Private Pensions: Process Needed to Monitor the Mandated Interest Rate for Pension Calculations
Published: 2003-02-27T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Employers with defined benefit plans have expressed concern that low interest rates were affecting the reasonableness of their pension calculations used to determine funding requirements under the Employee Retirement and Income Security Act of 1974 (ERISA). ERISA requires employers to use a variation of the 30-year Treasury bond rate for these calculations; however, in 2001 Treasury stopped issuing the 30-year bond. This report provides information on (1) what characteristics of an interest rate make it suitable for determining current liability and lump-sum amounts; (2) what alternatives to the current rate might be considered; and (3) how using an alternative rate might affect plan participants, employers, and the Pension Benefit Guaranty Corporation (PBGC).
section_title: What GAO Found
paragraphs: GAO analysis indicates the Congress intended that the interest rates used in current liability and lump-sum calculations should reflect the interest rate underlying group annuity prices and not be vulnerable to manipulation by interested parties. In 1987, 30-year Treasury bond rates appeared to have both of these characteristics. However, the Department of the Treasury stopped issuing new 30-year Treasury bonds in 2001. Actuaries and other pension experts have proposed a number of alternative interest rates, including alternatives based on interest rates set in various credit markets--including composite rates for long-term Treasury securities, long-term high-quality corporate bond indices, 30-year rates on securities issued by government-sponsored enterprises, such as Fannie Mae, 30-year interest rate swap rates--and PBGC interest rate factors based on surveys of insurance company group annuity purchase rates. Each alternative has attributes that may make it more or less suitable as an interest rate for the calculation of current liabilities, PBGC premiums, and lump-sum amounts. Additionally, the relationship of any interest rate to the underlying group annuity purchase rates may change over time and, unless the relationship is periodically evaluated, the Congress may be unable to appropriately respond to those changes. If the alternative interest rate selected to replace the current statutory rate immediately results in a higher interest rate level, which is likely, it would generally lower participant lump-sum amounts, lower minimum employer funding requirements, and reduce PBGC premium revenue. However, if the alternative interest rate produces a lower interest rate level, plan participants would generally receive larger lump sums, some employers would need to increase contributions to their plans, and PBGC may experience an increase in revenue.

section_title: Letter
paragraphs: In 2001, groups representing employers with defined benefit plans  expressed concern that low interest rates were affecting the  reasonableness of their pension calculations. Under the Employee  Retirement Income Security Act of 1974 (ERISA), as amended, and the  Internal Revenue Code (IRC), these calculations affect how much  employers are allowed or required to contribute to their pension plans,  how much employers must pay to the Pension Benefit Guaranty  Corporation (PBGC) for federal insurance of the benefits promised by the  plan, and how much plan participants receive when pension benefits are  distributed in a lump sum. When making such calculations, the laws  require that employers use interest rates on 30-year Treasury bonds, or  interest rates that are based on 30-year Treasury bond rates. Specifically,  the laws require employers to use    an interest rate from within a permissible range of a 4-year weighted  average of 30-year Treasury bond rates to calculate a plan’s total liability,  termed the plan’s current liability, and to use that calculation to assess its  funding level. If plans are funded below certain thresholds as defined in  the IRC, employers are to determine minimum contribution amounts on  the basis of those assessments. If a plan is fully funded as defined in the  law, employers are precluded from making additional tax-deductible  contributions to the plan.  the interest rate on 30-year Treasury bonds to assess a plan’s funding level  and, if required, pay an additional premium, termed the variable-rate  premium, to PBGC for federal insurance of their plan’s benefits.  the interest rate on 30-year Treasury bonds to determine the minimum and  maximum values of lump-sum distributions, and whether a benefit can be  distributed as a lump sum without a participant’s consent. When  determining the minimum lump-sum distribution payable, the 30-year  Treasury rate is the highest rate that an employer can use in making the  calculation.
