Report to Congress 

on 

The Effect of the Full Funding Limit 

on Pension Benefit Security 

Department of the Treasury 

May 1991 
Report to Congress 

on 

The Effect of the Full Funding Limit 

on Pension Benefit Security 

Department of the Treasury 

May 1991 
DEPARTMENT OF THE TREASURY 

WASHINGTON 

ASSISTANT SECRETARY 

May 1991 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

u.s. House of Representatives 

Washington, D.C. 20515 

Dear Mr. Chairman: 

Section 9301 of Public Law 100-203, the Omnibus 

Budget Reconciliation Act of 1987, provides that the 

Secretary of the Treasury or his delegate shall conduct a 

study of the effect of amendments made by that section to 

section 412(c) of the Internal Revenue Code of 1986 

(concerning the full funding limitation on defined benefit 

plans) on pension benefit security. 

Pursuant to that directive, I hereby submit "Report 

to Congress on The Effect of the Full Funding Limit on 

Pension Benefit Security." 

I am sending a similar letter to Representative 

Bill Archer. 

Enclosure 

Sincerely, L() 7.> 

~- Gideon 

Assistant Secretary 

(Tax Policy) 
• 

DEPARTMENT OF THE TREASURY 

WASHINGTON 

SISTANT SECRETARY 

May 1991 

The Honorable Lloyd Bentsen 

Chairman 

Committee on Finance 

United States Senate 

Washington, D.C. 20510 

Dear Mr. Chairman: 

Section 9301 of Public Law 100-203, the Omnibus 

Budget Reconciliati on Act of 1987, provides that the 

Secretary of the Treasury or his delegate shall conduct a 

study of the effect of amendments made by that section to 

section 412(c) of the Internal Revenue Code of 1986 

(concerning the full funding limitation on defined benefit 

plans) on pension benefit security. 

Pursuant to that directive, I hereby submit 

"Report to Congress on The Effect of the Full Funding Limit 

on Pension Benefit Security." 

Packwood. 

Enclosure 

I am sending a similar letter to Senator Bob 

Sincerely, . 

puJ P~h- Kenneth W. Gideon 

Assistant Secretary 

(Tax Policy) 
TABLE OF CONTENTS 

CHAPTER 1: EXECUTIVE SUMMARY 

I. 

n. 

BACKGROUND OF THE REPORT 

A. 

B. 

c. 

D. 

Mandate for Study 

Pensions and Retirement Savings 

Defined Benefit and Defmed Contribution Plans 

Tax Rules Governing Defined Benefit Plans 

SUMMARY OF THE REPORT 

A. 

B. 

c. 

Pension Funding and the OBRA 87 Limit 

Evidence from the Data 

Policy Options 

CHAFfER 2: PENSION FUNDING AND THE OBRA 87 LIMIT 

I. 

II. 

INTRODUCTION 

A. 

B. Tax Treatment of Defined Benefit Plans 

Pension Funding Limits 

PENSION FUNDING 

A. 

B. 

c. 

D. 

E. 

The Nature of the Tax Benefit 

The Tax Benefit of Pension Funding 

A Complete Pension Population 

Pension Funding for a Complete Population 

Tax Benefits for a Complete Population 

- 1-

Page 

1 

1 

1 

1 

1 

2 

3 

4 

4 

5 

7 

7 

7 

7 

8 

8 

9 

15 

16 

21 
Table of Contents - Continued 

ID. PENSION FUNDING LIMITS 

A. 

B. 

c. 

Before OBRA 87 

Funding Limits in The Example 

Effects of Actuarial Assumptions 

IV. OBRA 87 Full Funding Limit 

A. 

B. 

c. 

D. 

E. 

The Limit 

Effects of the OBRA 87 Limit: "Correct" Actuarial 

Assumptions 

Effects of the OBRA 87 Limit: Older Population 

Effects of the OBRA 87 limit: Low Discount Rate 

Effects of the OBRA 87 Limit: Annuitized Benefits 

Page 

23 

23 

25 

27 

30 

30 

31 

35 

35 

40 

CHAPTER 3: EMPffiiCAL EVIDENCE ABOUT THE FULL FUNDING LIMIT 45 

I. 

n. 

INTRODUCTION 

HOW FUNDING RATIOS ARE DISTRIBUTED 

A. 

B. 

c. 

D. 

The Distribution 

Benefit Formula 

Actuarial Funding Methods 

Factors That Affect Accrued Liability 

m. THE OBRA 87 FULL FUNDING LIMIT 

A. 

B. 

c. 

D. 

Plans Affected by the Limit 

Degree of the Effect 

Why Plans Are Affected by the OBRA 87 Limit 

Effect on Funding Levels and Benefit Security 

-11-

45 

45 

45 

49 

50 

54 

56 

56 

57 

59 

66 
Table of Contents - Continued Page 

CHAPTER 4: OYfiONS FOR FURTHER CONSIDERATION AND ANALYSIS 71 

I. MAINTAIN CURRENT LAW 

A. Advantages 

B. Disadvantages 

II. ALLOW ELECTION OF A PROJECTED LIABILITY LIMIT, 

71 

71 

71 

AND REDUCE CURRENT LIABILITY Lll\flT 72 

A. Advantages 

B. Disadvantages 

m. ALLOW ELECTION OF PROJECTED LIABILITY LIMIT, 

72 

73 

WITH NO REDUCTION IN CURRENT LIABILITY LIMIT 73 

A. Advantages 

B. Disadvantages 

GLOSSARY 

APPENDIX A: SYNOPSIS OF FEDERAL TAX LAWS RELATING TO 

PENSIONS 

I. TAX TREATMENT OF CONTRIBUTIONS, EARNINGS AND 

WITHDRAWALS 

A. Contributions 

B. Earnings 

C. Withdrawals 

-111-

73 

74 

75 

79 

79 

79 

79 

80 
., 

Table of Contents - Continued 

n. LIMITATIONS ON TAX PREFERENCES 

A. 

B. 

c. 

Contribution and Funding Limits 

Limitations on Withdrawals 

Non-discrimination Rules 

APPENDIX B: DESCRIPTION OF DATA AND METHODS USED IN 

CHAYfER 3 

L DATA SOURCES 

ll. MATCHING AND WEIGHTING 

m. IMPUTATION PROCEDURES 

A. 

B. 

c. 

D. 

E. 

Actuarial Method 

Discount and Salary Assumptions 

Percentage of Current Liability For Active Employees 

Construction of the Age Index for Active Employees 

Accrued Liability 

IV. METHOD FOR ESTIMATING DISTRIBUTIONS 

V. ADJUSTED CURRENT LIABILITY 

BffiLIOGRAPHY 

-ivPage 

81 

81 

83 

84 

87 

87 

88 

88 

88 

89 

89 

89 

90 

91 

91 

93 
CHAPTER 2: 

2.1 

2.2 

2.3 

2.4 

2.5(a) 

2.5(b) 

2.5(c) 

2.6 

2.7 

2.8(a) 

2.8(b) 

LIST OF F1GURFS 

Effect of Special Tax Treatment on the Cost Per 

Dollar of Payment at Age 65 

Pension Funding: Assets as Percentages of the 

Present Value of Future Benefits at each Age 

Distributions of Current Ages and Ages Hired for 

Active Employees After 25 Years 

Funding Ratios: Assets over Current Liabilities, 

Single Cohort of Employees Hired at Age 30 

Funding Ratios: Assets over Current Liabilities 

Complete Plan Population 

Annual Contributions under Methods 1 and 2 as 

Percentages of Contributions Under Method 3 

Tax Benefit Per Dollar of Long-Term Pension Cost 

Complete Plan Population 

Effect of a Lower Actuarial Discount Rate 

Assumption on Pre-OBRA 87 Funding Ratios 

Annual Contributions at 6 Percent Discount Rate as 

Percentages of Contributions at 7 Percent Discount 

Rate 

Effects of OBRA 87 on Funding Ratios Under 

"Correct" Actuarial Assumptions 

Contributions With OBRA 87 Limit as Percentages 

of Contributions Without the OBRA 87 Limit 

2. 9(a) Effects of OBRA 87 on Funding Ratios for an 

Older Pension Plan 

-vPage 

10 

12 

17 

19 

20 

22 

24 

28 

29 

33 

34 

36 
I . 

List of Figures - Continued 

2.9(b) 

2.10(a) 

2.10(b) 

2.11(a) 

2.11(b) 

CHAPTER 3: 

3.1 

3.2 

3.3 

3.4 

3.5 

3.6 

3.7 

Effects of OBRA 87 on Contributions for an Older 

Pension Plan 

Effects of OBRA 87 on Funding Ratios for Plan 

That Uses a 6 Percent Discount Rate in 

Years 2-26 

Effects of OBRA 87 on Contributions for Plan That 

Uses a 6 Percent Discount Rate in Years 2-26 

Effects of OBRA 87 on Funding Ratios for Plan 

That Buys Private Annuities 

Effects of OBRA 87 on Contributions for Plan That 

Buys Private Annuities 

Distribution of Funding Ratios in 1989: All Private 

Single Employer Pension Plans 

Distributions of Funding Ratios in 1989: Effect of 

Benefit Formulas 

Distributions of Funding Ratios in 1989: Effect of 

Actuarial Funding Methods 

Distributions of Accrued Liability in 1989: Effect 

of Actuarial Funding Methods 

Distributions of Accrued Liability and Lower 

Funding Limits for Earnings Based Plans 

Effect of Actuarial Factors on Accrued Liability 

Distribution of Funding Ratios in I 989: Effect of 

OBRA 87 

-VIPage 

37 

38 

39 

42 

43 

46 

48 

52 

53 

58 

64 

68 
CHAPTER 2: 

2.1 

CHAPTER 3: 

3.1 

LIST OF TABLES 

A Pension Population Over Time 

Estimated Distributions of Factors That Affect 

Accrued Liability for Earnings Based Plans 

in 1989 

3.2 The Effects of Funding Methods on Whether 

Earnings Based Plans Were Affected by the 

OBRA 87 Limit in 1989 

3.3 Median Actuarial Factors for Earnings Based Plans: 

Plans Affected Compared to Plans Not Affected by 

the OBRA 87 Limit 

-vnPage 

14 

55 

60 

62 
CHAPTER 1: EXECUTIVE SUMMARY 

I. BACKGROUND OF THE REPORT 

A. Mandate for Study 

This report was prepared in response to a Congressional mandate. Section 9301 of the 

Omnibus Budget Reconciliation Act of 1987 (OBRA 87) amended the full funding limitation for 

qualified defined benefit pension plans. The section also required that the Treasury conduct a 

study of the effect of the amendments on benefit security under defined benefit pension plans. 

B. Pensions and Retirement Savings 

Pension coverage provides employees a formal method of saving for retirement. A 

portion of each covered employee's compensation is contributed each year to a pension fund, 

and amounts in the fund are invested. When the employee retires, the accumulated contributions 

and investment earnings of the pension fund are used to pay pension benefits. Although 

employees typically save for retirement in various ways, the special features of pensions, as well 

as Federal tax and nontax pension policies, make pensions an important form of retirement 

savings for many employees. 

One indication of this importance is the fact that 27 percent of retiree households receive 

income from a private pension or annuity. 

1 This percentage for current retirees has been 

growing rapidly, reflecting the expansion of employee pension coverage in the 1940's and the 

1950's. Currently, 46 percent of private-sector wage and salary workers are covered, compared 

to only 15 percent in 1940 and 25 percent in 1950.2 As pension coverage has grown, so have 

the assets in pension funds, which now total $2.6 trillion, or one-fifth of total financial assets 

in the United States.

3 These assets include 25 percent of the value of publicly-traded corporate 

equity and 40 percent of the value of corporate bonds.• 

C. Dermed Benefit and Dermed Contribution Plans 

There are two basic forms of pension plans: defined benefit plans and defined 

contribution plans. In a defined benefit plan, the retirement benefit is specified ("defined") in 

the plan. Typically, the retirement benefit depends on the employee's length of service with the 

1

These figures are for households with a head at least age 65 in 1986. See Piacentini (1990). 

2

The 46 percent figure is an estimate for 1987. See Warshawksy (1989). 

3

Federal Reserve Board (1990). 

4

Hoffman (1989). 

-1-
-2-

employer and the employee's earnings history.5 This benefit structure generally means that 

employees will receive larger benefits if they remain with one employer than if they have several 

employers during their working years. The other special feature of defined benefit plans is that 

the employer bears the risk of investments in the pension fund because the pension benefit is 

defined in the pension agreement and does not depend on the assets in the pension fund. 

Defined contribution plans may take several forms -- money purchase, profit sharing, 

ESOPs, etc. --but all have the same basic features, and these features differ fundamentally from 

those of defmed benefit plans. In a defined contribution plan contributions are made to, or set 

aside in, an account maintained for each participating employee, and investment earnings are 

allocated to each employee's account. Benefits at retirement from a defined contribution plan 

depend entirely on the assets in an employee's account, which means that the investment risk 

is borne by the employee. Further, except in cases where some part of the contributions are 

made by the employer and there is a vesting period for these contributions, defined contribution 

assets are immediately nonforfeitable to the employee; the plans therefore typically provide no 

added incentive for an employee to remain with a single employer. 

Currently, nearly the same percentage of workers are covered by a defined benefit plan 

(31 percent) as are covered by a defmed contribution plan (30 percent). 6 Because this report 

is concerned with the full funding limit which applies only to defined benefit plans, the 

remainder of this section focuses on these plans. 

D. Tax Rules Governing Defined Benefit Plans 

If properly designed and administered, a defined benefit pension plan can qualify for 

special tax treatment under the Internal Revenue Code (Code). When a plan qualifies, employer 

contributions to the pension fund are tax deductible by the employer, but excluded from the 

taxable income of the employees. Investment income of the plan's pension fund is exempt from 

tax. Retirement benefits are not taxed to the employees until the benefits are paid. This special 

tax treatment of qualified plans reduces employers' and employees• long term after-tax cost of 

pension benefits. 

Under the Code, employers' deductible pension fund contributions are subject to 

minimum and maximum limits. The minimum contribution limits were established to ensure that 

pension fund assets are large enough to secure pension liabilities against the risk of default. The 

maximum contribution limits were established to limit and to allocate efficiently the loss of 

federal tax revenue associated with the special tax treatment across qualified plans. 

5

For example, the benefit might be defined as a specific fraction of the average earnings in 

the last five years in employment, multiplied by the number of total years with the employer. 

~is figure is an estimate for 1987, from Warshawsky (1989). Note that some workers are 

covered by both types of plans, so that the percentage of workers covered by at least one plan 

is only 46 percent, as noted in Section B above. 
-3-

As part of the maximum contribution limits, the Code imposes a "full funding limit" . 

The full funding limit prevents employers from making deductible contributions when pension 

fund assets exceed a legally specified percentage of pension liability. Before the changes made 

by OBRA 87, the full funding limit was 100 percent of an employer's "accrued liability" . 

Accrued liability, which can be measured in several different ways, accounts for both employee 

pension benefits accumulated to date and pension benefits for current employees associated with 

the past that are expected to accumulate in the future. Section 9301 of OBRA 87 amended the 

Code to create a new full funding limit equal to the lesser of the old full funding limit or 150 

percent of an employer's "current liability". Current liability accounts for employee pension 

benefits accumulated to date, but includes no allowance for employee pension benefits associated 

with the past that are expected to accumulate in the future. As a result, the new full funding 

limit can be lower than the old full funding limit for some plans. 

ll. SUMMARY OF THE REPORT 

This report examines the effects of the OBRA 87 change in the full funding limit on 

pension benefit security. The report concludes that the effects are likely to be small. The new 

limit can affect benefit security in two ways. First, for some plans, the new limit could increase 

the private cost of pension benefits by lowering the tax benefit associated with pension funding; 

however, the increase in private cost will be very small relative to the tax benefit associated with 

pension funding. 

Second, for some plans, the new limit will decrease the level of pension fund assets 

relative to pension liability. A lower level of pension fund assets could increase the risk of 

default on pension benefits. The increase in risk would be borne both by plan participants and 

by the Pension Benefit Guaranty Corporation, which insures the pension benefits of most private 

defined benefit plans up to specified benefit levels. However, the OBRA 87 change in the full 

funding limit will only decrease the funding levels of well-funded plans and, even then, only 

slightly. The change in the limit is therefore likely to have an insignificant effect on the risk 

of pension benefit default. 

The remainder of the report is divided into three chapters. Chapter 2 uses a pension 

model to analyze pension funding and the effects of the special tax treatment on pension cost for 

qualified defined benefit plans. Chapter 2 also analyzes the potential effects the OBRA 87 

change in the full funding limit on employer contributions, levels of pension funding , and the 

long-term private cost of pension benefits. Chapter 3 uses 1989 pension data to analyze the 

actual effects of the OBRA 87 change in the full funding limit. Chapter 4 presents policy 

options for further consideration and analysis. 
-4-

A. Pension Funding and the OBRA 87 Limit 

In typical situations, the special tax treatment accorded to pensions can reduce the long 

term after-tax private cost of a defined benefit pension by more than 40 percent. 7 More rapid 

pension funding results in greater tax benefits and lower private cost. The OBRA 87 change in 

the full funding limit reduces the maximum speed of funding and therefore reduces the maximum 

potential tax benefits. For affected plans, contributions are decreased in the short run but 

increased in the long run. The net result is to slightly decrease the tax benefit and increase the 

long term after-tax private cost for the affected plans. As shown in Chapter 2, the change under 

OBRA 87 could increase the long term cost of a pension by as much as four percent, although 

this is an extreme possibility. The effect on cost is likely to be much smaller for most plans. 

The analysis in Chapter 2 indicates that the effects of the OBRA 87 change in the full 

funding limit, although small, are likely to differ substantially across plans. Many plans are 

unlikely to be affected. Plans with the following characteristics are most likely to be affected: 

o Plans that use optional actuarial methods that fund at a faster rate than other 

plans; 

o Plans established by relatively new firms that cover younger than average 

populations of employees; 

o Plans funded under lower than average discount rate assumptions; 

o Plans that annuitize benefits by purchasing private insurance annuity contracts. 

B. Evidence from the Data 

Actual pension plan data for 1989 show that about 49 percent of earnings-based single 

employer defined benefit plans have been affected by the OBRA 87 change in the full funding 

limit. 8 Such plans are affected because their OBRA 87 full funding limit is lower than their old 

full funding limit. The other 51 percent of earnings-based plans are not affected because their 

OBRA 87 full funding limit equals the old full funding limit. 

The data show the degree to which plans are affected by the OBRA 87 change in the full 

funding limit. They also show how the actuarial and demographic factors examined in Chapter 2 

7"Long term after-tax cost" refers here to the after-tax present value of all future 

contributions to the pension fund. See Section IT of Chapter 2 for examples demonstrating the 

cost savings to pensions due to special tax treatment. 

Brhese percentages are weighted by current liability. The corresponding unweighted 

percentage was 59 percent of plans. 
-5-

determine which plans are affected. The factors matter even when they are varied one at a time. 

The data show that about 37 percent of earnings-based plans have been affected by the OBRA 87 

full funding limit because they are funded under "level funding" methods. This group of plans 

would not have been affected by the OBRA 87 change if they had been funded under the 

typically slower "projected unit-credit" method. About 20 percent of earnings-based plans have 

been affected by OBRA 87 because they are funded under discount rate assumptions that are 

lower than average relative to projected salary growth rates. About 6 percent of earnings-based 

plans have been affected by OBRA 87 because they cover active employee populations that are 

younger than average. Although the ages of active employees are found to be less important 

than the funding method and discount rate in determining whether or not plans are affected by 

the OBRA 87 limit, employee ages are found to be the most important determinant of the 

magnitude of the effect. The data also show that about 4 percent of earnings-based plans have 

been affected by OBRA 87 because their active employees account for a higher than average 

percentage of current liability. 

9 

Further, the analysis presented in the last section of Chapter 3 shows that the OBRA 87 

change in the full funding limit is likely to result in about a six percent decrease in average 

funding levels of earnings-based plans. However, the analysis shows that OBRA 87 will only 

decrease the funding levels of the best funded plans and, even then, usually only slightly. The 

results therefore imply that the OBRA 87 change in the full funding limit is likely to have a 

relatively insignificant effect on employees' pension risk. Overall, the OBRA 87 change in the 

full funding limit appears to have had a very small effect on benefit security. 

C. Policy Options 

Three full funding limit options are presented for further consideration and analysis. 

1. Maintain current law. 

2. Allow election of projected liability limit. and reduce current liability limit. 

Under this option, taxpayers would be allowed to make a one-time election to 

compute their full funding limit each year as the lesser of accrued liability or 100 

percent of projected liability. Projected liability would be computed under the 

method used to calculate the Projected Benefit Obligation (PBO) under the rules 

of the "Statement of Financial Accounting Standards No. 87. "10 Both the 

assumed discount rate and salary growth rates used to calculate projected liability 

would be subject to restrictions. To maintain the revenue neutrality of this 

~e sum of the percentages noted in this paragraph exceeds 49 percent because the factors 

are varied one at a time in order to measure their relative importance independently of their 

correlation with each other. 

1

0pinancial Accounting Standards Board, 1985. This is essentially the projected unit-credit 

method. 
-6-

option, the limit on current liability would be reduced from 150 percent to 147 

percent. Taxpayers who did not make the one-time election would therefore be 

subject to a full funding limit of the lesser of accrued liability and 147 percent of 

current liability. 

3. Allow election of projected liability limit with no reduction in current liability 

li.mil. This option is the same as option 2, except that the current 150 percent 

limit on current liability would be retained. Thus, taxpayers could make a onetime election to compute their full funding limit each year as the lesser of accrued 

liability or 100 percent of projected liability; if no election were made, the limit 

each year would be the lesser of accrued liability and 150 percent of current 

liability. This option is estimated to lose approximately $600 million over five 

years and would require an appropriate revenue offset. 
CHAPTER 2: PENSION FUNDING AND THE OBRA 87 LIMIT 

I. INTRODUCTION 

A. Tax Treatment of Def"med Benefit Plans 

If properly designed and administered, a defmed benefit pension plan can qualify for 

special tax treatment under the Internal Revenue Code (Code). First, contributions to pension 

funds are deductible by the employer, but excluded from employees' current income for both 

income and social security tax purposes. Second, investment earnings of a pension fund are 

fully exempt from tax at the pension fund level, and are also not currently taxable to employees. 

