Normal Cost

In Detail

Normal cost represents the portion of a pension plan's annual expense attributable to benefits being earned in the current year by active employees. It is distinct from the amortization of unfunded liabilities, which addresses past shortfalls. Think of normal cost as the "current year's tab" — the cost of one more year of service for all active plan members. For a plan where employees earn 2% of salary per year of service, the normal cost is roughly the present value of that 2% increment for all active members.

Normal cost is typically expressed as a percentage of covered payroll. For most defined benefit plans, normal cost runs between 10-25% of payroll, depending on the plan's benefit formula, employee demographics, and actuarial assumptions. The employer's annual required contribution equals the normal cost plus the amortization payment on any unfunded liability. When employers fail to pay the full annual required contribution, they are effectively underfunding the plan for the current year, adding to the unfunded liability.

Monitoring whether a plan's sponsor is paying at least the full normal cost provides insight into the sponsor's commitment to maintaining the plan's financial health.