate and other assumptions, so the same promises can show a very different accrued liability under different (and sometimes self-serving) assumptions.
A plan promises 1,000 a month from age 65. A member aged 45, halfway through a 40-year career, has 'earned' about half of that promise so far. The present value today of that earned half is her accrued liability; the present value of the additional slice she will earn this year (one more year of service) is her normal cost. Add up every member and you get the plan's total accrued liability and total normal cost.
Accrued liability = the past already earned; normal cost = this year's new slice.
The accrued liability is an estimate, not a measured fact. Lower the discount rate and the same promises look much more expensive — so always ask what assumptions a liability figure rests on before comparing plans.