Third, although pension benefits are subject to tax when they are received, such taxation can be 

deferred. This includes the opportunity to transfer certain pension benefit payments into an 

Individual Retirement Account (IRA) or another employer's qualified plan as well as other 

favorable distribution options which can reduce the tax owed on a "lump sum" pension benefit 

payment. Finally, an individual's tax rate in the years when the benefits are received may be 

lower than the individual's tax rate during the employment years when the pension benefits were 

promised or pension contributions were made. 1 

B. Pension Funding Limits 

Because there is risk that the employer's business may terminate before all benefits are 

paid, employers who sponsor defined benefit plans establish pension funds to secure future 

retirement benefits. Under the Internal Revenue Code and the Employee Retirement Income 

Security Act of 1974 (ERISA), a private employer who sponsors a defined benefit pension is 

required to fund the pension liabilities. An employer is required to pay an excise tax if the 

employer's annual pension fund contributions fall below minimum funding requirements unless 

a waiver is granted by the IRS. If the pension fund is too small relative to pension liabilities, 

the employer is required to pay higher insurance premiums to the PBGC. 

The Internal Revenue Code and ERISA impose minimum and maximum limits on the 

funding of future defined benefit pension liabilities. Minimum funding rules were established 

to lower the risk of default on future benefit payments to employees directly, and to lower the 

insurance risk exposure of the PBGC. Maximum funding limits were established to control the 

loss of federal tax revenue due to the special tax treatment of defined benefit plans. The 

Omnibus Budget Reconciliation Act of 1987 (OBRA 87) imposed a new, sometimes stricter 

upper limit on pension funding. When the new OBRA 87 limit is lower than the old upper 

funding limit, the new limit lowers the maximum speed at which pension liabilities can be 

funded. 

1

See Appendix A for a more complete description of the tax treatment afforded pensions. 

-7-
-8-

ll. PENSION FUNDING 

The effects of. the OBRA 87 funding limit depend on the speed of pension funding. This 

section begins by showing how the favorable tax treatment of pension funds compares to the tax 

treatment of a regular savings account. Additional considerations are then added to show the 

relation among the tax benefit received by pensions, the speed of pension funding, and the 

demographic characteristics of each employer's population of pension plan participants.2 

A. The Nature of the Tax Benefit 

The nature of the tax benefit received by defined benefit pensions and its relation to the 

speed of pension funding can be illustrated by a simple savings account example. Suppose that 

a 30 year old individual decides to accumulate $559 (the savings target) by age 65 in a regular 

savings account that pays 7 percent annual interest. Suppose, also, that the individual is always 

taxed at a rate of 28 percent. Under normal income tax treatment, contributions to the savings 

account would come from the individual's after-tax income. Further, the interest income would 

be taxed as it accrues so that the after-tax annual yield would be 5.04 percent (=7%-.28*7%). 

Because both contributions and earnings would be taxed currently, withdrawals from the savings 

account would be free of tax. 

The present discounted value of the individual's contributions to the account, discounted 

to age 30 at the after-tax rate of 5.04 percent, would be $100, which is also the present value 

of $559. In other words, in present value terms at age 30, each dollar of savings for age 65 

"costs" a dollar of contributions. Further, this equivalence of cost to value would be true 

regardless of the age at which savings account contributions are made. For example, for a 

single contribution to be enough, the individual would have to contribute $100 at age 30, $164 

at age 40, or $267 at age 50. Regardless of the age, the present value of contributions would 

be $100 when discounted to age 30 and the total would equal $559 at age 65. 

Now suppose that the savings account, unlike a regular savings account, is granted 

special tax treatment like that granted to pensions. The contributions are tax deductible, the 

interest income is tax exempt, and the final savings account withdrawal at age 65 is fully 

taxable. Unlike under normal tax treatment, the $559 after-tax savings at age 65 would cost the 

individual less than its present value of $100. For example, under the special tax treatment, the 

individual could contribute $73 at age 30, which would appreciate at 7 percent for 35 years and 

be worth $776 (before tax) at age 65. At age 65, the individual would pay $217 in taxes and 

receive $559 after tax, which would have a present value at age 30 of $100, just as under the 

normal tax treatment. However, the employee would only contribute $73 at age 30. Because 

the $73 contribution at age 30 would be deductible, it would only cost the individual only $52 

after tax. In other words, the present value of each $1 of final payment at age 65 would cost 

2

The use of actuarial terminology is minimized. The glossary on page 75 provides a 

summary description of actuarial terms used in the report. 
-9-

the individual $0.52 if the contribution is made at age 30. The tax benefit would be $0.48 per 

dollar of final savings. Alternatively stated, the special tax treatment would reduce the cost by 

48 percent when compared to saving in an ordinary savings account. 

Furthermore, unlike an ordinary savings account, the after-tax cost would now depend 

upon the age at which contributions were made. Working through the same calculations, a 

single contribution of $143 would be sufficient at age 40. Because the contribution would be 

tax deductible, the individual would only give up an after-tax amount of $103 at age 40. The 

present value of the target savings amount, i.e., $559, discounted from age 65 to age 40 would 

be $164. Therefore, if a single contribution is made at age 40 instead of age 30, the cost 

per-dollar of final saving would be $0.63 ( =$103/$164) and the tax benefit would only be $0.37 

(=$1.00-$0.63) rather than $0.48. 

The results of simHar calculations for other ages of contribution are shown in Figure 2.1. 

The figure shows that the longer the individual waits to make contributions to the tax-favored 

savings account, the greater the cost, and the less the tax benefit. In the extreme, there is no 

tax benefit at all if contributions are made immediately before the funds are withdrawn at 

age 65.3 

Normally, savings would be spread out over an individual's lifetime. But the relation 

between the timing of contributions and the size of the tax benefit would be the same: For a 

fixed amount of final savings, i.e., a savings target, a faster contribution "speed" (contributing 

more at early ages and less at later ages) would lower the private cost of the target savings and 

increase the tax benefit. 

B. The Tax Benefit of Pension Funding 

The relation between the speed of saving and the tax benefit illustrated in the special 

savings account example above in Section IT.A extends to the funding of defined benefit pension 

obligations. For a defined benefit pension plan, like the special savings account example, there 

is a targeted amount that an employer tries to fund by the time employees retire and begin 

receiving pension benefits. With the help of an actuary, an employer decides on a funding 

method that determines an expected path of future contributions. Each funding method is 

designed to reach the future funding target by spreading contributions over time. Different 

3

Such an age effect on the tax benefit results from a combination of two factors: the 

deferral of taxes until age 65 and the exemption from tax of interest income as it is earned in 

in the special savings account. These two factors combined are equivalent to not allowing 

deductions for contributions to the special savings account, but never taxing the interest income, 

i.e., where interest would be exempt from tax when earned and withdrawals from the account 

would be free of tax. The benefit of the tax exemption would therefore be compounded over 

time so that contributions made at an earlier age would yield larger tax benefits and lower cost 

than contributions at a later age. 
a 

--0 

~ 

""" v 

~ 

~ 

C/J 

0 

u 

Note: 

Figure 2.1 

Effec t of Special Tax Treatment on the 

Cost Per Dollar of Payment at Age 65 

$1.00 r-~-----:--------:-----:------:-----:----~------:1.,....---, 

• •

. ••• •••••••••••••••••••••. • ··· ···················-·. ··· 0 ••••• •••••••• •••• 

. . . . . . . . . . . . . . . . . . 0.90 . . . . •••••••••••••••••••••• , •••••••• • ••••••••••••• ·-:· •• ••••••••••••••• • • ·· · -:···· •••••••••••••••• ···-:· •••• 0 ••••• 0 •• • •••••••• -:· •• 

. . . . . .................................... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...................... , ....................... {• ••••••••••••••.••••••• <· ...................... ·:· •••••••••• ••••••••••••• ; •••• . . ··················:·. ·······················=······· . . . . . . . . . . . . . . . . . . . . . ······· ...................... ........................... . 0.80 . . . . . . . ••• • • • • ••• • ••• ••••••• • , ••• 0 0000. ooo 000000 0000011.0 •• 0 0 • ••••••• 0000 0000 00 ...... . ..... 0 • •• •••••• 0 0 0. 'oo o o ••••• • •• 

. . . . . . . . . . . . . . . . . . . . .................................................................... ..... :7"1"''' .......................... ............................. 

....................................................... -:·...

~ 

. .. .. . .. . . . . . . . . . . .•. .... .. .. . . . . . . . ... . .................... . . . . . 

. . . . . . •••• 0 ••••• • ••••••••••• , , ••••••••••••••••••••• '1' 0. 0.. 0 00 ••• •••••• '1' ........ 0 0 0 •• 0 .. . ••••• • •• 0 ••••••••• • ••••• 0.. 0.... •• ••• • • •••••• •••• ••••• •• ••• •• ••• • • •• ••• • ••••• 

0 .70 . . . .... . ................ oo oo oo· .. oooooo 

. . . . . . . . . . 

0.60 .. .•..• .•.. • ..•••................ , .................... 0. 0 .......... 0........... . .... 0 ......••.••• .• .. •. .. ... . . . . . . . . .. .. . . . . .... . 

........ ...................... ................... ............................. ...................... ...................... ...................... ..... . 

0.50 . 

30 35 40 45 50 55 60 65 

Age of con lribu lion 

All te rms expressed as after· tax present values 

Inte r est rate = 7%, Tax r ate = 28% 

I 

-

<? 
-11-

methods spread contributions at different speeds than others. Further, like the special savings 

account in Section IT.A, the employer's cost can be decreased and the tax benefit of pension 

funding can be increased by choosing a funding method that accelerates contributions. 

The most important elements of this process can be illustrated by an example of a plan 

offered by an employer to a group of employees, all aged 30 and all hired at the same time, i.e., 

a single "cohort" .

4 The pension plan promises these employees a retirement annuity that starts 

at age 65 and pays a fixed annual amount that continues for the remainder of each employee's 

life. The annual amount is determined by multiplying the employee's completed years of service 

at age 65 by the employee's average annual salary in the final five years of active employment, 

and multiplying the result by 1.5 percent. Such a plan is often called a "final pay" plan, which 

is the most common type of defmed benefit plan for medium and large plans. 

To illustrate how the benefit under the final pay plan in the example would be calculated, 

suppose that an employee was hired at age 30 and retires after 35 years at age 65. Suppose, 

also, that the employee's annual salary averaged $30,000 in the last five years of employment. 

Then this employee's annual retirement benefit would be $15,750 (=35*$30,000*.015). 

The Internal Revenue Code and associated regulations permit the employer to choose 

from a number of different funding methods. The alternative methods generate different answers 

in terms of the current year contribution requirement and the pattern of the contributions in 

future years. In order to illustrate the difference the choice of funding method can make for the 

model plan, four funding methods are illustrated in the example. 

Figure 2.2 shows the time paths over which the employer's expected future pension 

liabilities might be funded under each funding method. s The actuary uses assumptions about 

employee turnover rates, employee mortality, salary growth, and expected investment earnings 

of the pension fund to determine the amount of assets which whould be accumulated in the fund 

in order to provide for the benefits that begin at age 65. Under each method shown, there 

should be no further contributions required after age 65. Each actuarial method defines a unique 

pattern of asset growth towards the target accumulation at age 65 over the years prior to 

retirement. The curves in Figure 2.2 show the ratio of the total pension fund assets, for each 

age from 30 to 65, to the expected present value of the projected age 65 accumulation. 

Under funding method 1, the fastest method shown, the annual contribution made on 

behalf of each active employee is held at a constant dollar amount over all years until the 

employee separates from active service or retires at age 65. This method is not commonly used 

"This example is based on Winklevoss (1977). 

5

A summary description of these methods is contained in the Glossary on page 75. 
100 

90 

80 

'0 

Q) 70 

'0 

~ 

;::3 60 

"""' 

Q) 

bD 50 «1 

+) 

~ 

Q) 40 

() 

~ 

Q) 30 0.. 

20 

10 

0 

30 

Figure 2.2 

Pension Funding: Assets as Percentages of the 

Present Value of Future Benefits at each Age 

: : ~-

35 40 45 50 55 60 65 

Age of active employees 

Method 1 

Tax benefit = $.44 

Method 2 

Tax benefit = $ .38 

-----

Method 3 

Tax bene fit = $.33 

--·-··- I 

t-.) 

- Method 4 I 

Tax bene fit = $.24 

---
-13-

for funding final average pay plans, but has been included in the model because it demonstrates 

an extreme pattern of funding and would be allowed under the Code for the example plan.

6 

Under funding method 2, contributions are held at a fixed proportion to annual salary 

payments, which increase over time. This method is popular with employers, partly because 

it allows them to budget pension contributions as a percentage of cash compensation. Both 

methods 1 and 2 are called level funding methods, which do not attempt to match the funding 

pattern with the pattern that employees "accrue" pension benefits. 

In contrast, funding methods 3 and 4 in Figure 2.2 are often called "accrued methods" 

because they are based on the rate at which employees accrue future pension benefits. Under 

method 4, the slowest funding method, contributions equal the rate at which employees accrue 

benefits according to the plan agreement, without accounting for expected future salary 

increases. The pattern of funding under method 4 therefore reflects the pattern of benefit accrual 

under the plan agreement, which begins slowly and then accelerates. Method 3 is like method 4, 

except that it accounts for expected future salary increases in a way that holds each employee's 

benefit accrual rate constant over all years of service. Method 3 therefore smoothes the pattern 

of fund growth relative to the pattern of benefit accrual. 

Contributions under methods 1, 2, and 3 all depend on projected future benefit accruals 

of current employees under assumptions about future salary growth, employee mortality, and 

employee turnover, whereas contributions under method 4 do not depend on projected future 

benefit accruals of current employees. 

Contributions to the pension fund are not included in the taxable income of employees 

just as contributions were deductible in the special savings account example. Similarly, the 

pension fund is tax exempt on its investment income and pension benefits are fully taxed when 

they are paid. For these reasons, as in the special savings account example, faster rates of 

funding entail a larger tax benefit or, equivalently, a lower private cost of providing future 

retirement benefits. For example, Figure 2.2 shows that at an interest rate of 7 percent and a 

tax rate of 25 percent, the per-dollar tax benefit amount ranges from $0.24 under method 4, the 

6

For technical reasons, method 1 is not always faster than method 3. For example, if a plan 

is designed so that the plan formula can count no more than 30 years of service, method 3 would 

fund the projected future benefits for a 25-year-old employee over 30 years, whereas method 1 

would fund the employee's projected future benefits over 40 years. It is possible that the 

difference in amortization periods would reverse the relative funding speeds of methods 1 and 

3 shown in the example. Similarly, differences in accounting for Code Section 415 limits, which 

limit benefits under defined benefit plans, may affect the relative speeds of funding under the 

methods. Nevertheless, such additional considerations would unecessarily complicate the 

example and would distract from the central points of this chapter. Further, such considerations 

would be exceptions to, rather than central characteristics of, the illustrated methods and their 

relative speeds of funding. 
-- -

-14-

Table 2.1 

A Pension Population Over Time 

Year 

Population statistics 1 10 25 40 

Active Emplovees 

Number 10,000 16,400 20,000 20,000 

Average age 35.0 36.7 39.5 40.4 

Average service 4.8 6.4 9.2 10.3 

(years) 

Inactive participants 

Retired 30 525 2,000 3,620 

Vested terminated 70 1,164 4,580 7,760 

Disabled 0 33 220 440 

Surviving spouses 0 16 120 320 

Source: Simulations based on Winklcvou (1977) 
-15-

slowest method, to $0.44 under method 1, the fastest method shown.7 That is, the special tax 

treatment reduces the present value of future pension fund contributions relative to what 

contributions would have been under normal tax treatment by as much as 44 percent under the 

illustrated funding methods. Faster funding methods can thus entail substantially larger tax 

benefits and lower private pension costs. 

C. A Complete Pension Population 

Actual pension plans are a bit more complicated, but many aspects of pension funding 

can be readily illustrated in terms of the example of one cohort of employees discussed above. 

This is because actuarial methods of pension funding were developed by recognizing that the 

population covered by a pension plan is actually a collection of cohorts hired at different ages 

and at different points in time. The methods and concepts developed for a single cohort 

therefore generally extend to funding a pension plan for a complete population. However, to 

aid in the examination of the effects of the OBRA 87 funding limit in later sections of this 

chapter, this section introduces an example of a more complete population. The basic intuitions 

behind the relation between the speed of funding and the size of the tax benefit, however, are 

most readily seen in the simpler examples described above. 

A typical defined benefit pension plan covers a population that includes active employees 

who are currently accruing or earning pension benefits but are not yet retired. The population 

also includes other people, mostly ex-employees who are inactive and are no longer accruing 

benefits. The inactive group would typically include those who have retired and are currently 

receiving benefits. In addition, the inactive group would include those vested workers who have 

separated from service to the employer and who expect to receive benefits based on past years 

of employment service when they retire. Other inactive members of the population might 

include surviving spouses who receive benefits as part of a joint employee/spouse annuity as well 

as disabled employees. 

Table 2.1 shows how such a population might develop over time. At the end of year 1, 

when the employer's firm and the pension plan are relatively new, the population is made up 

almost entirely of active employees because there has been little time for the other population 

groups to develop. As years pass, however, the inactive populations grow. Also, the table 

shows how the average age and years of service would increase over time for the population of 

active employees. Often when a new firm is growing rapidly and many of its employees have 

been recently hired, the active employees as a group will tend to be relatively young. 

Eventually, through many years of slower growth or no growth, the active employees tend to 

age faster than new, younger employees are hired. As a result, the average age of active 

workers tends to increase over time and eventually stabilize. Such a growth pattern is shown 

in Table 2.1 and is used in the pension plan example throughout the rest of this chapter. 

• 7 A 25 percent tax rate was chosen because it is the average marginal tax rate on corporate 

mcome. 
-16-

For such a population growth pattern, Figure 2.3 shows how the active employees' ages 

would be distributed after 25 years. The area under the solid curve shows how current ages 

would be distributed in the active employee population. The area inside each rectangular grid 

under the curve equals 2.5 percent of all active employees. Thus, for example, because there 

are about 8.5 rectangular grids under the solid curve between the 20-year and 30-year marks on 

the horizontal axis, the figure shows that about 21 percent ( =8.5*2.5 %) of the active employees 

would currently be less than age 30. In contrast, following the same reasoning, the dashed 

distribution of ages hired shows that about 45 percent of the currently active employees would 

have been hired when they were age 30 or younger. As illustrated below in Section II.D, the 

nature of these age distributions can heavily influence observed levels of pension funding. 

D. Pension Funding for a Complete Population 

Observed levels of pension funding (defined below) and the size of the tax benefit 

associated with funding both depend on the actuarial method of funding and the ages, length of 

service, and other demographic characteristics of an employer's covered population. 

Understanding these interactions is fundamental to understanding the effects of the OBRA 87 

funding limit. This section explains how such interactions work. 

Under ideal conditions, with no uncertainty about interest rates, salary growth, turnover 

rates, etc., each part of a pension population could be associated with its own level of funding. 

The level of funding associated with the plan as a whole, then, would be determined by how the 

different parts of the population are mixed together. 

To show how this works, "funding level" must first be defined . Throughout the 

remainder of this chapter, "funding level" and "funding ratio" are used interchangeably. Both 

terms refer here to the ratio of pension assets to the pension's current liability, expressed as a 

percentage. "Current liability" is defined here as the expected present value of future benefits 

accrued in years of employment service up to the current date, ignoring future accrual that is 

expected to result from employees' future years of active service and future salary increases. 

Further, this definition of current liability treats all active employees as being fully vested in 

their accrued retirement benefits, even though some recently hired employees may not be fully 

vested under the plan. Under this definition, current liability is essentially a measure of 

termination liability, which is the current value of benefits that the employer would owe to plan 

participants if the employer chose to immediately terminate the pension plan. 8 For the inactive 

parts of a covered population, such as the retirees, all benefits have already been accrued. For 

this part of the population, the current liability would equal the expected present value of future 

benefits. Under standard pension funding methods, therefore, the accumulated fund assets for 

&nere may be differences between this definition of current liability and termination liability 

for other types of plans and under conditions that differ from the assumptions of the examples 

in this chapter. Further, this definition of current liability may differ in technical ways from the 

way that current liability is defined under the Internal Revenue Code. 
5 

C/) 

Q) 

Q) 

~ 4 

-Cl. 

8 

Q) 

Q) 3 > 

·-

~ 

C) 

«' 

c.-. 

0 2 

Q) 

bD 

«' 

~ 

~ 

Q) 

C) 1 

""' Q) 

p.. 

0 

Figure 2.3 

Distributions of Current Ages and Ages Hired 

For Active Employees After 25 Years 

·········· c/... . . ·................. . ~ ....... . 

. . . . : . 

. : . . : . 

20 25 30 35 40 45 50 55 60 65 

Age of active e mployees 

Current 

ages 

Ages 

hire d 

~~-----

I 

---.J 

I 
-18-

the inactive part of the covered population would normally be expected to equal the current 

liability. No future fund contributions for this group would be expected to be necessary. In 

contrast, for the population of active employees, current liability would normally be much 

smaller than the expected present value of future benefits. This is because the latter measure 

accounts for all expected future benefit accruals whereas current liabilities only account for 

benefits accrued to date. 

Comparison of Figures 2.2 and 2.4 demonstrates the potential importance of the 

distinction between current liabilities and projected benefits for active employees. Recall that 

Figure 2.2 shows how a fund would be expected to accumulate under four different standard 

funding methods for a pension that covers a single cohort of active employees. The fund asset 

values at each age in Figure 2.2 are expressed as percentages of the expected present value of 

future benefits. Under all four methods, contributions to the fund are spread out over the entire 

35 years of active employment, but the methods are all expected to reach the same target of 100 

percent by age 65. As Figure 2.2 demonstrates, the fund is always smaller than the expected 

value of future benefits until age 65. In contrast, Figure 2.4 shows what happens when the same 

assets are instead compared to current liabilities. Although, as shown in Figure 2.2, assets are 

small relative to the expected present value of projected future benefits at early ages, Figure 2.4 

shows that the assets are quite large relative to current liabilities under the first three methods. 

This is because current liabilities only measure the liabilities associated with benefits accrued up 

to the current date. 9 

The patterns shown in Figure 2.4 for a single cohort show why funding ratios for a whole 

pension population would depend heavily on the age distribution of active employees. As shown 

in the figure, the funding levels associated with young employees, who have few years of 

service, tend to be very high under the first three funding methods that take into account 

expected future service and salary increases. For any method that depends on expected future 

accrual, younger active worker populations tend to be associated with higher funding ratios. 

