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Actuarial Audits: Figuring Out What Is Right For You

Roeder Financial       September 2010

Completing an actuarial audit is like going to the dentist’s office: The task is needed but nobody looks forward to it! There is one obvious reason to have an audit: to discharge your plan’s fiduciary duty that the computed rates and liabilities are reasonable. However, there are two more subtle reasons to have an audit. On a positive note, an audit can improve a process that is already solid. Even if so, the actuarial process is complicated and it is not unusual for a couple improvements to emerge from an audit.

Another advantage of an audit is to keep the skeptics and political wolves at bay. The bear market that started in 2001 has caused actuarial rates to increase. There can be an innate skepticism by the public in accepting the increasing rates in Actuary A’s report due to the many assumptions of anticipated activity in coming decades. Getting Actuary B to opine on the validity of the actuarial process can go a long way toward quelling such skepticism and, in some cases, discontent.

There is a more subtle reason to have an audit. Suppose you have confidence in the ability of your actuary and feel comfortable that he/she has acquired knowledge of the complexities of your system over time. You might actually even like your actuary and not immediately want to get off the phone when he/she calls! An audit is actually a way to help retain your actuary for a longer period of time without breaching your fiduciary duty. In the absence of an audit, there will be more pressure to periodically replace your actuary as part of your quality control process. You may not want to throw out the baby with the bath water!

There are three different levels of an actuarial audit depending on the rigor needed.

Level A: Consists of a review of the last three actuarial valuations. The review would opine on internal consistency of recent results and the reasonableness of assumptions without any in-depth analysis of actual experience. The review would also take into account the assumptions used by the system’s peer group. Last, the review would ensure that the plan provisions in the actuarial report summary are accurate.

Level B: Level A work is included but there is more detailed analysis. The incumbent actuary would provide the auditor with “sample life” data so that the reviewer could opine on the reasonableness of the actuarial numbers for a small, carefully selected group of participants. The most recent experience study would be analyzed to see if the assumptions are consistent with actual experience. If employee contribution rates are actuarially determined, there would be an analysis of such rates.

Level C: Level A and Level B work is included. There is also a parallel valuation that is done from scratch. The plan sponsor provides the same raw data that was provided to the incumbent. Results are compared from the two valuations. If the present values and the rates are close, then the incumbent’s actuarial results are affirmed. If not, the differences are analyzed and resolved between the incumbent and the auditor. Any unresolved differences are reported to the sponsor.

The fee differential in the different Levels is wide. It would not be unusual for Level B fees to be 4 times Level A fees or for Level C fees to be 10-15 times those of Level A.

There is another factor that needs to be considered in the actuarial audit process. To many laypeople, the actuarial process is complex and befuddling. Thus, it is difficult to know how balanced the audit process is. If there is a concern that the auditor will be overly critical or picayune, the auditor can be prohibited to become the incumbent actuary for a period of time after the audit is completed, say 2-5 years. This is a judgment call that has both pros and cons. The pro is that it reduces the temptation for an unethical actuary to be unduly critical. The con is that the knowledge gained by the auditor could be invaluable if they were to become the next incumbent.

We recommend that some form of actuarial audit be completed every 3-5 years. A parallel valuation should be done at a less frequent interval. The need for a parallel valuation will be a function of the length of tenure of the incumbent. When a new incumbent is selected, many functions of an actuarial audit are completed during the transition process.

When you leave the dentist’s office, it is a good feeling that you got a distasteful duty out of the way. Hopefully, completion of an actuarial audit will leave you with the same good feeling!

Rick Roeder, FSA

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