Generally, the interest rates specified in the law were intended, within  certain parameters, to reflect the price an insurance company would  charge to take responsibility for the plan’s pension payments. The price  that insurance companies would charge employers for this service reflects  current interest rates, the expected mortality and retirement rates of  participants for the plans they are considering, and the insurance  companies’ expected expenses and required profit. These factors may be  expressed as a single rate, called the group annuity purchase rate, which is  the interest rate underlying the actual group annuity price. In the late  1990s, when fewer 30-year Treasury bonds were issued and economic  conditions increased demand for the bonds, the 30-year Treasury rate  diverged from other long-term interest rates, an indication that it also may  have diverged from group annuity purchase rates. In 2001, Treasury  stopped issuing these bonds altogether, and in March 2002, the Congress  enacted temporary measures to alleviate employer concerns that low  interest rates on the remaining 30-year Treasury bonds were affecting the  reasonableness of the interest rate for employer pension calculations. To  help the Congress decide what, if any, additional measure to take, you  asked us to determine: (1) what characteristics of an interest rate would  make it suitable for determining current liability and lump-sum amounts;  (2) what alternatives to the current interest rate might be considered; and  (3) how using an alternative rate might affect plan participants, employers,  and PBGC.
To determine the characteristics of a suitable interest rate, we reviewed  pension laws and their legislative history with respect to the calculation of  current liability and lump-sum amounts. We also interviewed Labor,  Treasury, and PBGC officials who might play a role in assessing alternative  interest rates. To identify and examine the advantages and disadvantages  of potential alternative interest rates, we interviewed representatives and  reviewed documents from a number of government, actuarial, pension  plan sponsor, and investment entities. We also compared rates and other  market statistics for suggested alternative debt securities with rates for   30-year Treasury bonds from 1987 to 2002. To determine how alternative  rates might affect employers, plan participants, and PBGC, we created  hypothetical examples, based on discussions with actuaries and pension  consultants, in which we tested the effect of changes in rate levels on  current liabilities and lump-sum payments. We did not assess alternative  methods for specifying interest rates. For example, we did not assess  whether the interest rate for current liability calculations should be  specified as a 4-year weighted average or current market rate. Our scope  and methodology is explained more fully in appendix I.
subsections: section_title: Background
paragraphs: Interest rates are key assumptions in calculating the present value of  promised future pension benefits. When interest rates are lower, more  money is needed today to finance future benefits because it will earn less  income when invested. At a 6-percent interest rate, for example, a promise  to pay $1.00 per year for the next 30 years has a present value of about   $14. If the interest rate is reduced to 1.0 percent, however, the present  value of $1.00 per year for the next 30 years increases to about   $26 because the $26, when invested, will earn the relatively small income  associated with a 1-percent interest rate. Therefore, lower interest rate  assumptions result in higher current liability and lump-sum amounts.
The interest rate appropriate for measuring the present value of a plan’s  pension liabilities may differ depending on a number of factors, including  the purpose of the measurement. For example, the interest rate  appropriate for measuring the present value of a plan’s pension liabilities  on an ongoing basis may reflect the assumed rate of return that the plan is  expected to achieve on the investment of its assets. On the other hand,  the interest rate appropriate for measuring the present value of that same  plan’s pension liabilities at plan termination may reflect interest rates  implicit in annuity purchase rates.
Before ERISA, few rules governed the funding of defined benefit plans,  and there were no guarantees that participants would receive promised  benefits. When the pension plan of a major automobile manufacturer  failed in the 1960s, for example, thousands of defined benefit plan  participants lost their pensions. As part of ERISA, the Congress  established PBGC to pay pension benefits in the event that an employer  could not. In addition to establishing PBGC, ERISA and IRC require  employers to make minimum contributions to under-funded plans and  prevent employers from making tax-deductible contributions to plans  exceeding specified funding limits. “. . . the determination of whether an interest rate is reasonable depends on the cost of  purchasing an annuity sufficient to satisfy current liability. The interest rate is to be a  reasonable estimate of the interest rate used to determine the cost of such annuity,  assuming that the cost only reflected the present value of the payments under the annuity  (i.e., and did not reflect the seller’s profit, administrative expenses, etc.). For example, if an  annuity costs $1,100, the cost of $1,100 is considered to be the present value of the  payments under the annuity for purposes of the interest rate rule, even though $100 of the  $1,100 represents the seller’s administrative expenses and profit. In making the  determination with respect to the interest rate . . . other factors and assumptions (e.g.,  mortality) are to be individually reasonable.”