Figure 2.5(a) shows a 50-year history of funding ratios for a plan that covers the whole 

population described by Table 2.1. The funding levels are expressed as ratios (percentages) of 

total plan assets to total current liabilities. Like the example of a single cohort, the funding 

ratios are highest under the fastest funding methods. Further, even though the ratios exceed 

100 percent of current liability, future contributions are expected to be necessary under all four 

methods. 10 

~e fourth method yields funding ratios below 100 percent of current liabilities in Figure 

2.4 because the plan under all four methods in the single cohort example is assumed not to vest 

employees, whereas current liability is measured as if employees are immediately vested. 

1

0funding ratios that exceed 100 percent of current liability only imply that the assets would 

be more than enough to pay future benefits accrued to date if, for example, the pension plan was 

immediately terminated and active employees stopped accruing future retirement benefits. 
1,000 

900 

800 

"0 

Q) 700 

"0 

~ 

;:3 600 ct-. 

Q) 

b.fl 500 

"" ..,..> 

~ 

Q) 400 

C) 

~ 

Q) 300 ll.. 

200 

100 

0 

Figure 2.4 

Funding Ratios: Assets over Curre nt Liabilitie s, 

Single Cohort of Employees Hire d a t Age 30 

0 • • 0 

························· 0 ·· ······················

0 ······················ ·····················-········ • ······················· 0 ·································· • · 0 • • • • 

0 • • • 0 

• • 0 • • 

• • 0 • • 

• • 0 • 0 

• • • • • 0 

0 • • 0 • 0 

• • • 0 • • 

0 •••••• •••••••• 0 0 0 0 0 0 •••• • • 0 ..... . 0 . •• 0 0 • • • • •••••• 0 ••••••••••••• 0 •• 0 • ••••• 0 •• 0. 0 •••••••••• • 0 • •• ., ••••••• 0. 0 • • ••••••••• • ••••••••••••• 0 ••• • ••••••• 0 0 0 •••••• • •••• 0 ••• 0 

• • • 0 • • 

0 • • • • • 

0 • • • • • 

. . . . . 0 • • • • 

• 0 • • • 

. . . . . . . . . . . ······•····················· . ·. :············ ·······!······················ ······················:············ . ··········!·. ·····················!····················· . . . . . . . . . . . . . . . . . . . . . . . . • • 0 • • 

·············· . 

. ··············-. . ···················· ·····················-. 

. ····························· . 

. ···············. 

. ······················ • • • • 0 

0 • • • • 

. . . . . . . . . . . . . . ·····•••ooo ·····················V·····················t······················•········•oo•••······· 

•••••• ·:- • • ••• • • 0. 0 ••••••• • •• 0 •• 0 ••• 0 0 •••••••••• 0 •• • ~ •••••••••••••••• 0 •••• 

. . -··················- ooooooo•••········••o•• o•••••••• o••••••••ooo 

........ = = ·:r::·: +:: :: :::::r:::::·:: ~ r··;;;;; ·-! ---·- r- - : : 

30 35 40 45 50 55 60 65 

Age of ac tive e mployees 

Me thod 1 

Me thod 2 

-------

M

_.._.._ 

e thod 3 

Me thod 4 

--- I 

10 -

• 
300 

275 

250 

'0 

Q) 

'0 225 ~ 

c._. ==' 

Q) 

200 

bD 

~ 

+) 175 ~ 

Q) 

C) 

~ 150 Q) 

p... 

125 

100 

75 

Figure 2 . 5( a) 

Funding Ratios: Assets over Current Liabilities 

Comp lete Plan Population 

···············:-··············-:· ··············-:···············-:·············· · ................................................ ...................... . 0 0 • 0 

. . . . 0 • 0 • 

0 • • 0 

0 • 0 0 

• 0 • 0 

0 • 0 0 

• 0 • • 

. . . . .............................................................................................................................................. _ .. , .. • • • 0 

. . . . . . . . 0 • • • 

0 • • 0 

. . . • • • 0 

. . . • 0 • • 

o ooo o o lo oooo oo o o o o oooo}oo o o ooo o o ooo; o oo o oo ooo oo oo oo:oo oo oo o o ooo o oo o \ • • o o o o o o o o o oo ••<\•• o oooooo oo oooo ooo oo o o o o o o o o o o oo oo ooo o o o o o o o • o • o O • o • •• •• o • o o:;, • ooooo o oo o oo o o o : o o o o oo 

0 • 0 • • 

• • • 0 

0 • • • 

. . . . ' : . : : : ' . . . . . ........ ....... ~, ··· ······· ··f··· ·· ·· · =···············1···············1··············· .............................................. ~ ...................... . 

!'.,. : : : l ......... : : . l ········ ······ ·:· ······ ···~ -- ······ ·············· ···· ···············:···············:······························-····· : : --· : : : . . . -- . 

········ ······f···············r··········· ··· l····· ·· t·~ ·--+ ~·:~t······· ··············· ············· ·f···· ·· ·····T····· ......__ : : : : : : ---~-- : ! : 

~II I Jet : ; ! : ! ----------· : .... ····.··. ·-~·- ···········1··· '' , ~-· ••~'~· · ~i······;; ::...:.: · ........ ······ ·-· ........... -~ ··· ........ ···· ~ ········· ··· ··r·f!t-~.· ·~···· .. ! ! : ! ! Tl 1T¢II II_.. : : : : : : : : =- .. - •. .,.._ .. - .• -., . . . . . . . . . . . . . . . . . . . __ ___ ._..;-........... .-. ..-. ..... ~---- .;.-. .- --- ..;.-. -- . .-...; ..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 

0 5 10 15 20 25 30 35 40 4'5 50 

Year 

Method 1 

Method 2 

---~-~ 

Me thod 3 

Me thod 4 

--- I 

tv 

<? 
-21-

The funding levels shown in Figure 2.5(a) are higher in earlier years of the plan's history 

for two reasons. First, the employees are younger (see Table 2.1). Further, as shown earlier 

in Figure 2.4, such a preponderance of young active employees would tend to drive funding 

ratios higher for any funding method that accounts for projected future service and salary 

increases. 11 

Second, funding levels shown in Figure 2.5(a) are also higher in early years of the plan's 

history because the inactive parts of the plan population are relatively small in the early years. 

This pattern occurs because the funding ratio for the entire population is a weighted average of 

funding ratios associated with the active and inactive parts of the population. Under ideal 

conditions, the inactive parts of the population would be expected to be funded at exactly 100 

percent of current liability, whereas the active worker part of current liability would tend to be 

funded at levels exceeding 100 percent. Therefore, as the inactive population grows in size 

relative to the active employee population, funding ratios tend to approach 100 percent of current 

liability for the pension population as a whole. 

E. Tax Benefits for a Complete Population 

Conceptually, the tax benefit of pension funding works the same for the complete plan 

as it does in the special savings account and single employee cohort examples. For the same 

reasons as in those examples, faster funding methods lead to larger tax benefits and lower long 

term employer cost because accelerated contributions benefit from compounding over more years 

from the deferral of taxes on contributions and the tax exemption of pension fund investment 

income. 

Figure 2.5(b) shows how faster funding would affect contributions over a 50-year history 

of the complete pension population. Figure 2.5(b) shows contributions under methods 1, 2, 

and 3 as percentages of contributions that would have been made under method 3. As shown 

in the figure, the funding methods that require the largest contributions in the early years require 

the smallest contributions in later years. Further, because of the special tax treatment, the 

employer's present value of all contributions would be lower under the faster funding methods. 

For example, the present value of all future contributions under method 1, discounted at the 

after-tax interest rate, would be II percent lower than the present value of all future 

contributions made under method 3. This implies that the employer could decrease long term 

pension cost by 11 percent by choosing method 1 instead of method 3. 

11Plans are often started when the covered employees already have some active service. 

Often, when the plan is started, the employer grants the employees credit under the plan formula 

for the past service. In such a situation, the part of the employer's liability due to the past 

service is funded gradually. For simplicity, however, the plan in the example ignores the 

funding of past service credits. If there were unfunded past service liabilities in the example, 

the funding levels shown in the figures would tend to overstate actual funding levels in the early 

years. 
rJl 160 ~ 

0 

.... 150 +-) 

~ 

.0 

.... 

~ 

+-) 140 ~ 

0 

C,) 130 

I"? 

'0 

0 120 

..c: 

+-) 

Q) 

e 110 

ct-. 

0 

Q) 100 

btl 

~ 

+-) 

~ 90 

Q) 

C,) 

~ 

Q) 80 

0.. 

Figure 2 . 5(b) 

Annual Contributions under Methods 1 and 2 

as Percentages of Contributions Under Method 3 

Method 1 

. · ··· ·····r t · ·l· · t · · H. . • ••• • •• •• •••••• • H • • H • • • • • • • • Meth d 2 

···· ········ ·· ·····~···· . . : . : : . . 0 . . . . . . 

: 1 · ·r ··r·· ····t··········: ····:· · ······· ·· ·· ,. ······ L. -----

······1 .. -~· .. ·····1············· '····· : : . : . : : . Me thod 3 

,--, . . 

-~----~- : .......... ,.,. a~rww : --~-~~~~-" . .... _ ..... ···:·········· : : : 

0 : : 0 

. . . . ...... ··············· ················. ··············-······················ . . ·········. ········· • • • 0 

0 • • • 

0 • • • 

. . . . . . . . . . . . . . . . . . . . 0 • • • 

...... ............... ···············:-··············-:···············-:···············'!··············· ..................... . • 0. , , ••••• 0 •••••• 0 0 ·:-•• • 0 •••• ; ••••• ·!'. 0 0 •• 

0 5 

. . . . . . . . . . . . . . . . 

10 15 20 25 

Year 

. . . . 

30 35 40 45 50 

I 

tv 

tv 

I 
-23-

Figure 2.5(c) summarizes how the choice of a funding method would affect the long term 

tax benefits for the complete population. The bars in the figure show how much the present 

value of future contributions would be reduced by the special tax treatment of pensions. The 

amounts are measured on a per-dollar basis. For example, for each dollar of contributions that 

would have been necessary in the long run (in present value terms) without the special tax 

treatment, pension funding under method 1 would result in a $0.42 reduction. In other words, 

for the plan in the example, the after-tax present value cost of all future benefit payments are 

reduced by 42 percent under method 1 by the special tax treatment of qualified pensions.

12 

For added illustration, Figure 2.5(c) also shows that the special tax treatment would offer 

no cost advantage if pension benefits were not funded in advance, i.e., in a "pay as you go" 

fashion. This is true because, to the extent tax rates do not change, the tax benefit can only be 

realized by funding future pension liabilities in advance. 

ill. PENSION FUNDING LIMITS 

A. Before OBRA 87 

An employer's pension funding decision normally has two important features: the long 

term strategic choice of an actuarial funding method and short-term decisions about how much 

to contribute to the fund annually. Likewise, the Internal Revenue Code (Code) regulates these 

two aspects of an employer's pension funding decisions. Section 412 of the Code regulates an 

employer's long term actuarial funding strategy by limiting the choice of actuarial funding 

methods and assumptions that may be used to establish a funding level standard called "accrued 

liability. "13 To regulate pension fund contributions in the short run, Section 404 of the Code 

limits annual deductible contributions by comparing the difference between assets and accrued 

liabilities to the annual contributions that would normally be necessary under an employer's long 

term actuarial funding method. Such contributions are referred to as "normal costs" . The 

normal cost would generally be the maximum allowable deductible contribution allowed by the 

Code under Section 404 if all actuarial assumptions were always exactly correct, if plan benefits 

began accruing at the same time as the funding started, and if neither actuarial assumptions nor 

benefits ever changed. Under such conditions, by always setting contributions equal to normal 

12Note that the tax benefit shown in Figure 2.5(c) for the complete population are similar 

to the tax benefits shown in Figure 2.2 for the single cohort example, even though the complete 

population is considerably more complicated. 

13Note that "accrued liability" is an accounting measure defined by the optional actuarial 

funding method, and does not necessarily measure legal or economic pension liability. Under 

method 3, accrued liability is essentially the same as the "Projected Benefit Obligation" (PBO) 

as defined under the Financial Accounting Standard 87 (Financial Accounting Standards Board, 

1985). See the glossary on page 75 for a definition of accrued liability. 
Figure 2.5(c) 

Tax Benefit Per Dollar of Long-Term· Pe nsion Cost 

Comp lete Plan Population 

$1 .00 r----- --------- -------------. 

ti; 0. 75 --0 

'0 

1-. 

Q) 

~ O.'iO 1 ............ $0.42 ...... ~ c... 

Q) 

~ 

Q) 

.a 

>< 

~ 

E-o- 0.25 ········ 

0.00 

Method 1 

$0.00 

Method 2 Method 3 Method 4 Pay-as-you-go 

Type of pension funding n1e thod 

~ .,... 

I 
-25-

cost in the short run, pension assets could be expected to always equal accrued liability in the 

long run. 

In practice, however, actual salary increases, fund investment earnings, and other factors 

that affect pension funding usually differ from even the best actuarial assumptions. In addition, 

plan benefit formulas, actuarial assumptions, or funding methods are sometimes changed. As 

a result, annual contributions equal to the normal cost may be too large or too small. To 

account for such variation, therefore, the Code rules specify how annual contributions may be 

adjusted to allow for unexpected differences between accrued liability and the value of plan 

assets. When there is a shortfall of assets relative to accrued liability, the Code rules prescribe 

that the shortfall should be amortized over a period of 5 to 40 years. 

Together, Sections 404 and 412 of the Code actually establish a range for deductible 

annual contributions. Maximum and minimum deductible annual contributions are determined 

by comparing normal cost to the shortfall of assets relative to accrued liabilities (plus normal 

cost) under the employer's chosen long term funding method. For the maximum, any shortfall 

would be amortized over 10 years. Minimum deductible contributions are determined by 

amortizing the shortfall over period of up to 40 years, depending on the reason for the shortfall. 

In addition, employers can affect the long-run speed of funding by choosing a faster or slower 

funding method within the range of funding methods allowed under the Code, although the 

chosen method can only be changed periodically and is therefore a long term decision. 

To enforce the minimum and maximum contribution limits, the Code imposes an excise 

tax of ten percent of the shortfall or excess contributions for being outside of the allowable 

range. Excise taxes are collected in addition to disallowing deductions for contributions that are 

larger than the maximum. 

B. Funding Limits in the Example 

This section shows how the limits before OBRA 87 would work in the complete pension 

example. Section Ill.C shows how the upper limits in the example could be raised and the tax 

benefits of pension funding increased by an employer's choice of actuarial assumptions. 

Subsequent sections examine the effects of changes in the full funding limit under OBRA 87. 

In the complete pension example so far, it is assumed that actual salary increases, fund 

investment earnings, etc., have the same values as were used in the actuarial calculations, i.e., 

the actuarial assumptions are always exactly correct. 14 It is also assumed that benefits, 

actuarial assumptions, and funding methods have not changed. Thus, the funding levels shown 

in Figure 2.5(a) also shows the long term funding standards, i.e., accrued liability, that an 

14However, the population simulation model uses a random number generator to determine 

uncertain events such as employee separation and mortality, although the actuarial assumptions 

about the probabilities of such events are always correct in the simulations. 
-26-

employer might have used to apply the Code funding and contribution limits before OBRA 87. 

The highest line in the figure, i.e., for method 1, represents the long term funding standard 

under the fastest funding method considered in the example. The third highest line, for 

method 3, would be the funding standard for the slowest funding method considered in the 

example. 1

s 

Suppose that the employer chooses method 1, the fastest funding method shown. Each 

year, the employer would calculate the accrued liabilities plus the normal cost under method 1, 

which would equal the values shown in the highest line of Figure 2.5(a) where they are 

expressed as percentages of current liability. Then, to calculate the maximum deductible 

contributions, the employer would compare the accrued liabilities plus normal cost to the end-ofyear value of plan assets before contributions are made. If the plan assets exceed accrued 

liabilities plus normal cost before contributions were made, then no deductible contributions 

would be allowed for that year. If, however, assets were less than accrued liabilities plus 

normal cost, but the shortfall was no larger than the normal cost, then the amount of the 

shortfall would equal the maximum deductible contribution. Finally, if assets were less than 

accrued liability, not including the current year normal cost, then the maximum deductible 

contribution would equal the normal cost plus a fraction, determined by 10-year amortization, 

of the additional shortfall. The minimum deductible contribution in this last case would be 

determined by amortizing the additional shortfall over a period of up to 40 years, depending on 

the reasons for the additional shortfall. 

Similarly, the other lines in Figure 2.5(a) would be the long term funding standards if 

the employer chose one of those funding methods. However, for the final pay plan in the 

example, method 4 would not be allowed by the Code and regulations thereunder. For final pay 

plans, the funding method must account for expected future salary increases by at least spreading 

out benefit accruals in constant dollar amounts (as in method 3) over each employee's total 

expected years of active service. Employers are required to base the funding method for such 

a plan on projected future salaries. Method 4 would not be allowed because its funding pattern 

would reflect actual benefit accruals based only on current and past salary under the plan 

formula in the example: dollar amounts of accrual for each employee begin small and grow with 

salary growth. 16 

For the plan in the example, which experiences no economic surprises and no other 

changes, the ratios shown in the top line of Figure 2.5(a) (for method 1) would be the actual 

observed history of funding ratios if the employer were to choose the fastest funding method in 

the example and always make the maximum deductible annual contributions. Similarly, the line 

for method 3 shows what the funding history would normally be if the employer were to choose 

J.5For the plan in the example, and under the assumptions of the example, methods 1 and 3 

correspond to the fastest and slowest methods allowed under the Code. 

~he present value of accrual also grows because the term over which the present value is 

calculated decreases as the employee ages. 
-27-

the slowest funding method and make the minimum annual contributions. The histories of 

funding ratios under methods 1 and 3 in Figure 2.5(a) thus show how the Code funding and 

contribution limits before OBRA 87 established a long term range for the speed at which pension 

liabilities could be funded. For the plan in the example, 44 percent would effectively be the 

maximum tax benefit that could be expected by choosing the fastest long term funding method 

(method 1) allowed by the Code for this plan. 

C. Effects of Actuarial Assumptions 

Up to this point, the example has been constructed as if all of the employer's actuarial 

assumptions were economically correct and are never changed. The example shows that an 

employer could minimize long term pension cost and maximize the tax benefit of funding by 

choosing the fastest funding method allowed under the Code. This section shows how an 

employer could further increase the speed of funding and lower the long term cost by the 

changing actuarial assumptions. 

Although other assumptions matter, the most important actuarial assumption is the 

discount rate. So far in the example, a 7 percent discount rate has been used. The example has 

also used an investment rate of return of 7 percent. Suppose, instead, that the employer uses 

a 6 percent actuarial discount rate to construct the contribution limits for years 2 through 25 

even though the actual rate of return is 7-percent. Suppose also that the employer uses method 1 

to calculate the long term funding and annual contribution limits. 

Figure 2.6 shows how the funding limits would be affected. The dashed lines show the 

history of upper and lower funding limits as percentages of current liability if the 7 percent 

discount had been used. In contrast, the solid lines show the history of upper and lower funding 

limits calculated at a 6 percent discount rate for 25 years. 

17 As shown in the figure, lowering 

the discount rate from 7 to 6 percent would increase the funding ratio to 293 percent of current 

liability by year four. 

As a result of the lowered discount rate assumption, the employer would be allowed to 

contribute larger amounts in the early years of the plan. Because actual economic liabilities and 

the investment rate of return would not be affected by the employer's discount rate assumption, 

the increased contributions in the early years would be offset by lower contributions in later 

years. The net effect would be to increase the speed of funding and the tax benefit. Figure 2. 7 

shows that lowering the actuarial discount rate would increase the contributions by between 50 

and 60 percent in the first five years. The effect on annual contributions would then decrease 

in later years because the actual investment rate of return would still be 7 percent. When the 

actuarial discount rate is eventually changed back to 7 percent in year 27, no deductible annual 

contributions would be allowed through year 32, and contributions would be reduced in years 33 

17Current liabilities, which are in the denominator, are discounted at a 7 percent annual rate. 
300 

~ 275 

·

-.0 -

Cd 250 ·--

~ 

s:: 225 

(lJ 

J.. 

J.. 

::s 200 

C) 

ct-. 

0 175 

(lJ 

~ 150 ~ 

Figure 2.6 

Effect of a Lower Actuarial Discount Rate 

Assumption on Pre-OBRA 87 Funding Ratios 

• I . . s:: 

(lJ 

C) 125 

J.. 

. . . . •• ·--. -----; ·- - ,_ ____ ; ___ ·<1-.•• ... - - - - - - -- L. .. ! ... .. . . ····)· .. , . 

:::: 0: : ::L .. . ....... j·· .. ... . . . . . .. . .. .. r (lJ 

0.. 100 

75 

0 5 10 15 20 25 

Year 

Notes: For 6% example, 6% discount rate is use d 

by the plan in years 2-26. Cm·re nt liability 

is calc ulated at 7% discount r ate in all years. 

30 35 40 45 50 

6% discount 

method 1 

7% discount 

method 1 

----- 6% discount 

method 3 

7% discount 

method 3 

• !-..,) 

00 

I 
160 

140 

120 

Q) 

bD 

ro 100 +) 

c::: 

Q) 

C) 

s.. 80 

Q) 

p.. 