In 1987, the range of permissible interest rates was from 10-percent below  to 10-percent above the weighted average 30-year Treasury bond rate. In  1994, IRC was amended to reduce the upper limit of the permissible range  of interest rates from 10 percent to 5 percent above weighted average  rate. The House Report accompanying the bill stated that the 1987  legislation was intended to address the chronic under-funding of pension  plans that had persisted since passage of ERISA. However, when  measuring current liability, plans could decrease contributions by  choosing an interest rate at the high end of the range. According to the  report, the highest allowable interest rate was reduced to 105 percent to  minimize a plan’s ability to decrease its current liability through the choice  of interest rates.
Additionally, in 1994, IRC was amended to require that employers  determine the minimum value of certain optional forms of benefit, such as  lump sums, using an interest rate no higher than the interest rate for   30-year Treasury bonds. To prevent employers from exceeding the  maximum lump-sum payment specified by law, IRC also required  employers to use an interest rate no lower than 30-year Treasury bond  rates when calculating lump sums for certain highly paid employees. The  Congress enacted the amendment for a number of reasons, including to  ensure that rates for determining lump-sum payments better reflected  prices in the insurance annuity market.
Figure 1 shows, for 1987 to 2002, the range of allowable rates for current  liability calculations and the allowable interest rates for lump-sum  calculations. In November 2002, for example, the interest rate for 30-year  Treasury bonds was 4.96 percent. That month, the 4-year weighted average  rate for 30-year Treasury bonds was 5.58 percent, and the range of  allowable interest rates for current liability calculations was 5.02 percent  to 6.70 percent.
section_title: Interest Rate Should Reflect Group Annuity Purchase Rates
paragraphs: Our analysis of the law and related congressional documents, and  discussions with PBGC and Treasury officials, indicates that the interest  rates used in current liability and lump-sum calculations were to have two  characteristics. They were to: (1) reflect group annuity purchase rates and  (2) not be vulnerable to manipulation by interested parties. Because actual  group annuity purchase rates are unknown, the Congress specified rates to  regulate an employer’s selection of an interest rate. While 30-year Treasury  rates may have been close to group annuity purchase rates in 1987, PBGC  was not aware of any available studies that documented that proximity.  Officials said that, in addition to their possible proximity to group annuity  purchase rates, the Congress adopted 30-year Treasury bond rates as the  basis for interest rates because they could not be easily manipulated by  interested parties. In this regard, Treasury bonds were actively traded in  large markets and interest rate data for them were available from  government sources, which helped ensure that the rates accurately  represented market conditions and could not be easily manipulated by  interested parties. However, the Department of the Treasury stopped  issuing new 30-year Treasury bonds in 2001.
subsections: section_title: Information on Actual Group Annuity Purchase Rates Is Not Available
paragraphs: Information needed to determine actual group annuity purchase rates is  not available because annuity purchases are private transactions between  insurance companies and employers who terminate their pension plan. To  terminate a defined benefit plan, an employer determines the benefits that  have been earned by each participant up to the time of plan termination  and purchases a single-premium group annuity contract from an insurance  company, under which the insurance company guarantees to pay the  accrued benefits when they are due. The insurance company determines  the employer’s premium by analyzing participant demographics and  making assumptions about a number of variables, including:    Interest rates. The assumed interest rate is used to determine the  present value of projected benefit payments and costs at the annuity  purchase date. Rates reflect current market rates for the securities in  which the company is likely to invest the premium paid by the plan:  generally fixed income securities, such as corporate bonds and mortgage- backed securities, with a relatively low credit risk. Interest rate  assumptions may vary according to a number of factors at plan  termination, including the projected cash flow of the plan and the yield  curve on relevant securities.(See app. II.) Interest rates are adjusted to  produce the insurer’s target level of capital requirements and profits from  the annuity.