60 

40 

20 

0 

Figure 2.7 

Annual Contributions at 6% Discount Rate as 

Percentages of Contributions at 7% Discount Rate 

. . . • • • 0 • • 

· · ··•····· • •••••••••• ••••••• • ••••••••• ; •••••••• 0 ••• 0 •• • ; ••••• • ••••••••• ,: ••• ••••••••••• • • ; ••••• •• ••• •••••• ; ••• • • • • • • •• •••• • ; • •• •••••••••••• 

. . . . . • • 0 • • 

. . . . . • • 0 • 

• 0 0 • 

• • • 0 

• • • 0 

. . . . . • • • • • 0 • 

o oooo o oooo o o ooo ooooo oo~oooo ••• o o oooo oo o flo ••• o ooo o o oo o o o " " " oo o o o oo oooooo o o# o o ••• o ooo oo ••• oo o ooo ooo•• o o oooo o O ooo oo o o o o oo •••••* •• ••••• o o o oo •• o • "' •••• •• • • • 0 • • • 

• • • • • • 0 

. . . . . . . . . . . . . . • • • • • • 0 

. . . . . . . • • • • • • 0 

. . . . . . . • • 0 0 • 0 • 

• •••••••••••••••••••••••••••••••• •••••••••••• ; •••• ••• ••••••••• :, ••••••• • ••• ••• • .,:.. •••••• •••• ••••• : ••••• •••••• o••·• •••••••••••••• o.:oooo• o oooo •• ••••:. •••• • ••••••••••• :.oooo•o 

• 0 • • • 

. . . . . . . . . . . . . . . . . . . . . •••••• o ·•······ ·····•••oooooooo ················~················~·· ·00000 0000 •••• o o o o ooo oioo oooo o• • • ••··.:. · ,;.-----""'------.. -----· 

. . . . . . . . . . . . . . 0 • • • • 

••••o•••······· •• • ••••• ••••• •• • · · ·· · ······••o••• ········· · ····••.; ••·••oOoooo0000-00 ooooooooooo ooooooooooo ••• 00000000000000 00 ooo o o o oo o ooo••··················· .. ••o o oo 

• 0 0 0 • 

• 0 • • • 

• 0 • • • 

• 0 • 0 • 

• • • 0 • 

. . . . . . . . . . . . . . . . . . . . 0 0 0 0 0 o #o 0 0 0 0 0 o 0 0 o o oo oo o o o o o o o o o o o o o o o o o oo o o o o o o o o o o o o o ~ o o o o o o o o o o o o o o o •!" oo o o o o o o o oo o o o o -:• o o o o o o o o o o o oo o o o o o o o o o o o o o o o oo o o o o oo o o o o o o o o o o o 0 o oo o o o • o o o o~ o o o o 0 o o o o o o o o o o •:- • o oo o o 

. . . . . . . . . . • • • • 0 

• • • • 0 

. . . . . • • • • 0 

. . . . . . . . . . . . . . . ••••••••o••···· oooooooo•••····· ••• •••oooooooo •••·· · ···· · ··· · ··· - ··········••oo •-··· •••••••••• ••••• • oo 000000 ••••••ooo••••··· ooooooooooooooo••··········o····-•o•••• . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .............................................. •) ............... ·:· ................ ;. . . . . . . . . . . . .. . . . . . . . . ...................................... ) ................ ; ...... . . . . . . • • • 0 • 

• • • 0 • 

• • • 0 • 

. . . . . • 0 • • • 

• 0 • • • 

• 0 • • • 

• • 0 • • 

0 5 10 15 20 25 30 35 40 45 50 

Year 

Notes: For 6% example, 6% discount rate is use d 

in years 2-26. As a result, longrun cost is 

deer e a sed by 4.2% ove r 50 years. 

I 

tv 

\0 

I 
-30-

and 34. After year 34, contributions would be the same as if the actuarial discount rate had 

never been lowered. 

The use of a lower discount rate would therefore speed up the contributions and the 

employer would realize a higher tax benefit and lower long term pension cost. By lowering the 

actuarial discount rate by one point and speeding up contributions in the short run, the employer 

in the example would lower the cumulative present value of all future contributions and therefore 

decrease pension cost over the next fifty years by 4.2 percent. Likewise the long term tax 

benefit would increase from 42 percent to 44.4 percent. 

Similar cost reductions can be created by changing other actuarial assumptions such as 

the expected future salary growth rate or the expected future rate of employee turnover, although 

changing such assumptions might not have as large an impact on the long term tax benefit as 

changing the discount rate. 

IV. OBRA 87 Full Funding Limit 

A. The Limit 

The Code and regulations thereunder clearly specify a range of funding methods that may 

be used to fund qualified plans. However, the ability of employers to significantly increase the 

tax benefits of a pension by changing actuarial assumptions can conflict with the provision that 

such assumptions should be "reasonable". This ability to increase the tax benefits of a pension 

by changing actuarial assumptions can create a significant element of selectivity in the funding 

and contribution limits. 

If the effects of the Code limits only depended on a single assumption, such as the 

discount rate, then the solution to this problem of selectivity would be straightforward. For 

example, the Code could require the assumed discount rate to fall within a narrow range of a 

readily observed standard, objective measure such as the current annual yield to maturity on long 

term U.S. Treasury bonds. However, the solution to the problem is not so straightforward 

because many actuarial assumptions can be important in specifying the Code contribution and 

funding limits for each employer. The important assumptions include the discount rate, the 

expected future rate of return on pension assets, the expected inflation rate, the expected rate 

of future salary growth for each active employee, the mortality rates, the expected future rate 

of employee turnover, and other assumptions. An employer's adjustments to any of these 

actuarial assumptions could influence the contribution and funding limits in a way that would 

increase the employer's tax benefits of pension funding. Further, many of the assumptions can 

be expected to vary over time, across employers, and over plan participants, even if they are 

the best assumptions. It would therefore be very difficult to adequately regulate the actuarial 

assumptions by constructing objective, readily measured standards of "reasonableness." 
-31-

As an alternative to imposing stricter rules about actuarial assumptions, the Omnibus 

Budget Reconciliation Act of 1987 (OBRA 87) took a new approach to solving this problem by 

creating an additional full funding limit that would depend on fewer actuarial assumptions. 

Before OBRA 87, Code Section 412 used each employer's accrued liability as the long term full 

funding standard. OBRA 87 changed the full funding standard to equal the lesser of an 

employer's accrued liability or 150 percent of the employer's current liability .

18 Further, under 

the new rules current liability for use in the funding limit must be calculated at an actuarial 

discount rate that falls within a 90-to-110 percent corridor of a four-year moving average of the 

annual yield to maturity for 30-year U.S. Treasury Bonds. 

The new approach to limiting pension funding is fundamentally different from the old 

approach because the additional full funding limit, i.e., 150 percent of current liability, does not 

depend on an employer's funding method. Moreover, the new limit is less sensitive to actuarial 

assumptions because current liabilities only depend on benefits accrued to date. Future salary 

growth does not matter. As a result, the new funding limit does not require such strict 

regulation of actuarial assumptions as might otherwise be required. Further, the most important 

assumption, i.e., the discount rate, must now fall within a well-specified and narrow range of 

an objective index for calculating the new funding limit. 

While this new solution to regulating pension funding has the advantage of making the 

maximum contribution limit less selective and less subject to possible abuse, the new approach 

also has side effects that might be undesirable to policy makers. In order to evaluate the new 

funding limit relative to other possible funding limit policies, therefore, it is necessary to 

understand both the possible advantages and disadvantages of the OBRA 87 full funding limit. 

B. Effects of the OBRA 87 Limit: "Correct" Actuarial Assumptions 

This section uses the example developed above to show how the new OBRA 87 limit 

would affect a young plan that uses the best possible actuarial assumptions. 

Recall that Figure 2.5(a) shows what the pre-OBRA 87 funding standards under various 

funding methods would be under the "correct" assumptions with no economic uncertainty. 19 

The ratios of the funding standards to current liabilities shown in the figure depend on the 

employer's chosen funding method and the demographic characteristics of the covered 

population. The new, additional full funding limit under OBRA 87 would be the lesser of the 

old full funding standard and 150 percent of current liabilities. OBRA 87 would therefore only 

1

&ne term "current liability" in the Code is similar to the current liability defined in this 

chapter but may differ in its technical aspects. 

~e use of "correct" here is not meant to imply that they are the correct assumptions to 

be used in practice. The usage only implies that they are the correct assumptions for the 

example. 
-32-

affect the plan shown in Figure 2.5(a) if the old funding standard, accrued liability, would have 

exceeded 150 percent of current liability. 

Figure 2.5(a) shows that the plan would never be affected under method 3 because, under 

method 3, accrued liability never exceeds 150 percent of current liability in the example. 

However, the figure also shows that the plan would have been affected under the faster funding 

methods (methods 1 and 2), depending on when the law became effective. For example, after 

year 33 the new limit would not matter under any of the funding methods shown. Figure 2.5(a) 

therefore illustrates two of the most important determinants of the effect of the OBRA 87 limit. 

First, plans that use faster funding methods are more likely to be affected. Second, plans with 

younger active worker populations and fewer nonactive plan participants are more likely to be 

affected by the OBRA 87 limit. 

Figures 2.8(a) and 2.8(b) show how OBRA 87 would affect the plan if the new limit was 

imposed in year 2. The dashed line in Figure 2.8(a) shows what the funding ratios would have 

been under method 1. The solid line in Figure 2.8(a) shows what would actually happen to 

funding levels as a result of OBRA 87. Because accrued liability exceeds 150 percent of current 

liability in the early years, the new limit would become the funding standard until the accrued 

liability falls below 150 percent in year 33. After that, the old and new funding standards would 

be identical. 

Figure 2.8(b) shows what would happen to annual contributions by showing annual 

employer contributions under the OBRA 87 limits as a percentage of what contributions would 

have been without the OBRA 87 limit. As a result of the 150 percent limit, no contributions 

would be permitted for the first five years of OBRA 87. Thereafter, contributions would be 

allowed but restricted by the 150 percent limit. After year 33, the new limit would not be 

binding because the old limit would have been below 150 percent of current liability anyway. 

Eventually, by year 45, contributions would equal what they would have equalled without the 

OBRA 87 limit. 

Figure 2.8(b) also shows that as a result of being limited to making no contributions in 

the first five years of OBRA 87 and reduced contributions in years 6 through 12, the employer 

would eventually, after year 12, make larger contributions than would have been made without 

OBRA 87. Future liabilities do not change because of OBRA 87. The OBRA 87 limit would 

merely delay funding of future liabilities. Further, Figure 2.8(b) shows that contributions 

increase long before the old funding limit, accrued liability, falls below 150 percent of current 

liability in year 33. 

As a result of delaying contributions, the OBRA 87 limit effectively slows the speed of 

funding and decreases the long-run tax benefit in the example. In the example, the present value 

of all future contributions increases by 4. 1 percent through year 50. Similarly the long-run (perdollar) tax benefit under funding method 1 is decreased by 2 cents from $0.42 per dollar to 

$0.40 per dollar. 
300 

275 

250 

"0 

Q) 

"0 225 ~ 

::::1 

ct-. 

Q) 

200 

bll 

.., 

175 +) 

~ 

Q) 

C) 

150 """ Q) 

0.. 

125 

100 

75 

Figure 2.8( a) 

Effects of OBRA 87 on Funding Ratios 

Under "Correct" Actuarial Assumptions 

: . . . -·-- si : : 

. . . . . • • • • • • ••••• · · ··" . . . . .. . ...... ........... . .. . 0 ••• ""' •• 0 •• • 0 ••••• 0 . ,, •••• •• •••• • ••••• 0 •••••••••••• ••• •••••••• • ••••••• •••••• 0 • • •• 

• • • 0 

. .... ..................... . . . . . . . . . . . . . . . 0 • • • . . . .. . . . . 0 • • • . . . . . . . . . . . . . . . . . . . . . . . . 

0 5 10 15 20 25 30 35 40 45 50 

Ye ar 

Without 

OBRA 

----- With 

OBRA 

Method 3 

I 

UJ 

UJ 

I 
Q) 

b1l 

~ 

.....> 

Figure 2 .8(b) 

Contributions With OBRA 87 Limit as Percentages 

of Contributions Without the OBRA 87 Limit 

l501l--~--~--~--~--~--~---;---:--~--~-

125 • <•••< •••<••. ••• •• ••>· ~ ............ r uu•••••••••••••••••••• 

100 ...... .. ....... ................................................................................ . 

~ 75 ............................................................................................................................................. .................... . 

<:.> 

J.. 

Q) 

p.. 

50 ................................................................................................................. ;; .......... .. : ............ ............... ..... . 

25 ....... . ......................... ··············· ............... ··············· ··············· ................................................... . 

0 

0 5 10 

Note: Longrun cost is increased 

by 4. 1% over 50 years. 

15 20 25 30 35 40 45 50 

Year 

I 

w 

~ 

I 
-35-

C. Effects of the OBRA 87 Limit: Older Population 

If the plan in the example was older when the new OBRA 87 limit was imposed, then 

the new limit would affect it less. If the plan had been more than 33 years old, the OBRA 87 

limit would have had no effect at all. This is because the pre-OBRA 87 funding standard, i.e., 

accrued liability, becomes lower as a percentage of current liability as the active employee 

population grows older and as the inactive populations grow in relative size. 

Figures 2.9(a) and 2.9(b) show what would happen to the example plan if the OBRA 87 

limit was imposed in year 11 instead of year 2. This example shows the effect on a plan that 

is older than the plan in the previous example. Like the patterns shown in Figure 2.8(b), 

Figure 2.9(b) shows that no contributions would be allowed in the first five years of the 

OBRA 87 limit. Further, contributions would increase in years after that, but not by as much 

as they would have for the younger plan in terms of present value. As a result, the sponsor's 

long-run cost increase would be only 2.6 percent through year 50, whereas the sponsor of the 

younger plan in the first example would have experienced a long-run cost increase of 4.1 

percent. 

This example shows how plans that were affected by the OBRA 871imit, but were older 

when the new limit took effect, would be less affected in the long run. 

D. Effects of the OBRA 87 Limit: Low Discount Rate 

Recall from the discussion of figures 2.6 and 2.7 in Section III.C that before OBRA 87 

an employer was able to increase the long term tax benefit and decrease long term pension costs 

by using a lower discount rate in order to speed up the rate of funding. Figures 2.10(a) and 

2.10(b) show how such a plan would be affected by the OBRA 87 limit. 

This example was constructed to show the effects of two features of the OBRA 87 full 

funding limit. Not only is the new limit equal to 150 percent of current liability, but current 

liability must be calculated using a discount rate that is within a 90-to-110 percent corridor of 

average long term U.S. Treasury-Bond rates. To combine these two features, Figures 2.10(a) 

and 2.10(b) were constructed to show what would happen if the employer normally uses a 

6 percent actuarial discount rate, but is required by OBRA 87 to use a 7 percent discount rate 

to calculate current liability for determining the new funding limit. 

Figure 2.10(a) shows that because the employer would have used a 6 percent actuarial 

discount rate in years two through 26, the funding standard would have been higher for those 

years without the OBRA 87 limit. Recall that this same pattern was shown in Figure 2.6. 

However, because the OBRA 87 limit is imposed in year 2 and is calculated at a 7 percent 

discount rate, the new funding standard would result in a pattern of funding that is identical 

under OBRA 87 to the pattern for the first example that was shown in Figure 2.8(a). This 

funding pattern under the OBRA 87 limit is shown by the solid line in Figure 2.10(a). The 
~ 

Q) 

~ 

1::: 

~ 

It-o 

Q) 

QD 

~ 

~ 

1::: 

Q) 

C) 

$.4 

Q) 

p... 

Figure 2. 9( a) 

Effec ts of OBRA 87 on Funding Ratios 

For an Older Pe n sion Plan 

0~~--~--~--~~--:----;---;----;----;---;----~ 

275 

250 

225 

200 

175 

150 

125 

100 

75 

...... . ]\ . ?-...... . . . ........ . ... ! • ; _ 

. ..i... .......... T ... ''!· ••• ! ! ··········!·············-r·· ; ......... , . • •••,..- .. ._.ioee I :.: ... :::1 .. : ]......... ;.. : i ! .... ; . . . 

. . 

--~ • 1 •u • . ,, . . ; . . . . . . . .. . .. ... ( ........ . .. . .. . ; .. .... ...... ... , ...... . ....... . ; ....... ..... ... ; ....... . . . ..... ~ ..... . 

; : *!»• ··- i : : : : : : : : : II ....... . 11-·1 : : : ~ ~ ~ ~ ~ ~ -.. r .. - . ·-~~-.. ~ 

... .. .. . .. . .. ·< .. .. r···· T ···········r·· . .... .. !. . r··· ····< . 

0 5 10 15 20 25 30 35 40 45 50 

Year 

Wilhoul 

OBRA 

--- .--

Wilh 

OBRA 

Method 3 

I 

1..-) 

7' 
Q) 

btl 

~ 

~ 

d 

Q) 

CJ 

~ 

Q) 

a.. 

Figure 2. 9(b} 

Effects of OBRA 87 

on Contributions for an Older Plan 

150r-~--~--~----;----;----;---:---~----~--------~ 

125 . . . •••••• c • •• ••• • ••••••••• ' ············. •••! .........•... ···! ............... •!. . . . . . . . . . . . . 

1 00 1 ...... (...... .. .......... ; ................ ~ ....•.........• ~ ................ , ................ , ................ , ... .. 

75 I ·····!······ ·· · ··············· t ·· ····· .. , ........... ·········· ··············· ··············· .... ·· · · .. · .. ·········· ······ 

50 !···· .. ~ ................................... , ......... ··/·········· ............... .............................................. ··············· .................... . 

25 !. ..... : ......................................................... ............... ··············· ............................................... .................... . 

o~~--~----~._~----~--~----~--~----~--~----~~ 

0 5 10 15 20 25 30 35 40 45 50 

Year 

Nole: Longrun cosl is increased 

by 2.6% over 50 years. 

I 

l.oJ 

.....J 

I 
300 

275 

"0 250 

Q) 

"0 

~ 225 

==' c.-. 

Q) 200 

bD 

(13 

~ 

~ 175 

Q) 

C) 

~ 

Q) 150 ~ 

125 

100 

75 

Figure 2 .10(a) 

Effects of OBRA 87 on Funding Ralios for Plan 

That Uses a 6% Discount Rate in Years 2-26 

• • ' • ' ' 0 • • • ••• u.[,, ••••••+• uuu. ,•••• u ;.,..•• ..... ' • ' ' ' • ' ' 0 . • •• •u •• •••' ouo I uuo ·········I ' • • •' • 

' / ; ' ; ' u u uuiuuuu' ' ! ; 0 0 ;..,,_, ..... _,_ ! 

.... T:::.::: : r: : J ::: T ·: I: u uuju u u 't:~~: c : UUu • u• u u u uuo u uuuu Vu 

: . 

0 5 10 15 20 25 30 35 40 45 50 

Year 

Note: 6% discount is used by plan in years 

2-~6. Current liability is calculated at 7% 

discount rate in all ycm·s. 

Without 

ODRA 

.. ~.- --~ 

With 

OBRA 

Method 3 

I 

Y-J 

00 

I 
250 

225 

200 

175 

Q) 

Figure 2.10(b) 

Effects of OBRA 87 on Contributions for Plan 

That Uses a 6% Discount Rate in Years 2-26 

. . . . ........................................ ······················· . . ··········-···············-·. ················. ········ ..... ·················································-······ . . . . . . . . • 0 0 0 

. . . . • 0 • 0 

• • 0 • 

0 • 0 0 

........................................... ·· ·············:··············· :- ··· ··· ··· ··· ~······ ····· ··· !•• • ....... . ....................................... ......................... . • • 0 0 

• • 0 • 

0 • 0 • 

0 • • • 

. . . . 0 0 • • 

0 • • 0 

••• ••••••••••• • • •••• • •• • ••••••• • ••••• •• • • ••• ••••••••••• • ,. ••••••••••• •• 0 0 ·=· ......... 0 ·····"!······ .......... (•. ......... . ................. ·•··· ..................................... 000 

. . . . • 0 • • 

• 0 • • 

0 • • • 

:f 150 

. . . . • 0 • • 

. . . . .......... oooo•••••••••••o•••··· · ········ •••••••• •••••••• :, ••••.•••••••.••. ; ••. 0 • •• 0 00 0 •••• .; ••••••••• ooo .••. ,0 00000 ••• 0. • 0 ••• •••••••••••••• • •••• •• ····••••oo, .••...•••• Oooooo, ••.••• 0 • • • 

..,; 0 • • • 

. . . . s:: . . . . . . . . . . Q) 125 CJ 

$.., 

. . . . . . . ··········•·•• •• oo ooooo ooo oooooooo oooooo. 

o••··············. · ········· ···o···. - ···· ··········- ·····················••••o•• ••••••••o• . . . . . . . . . . . . . . . Q) 

ll.. JOO . . . . . . . . . •••••o"'•••· ·· ··•••••ooo ••••oooooooooo oo o; •••.••••.••••••• ~ ·········~·· ·•oo oooo •••• .:.·-···· ····· ~· ·•o •••·· ····· oooo oooo•••••· ·· ... ~ ~ i . . . . . . . . . . . . . . . . . . 75 

50 

. . . . . . ......................................... ............... f ............... -r···············r ............... r··············· ................ ················r······ .. ········r······ 

..•...•••••••••••••••.• , .••.••• •••••• •• ·············•·•i o••·•···•••ooooo; .•............• ,: •••. .. .••••••••. , •.•. . . ......•... 00 000 0 0 0000 00000 · ···-···········i ••••••oooooooooo;. •.•.•. . . . . . . . . . . . . . . . . . . • • • • 0 • 

. . . . . . 

I . . I : = : : = : 25 ...... ~ ................ ···· .......................... :················:····· .......... ~ ................ ~ ................................................ : .. ·············-:-··· .. . • 0 • 0 • • 

• 0 • • • • 

. . . . . . . . . . . . 0 ; : : : : : : 

0 5 10 15 20 25 30 35 40 45 50 

Year 

Noles: Longrun cosl is increased by 8. 7% over 

50 years. Denominator (contributions without 

ODRA 87) is zero in years 27-32. 

I 

Yo) 

10 

I 
-40-

employer's new limit under OBRA 87 would therefore not be affected by the employer's choice 

of a low-discount rate. 

20 

Figure 2.10(b) shows how contributions would be affected. As in the first two examples, 

the OBRA 87 limit would not allow any contributions in the first few years, but contributions 

would increase in the following years. In this example, the OBRA 87 limit would lead to the 

same maximum annual contributions as in the first example, but the contributions without 

OBRA 87 would have been larger in the early years in this example (compare Figures 2.8(b) 

and 2.10(b)). As a result, the OBRA 87 limit would increase the long term pension cost by 

more in this example than it would have in the first example. The long term cost would increase 

in this case by 8.7 percent through year 50, whereas the increases would have been only 

4.1 percent in the first example. Note, however, that the resulting long term tax benefit under 

OBRA 87 would be the same as it would be in the first example under OBRA 87, i.e., 

40 percent. 

This example shows that the OBRA 87 limit can be effective in preventing employers 

from increasing their tax benefits by adjusting actuarial assumptions. However, even though the 

new limit can have such an effect, this example also shows that the total effect of OBRA 87 

depends upon the employer's choice of actuarial assumptions, the funding method, and the 

demographic characteristics of the employer's covered population of pension participants. 

E. Effects of the OBRA 87 Limit: Annuitized Benefits 

The accrued liability for a plan population is the sum of the accrued liability for active 

employees and the accrued liability for inactive participants such as retirees and vested 

ex-employees. The accrued liability for active employees is defined by the funding method and 

tends to be greater than 100 percent of current liability under methods that depend on projected 

future salaries. In contrast, the accrued liability for inactive participants would equal 100 

percent of current liability regardless of the funding method. As a result, total accrued liabilities 

would tend to be higher as a percentage of current liabilities for plans that have relatively fewer 

inactive participants. Such plans are therefore more likely to have been affected by the 

OBRA 87 limit because it is more likely that their pre-OBRA 87 funding standard, accrued 

liability, would be above 150 percent of measured current liability. 

In the preceding examples, the plan was assumed to have relatively fewer inactive 

participants in the early years when the active employees also tend to be younger. These two 

combined factors increased the impact of OBRA 87 on younger plans in the example relative to 

~ote that the OBRA 87 limit would even be binding under the slowest method in the 

example in years 3 through 13. This occurs in the example because the employer uses a low 

discount rate. In principle, however, this phenomenon could also occur even under the "correct" 

7 percent discount rate for a population with even younger active employees than in these 

examples. 
-41-

older plans. However, plans do not have to be relatively new and have young active employees 

for inactive participants to account for a relatively small fraction of liabilities. Even older plans 

can have a relatively small fraction of liabilities allocated to inactive participants. For example, 

an employer might purchase annuity contracts from a private insurer on an ongoing basis when 

employees retire. Once such an annuity contract is purchased, the associated liabilities no longer 

belong to the employer and are therefore no longer counted as part of either accrued liabilities 

or current liabilities. As another example, employers sometimes purchase privately-insured 

annuity contracts for inactive participants on a one-time basis. In either case, the purchase of 

annuity contracts would increase the ratio of accrued liabilities to current liabilities and would 

therefore increase the likelihood that the OBRA 87limit would affect the employer's contribution 

limits. 

This example was. constructed to show the possible importance of such private annuity 

purchases. This example uses the same assumptions as the first example, except that it is 

assumed that annuity contracts are purchased whenever a participant leaves active service either 

to retire (an immediate annuity) or to be part of the vested, non-retired population (a deferred 

annuity). As a result, total accrued liabilities and total current liabilities in this example only 

account for active employees. 

Figures 2.ll(a) and 2.ll(b) show what would happen. The top, dashed line in 

Figure 2.1l(a) shows the history of pre-OBRA 87 funding standards (accrued liability) and 

funding levels as they would be measured for such a plan. Note that the levels are higher than 

those shown for the first example in Figure 2.8(a). This is because Figure 2.11(a) only accounts 

for active employee liabilities. As a result, the figure shows that the OBRA 87 Limit would 

become the funding standard for all 50 years of the example, whereas the OBRA 87 Limit only 

matters for 33 years in the first example. 

Figure 2.1l(b) shows how contributions would be affected by the OBRA 87limit. As 

in the previous examples, contributions would not be allowed in the first few years of OBRA 87, 

but would increase thereafter. In terms of present value, the contributions in this example would 

not be affected by OBRA 87 over the 50-year period. However, the present value of all future 

contributions would eventually increase as a result of the OBRA 87 limit because contributions 

would be slower. 

This example shows that the OBRA 87 limit is more likely to affect plans that purchase 

private annuity contracts. The new 150 percent OBRA 87 limit would not account for the fact 

that under normal conditions, as determined by the old full funding standard, assets would 

normally be higher as a percentage of measured current liabilities than they would have been if 

there were no annuity purchases. 
300 

275 

250 

'\j 

~ 225 ~ 

~ 

'+-< 200 

Q) 

b.O 

ro 175 +) 

~ 

Q) 

CJ 150 s... 

Q) 

0.. 

125 

100 

75 

...... , ....... . 

Figure 2. 11 (a) 

Effec ts of OBRA 87 on Funding Ratios for Plan 

That Buys Private Annuities 

...... i ........... \1. .. I ............. L ..... .r~ ~r-~ .. ~~~ ~~ ~r· · ···· · ···· ··-··· .... :

: 

... : ~ ·····-·· : .. ··-

: : ······ ............... ., : ... :· : .... ·

, ----·- .. ····· ·:·· ·- --~---- ·-·r··· · r·= ·· 

..... -~······. ········: .... 

-~~-~~· 11-11-11 I : : I! I .. .,. ..... 

. .... . .. ..... T ......... t ....... ·r ....... l ... :: .. f . . '~" ,_ -· .. t ....... ,,_,.; ... ,, *'. . 

···· ··· · T·········r· ···r·· r······· r· ···r····· ··· ·······-r r· · ··r 

0 5 10 15 20 25 30 35 40 45 50 

Year 

Without 

OBRA 

~~--~--

With 

OBRA 

Me thod 3 

j.. 

IV 

I 
~ 

bJl 

ro 

~ 

~ 

~ 

CJ 

.... 

~ 

p.. 

120 

Figure 2.11(b) 

Effects of OBRA 87 on Contributions for Plan 

That Buys Private Annuities 

. . ....................................................... ···············-·· . ·············-. ···· 

. 

. . 

. . 

100 cLJ 

. . •••••• , ••••••••••••••••••• ••••••••• ••••• •••••••• ••••••• ·· ~· · ••• • •••• •••••••• : •••••••••• •• •• •• ; ••• ••••••••••••• ; •••••••••••• 'llr:. .~ ••••••••• •.••••• , •••• •• 

80 ................................ .. . . . •••••••••••. •.. •. ··i .......•.•••••.• :, ••. ..... . 00 •••• .,; •••• 0 •• 0 •••••••• i• •••••••••.•• 0 •• ; • ••• ••••••••••• · • ·· • •••••••••••• ·i· ........ 0 ••••• - :· •••••• 

60 ............................... .. ...... , ................ ~ ................ ~ ................ : ................ ( ................ , ................ , ................ ~ ................ ~ ..... . 

40 ! ...... ! ................ ; ........ ...... ................ ~ ......................................................................................................... ..... . 

20 ! ...... ~ ................ : ................................ ... .. .......... ............... ............... ............... ............... ............... .. ................. .. 

0 ; : 

0 5 JO 15 20 25 30 35 40 45 50 

Year 

Note: Longrun cost is r educed 

by 0.3% over 50 years. 

~ w 

I 
----~------------- ----------- --------------------------------

CHAPTER 3: EMPIRICAL EVIDENCE ABOUT THE FULL FUNDING LIMIT 

I. INTRODUCTION 

The analysis in Chapter 2 shows that the effects of OBRA 87 depend on many factors 

that can differ among plans. For example, plans that cover younger employees are more likely 

to be affected than plans that cover older employees. Likewise, employers that fund faster are 

most likely to be affected, as are employers that use low discount rates and employers that 

privately annuitize retirement benefits. The reasons that such factors matter and the ways that 

they matter are shown in Chapter 2, but the extent to which they matter is an empirical issue. 

Based on data from 1989 financial statements of corporate pension sponsors, the analysis 

in this chapter examines the degree to which private, single employer defined benefit pension 

plans have been affected by the OBRA 87 full funding limit and the extent to which actuarial 

factors and demographic factors matter. In addition, the last section of this chapter examines 

the likely effects of the OBRA 87 funding limit on employees' pension risk. 

II. HOW FUNDING RATIOS ARE DISTRIBUTED1 

A. The Distribution 

Figure 3. 1 shows how funding ratios were distributed in 1989 for all private, 

single-employer defmed benefit pension plans in the United States. 

2 The distribution is based 

on data from 1989 financial statements of private employers whose pension assets totaled 

$652 billion, or about 85 percent of all private, single-employer defmed benefit pension assets. 

3 

The area under the curve in Figure 3. l shows the percentage distribution of funding ratios. The 

area inside each rectangular grid under the curve represents five percent of the plans. Thus, for 

example, because there are about five rectangular grids under the curve between the 150 

1

See the Glossary on page 75 for a summary description of actuarial terms used in this 

chapter. 

2 As in Chapter 2, funding ratios are defined here as assets expressed as a percentage of 

current liability. Current liability was measured for this chapter by using the Accrued Benefit 

Obligation reported on financial statements. ln Section m below, current liability is adjusted 

to account for discount rate requirements under OBRA 87. See Appendix B for details. The 

measure of current liability used in this chapter is only an approximation to "current liability" 

as it is defmed under the Code. 

3Data used throughout this chapter are from Compustat 11, Standard & Poor's Compustat 

Services, Inc. and IRS Form 5500 as noted on each figure and table. Appendix B further 

describes the data and methods. 

-45-
Figure 3 .1 

Distribution of Funding Ratios in 1989: 

All Private Single Employer Pension Plans 

1.5 

-"0 , • 

Ill 1.0 1... ... ,, . . . . \ ..... .......... . 

~ ........ ..... ... ..L.. ... . L ........... l.. ... .. ..l ....... \I.. . .... ::::::::r::::::::::: r:::::::::::::r::: 

Q) 

...,_) 

..c:: 

bll 

·-

Q) 

~ 

. . . .. .. . ............ ................ ................ , ................ .,. ..... . It-t '( ................ ..... 

'"7' ....................... . 

0 

Q) 

~ 0.5 ...... . ,._) 

. . . . . . . . . . . . . . . . . . . . . . . . 

. . . . •••••••••••••••••••••• ••• •••••••• 0 • •• • , •••••••• • ••••••• , •••••• 

~ 

Q) 

C) 

s.. 

Q) ··· ······ ·· ~··············· · ··············· ............... ··············· ............... ··············· ·············· ··············· ............... ..... . 

~ 

0.0 : 

50 70 90 110 130 150 170 190 210 230 250 

Assets as a percentage of c utTe nt liability 

Source: Compustat II 

(see Appe ndix B for details) 

~ 

'?' 
-47-

and 170 percent marks on the horizontal axis, the figure shows that about 25 percent (=5*5%) 

of plans had funding ratios between 150 percent and 170 percent of current liability. Likewise, 

because the area under the curve is relatively small to the right of the 190 percent mark on the 

horizontal axis, the figure implies that only a small percentage of plans (about 5 percent of 

plans) had funding ratios higher than 190 percent of current liability. 

Throughout this chapter, unless otherwise noted, plans are weighted by dollars of current 

liability for the purpose of calculating statistics and distributions. Such weighting causes plans 

to be represented in direct proportion to their size. As a result of weighting, the areas under 

the curve in Figure 3.1 actually represent percentages of dollars of current liability of plans. 

However, when discussing distributions and statistics, the term "percentage of plans" is used 

throughout this chapter as shorthand for "percentage of dollars of current liability of plans." • 

Figure 3.1 shows that funding ratios of plans varied widely in 1989. The average funding 

ratio was 139 percent of current liability, but Figure 3.1 shows that a significant percentage of 

plans were funded at much higher levels. For example, 50 percent of the plans were funded at 

levels higher than 144 percent of current liability. Further, 10 percent of the plans had funding 

levels higher than 178 percent of current liability. The figure also shows that a significant 

percentage of plans were funded at levels far below the average. For example, 10 percent of 

the plans had funding ratios lower than 83 percent of current liability. 

Understanding the effects of OBRA 87 requires an understanding of the causes of the 

variation shown in Figure 3.1. Some causes of the variation are purely random. For example, 

funds may earn different rates of return on their investments simply by chance. Funds that have 

earned extraordinarily high investment returns tend to be funded at high levels. However, much 

of the variation shown in Figure 3.1 can be explained by systematic differences between plans, 

such as the type of benefit formula and the type of actuarial method used for funding. Further, 

funding levels can be systematically influenced by differences in actuarial assumptions, plan 

amendments, and demographic factors. 

•current liability was used as the weight because it is a more standardized and meaningful 

measure of plan size for this study than alternative measures such as total assets or employees. 

Unweighted statistics and distributions could be misleading because plan sizes vary enormously. 

Unless one is explicitly interested in the effects of plan size, it could be misleading, for example, 

to weight a plan with $10 million of current liability the same as a plan with $10 billion of 

current liability. As an extra check, however, all statistics and distributions were also computed 

without weights. The unweighted quantitative results differ from the weighted results, but the 

qualitative nature of the results and general conclusions of the analysis in this chapter are 

unaffected. 
-"0 

Q) 

,._) 

-'= bD 

·-Q) 

~ 

-

2.5 

en 

~ 1.5 

Cd 

-Cl. 

Figure 3.2 

Distributions of Funding Ratios in 1989: 

Effect of Benefit For'mulas 

., . : : . . : : . . 

..... 

0 

Q) 

bD 

Cd 

,._) 

~ 

Q) 

..... ,: ... . .... j \ ... !·· . .. . + ....... !···· : . . ... j.. . . . ... j.. . .l .......... .l. ................. . . '

. . . . . 

I , ... T .. ····:J.::···· J~~ :·.:--~···. ··· :--~ . . .1 .. ...... ; .... : J:. ·· .. I:·· .. ··::r ... :::~·· 

. I ·:.r···:.I ' .J·. J~:r . I.::···· .. · .. ! ' .. . .... ~ 0.5 

Q) 

p... 

: . : :...__, : : ' : 0 : : : : : ~ . 

50 70 90 11 0 1 30 1 50 1 70 1 90 2 1 0 2 30 250 

Assets as a per·cenlage of curTenl liability 

Sources: Cornpuslal II and IRS Forrn 5500 

(see Appe ndix D for de tails) 

Non-earnings 

based plans 

---

Earnings 

based plans 

,J:.. 

00 

I 
-49-

B. Benefit Fonnula 

Different defined benefit plans can use different formulas to calculate retirement benefit 

amounts. Out of all employees covered by medium and large private defined benefit plans in 

1989, 76 percent were covered by plans that use a formula based on annual employee earnings 

and years of service. s As an example of a typical earnings based plan, the plan examined in 

Chapter 2 calculates annual benefits by multiplying 1.5 percent times an employee's years of 

service times the employee's average annual salary in the final five years of service. In contrast, 

non-earnings based plans offer retirement benefits that are not based on annual earnings but are 

often based on years of service. For example, an employee might be promised $20 monthly for 

each year of active service. In such a plan, an employee's monthly retirement benefit would 

equal $600 after 30 years of service. In 1989, 24 percent of employees covered by private 

defined benefit plans were covered by non-earnings based plans. 6 

The funding levels of plans are greatly influenced by whether or not the plan formula is 

based on earnings. This is because earnings based plans are funded in a way that accounts for 

expected future employee earnings growth.

7 The pension funds for earnings based plans 

therefore typically contain assets that are large in value relative to current liability because 

current liability only accounts for past employee earnings. In contrast, non-earnings based plans 

are funded in a way that does not account for expected future employee earnings growth because 

the benefits paid by such plans are not based on earnings. The pension funds for non-earnings 

based plans therefore contain assets that are typically smaller in value relative to current liability 

when compared to the funding levels of earnings based plans. 

Figure 3.2 shows how the distribution of funding ratios for single employer earnings 

based plans differs froJll the distribution of funding ratios for non-earnings based plans. The 

distribution for earnings based plans is represented by the solid curve. Such plans had an 

average funding ratio equal to 145 percent of current liability. By comparison, funding levels 

of non-earnings based plans are considerably lower, as shown by the dashed curve. The average 

funding ratio for non-earnings based plans was only 75 percent of current liability in 1989. Such 

low funding ratios are a direct consequence of the fact that non-earnings based plans are not 

funded in a way that accounts for future earnings growth. 

8 

5

Source: U.S. Department of Labor, Bureau of Labor Statistics, "Employee Benefits in 

Medium and Large Firms, 1989," June, 1990. 

6

ibid. U.S. Department of Labor, Bureau of Labor Statistics. 

7

See Section II.B of Chapter 2. 

'Note that the funding ratios in Figure 3.2 are truncated below 50 percent of current liability 

for display purposes even though about 5 percent of non-earnings based plans are funded at 

levels below 50 percent of current liability. 
-50-

General price inflation provides another reason why non-earnings based plans are funded 

at such relatively low levels. In addition to not accounting for future earnings growth, the 

benefits of non-earnings based plans are often increased in an ad hoc fashion to reflect inflation. 

The increases are ad hoc in the sense that they are not promised by a formal pension contract. 

Every time such inflation indexing occurs, the employer's current pension liability is increased 

immediately. To account for the increased current liability, however, assets are only increased 

gradually under current law. As a result, non-earnings based plans tend to be funded at levels 

below 100 percent of current liability. 

Ad hoc inflation indexing also occurs sometimes for earnings based plans, but there is 

an important difference. The sponsors of earnings based plans may increase the fixed annuities 

paid to retirees after they retire to account for past inflation, but these increases do not affect 

the benefits that have been promised to currently active employees. This is because the benefits 

promised to active employees covered by earnings based plans increase automatically with 

earnings, which tend to already include adjustments for inflation. In contrast, the sponsors of 

non-earnings based plans sometimes index retirees' benefits, but when they do, they also 

increase the flat dollar amounts that have been promised to currently active employees. Thus, 

inflation indexing tends to have a relatively larger affect on the funding ratios of non-earnings 

based plans. This partly explains why the average funding level for such plans equaled only 

75 percent of current liability in 1989. 

The differences in funding levels caused by differences in benefit formulas also explain 

why the distribution of funding ratios for all single employer defined benefit plans shown in 

Figure 3.1 has two modes. (Note the two large bumps on the distribution.) The lower mode, 

centered at 85 percent of current liability, reflects the presence of non-earnings based plans. 

The higher mode, centered at 150 percent of current liability, reflects the presence of earnings 

based plans. Thus, as demonstrated in Figure 3.2, the distribution shown in Figure 3.1 is 

noticeably affected by variation in benefit formulas of different plans. 

C. Actuarial Funding Methods 

The solid curve in Figure 3.2 shows the distribution of funding ratios for earnings based 

plans, which make up most of medium and large private single employer plans. Under the 

Internal Revenue Code (Code), the funding methods for such plans must always account for 

projected future salaries. This is why the assets of earnings based plans tend to exceed current 

liabilities. However, even though the non-earnings based plans are excluded from the 

distribution, the solid curve in Figure 3.2 shows that the funding levels for earnings based plans 

still vary considerably among plans. Some of this variation could be caused by remaining 

differences in benefit formulas of different plans. For example, some earnings based plans 

calculate benefits based on average earnings in an employee's final few years of active service 

while other plans use formulas based on average earnings over all years of active service. 

However, another important source of systematic variation in the funding ratios of earnings 

based plans are differences in the actuarial funding methods used by employers. 
-51-

Employers may choose from a variety of funding methods that can each be associated 

with a different speed of funding, as shown in Chapter 2. Although other factors may also 

affect the choice of funding methods, faster funding methods increase the tax benefits and can 

decrease the private cost of a pension. Faster funding methods also result in higher levels of 

funding relative to current liability. These higher levels of funding are reflected in the data. 

Figure 3.3 shows how the choice of a funding method affects the distribution of funding 

ratios for earnings based plans. The dashed curve shows the distribution of funding ratios for 

plans that are funded under the "projected unit" method, which is like method 3 in Chapter 2 

and tends to be the slowest funding method allowed under the Code, although it is based on 

projected future salaries. 9 Plans funded under the Projected Unit method represent 22.6 percent 

of the current liabilities of earnings based plans. They had an average funding ratio equal to 128 

percent of current liability in 1989. The solid curve shows the distribution of funding ratios for 

plans that are funded under the other methods similar to methods 1 and 2 in Chapter 2. Such 

methods are called "Level" methods throughout the rest of this chapter because they are are 

designed to hold annual employer contributions constant (level) either in dollar terms or as a 

percentage of annual salary payments. Plans funded under Level methods represent 77.4 percent 

of the current liabilities of earnings based plans. They had an average funding ratio equal to 150 

percent of current liability in 1989. 

Level funding methods result in typically higher funding ratios than the Projected Unit 

method because the funding standard, i.e., accrued liability, is typically higher under Level 

funding methods. Equivalently, Level funding methods tend to be faster than the Projected Unit 

method. 10 As shown in Chapter 2, accrued liability is measured differently under each funding 

method. Faster funding methods are associated with higher levels of accrued liability relative 

to current liability. Because accrued liability is the funding standard against which assets are 

compared to determine annual employer contributions, higher accrued liabilities result in higher 

funding ratios. 

The relation between funding ratios and accrued liability under different funding methods 

can be seen by comparing Figures 3.3 and 3.4. Figure 3.3 shows the distributions of funding 

ratios for plans funded under different actuarial methods. Figure 3.4 shows the corresponding 

distributions of accrued liability expressed as a percentage of current liability. The dashed curve 

in Figure 3.4 is for plans that are funded under the Projected Unit method. Such plans had an 

average accrued liability equal to 122 percent of current liability. The solid curve in Figure 3.4 

is for plans that are funded under the Level funding methods. Such plans had an average 

accrued liability equal to 144 percent of current liability. The similarity between the 

~is method is often called the "projected unit credit" method. 

1

'Por technical reasons explained in footnote 6 of Chapter 2, Level methods are not always 

faster than the Projected Unit method. Because plans that use Level methods are found to be 

typically funded at higher levels than plans using the Projected Unit method, data suggest that 

Level methods typically fund faster than the Projected Unit method. 
Figure 3 .3 

Distributions of Funding Ratios in 1989: 

Effec t of Ac tuarial Funding Me thods 

1.75 

-'0 1.50 CL) 

+o) 

.a 

bD 

·-

CL) 1.25 ~ 

-(/) 

a 1.00 

"' ...... 

p,. 

1M 

0 0.75 

CL) 

bD 

"' +o) 0.5 0 a 

CL) 

C) 

.... 

CL) 0.25 ll.. 

0.00 

. . . . A, . .. . 

. ~ ..... l. .............. ,·····t··· , ............. . 

··+··········· ! I ! \ / : ........ . = ············~·········· ···· ·· ·+········· ····· T .. ·····:········ : I : ~ : 

.L .. ············!···f ··········-········· ~ ! ....... : ... ····!· ··· .. , · . .. : , . . : .......... .. ; ' .... ,........ ...... . : ,... . : . . : . . : 

~ . ........ . -- . . .................... , j.. ................. 0 ~ \ ~ I,. 0 ' ! ................ : ..... . 

..... T : ~ ~ \ t ~ .............. ! ......... , ....... , .. .. . I ' ' ... ·······';' . \ ! ........... ... :..... ··+······ . ·r·· . '" ~ ! • ·····~··· , . . ' . . \ ...•.... 

·----;--·,-/ ................... -............. , ............................ ! ........... \ '-

n . . •• ~ ..... ........ . .. ·: •••••• •••••••••• • • • • 0 •••• • •• 0 •• 0 • ••• •••• · : ••••• 0 ••• • 0 ••••••••• !•. 0 ••• 

. . . 

... ~"""····· •· ······· : . . 

. : 

80 100 120 140 160 180 200 220 

Assets as a pe r centage of c urre n t li ability 

Sources: Cornpuslal II and IRS Form 5500 

(see Appe ndix D fo r· d e tails) 

Projec te d 

Unit m e thod 

---

Leve l 

m e thod s 

I 

VI 

N 

I 
- 3.0 

"0 

~ 

..c: 

bJ 2.5 

·-

Q) 

~ 

-

~ 2.0 

-"' Po. 

'0 1.5 

Q) 

:f ,._) 1.0 

a 

Q) 

C) 

M 

~ 0.5 

0 .0 

Figure 3.4 

Distributions of Accrued Liability in 1989: 

Effect of Actuarial Funding Methods 

. . . . . . . . . 

; i i ~ -· . .... . ' ..... " l· ... . i ... ". "". " r""""".". " ... r " ". : :::: :: ::: 

; ... : ....... ---~ \ ' ; : ' ; ' "" ,, """" .. , ' . --r·--·--· l 1

! i l L. .... . ) .. +· · :-- . ---:----·-- l ' , . . I . . \ . .. ....... ' . . , . . . . . . ...... . . . . . . . ' :......... . ' . . ' . . ' " ....... ----·t----------+----r r ....... : ' : : i . L .. .. i .. .. .. i + -- ---- r--.... ... · 

: l I ' ' \ ' ; ............ !.......... , ' ' ' ' 

i i i ........ L ... 4--"! ........... i i ! i ! i ........... ; .. --· ' . ,............ ' ' ' . ' ' ' . ............ ' ---·t · · -- ~ i i ' i : · r ..... i : : . . ' . ,......... . ' . . 

""T "A------.... + " . " " . "" .. l . .). " . + T . . +---- " . . " ' ... " --< ... • • 

. I . ...... \ . . . . . . . . ..... . . . v "''!' " ..... "l ........ :. \ ,. . . ...... i ; .. + ' ..... . .....• ~ .: ............ f ........... : i "!- - .... - ..i. ' - ' .. . ....... ; i . ! j i ; - ~ 

100 11 0 120 1 30 14 0 l so 160 170 180 1 90 200 2 1 0 220 

Accrued as a percentage of c urren t li ability 

Sources: Compustat II and IRS Form 5500 

(see Appendix B for deta ils) 

Projected 

Unit method 

---

Level 

methods 

tA 

w 

I 
-54-

distributions of funding ratios in Figure 3.3 and the distributions of accrued liability ratios shown 

in Figure 3.4 suggests that differences in actuarial funding methods are an important systematic 

reason why funding ratios vary among plans. 

D. Factors That Affect Accrued Liability 

The similarity between distributions of funding ratios and accrued liability ratios shown 

in Figures 3.3 and 3.4 also suggests that much of the systematic variation of funding levels can 

be explained by other factors that affect accrued liability in addition to the optional funding 

method. Such factors include the current ages and typical retirement ages of active employees, 

the actuarial discount rate, the salary growth rate, and the percentage of total plan current 

liability that is associated with active employees. Differences in the values of this last factor can 

reflect variation among plans either in plan ages or in the degree to which benefits have been 

annuitized through the purchase of private annuity contracts. 

Table 3.1 shows how such factors vary across earnings based plans. The first row of the 

table shows that the ages of active employees tend to vary across plans. 

11 As shown in 

Chapter 2, such variation can systematically affect accrued liability and funding levels. Higher 

values of the age index correspond to active employee populations for which the time remaining 

before retirement tends to be greater, mostly because the employees are younger}2 Higher 

values of the index therefore tend to be associated, other things fixed , with higher accrued 

liability and funding levels. The table shows that the mean value of the index was 149 and the 

median (50th percentile) was 146. Five percent of the plans had an index that was lower than 

125 because they had relatively old active employee populations. Another 5 percent of the plans 

had an index value higher than 179 because they covered relatively young active employees. 

The other rows of Table 3.1 also show how other important factors vary across plans. 

The variation in such factors is important because they are systematic sources of variation in the 

ratio of accrued liability to current liability and in the funding ratios. As shown in Section lll 

below, such factors can be important determinants of the degree to which plans have been 

affected by the OBRA 87 change in the full funding limit. 

11The age index was constructed by adjusting the active employee ratio of PBO to ABO for 

differences among plans in the discount rate, the salary growth rate, and turnover rate 

assumptions (ABO and PBO are the accrued benefit obligations and projected benefit obligations 

reported on financial statements). The remaining variation in the index after the adjustment is 

due to differences among plans in the typical time remaining until retirement. Such variation 

would be caused partly by differences in retirement ages, but mainly by differences among plans 

in the ages of active employees. Details about the construction of the age index are in 

Appendix B. 

12In addition, the index may be higher for plans in which the typical retirement age is higher. 
Table 3.1 

Estimated Distributions of Factors that Affect Accrued Liability 

for Earnings Based Plans in 1989 

Percentile of factor 

amon& earnin&s based l!lans• 

Factor 5th 25th 50th " 75th 95th 

Age inde•, active employees" 125 . 139 146 1S6 179 

Discount rate 6.7% 7.2% 8.2% 8.7% 9.7% 

Salary growth rate 1.4% 4.8% 6.3% 7.0% 8.0% 

Spread (discount minus salary) 0.0% 1.3% 2.1% 2.9% 6.8% 

Percentage of current liability 

due to active employees 20.4% 32.5% 47.2% 52.7% 72.2% 

Sources: Compustat II aad IRS Form SSOO (sec Appeadill 8 for details) 

Notes: 

• Piau are wei&btc:d by dollan or curreatliability iD 1989 . 

._ Lar&er iadn valucssuueat tbat tbe time remainin& before retirement is &realer oa avera&e. 

i.e., tbal tlac active employees tead to be youa&er. 

Mean 

149 

8.2% I 

VI 

S.9% VI I 

2.3% 

45.2% 
-56-

Higher discount rates (row 2 of Table 3.1), other things constant, tend to be associated 

with lower accrued liability and funding levels. Higher salary growth rates (row 3), other things 

constant, tend to be associated with higher accrued liability and funding levels. Higher 

"spreads" (row 4), i.e., the difference between the discount rate and the salary growth rate, tend 

to be associated with lower accrued liability and funding levels. Higher percentages of current 

liability associated with active employees (row 5) tend to be associated with higher accrued 

liability and funding levels. Higher values of this last factor are associated with relatively young 

plans and plans that have annuitized benefits by purchasing private insurance contracts. 

m. TilE OBRA 87 FULL FUNDING LIMIT 

In this section, the effects of the OBRA 87 full funding limit are examined by measuring 

the degree to which plans have a pre-OBRA 87 funding limit that exceeds the new funding limit 

under OBRA 87. Further, this section examines the importance of the factors discussed above 

in Section ll. Because such factors affect both accrued liability and current liability, they also 

influence the degree to which plans are affected by the OBRA 87 full funding limit. 

A. Plans Affected by the Limit 

The OBRA 87 full funding limit is the lesser of accrued liability or 150 percent of current 

liability. Further, current liability must be computed by using a discount rate that reflects 

annuity purchase rates and falls within a 90-to-110 percent corridor of a four-year moving 

average of the annual yield on 30-year U.S. Treasury Bonds. If the discount rate assumption 

used for a plan falls outside the corridor, then current liability is adjusted for the difference 

when computing the OBRA 87 full funding limit. After such an adjustment is made, the 

resulting current liability is called "adjusted current liability" throughout the rest of this 

chapter. 13 

Because accrued liability was the full funding limit under pre-OBRA 87 law, a plan is 

only affected by the OBRA 87 limit if accrued liability exceeds 150 percent of adjusted current 

liability. According to the data for 1989, 49 percent of earnings based plans were affected in 

this way by the OBRA 87 full funding limit. 14 

Some of the plans affected by the OBRA 87 full funding limit had maximum 

contributions reduced immediately by the OBRA 87 limit.u Other plans affected by the 

13See Appendix B for details of the adjustment for this study. 

~is percentage is weighted by dollars of current liability. The unweighted percentage, 

which does not account for the varying size of plans, was 59 percent of plans. 

·~e exact percentage of plans for which this was true can not be derived from the data 

examined in this study. 
-57-

OBRA 87 limit had fund assets that were large enough that contributions would not have been 

allowed in the short run even under the pre-OBRA 87 full funding limit. The effects of the 

OBRA 87 limit will be delayed for such plans. 

As shown in Chapter 2, employers who are required by OBRA 87 to decrease pension 

contributions will eventually increase contributions relative to what contributions would have 

been without OBRA 87. This would be true even if their accrued liability always exceeds 150 

percent of current liability. The long term effect of OBRA 87 will be to slow the speed of 

funding and slightly decrease the long term tax benefit for the plans affected by OBRA 87. 

B. Degree of the Effect 

Although plans are affected by the OBRA 87 full funding limit if their accrued liability 

exceeds 150 percent of adjusted current liability, not all plans are affected to the same degree. 

For example, plans for which contributions are reduced immediately are likely to be affected 

more than plans for which contributions are not reduced immediately. This is because an 

immediate reduction in contributions is likely to have a larger effect on the speed of funding and 

the size of the tax benefit. As another example, plans are likely to be affected to a greater 

degree by the OBRA 87 funding limit if their accrued liability is larger relative to 150 percent 

of adjusted current liability. Plans with the highest relative accrued liability are likely to 

experience the largest reduction in the speed of funding and the tax benefit associated with 

funding. 

Figure 3.5 shows the degree to which some plans are more affected than other plans 

because they have a relatively higher accrued liability. The solid curve in the figure shows the 

distribution of accrued liability relative to adjusted current liability for all earnings based 

plans. 16 The 49 percent of plans affected by the OBRA 87 limit are represented by the area 

under the solid curve to the right of the 150 percent mark on the horizontal axis. The remaining 

51 percent of plans not affected are represented by the area under the solid curve to the left of 

the 150 percent mark on the horizontal axis. According to the figure, about 12 percent of all 

earnings based plans had an accrued liability that was between 150 and 160 percent of current 

liability. This is shown in the figure by the fact that about 12 percent of the area under the solid 

curve is between the 150 percent and 160 percent marks on the horizontal axis. OBRA 87 

reduced the full funding limit for such plans at most from 160 percent to 150 percent of adjusted 

current liability. Similarly, the figure shows that about another 12 percent of all earnings based 

plans had their full funding limit reduced from between 160 percent and 170 percent to 150 

percent of adjusted current liability. Further, the figure shows that about 11 percent of all 

earnings based plans had their funding limits reduced by the OBRA 87 limit from levels greater 

than 190 percent of adjusted current liability. 

~e dashed curve is discussed below in Section m.c. 
Figure 3 .5 

Distribu lions of Accrued Liability and 

Lower Funding Limits For Earnings Based Plans 

-'0 

~ 2.5 

.c: 

t:IG 

3.0 ' ' )r' . . ' i i ) .. j . - .... . .... I' . ,. . . ' . ........•. . . ' . , , ~ .......... ,... ' ' , 

.... + .......... : .... , .... ··· ·· ~,·· · · + ······T .. ... r· ... i I i I ....... ; ........................... . . : I ' . , . ' , . ; ········•···· . ..... 

~ 

~ 2 .0 

rn 

c: 

Cd 

-

0. 1.5 ct-. 

0 

~ 

~ 1.0 

+o) 

c: 

~ 

() 

J.. 

~ 

l:l.. 

0.5 

0.0 

i . ! . ! . . ! \ . ! ! . i ....... ! ........... !···········, .. i ; ........ . . . . : ! 1 ! ....... :.. .... ··+ · ·r · · · ! ! : ! 

. . ······>··· . \ . . . ' . . . . ..... . 

···r······r:. 1 ........ : . .\' ···-· . ·I· ···-········· .. . ·:······!· .. ·: ::: .. ~ ....... ,. ' . ' . . ' . . ' ...........• 

.... : / ........ .... . ········:"' .... " ..... , . . . +· ......... T ., .................. . .....•.. .., ' ' ' ' \ ' ' ' ........ , ....... . 

:, ' ... ..:. ..... , ... ,, L ... ; ... , . .. . ; ...... ,. , ~ ......... . . . . ...... . ·--- . . ····', · ··· ·1 . i · · r -: ! ~- .. 

. . 

\()() \ \() \~() \~() \b.~ \~() \b() \1() \~() \q() ~()() \() ~~() ~() 

As a pe r centage of a djuste d c urre nt li ability 

Sources: Comp us tal II a nd IRS Form 5500 

(see Appe ndix B for de t a ils) 

Projec te d 

Unit m e thod 

---

Ac tual 

plan m e thod 

I 

Ul 

00 

I 
-59-

C. Why Plans Are Affected by the OBRA 87 Limit 

1. Actuarial Funding Methods 

As shown above in Section II, plans that are funded under Level methods, which are 

typically faster than the Projected Unit method, tend to have higher levels of accrued liability 

relative to current liability than plans funded under the Projected Unit method. As a result, 

plans funded under the Level methods are most likely to be affected by the OBRA 87 full 

funding limit. The effects of funding methods are shown in Figure 3.4, which is discussed 

above in Section II.C. Figure 3.4 shows that earnings based plans funded under Level methods 

(the solid curve) are far more likely to have a high ratio of accrued liability to current liability 

than plans funded under the Projected Unit method (the dashed curve). Of all plans funded 

under the Level methods, 60.2 percent had an accrued liability greater than 150 percent of 

adjusted current liability and were therefore affected by the OBRA 87 full funding limit. By 

comparison, of all plans funded under the Projected Unit method, only 8.4 percent were affected 

by the OBRA 87 full funding limit. 17 

Figure 3.5 further illustrates the effect of funding methods. The solid curve shows the 

distribution of accrued liability for all earnings based plans expressed as a percentage of adjusted 

current liability. In contrast, the dashed curve shows an estimate of what the distribution of the 

accrued liability would be if all such earnings based plans had been funded under the Projected 

Unit method. The area under the dashed curve to the right of the 150 percent mark on the 

horizontal axis represents only 11.8 percent of plans. This implies that only 11.8 percent of 

earnings based plans would have been affected by the OBRA 87 limit if all such plans had been 

funded under the Projected Unit method. 

11 In other words, about 76 percent 

(=(48.5%-11.8%)/48 ~%) of the earnings based plans affected by OBRA 87 were affected 

because they use a Level method rather than the Projected Unit method. Therefore, the 

OBRA 87 full funding limit has mainly limited the degree to which plans can be funded under 

the typically faster Level funding methods. 

The effects of funding methods on whether or not plans have been affected by the 

OBRA 87 full funding limit are summarized in Table 3.2. These results imply that the choice 

of funding method is a major determinant of whether or not plans have been affected by the 

OBRA 87 full funding limit. 

17These are weighted percentages. The corresponding unweighted percentages are 70.4 

percent for Level method plans and 28.1 percent for Projected Unit method plans. The weighted 

percentages may be lower because the larger plans, i.e., those with larger amounts of current 

liability, tend to be older and more mature than the smaller plans. 

11Unweighted, 30.5 percent of earnings based plans would have been affected by OBRA 87 

if they were all funded under the Projected Unit method, whereas the unweighted actual 

percentage of earnings based plans affected by OBRA 87 was 58.5 percent. 
Table 3.2 

The Effects of Funding Methods on Whether Earnings Based 

Plans Were Affected by the OBRA 87 Limit in 1989 

Accrued liability 

Greater than 150% of adjusted current liability-. 

No greater than 150% of adjusted current liability 

All plans in column 

Accrued liabilit! under Proiected Unit method 

Greater than 150% of adjusted current liabilitf 

No greater than 150% of adjusted current liability 

All plans in column 

Percenta2e of earnin2s based olans 

Funding method• 

Level 

Funding 

Methods 

60.2% 

39.8% 

100.0% 

12.8% 

87.2% 

100.0% 

77.4% 

Projected 

Unit 

Method 

8.4% 

91 .6% 

100.0% 

8.4% 

91.6% 

100.0% 

22.6% 

Sourcca: Co•pustat II aad IRS For• SSOO (see Appeadiz B for details) 

Notes: 

• Percc:ata&e• wei&llted by dollan of curreat liability ia 1989. 

b Uawei&bted percc:ata&e• for tbil row are 70.4'%, 28.1'%, aad S8.S%. 

c Uawei&bted percc:ata&e• for this row are 31.4'%, 28. 1 '%, a ad 30.S%. 

All 

Methods 

48.5% 

51.5% 

100.0% 

11.8% 

88.2% 

100.0% 

100.0% 

$ 
-61-

2. Factors That Affect Accrued Liability 

Table 3.2 shows that 39.8 percent of plans funded under the Level methods have not been 

affected by the OBRA 87 limit, and that only 8.4 percent of plans funded under the Projected 

Unit method ~ been affected by the OBRA 87 limit. Thus, while these numbers show that 

the funding method is of central importance, they do not fully explain why some plans have been 

affected by OBRA 87 while others have not been affected. 

The other actuarial and demographic factors discussed above in Section ll.D can also be 

important determinants of whether and by how much plans are affected by the OBRA 87 limit. 

This is because such factors can affect accrued liability and can therefore cause accrued liability 

to exceed 150 percent of adjusted current liability. Table 3.3 shows how the medians of such 

factors differed between plans that were affected and plans that were not affected by the 

OBRA 87 limit. The top line shows how funding methods matter. It shows that 96.1 percent 

of plans affected by the OBRA 87 limit have been funded under the typically faster Level 

funding methods. In contrast, the table shows that only 59.6 percent of the plans not affected 

by the OBRA 87 limit have been funded under Level funding methods. The last column of the 

first row shows that 77.4 percent of all earnings based plans have been funded under Level 

methods. 

The second row of Table 3.3 shows that plans affected by the OBRA 87 limit tend to 

cover younger active employees and/or have older retirement ages on average than plans not 

affected by the OBRA 87 limit. The median index was 152 for plans affected by the OBRA 87 

limit, but only 141 for plans not affected by the OBRA 87 limit. 

The third row of Table 3.3 suggests that the discount rate has also been an important 

determinant of whether plans have been affected by the OBRA 87 limit. The table shows that 

the median discount rate was 8. 7 percent for plans not affected by OBRA 87. This analysis 

suggests that the discount rate used for plan funding has been an important determinant of 

whether plans have been affected by the OBRA 87 funding limit. However, some plans that 

have been funded under a relatively low discount rate have also been funded under a relatively 

low salary growth rate assumption. In such cases the low discount rate would be expected to 

have less effect. 

The discount and salary growth rates are both expressed in nominal terms in Table 3.3. 

Both nominal terms are the sum of an assumed inflation rate and an assumed real growth rate. 

For example, a nominal discount rate of 8 percent could be the sum of a 4 percent inflation rate 

and a 4 percent real discount rate. Likewise, a 6 percent nominal salary growth rate could be 

the sum of a 4 percent inflation rate and a 2 percent real annual salary growth rate. For the 

funding ratios of earnings based plans, the difference, i.e., the spread, between the real annual 

salary growth rate and the real discount rate often matters more than the absolute nominal level 

of each rate. This is because a lower real projected salary growth rate assumption tends to 

decrease accrued liability, but a lower real discount rate assumption tends to increase accrued 

liability. If the two assumptions are decreased by the same amount, they would tend to offset 
Table 3.3 

Median Actuarial Factors For Earnings Based Plans: 

Plana Affected Compared to Plans Not Affected by tbe OBRA 87 Limit 

Factor 

Percentage funded under 

Level funding methods• 

Age index, active employees"·c 

Discount rate" 

Salary growth rate" 

Spread (discount minus salary)" 

Percentage of current liability 

due to active employees" 

Not 

Affected 

by0BRA87 

59.6% 

141 

8.7% 

6.3% 

2.7% 

41.0% 

Affected 

by 

OBRA87 

96.1% 

152 

7.2% 

6.3% 

1.4% 

47.2% 

Sources: Co•pulltll aad IRS Fo1111 SSOO (see Appelldi• 8 ror details) 

Notes: 

• Perceata&ea, wei&latecl by dollan or c:arreat liability ia 1989. 

• Sample aad aabaa•ple •ediaaa, wei&lltecl by dollan or currealliability ia 1989. 

All 

plans 

77.4% 

146 

8.2% 

6.3% 

2.1% 

47.2% 

c Lar&er iade• values augeat lbat the lime remaiaia& before reliremeat iJ &realer oa avera&e, 

i.e., tbat tile aclive e•ployeca tead to be yoaa&er. 

I 

01 

N 

I 
-63-

each other and would thus have less effect on accrued liability than if only one of the 

assumptions was changed. 19 Plans for which the real discount rate exceeds the real salary 

growth rate by. less than other plans are likely to have an accrued liability that is higher relative 

to current liability. 

The effect of differences between real discount rates and real salary growth rates can be 

measured by subtracting the nominal rates. The difference between the nominal discount rate 

and the nominal salary growth rate equals the difference between the corresponding real rates. 

This is because a single inflation rate assumption is used for each plan. Thus, the difference in 

real rates can be measured by subtracting the nominal salary growth rate from the nominal 

discount rate. 

The fifth row of Table 3.3 shows, as expected, that the real discount rate exceeds the real 

salary growth rate by less for plans that have been affected by the OBRA 87 limit. For plans 

not affected by OBRA 87, the median spread was 2.7 percent. For plans affected by OBRA 87, 

the median spread was only 1.4 percent. This result suggests that some plans have been affected 

by the OBRA 87 limit because they have been funded under a real discount rate assumption that 

is low relative to the real salary growth rate assumption. 

The last row in Table 3.3 shows how the division of current liability between active and 

inactive employees differed between plans affected and plans not affected by the OBRA 87 limit. 

On average, at the median, the current liability for active employees accounted for 47.2 percent 

of the total current liability for plans affected by the OBRA 87 limit. In contrast, the median 

was 41.0 percent for plans not affected by the OBRA 87 limit, which suggests that this factor 

has had some effect on whether plans have been affected by the OBRA 87 limit. 

3. The Relative Importance of Factors 

The analysis so far suggests that the funding methods, the average age of active 

employees, the discount rate, the salary growth rate, the spread, and the division of current 

liability between active and inactive employees are all factors that help determine whether or not 

plans are affected by the OBRA 87 funding limit. Figure 3. 6 shows how important such factors 

have been in determining the degree to which plans are affected by the OBRA 87 limit. 

Figure 3.6 was constructed by adjusting each factor and then measuring the effect of the 

adjustment on each plan's accrued liability expressed as a percentage of adjusted current liability. 

For a particular "benchmark" percentage of adjusted current liability (for example, 150 percent), 

it is known how many plans actually had an accrued liability hi~her than the benchmark. For 

each factor and each benchmark shown on the horizontal axis, the vertical axis in Figure 3.6 

1

9rfhis reasoning applies to the liabilities for active workers in earnings based plans. For 

inactive plan participants, the projected salary growth rate does not matter, and so, changes in 

the discount rate matter independently of changes in the salary growth rate. 
100 

.... 90 

0 

.,.> 

80 CJ 

Cd 

c.-. 

;>-, 70 ~ 

'0 

60 Q) 

a 

·~ Cd 

- 50 ~ 

>< 

Q) 40 

Q) 

b.CI 

30 Cd 

.,.> 

a 

Q) 

CJ 20 .... 

Q) 

p... 10 

0 

Figure 3.6 

Effect of Actuarial Factors on Ac c rued Liability 

··-]-- :::::: ::·::::E:::::r:::::::::.:~_oor. .. .:r::·.·:. r ..... ooi::· J ::··:·::.r. ·.: · ..... 

. . . ' ' l -······---·•·· . . ' ,-. 

0

0

] •• ::·: • .1~1= ~ ~uwouuuuuouTwouwiOO .... T••oo •:J.:: ·:. :] uou u;uou ' / , . : . . :.: ........... ,.: ........ 

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' . •t ' + . . -+· •uu•i . '. ~ .. >., ••••••• . : 3· • 

uuo,uuuuuo" 0 o o ' .... ' ' 0 

0 

/ I u•ouuuuu. uu 

00.1 ~ oo::oof: .. :-:.r::::::::r: ::::::1::.::::::1:-: :I=I:I~~~.L ... JOOOo T .: 

' ,,_ , •• " ' . -.. <! ' ' ' ' 

r--~~~-~-~~ ~~~ --~--~~E I=·w -·:· L T.oo .. ::I.::::J . I 50 155 160 165 170 175 180 185 I 90 1 95 200 205 2 1 0 

Accrued as pet. of adjusted c urrent lial.>ility 

Actuarial 

method 

Discount 

spread 

---

Age index, 

active workers 

Percentage 

active .......... 

Note: All perce ntages and averages are 

weighted by dollat·s of c urrent liability. 

Sources: Compuslal II and IHS Forrn 5500 

(see Appe ndix U fot~ de tails ) 

t 
-65-

shows the percentage of these plans that would instead have an accrued liability J.w than the 

benchmark after the factor is adjusted. Figure 3.6 thus shows the relative importance of the 

factors in determining the degree to which plans have been affected by the OBRA 87 change in 

the full funding limit. 

The top line (solid) in Figure 3.6 shows the importance of the funding method. 

According to the figure, 76 percent of all plans (shown on the vertical axis) for which accrued 

liability was higher than 150 percent of adjusted current liability (shown on the horizontal axis) 

would have had an accrued liability less than 150 percent of adjusted current liability if they had 

used the Projected Unit method rather than a Level funding method. The figure also shows that 

50 percent of plans that had accrued liability higher than 210 percent of adjusted current liability 

would have had an accrued liability less than 210 percent of adjusted current liability if they had 

used the Projected Unit method rather than a Level funding method. Thus, the figure shows that 

the funding method choice is an important determinant of whether plans have been affected by 

the OBRA 87 limit. However, the figure also shows that the funding method choice is a less 

important factor for plans that have been affected the most, i.e., because they had very high 

levels of accrued liability relative to adjusted current liability. 

The second highest line (long dash) in Figure 3.6 shows how much the assumed spread 

between discount rates and projected salary growth rates matters. The figure shows that 

42 percent of the plans (shown on the vertical axis) for which accrued liablity exceeded 

150 percent of adjusted current liability (shown on the horizontal axis) would have had accrued 

liability lower than 150 percent of adjusted current liability if they had not assumed a spread that 

was lower than the median spread for all earnings based plans. Further, the figure shows that 

such reasoning applies to 50 percent of the plans for which accrued liability exceeded 

210 percent of adjusted current liability. Thus, the use of a relatively low discount spread 

assumption explains why many plans have been affected by the OBRA 87 limit. Further, a low 

assumed discount spread is a slightly more important explanation for plans that have been 

affected the most by OBRA 87. 

The third highest line (broken dash) shows the importance of the ages of active 

employees. Plans that cover younger active employees who have more years remaining before 

retirement tend to have higher levels of accrued liability relative to current liability and are 

therefore more likely to have been affected by the OBRA 87 limit. The figure shows the effect 

of covering active employees for which the age index is higher than the median, 146, for all 

earnings based plans.20 According to the figure, only 12 percent of the plans for which accrued 

liability exceeded 150 percent of adjusted current liability would have had an accrued liability 

less than 150 percent of adjusted current liability if the age index for their active employees was 

not higher than the median age index for all earnings based plans. However, the figure shows 

that the ages of active employees are much more important in determining whether plans are 

~us, their active employees are relatively young and/or retirement ages are higher than 

average. 
-66-

affected to a high degree by the OBRA 87 funding limit. For example, the figure shows that 

75 percent of the plans for which accrued liability exceeded 210 percent of adjusted current 

liability would have had accrued liability less than 210 percent of adjusted current liability if 

their age index was not higher than the median for all earnings based plans. Age is thus the 

most important factor for plans affected the most by the OBRA 87 limit. 

The lowest (dashed) curve in Figure 3.6 shows that about 8 percent of the plans affected 

by the OBRA 87 limit would not have been affected if their percentage of current liability 

associated with active employees had not been higher than the median for all earnings based 

plans. Further, the figure shows that this factor has no explanatory power for plans affected the 

most by the OBRA 87 full funding limit. 

In summary, Figure 3.6 shows that the choice of funding method is the most important 

determinant of whether plans have been affected by the OBRA 87 limit. The assumed spread 

between the discount rate and salary growth rate is the next most important factor. However, 

the spread and the funding method are less important than employee ages for plans affected the 

most by the OBRA 87 limit. The ages of active employees are of next greatest importance in 

determining whether plans have been affected by the OBRA 87limit. However, active employee 

ages are of greatest importance in determining which plans are affected the most by the 

OBRA 87 limit. Finally, the least important factor shown in Figure 3.6 is the percentage of 

current liability associated with active employees. 

D. Effect on Funding Levels and Benefit Security 

The OBRA 87 funding limit will result in lower levels of funding for affected plans. 

Lower funding levels can increase the risk that the assets in a pension fund will be insufficient 

to cover the legal pension liability in the event that an employer's business fails and the pension 

plan is terminated. Such an increase in risk can increase the risk that the PBGC would have to 

pay part of the retirement liability of failed employers out of the PBGC insurance fund. The 

increase in risk can also increase the risk to plan participants because the PBGC does not insure 

all retirement benefits of the plans it covers. For example, there is a ceiling on the annual 

benefit amount that the PBGC will insure. Also, the PBGC does not insure benefits not vested 

before such a plan termination. Further, benefit improvements such as ad hoc cost of living 

increases that occur within five years before such a plan termination are not fully insured 

because PBGC insurance coverage of benefit improvements is phased in over a period of five 

years. Any increased risk associated with lower levels of pension funding would therefore 

increase the risk both to the PBGC and to pension plan participants. 

The level of such risk is determined by many factors such as the risk of an employer's 

business failure and the level of diversification and investment risk associated with pension fund 

assets. However, one of the most important determinants of risk is the extent to which the value 

of pension fund assets exceeds the current value of benefits that have been promised to plan 

participants, i.e., the funding ratio. 
-67-

Figure 3. 7 shows how the OBRA 87 full funding Umit is Ukely to affect the distribution 

of funding ratios of private single-employer earnings-based defined ben fit plans. The solid curve 

shows the actual distribution of funding ratios in 1989. Because the OBRA 87 full funding limit 

had already been in effect in 1989, the distribution shown by the solid curve already reflects a 

partial effect of the OBRA 87 full funding limit. Plans with funding ratios in excess of 

150 percent of adjusted current liability probably had lower funding ratios than they would have 

had without the OBRA 87 change in the funding limit. 

The dashed curve in Figure 3. 7 shows how the distribution of funding levels might 

eventually shift as a result of the OBRA 87 limit. The shift in the distribution implies that the 

average funding level for earnings based plans will be decreased from 145 percent to 

136 percent of current liability as a result of the OBRA 87 limit, i.e., a -6.2 percent 

(=(136%-145%)/145%) shift in the average funding ratio. 

The small shift in the distribution between the solid curve and the dashed curve shows 

that some plans with the highest funding ratios will have lower funding ratios as a result of the 

OBRA 87 limit. For example, the solid curve shows that about 25 percent of plans had funding 

ratios higher than 170 percent of current liability in 1989. Many of these plans had high funding 

ratios because they had an accrued liability that was higher than 150 percent of adjusted current 

liability. Because OBRA 87 decreases their full funding limit to 150 percent of adjusted current 

liability, their funding ratios can also be expected to decrease. As a result, the dashed curve 

shows that only about ten percent instead of 25 percent of such plans would have funding ratios 

higher than 170 percent of current liability as a result of OBRA 87. This shift in funding ratios 

is reflected in Figure 3. 7 by the fact that some of the area under the solid curve at high levels 

of funding is "pushed" to funding ratios between 130 percent and 170 percent of current 

liability. In addition, as a result of the interest rate corridor rule under OBRA 87, some funding 

ratios will be lowered to below 150 percent of unadjusted current liability, as shown in the 

figure.

21 

The small shift in distributions reflects an assumption that funding ratios will not be 

decreased below 150 percent of adjusted current liability by the OBRA 87 limit. The shift in 

the distribution is small because many of the plans affected by OBRA 87 had accrued liability 

that was not much higher than 150 percent of adjusted current liability. This pattern was shown 

in Figure 3.5 above. For example, a plan that has a funding ratio of 170 percent and an accrued 

liability of 155 percent of adjusted current liability is likely to only have its funding level 

reduced to 165 percent of adjusted current liability. Further, a plan that has an accrued liability 

equal to 170 percent of adjusted current liability but has a funding ratio equal to 155 percent of 

current liability is likely to have its funding level only reduced from 155 to 150 percent of 

adjusted current liability as a result of the OBRA 87 funding limit. 

21Some plans would still have funding levels higher than the OBRA 87 funding limit because, 

for example, they have either earned extraordinarily high rates of return on their pension fund 

investments or experienced other unexpected actuarial events. 
Figure 3. 7 

Distribution of Funding Ratios in 1989: 

Effect of OBRA 87 

I ; : '': : 2 ·····-:-··· .......... ·············· ............. ·············-:-········•···· ·············· .............. ··············;············· .................... . 

: : . ' .' , : : 

l • l l ............................................................. t ..... , ....... t·\ ....................................... r······· .......................... . : . : ' . : . . . . . (/) : : : ' : c:: 1. ') : .... ~ ...................................................... .;. .... ......... ; .... ..................................... ; ................................. . «! : : • . • : - : : . . : 

Po. : : • • : .................................. ........................... >, ... . ..... , ....... ............................ ) ................................. . ...... 

0 , • l -~ : 4> : , : • : :f 1 ..... 7 ........................................ ... ,f ....... :. ........ . ............. ~ .............. ~ .................... . ...,> ,.. : . ' . : . : 

.... : ' ' : : 4> ...... ;............. .............. .............. .. ..................... , ............ .. .............. ; .............. j ................... .. CJ • • . 

$... : ' : : 4> : , : : 

p., : ~ : 0 .5 ..... .;.............. .. ........... .............. !' ............. : ............ ~ .............. : .................... . 

:, : : . ' . . : ' : : ............. .............. ...... . .......................... ; ........ -~ ............. ; .............. ; ..................... , 

: " : : : ~ : : 

: :' . . ' 0 I · · · . : : ' . :-? · I . . . . . . --·-~ .• , 

50 70 90 110 130 150 170 190 2 10 230 250 

Assets as a perce ntage of c urre nt liability 

Sources: Compustat II and IRS Form 5500 

(see Appe ndix B for de tails ) 

Ac tual 

dislribu lion 

Full e ffect 

of OBRA 87 

------

I 

0\ 

00 

I 
-69-

The decrease in funding levels resulting from the OBRA 87 change in the full funding 

limit will cause a small increase in the risk to plan participants and the PBGC because there is 

a small risk even at funding levels exceeding 150 percent of adjusted current liability. However, 

the figure shows that OBRA 87 will only affect well funded plans and, even then, only by 

relatively small amounts. Thus, the OBRA 87 full funding limit is likely to have an insignificant 

effect on employee benefit security. 
CHAPfER 4: OPTIONS FOR FURTHER CONSIDERATION AND ANALYSIS 

We have concluded that the OBRA 87 amendments to the full funding limit do not have 

a significant adverse effect on benefit security of defined benefit plans. However, the report 

indicates that the application of the OBRA 87 full funding limit may have an uneven impact 

among employers. In particular, plans that cover relatively young employees are likely to be 

most affected. This chapter discusses the advantages and disadvantages of three full funding 

options for further consideration and analysis. The options are not intended as Treasury 

recommendations. 

The first option is to maintain the current Jaw full funding limit without modification. 

The second option is to allow plans to make a one-time election to use an alternative full funding 

limit based on 100 percent of projected liability (defined below). Projected liability would be 

calculated under a single method for all plans, subject to restrictions on the discount and salary 

growth rate assumptions. For earnings based plans, projected liability would account for future 

salary growth. To maintain the revenue neutrality of the option, the current liability limit would 

be reduced from 150 percent to 147 percent. The third option is the same as the second option, 

except that the current liability limit would be retained at 150 percent. This option would lose 

revenue. 

Under an existing grant of discretionary regulatory authority, the second option could be 

implemented without legislation. However, any such change would, by necessity, adversely 

affect some taxpayers and benefit other taxpayers. For this reason, the Treasury Department 

has concluded that it will not exercise this authority unless directed by the Congress to do so. 

I. MAINTAIN CURRENT LAW 

A. Advantages 

The OBRA 87 change in the full funding limit has decreased the maximum funding speed 

and tax benefits that can result from pension funding for many plans. Plans are typically 

affected by the OBRA 87 limit if they are funded under actuarial assumptions or methods that 

entail faster rates of funding than other plans. The OBRA 87 limit has increased Federal tax 

revenues, but only by decreasing the tax benefits for the best-funded plans for which the tax 

benefits are the greatest and the effects on benefit security are likely to be the smallest. 

B. Disadvantages 

The OBRA 87 limit does not fully allow for demographic differences among plan 

populations. Plans are more likely to be affected by the OBRA 87 limit if they cover relatively 

young employees, which is most likely for plans sponsored by start-up firms. Further, the 

OBRA 87 limit is more likely to affect plans that purchase private annuity contracts for retirees. 

-71-
-72-

The OBRA 87 limit is also most restrictive for plans that use level funding methods, which allow 

plan sponsors to budget their pension contributions in a smooth fashion over time. Finally, even 

though the OBRA 87 limit is more restrictive than the old full funding limit, it still allows 

actuarial assumptions to have a significant effect on the speed and tax benefits of funding. 

D. ALWW ELECTION OF A PROJECTED LIABILITY LIMIT, 

AND REDUCE CURRENT LIABILITY LIMIT 

This option is designed to allow for differences in levels of pension funding that result 

from demographic differences among plans. Under this option, taxpayers could make a one-time 

election to compute maximum deductible annual pension contributions by using an alternative 

full funding limit equal to the lesser of accrued liability, as computed under a plan's funding 

method and actuarial assumptions, or 100 percent of projected liability. The election would be 

irrevocable without permission of the Internal Revenue Service, which would generally grant a 

revocation only when demographic shifts or changes in other factors expected to affect long-run 

pension funding were observed. Projected liability would be computed under the method used 

to calculate the Projected Benefit Obligation (PBO) under the rules of the "Statement of 

Financial Accounting Standards No. 87," (FAS 87). 1 The discount rate used to calculate 

projected liability would be required to equal the discount rate used to calculate current liability 

under the OBRA 87 limit. In addition, the assumed annual salary growth rate used to calculate 

projected liability would be required to be at least 2 percentage points less than the discount rate 

used to calculate projected liability. 2 

To maintain the revenue neutrality of the option, the current liability limit would be 

reduced from 150 percent to 147 percent. Taxpayers who did not make the one-time election 

would therefore be subject to a full funding limit of the lesser of accrued liability or 147 percent 

of current liability. 

A. Advantages 

The funding limit under this option is designed to result in the same level of Federal tax 

revenues as the OBRA 87 full funding limit, while still decreasing (relative to the pre-OBRA 87 

limit) the maximum funding speed and the maximum tax benefits that could be received by 

funding a pension. Like current law, this option would reduce the flexibility of using actuarial 

methods and assumptions to increase the speed and tax benefits of funding. As an advantage 

over current law, however, this option would be less biased against plans that cover younger 

'Financial Accounting Standards Board, 1985. Note that the PBO method is essentially the 

projected unit-credit method, which is like method 3 of Chapter 2. 

'lrfhis difference is called the spread. The average spread for earnings based plans, weighted 

by current liability, was 2.3 percent in 1989, as shown in Table 3.1. 
-73-

populations of employees. This option would also partially correct for differences in the effects 

of the OBRA 87 limit that may result because retirement benefits are annuitized by some plans. 

B. Disadvantages 

This option would slightly increase the complexity of the Internal Revenue Code for 

corporate taxpayers. However, th.e degree of additional complexity is limited by the fact that 

the method of calculating PBO under F AS 87 is already familiar to many pension actuaries and 

is already used for financial reporting by the many plan sponsors who are required to follow the 

PAS 87 rules. 

Relative to the OBRA 87 funding limit, this option would allow the speed of pension 

funding and the tax benefits to be more sensitive to actuarial assumptions. In particular, the 

salary growth rate assumption would be more important than for the OBRA 87 funding limit, 

even though the salary assumption would be restricted under this option. Other assumptions, 

such as those relating to employee turnover rates, mortality, and retirement ages would also have 

a greater effect on the funding limit under this option than under the OBRA 87 funding limit. 

The reduced current liability percentage needed to maintain revenue neutrality would 

require slightly slower rates of funding for some plans, and would also result in slightly lower 

levels of funding for such plans. 

m. ALLOW ELECTION OF PROJECTED LIABILITY LIMIT, 

WITH NO REDUCTION IN CURRENT LIABILITY LIMIT 

This option is the same as option 2, except that the current 150 percent limit on current 

liability would be retained. Thus, taxpayers could make a one-time election to compute their 

full funding limit each year as the lesser of accrued liability or 100 percent of projected liability; 

if no election were made, the limit each year would be the lesser of accrued liability and 150 

percent of current liability. This option would result in a loss of Federal tax revenues. This 

revenue loss is estimated to be approximately $600 million over five years. 

A. Advantages 

This option would have the same advantages as the second option. In addition, no plan 

would be required to have slower rates of funding or lower funding levels than allowed under 

current law. 
-74-

B. Disadvantages 

This option has many of the same disadvantages as the second option and would lose 

$600 million in revenue over five years. Implementation would require acceptable offsetting 

revenues from other sources. 
GLOSSARY 

Actjye employees: Employees who are currently working for an employer and participating in 

the retirement plan. (see page 15) 

Accrued liability: Pension liability as it is measured under each plan's funding method; 

sometimes called "ongoing plan liability". Accrued liability typically accounts for both benefits 

accumulated to date and benefits for currently active employees associated with the past that are 

expected to accumulate in the future. All else constant, accrued liability would typically have 

a different value when calculated under each different funding method. (see page 23) 

Current liability: A pension liability measure that accounts only for benefits accumulated up 

to the current date, not counting benefits associated with the past that are expected to 

accumulated in the future; sometimes called "termination liability". (see pages 16 and 87) 

fundin& level (fundin& ratiol: Pension assets as a percentage of current liability. (see page 16) 

Level methods: Funding methods designed to hold annual employer contributions constant 

(level) either as dollar amounts or as a percentage of salary payments. Methods 1 and 2 of 

Chapter 3 (see below) are examples of level methods. (see page 51) 

Method 1: Annual contributions made on behalf of each active employee are expected to equal 

a constant dollar amount over all years of active service. (see pages 11-13) 

Method 2: Annual contributions made on behalf of each active employee are expected to equal 

a constant percentage of salary payments over all years of active service. (see pages 11-13) 

Method 3: Annual contributions made on behalf of each active employee are based on the rate 

at which employees accrue future pension benefits. Benefit accruals are measured under 

method 3 by smoothing the rate of accrual over all years of active service. Such smoothing 

accounts for both past and expected future years of service and future salary increases. (see 

pages 11-13) 

Method 4: Same as method 3, but benefit accruals are measured simply by using a plan's 

benefit formula, not counting expected future years of service or future salary increases. 

(see pages 11-13) 

Nonnal costs: Under a plan's funding method, the annual contributions that would be normally 

be expected if actuarial assumptions were always exactly correct, if plan benefits began accruing 

at the same time that funding started, and if neither actuarial assumptions nor benefits ever 

changed. (see page 23) 

Projected unit-credit (or. projected uniO method: Essentially method 3 as described above. 

-75-
APPENDIX A 

SYNOPSIS OF FEDERAL TAX LAWS RELATING TO PENSIONS 
APPENDIX A: SYNOPSIS OF FEDERAL TAX LAWS RELATING TO PENSIONS 

I. TAX TREATMENT OF CONTRIBUTIONS, EARNINGS AND 

WITIIDRA WALS 

The Internal Revenue Code provides favorable tax treatment for certain trusts which are 

established to hold pension plan assets and for the participants in those plans. These tax 

incentives are available if the plans meet the qualification requirements described in Sections 

401-417 of the Code and act as an inducement for employers to provide retirement benefits for 

their employees. The tax benefits consist of the following: 

Exclusion of Contributions. Contributions made on behalf of employees to pension trusts are 

deductible by the employer, but excluded from employees' current income for both income and 

social security tax purposes. 

Tax Exemption of Pension Fund Earnings. Earnings on the funds in a pension trust are exempt 

from tax at the trust level. Neither are such earnings currently taxable to employees. 

Deferred Recognition of Income on Withdrawal. Even when benefits are withdrawn from a 

pension plan, taxation can be deferred as an employee has the opportunity to roll a lump sum 

payment into an IRA or another qualified plan. Alternatively an employee can elect special 

lump sum taxation which provides a partial reduction of the tax burden associated with receipt 

of a lump sum in a single year. 

A. Contributions 

A participant in a qualified pension plan does not recognize the value of employer 

contributions made on his or her behalf for tax purposes when the contribution is made, but 

rather recognizes the value when benefits are actually paid from the plan. This is true even if 

the payments are not subject to a substantial risk of forfeiture and despite the fact that employers 

can take deductions for pension plan contributions when they are made. 

This generous treatment contrasts with non-qualified deferred compensation plans, where 

an employee is taxed when the employer contribution is no longer subject to a substantial risk 

of forfeiture and the deduction is taken by the employer when the income is recognized by the 

employee. This treatment also contrasts with an individual's regular savings account deposit, 

which must be made from after-tax income. 

B. Earnings 

Generally no taxes are paid on the income earned by trust assets during the period that 

taxation is deferred. Depending on the length of the period involved, the amount of earnings 

-79-
-80-

deferred within the trust can be substantially more than the original contribution amounts. 

Again, this treatment contrasts with that on earnings in a regular savings account, which are 

generally subject to tax annually as earned. 

When the participant retires and is taxed on the amount of current benefits paid, there 

is no distinction as to whether the benefits are attributable to employer contributions or earnings 

on the trust fund. The character of the source of the funds and any additional preferential tax 

treatment associated with the investments disappears when benefits are paid from the trust. 1 

Thus, even if a trust were invested entirely in tax-free municipal bonds, the earnings on the trust 

fund are taxed at the time benefits are paid. Note that the taxation of all pension benefits, 

contributions as well as earnings, when paid preserves the tax exemption of the earnings. 2 The 

tax on the earnings portion of benefits simply recoups the present value of the tax savings from 

the exclusion of contributions. 

C. Withdrawals 

An employee is generally taxed on the benefits he or she receives on a cash basis. 

However in the event that a participant elects to receive his benefits in a lump sum distribution 

as defined in the Code, several additional tax breaks are available. 

o An employee can elect to roll over any portion of the benefit into an Individual 

Retirement Account (IRA) or other qualified plan and defer taxation on that portion 

of the distribution until it is withdrawn from the IRA. (Withdrawals from an IRA 

need not be made before age 70 1/2.) 

o To the extent that an employee receives employer secunues as part of the 

distribution, an election can be made to be currently taxed on the cost value (at the 

time of contribution of those securities). This election allows the employee to 

defer recognition of any appreciation until sale of the securities. 

o If an employee is over 59 1/2 years of age and if certain other conditions are met, 

he or she may elect to "forward average" the distribution. Under forward 

averaging, the tax on the distribution is calculated as if the distribution was 

received in 5 equal annual installments and was the only income received in those 

years. The hypothetical tax for all 5 years is paid in the first year. This special 

tax treatment was more valuable in the era of sharply graduated tax rates. 

o If an employee was over 50 years of age on January 1, 1986, The Tax Reform Act 

of 1986 indefinitely grandfathered eligibility for two additional tax breaks. First, 

1

ln some cases, employees make after-tax contributions to pension plan. Under these 

circumstances, the character of the source of the funds is identified. 

~is assumes constant tax rates. 
-81-

such a participant can elect 10 year (instead of 5 year) forward averaging, provided 

that the tax is calculated using 1986 tax rates. The forward averaging option is 

available for these employees even if the distribution occurs prior to age 59 112. 

Secondly, these employees can elect to have the portion of their benefit associated 

with work prior to 1974 taxed at a flat 20 percent rate.3 

n. Lll\fiTATIONS ON TAX PREFERENCES 

In order for pension plans to receive preferential tax treatment, plans must satisfy 

qualification rules. These rules define allowable benefits and allowable pension funding. 

Effectively, the qualification rules limit the tax benefit of pension plans by limiting both pension 

benefits and the funding of pension benefits. 

The goals of the rules regarding benefits are to ensure that benefit levels are not excessive; 

to ensure that benefits are used for retirement purposes; and to ensure that rank-and-file 

employees (non-highly compensated employees) and employees who leave employment before 

normal retirement get their fair share of benefits provided by the plan. 

For defined contribution plans, plan funding and plan benefits are closely intertwined, and 

a relatively simple set of rules govern both. 

Because there is a weaker connection between plan funding and plan benefits for defined 

benefit plans, the rules for defined benefit plans are more complex than for defined contribution 

plans. The goals of the defined benefit plan funding rules are to ensure a plan has sufficient 

assets to provide for promised benefits and to prevent contributions which change the nature of 

a plan from a retirement plan to a tax shelter. 

A. Contribution and Funding Limits 

In general, contributions (including forfeitures) allocated to individuals in defined 

contribution plans are limited to the lesser of $30,000 and 25 percent of compensation. There 

are additional limits on profit-sharing plans and stock bonus plans. Profit-sharing plans and 

stock bonus plans are limited to 15 percent of total compensation in the aggregate (up to a 

maximum of $222,220 in 1991 for each plan participant). 

For a defmed benefit plan there is no specific percentage of pay limitation on 

contributions. Each year the employer must contribute enough to meet the minimum funding 

3

Under a separate grandfather rule, any employee who receives a lump sum distribution in 

1991 may elect to treat 10 percent of the distribution attributable to work prior to 1974 as a long 

term capital gain. 
-82-

standards. 4 Furthermore, any amount required to be contributed under these minimum funding 

rules is deductible regardless of the percentage of pay it represents. Deductions are limited 

however to an amount supported by the actuarial valuation, including the full funding limit. In 

the event an employer sponsors both defined benefit and defined contribution plans, the limit for 

the total deduction is the greater of the defined benefit limit and 25 percent of total compensation 

in the aggregate. 

In order to determine the minimum funding requirement and maximum deductible limits 

for a defined benefit pension plan, an actuarial valuation must be prepared. The valuation 

projects the future cash requirements of the plan on the basis of actuarial assumptions. The 

assumptions include interest rates, probabilities of death, probabilities of continued employment, 

and future salary increases (if benefits depend on earnings.) The future cash flow requirement 

is then discounted at the assumed interest rate and the result is called the actuarial present value 

of future benefits. 

The actuarial method allocates a portion of the actuarial present value of future pension 

benefits to each year of an employee's service. 

5 In general the allocation of future benefits is 

designed to produce a smooth pattern of contributions throughout an employee's career. The 

portion allocated to the employee's past work history is known as the accrued liability. The 

portion allocated to the present year's service is known as the normal cost. If there were no past 

services liability at the beginning of the plan, if all actuarial assumptions were always exactly 

correct, and if plan benefits and actuarial assumptions never change, the minimum funding 

standard would be the normal cost. Adjustments are made to the minimum funding standard as 

pension benefits are changed and as experience indicates that assumptions have not been 

realized. 

Prior to OBRA 87, the allowable contribution under the full funding limit was determined 

by comparing the accrued liability (plus the normal cost) with the actuarial value of plan assets. 6 

4

Plans that use the entry age normal cost method have the option of using an alternative 

minimum funding standard during any plan year. As a result, these plans have the flexibility 

of using the higher standard during years they want to contribute more and the lower standard 

during years they want to contribute less. 

5

See Chapter 2 for discussion of the impact of the actuarial method on pension funding. 

6

If the full funding limit is less than the minimum funding requirement, the minimum 

funding requirement is reduced to equal the full funding limit. To the extent that the assets are 

less than the accrued liability, the plan has an unfunded accrued liability, which is amortized 

over a period of 5-40 years (the amortization period depends on the reason there is an unfunded 

accrued liability). These amortized contributions are in addition to contributions for the present 

year normal cost. To the extent that the plan is "overfunded", contributions are temporarily 

reduced until assets no longer exceed accrued liability (including the present year's normal cost). 

(continued ... ) 
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The accrued liability (and normal cost) is a function of the actuarial method used for 

funding the plan and the actuarial assumptions used in the valuation. Thus a plan could be 

"overfunded" as measured by one actuarial method and yet have an unfunded accrued liability 

when measured by another method or by the same method but using different assumptions. 

OBRA 87 revised the full funding limit. Under OBRA 87, a plan must suspend 

contributions if the assets exceed either 150 percent of the current liability (regardless of the 

funding method otherwise used by the plan) or the accrued liability {plus normal cost) as 

calculated by the funding method used by the plan. Current liability is calculated as the sum of 

accrued liability and the normal cost under the unit credit funding method.

7 Further, the 

interest rate used in calculating current liability must be within 10 percent of the weighted 

average of the rates of interest on 30-year Treasury securities during the four-year period ending 

on the last day before the beginning of the plan year. 

B. Limitations on Withdrawals 

Since there are limits on contributions allocated to individuals in defined contribution 

plans, there are no limits on pension benefits withdrawn from the pension fund. 

For defined benefit plans, there is a limit on the amount of benefits which may be paid by 

the plan. The 1991 limit on annual pension benefits is the lesser of $108,963 and 100 percent 

of earnings for pensions payable at age 65. If the form of distribution is other than a life 

annuity (or qualified joint and survivor annuity) payable at age 65, the benefit limit is adjusted 

actuarial I y. 

The defmed benefit limit was $90,000 in 1987 and increases each year at the rate of 

inflation. The defined contribution limit on contributions will also track the rate of inflation 

once the defined benefit limit exceeds $120,000.1 

6

( ... continued) 

Effectively, contributions are limited to the amount required to increase assets to level of the 

accrued liability (plus normal cost). 

7

Current liability is determined by the amount of benefits that an employee has accrued to 

date. In order to calculate current liability, the pension benefit is determined based on the 

benefit formula, current years of service and the earnings history (if benefits depend on 

earnings). The Value of the pension benefits are then discounted to the present year. 

1

If an employee participates in both types of plans, he or she is limited to a total of 100-140 

percent of the individual limits. Where in the range of 100-140 percent the employee's 

combined plan limit falls depends on whether the dollar limit or the percentage of pay limit is 

the effective constraint and whether the plan is "top-heavy". For example, if the total limit for 

the employee was 125 percent and he or she was at the dollar limit for the defined benefit plan, 

(continued ... ) 
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In addition to the limits regarding the amount of distributions, the Internal Revenue Code 

incorporates a set of excise taxes to discourage the use of pension plans for purposes other than 

retirement. For example, there is a 10 percent additional income tax in most cases if benefits 

are paid prior to age 59 112. Similarly, there is a 50 percent excise tax if benefits are not paid 

out beginning with the attainment of age 70 112 and extending over a participant's life 

expectancy. 

C. Non-discrimination Rules 

In return for extending tax preferences to employers as incentives for providing pension 

plans to their employees, Congress required that meaningful benefits be provided to rank-and-file 

employees. This requirement is enforced in two principle ways. First, non-discrimination rules, 

require (with certain limited exceptions) that benefits be proportional to compensation, where 

compensation is limited to $222,220 (indexed for increases in the cost of living). Second, the 

vesting rules permit an employee's benefits to be forfeited only if the employee leaves the 

employer before completing a minimum period of service. Generally, benefits must become 

nonforfeitable under a 5 year cliff or a 3-7 year graded vesting schedule. The vesting rules 

work in conjunction with accrual rules which define the minimum acceptable level of benefits 

payable to early leavers when compared to benefits for employees who remain with the employer 

until retirement. 

1

( ••• continued) 

he or she would be limited to 25 percent of the otherwise permitted defined contribution plan 

allocation. 
APPENDIX B 

DESCRIPTION OF DATA AND METHODS USED IN CHAFfER 3 
APPENDIX B: DESCRIPTION OF DATA AND METIIODS USED IN CHAPTER 3 

I. DATA SOURCES 

The data are primarily from two sources. Data on assets and liabilities for 1989 are from 

Compustat ll, published by Standard & Poor's Compustat Services Inc. Other data about plans 

are from a matched sample of information from the 1984 IRS Form 5500. The sample of 1984 

IRS Form 5500 data was initially prepared by the U.S. Department of Labor, Pension and 

Welfare Benefits Administration. As described below in Section III, some actuarial data from 

a matched sample of 1984 Form 5500's were used to impute 1989 actuarial variables such as 

the discount rates and salary growth rates for plans in the sample. The imputation procedure, 

as described below, also used results from The Wyatt Company's 1989 Survey of Actuarial 

Assumptions and Fundin~ 1 

Data from Compustat II are from the 1989 financial statements of private employers that 

sponsor single employer defined benefit plans. The sample consists of companies that issue 

publicly traded common stock and file 10-K forms with the Securities and Exchange 

Commission. Wholly-owned subsidiaries that trade preferred stock and/or debt are also included 

in the sample. The sample excludes some banking institutions and closely held companies. 

Pension assets held by plans sponsored by companies in the sample accounted for approximately 

85 percent of private single employer defined benefit assets in 1989. 

The Compustat II data on pension assets and liabilities were prepared by companies under 

rules of the •statement of Financial Accounting Standards No. 87, Employers' Accounting for 

Pensions, • issued by the Financial Accounting Standards Board (FASB). Under FAS 87 rules, 

assets are reponed at their current market value. Liabilities are calculated and reponed in two 

ways: as Accrued Benefit Obligations (ABO) and Projected Benefit Obligations (PBO). 

Accrued Benefit Obligations were used in Chapter 3 as the measure of unadjusted current 

liability.2 Discount rate adjustments to current liability for the purpose of measuring the 

OBRA 87 full funding limit are described below in Section V. Projected Benefit Obligations 

1

Wyatt Company (1989). 

2

ABO was used as an approximation to current liability, unadjusted for differences between 

the disclosure discount rate and the discount rate used to calculate the OBRA 87 full funding 

limit. Adjustments for such differences are discussed below in Section V. Both ABO and 

current liability are based on employees' past service, not counting projected future service and 

salary/benefit increases. However there are differences in the way that the two concepts, in 

practice, treat nonvested benefit accruals and the Code Section 415 limits on benefits. If the 

current liability used for applying the OBRA 87 limit counts nonvested benefits more heavily 

than ABO counts non vested benefits, then ABO would possibly understate the unadjusted current 

liability. On the other hand, ABO may count benefits in excess of the Code Section 415 limits, 

whereas current liability would not, thus causing ABO to possibly overstate the unadjusted 

current liability. 

-87-
-88-

equal an employer's accrued liability as it would be calculated under a method like method 3 in 

Chapter 2 and under the actuarial assumptions used for discosure purposes. For non-earnings 

based plans, PBO equals ABO. An employer's actual accrued liability would be different from 

PBO if they used a different actuarial method and/or different actuarial assumptions for funding 

purposes. 

Companies in the Compustat II sample sometimes sponsor more than one defined benefit 

plan. Under the PAS 87 rules, and in Compustat II, plans of each employer are grouped 

according to whether or they are overfunded relative to ABO. Plans were grouped according 

to the same rules for the analysis in Chapter 3. 

ll. MATCHING AND WEIGHTING 

Much of the analysis for Chapter 3 required information about actuarial assumptions and 

funding methods used for plans in 1989. Such data were imputed, as described below in 

Section ill, based on data from the 1984 Form 5500 of a matched subsample of employers 

whose plans are also in the 1989 Compustat II sample. Exact matches were made by using 

Employer Identification Numbers (EIN). 

The matched subsample equals about 11 percent of the original Compustat II sample of 

earnings based plans. This subsample includes plans for which the plan formula is based on 

employee earnings and years of service. 

Sample weights were constructed so that the marginal distribution of funding ratios, 

weighted by ABO, was approximately the same in the full sample and subsample of earnings 

based plans. This was done by reweighting plans in the subsample so that the percentages of 

ABO were the same as the full sample in the six funding ratio brackets bounded by 120.6, 

143.9, 157.9, 180.8, and 198.3. 

ID. IMPUTATION PROCEDURES 

A. Actuarial Method 

The actuarial funding method for earnings based plans was imputed from the Form 5500 

data. The funding methods were divided into two classes: the (projected) unit credit method 

and other (level) funding methods. When there was more than one plan in the Form 5500 

sample with the same EIN as an employer in the Compustat II sample, i.e., when there were 

multiple donors, the actuarial method used for the largest plan donor (in terms of total 

participants) was used in the imputation. 
-89-

B. Discount and Salary Assumptions 

Values of the 1984 salary growth rates, discount rates used for funding, and discount rates 

used for disclosure were imputed from the Schedule B data of the Form 5500 sample. In cases 

of multiple donors from the Form 5500 sample, the annual salary growth rate of the largest plan 

was used. Discount rate assumptions were averaged across multiple donors. 

Values of these three assumptions were imputed for 1989 by assuming that a plan's 

deviation from the unweighted mean for all plans, in each case, did not change between 1984 

and 1989. The 1989 means are from the 1989 Wyatt "Survey of Actuarial Assumptions and 

Funding. "3 For example, if a plan's 1984 discount rate for funding was 7 percent, then its 

deviation from the unweighted matched sample mean in 1984 was -.82 (=7.0-7.82). The 

imputed 1989 discount rate for funding for this plan would have been 7.18 (=8-.82), where the 

mean from the 1989 Wyatt survey was 8 percent. The same procedure was used to impute the 

1989 salary growth rates and 1989 disclosure interest rates. 

C. Percentage of Current Liability for Active Employees 

The percentage of current liability for active employees was computed based on 

information from the 1984 Form 5500, Schedule B answers to questions 6(d) and 6(f). The 

denominator was the total value of vested benefits from question 6(d). The numerator was the 

total value of vested benefits other than for retired participants and beneficiaries from 

question 6(d), multiplied by the ratio of active participants to active plus vested terminated 

participants from question 6(f). When there were multiple donors from the Form 5500 sample, 

the totals were computed using all donors. 

D. Construction of the Age Index for Active Employees 

The age index was constructed by adjusting the active employee ratio of PBO to ABO for 

differences among plans in the disclosure discount rate, the salary growth rate, and the turnover 

rate assumptions. First, the unadjusted ratio of PBO to ABO for active employees was 

calculated using the following formula: 

Unadjusted (PBO/ABO)actives = [(PBO/ABO)- f] + (1 -f), 

where f is the fraction of ABO accounted for by inactive plan participants. The ratio of PBO 

to ABO for active employees was then multiplied by the following factor to account for 

deviations of the salary growth rate from the 1989 mean rate of 5. 9 percent, the disclosure 

3

Unweighted means from the Wyatt survey were: 7.2 percent in 1984 and 8.0 percent in 

1989 for the funding discount rate; 7.5 percent in 1984 and 8.3 percent in 1989 for the 

disclosure discount rate; 5.9 percent in 1984 and 6.0 percent in 1989 for the salary growth rate. 
-90-

discount rate from the 1989 mean funding discount rate of 8.2 percent, and the average 

percentage turnover rate from the mean of 14 percent.4 

Adjustment factor = (5.9/annual salary growth)·

1 

x (8.2/discount rate for funding)··

31 

x (14/average percentage turnover rate)"·

042 

The exponents in the formula, i.e., .1, -.31, and -.042 were estimated by regressing the natural 

logarithm of the unadjusted ratio of PBO to ABO for active employees on a constant and the 

logarithms of the annual salary growth, discount rate for funding. and average percentage 

turnover rate. For the regression estimation, observations were weighted by ABO. The 

T-statistics for the regression coefficient estimates .1, -.31, and -.042 were 5.0, -4.3, and -3.1, 

respectively. 5 

E. Accrued Liability 

For earnings based plans that used the projected unit credit method, the ratio of accrued 

liability to current liability was measured as the 1989 ratio of PBO to ABO. For this purpose, 

PBO was adjusted for differences between each plan's funding discount rate and its disclosure 

discount rate by multiplying PBO by the factor (1 + .13 x (disclosure discount rate - funding 

discount rate). The 13 percent adjustment factor was derived from simulations based on the 

complete pension simulation model used in Chapter 2. For other earnings based plans, the 1989 

ratio of PBO to ABO, similarly adjusted for differences between the funding and disclosure 

discount rates, was used as a measure of the ratio of accrued liability to current liability as it 

would be calculated under the projected unit credit method. However, the actual 1989 ratio of 

accrued liability to current liability for plans that did not use the projected unit credit method 

was imputed using regression methods. For such plans. the following estimated regression was 

used. 

(100 X Assets/ABO) = 126.2 

+ .51 x [(age index for active employees)] 

- 13.2 X [(discount rate for funding)] 

+ 6.4 x [(annual salary growth rate)] 

4The turnover rate is the percentage annual turnover rate, averaged over employee ages 25 

and 40. 

snte R-squared for the regression equalled .23. 
-91-

+ .25 x [(percentage annual turnover, average at ages 25 and 40)] 

+ 31.0 x [(fraction of CL due to actives)] 

The regression parameters were estimated by a weighted (by ABO) least squares method using 

the ratio of assets to ABO. The sample size was 136 and consisted of earnings based plans that 

were not funded under the projected unit credit method. The R-squared equalled .45, which 

implies that the imputation regression explained 45 percent of the weighted sample variation in 

the ratio of assets to ABO. T-statistics of the regression coefficients 126.2, .51, -13.2, 6.4, .25, 

and 31.0 were equal to 3.8, 3.8, -5.7, 5.6, 0.9, and 2.0, respectively. 

For the plans in the sample used to estimate the regression, the regression was used to 

impute the ratio of accrued liability to ABO (times 100), under the assumptions: (1) that the ratio 

of assets to ABO equals the ratio of accrued liability to ABO plus random noise for such plans 

and (2) that the ratio of accrued liability to ABO is systematically correlated with the actuarial 

and demographic variables on the right hand side of the regression. If the projected value from 

the regression was less than the actual 1989 ratio (times 100) of PBO to ABO, then the ratio of 

PBO to ABO (times 100) was used as the imputed value, adjusted for differences between the 

funding and disclosure discount rates. 

IV. METHOD FOR ESTII\1A TING DISTRIBUTIONS 

Distributions were estimated by using kemal density estimation methods. 6 The kemal 

density estimates can be thought of as smoothed histograms that have the properties of a density 

function, e.g., they integrate to one. The estimates also have other desirable statistical 

properties such as consistency. 7 

V. ADJUSTED CURRENT LIABILITY 

Unadjusted current liability was measured using the 1989 ABO reported for each plan. 

For Figures 3.5, 3.6, and for the purpose of computing the OBRA 87 full funding limit, for 

example, for Tables 3.2 and 3.3 and Figure 3.7, ABO was adjusted to account for the interest 

rate corridor rule of of the OBRA 87 limit. The midpoint of the corridor for the sample period 

equalled 8.8 percent. Because ABO is computed under the disclosure discount rate, ABO was 

adjusted when the disclosure discount rate was less than the midpoint of the corridor. The 

adjustment was made by decreasing ABO by 8 percent for every 1 point deviation from the 

midpoint of the corridor. The 8 percent adjustment is an approximation based on simulations 

6

See Silverman (1986). 

7

See Silverman (1986) for analysis of these properties. 
-92-

of the pension model used in Chapter 3. Lacking information about the actual interest rate used 

for calculating the OBRA 87 limit, the midpoint of the corridor was used in the adjustment even 

though plans are allowed to use a discount rate as low as 90 percent of the midpoint for 

computing the limit. This assumption is conservative and would tend to overstate the percentage 

of plans affected by OBRA 87 if plans actually used a discount rate lower than the midpoint for 

calculating the OBRA 87 limit. 
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Harlan Weller, who also prepared Appendix A. 
Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300