Mortality rates. The assumed mortality rate reflects death rates  associated with known or assumed characteristics of the participant  population, with some adjustments to account for future potential  improvements in mortality.
Administrative expenses, taxes, and other costs. Administrative  expenses for annuities include the cost of setting up accounts and tracking  payments. Many insurers assume a flat rate for each annuitant in pricing  some administrative expenses, such as account set-up charges. Some  insurers reduce their interest rate assumption to account for those  expenses.
Information about insurance company assumptions, or premium payments  and projected benefits, would be needed to estimate actual group annuity  purchase rates; however, this information is often not available publicly.  For example, employers who decide to terminate their pension plans  typically contact a broker or consultant who then solicits bids for a group  annuity contract from qualified insurance companies. Insurance  companies bid on the contract through the broker or consultant.  Negotiations or an auction may take place, which may further affect the  price. Insurance companies typically do not disclose assumptions made  during this process.
section_title: Thirty-Year Treasury Bonds Had Desirable Characteristics, but Are No Longer Issued
paragraphs: Thirty-year Treasury bonds had several desirable characteristics when  they were selected to approximate group annuity purchase rates in 1987.  For example, the American Academy of Actuaries said that in 1987, the   30-year Treasury bond rate plus 0.3 percentage points (30 basis points)  would have replicated group annuity purchase rates. This would indicate  that the difference between the rate of return on 30-year Treasury bonds  and the typical insurance company investment (such as long-term, high- quality corporate bonds) approximated the expenses and other annuity  pricing factors that insurance companies would consider. The extent to  which 30-year Treasury bond rates maintained their proximity to group  annuity purchase rates would depend upon how closely Treasury rates  continued to approximate insurance company investment rates of return,  after adjusting them for expected administrative expenses and other  annuity pricing factors.
Additionally, policymakers said that 30-year Treasury bond rates were  selected as the interest rate in 1987 in part because interested parties  could not easily manipulate Treasury rates. Two characteristics of 30-year  Treasury bonds that would indicate their rates could not be easily  manipulated were their “transparency” and “liquidity.”
Thirty-year Treasury bond rates were transparent. For a rate to be  transparent, information about it must be widely available and frequently  updated. The Federal Reserve Board of Governors, using data provided by  the Department of the Treasury, published information on 30-year  Treasury rates. The Department of the Treasury constructed 30-year  Treasury bond rates using data collected from private vendors and  reviewed and compiled by the Federal Reserve Bank of New York.
Thirty-year Treasury bonds were liquid. For a bond to be liquid, the  market in which it is traded must be large and active so that isolated  events or erratic behavior by a single market participant are unlikely to  have a major effect on market prices. According to a senior market  analyst, the 30-year Treasury bond market in 1987 was likely the deepest  and most liquid market in low risk 30-year bonds in the world.
While 30-year Treasury bonds had several favorable characteristics when  they were selected to approximate group annuity purchase rates, their  issuance has since been suspended. The 30-year Treasury bond rates that  are currently used as an interest rate for pension calculations are  published by the Internal Revenue Service (IRS) based on rates for the last  30-year Treasury bonds, which were issued in February 2001.
section_title: Alternative Interest Rates Have Advantages and Disadvantages Compared with Treasury Bond Rates
paragraphs: Actuaries and others have proposed a number of alternatives that could be  used to control the selection of interest rates for current liability and  lump-sum calculations, including (1) interest rates set in credit markets for  various securities, such as long-term Treasury securities; long-term, high- quality corporate bonds; 30-year GSE bonds; and 30-year interest rate  swaps; and (2) PBGC interest rate factors based on surveys of insurance  company group annuity purchase rates. As shown in table 1, each  alternative has characteristics that affect its likelihood of approximating  group annuity purchase rates over time and its potential vulnerability to  manipulation. For example, the closer an alternative’s interest rate levels  match the net return on investment of insurance companies offering group  annuities, the more likely that alternative will match group annuity  purchase rates. Similarly, the closer the underlying credit rating of an  alternative matches that of an insurance company offering group  annuities, the more likely that alternative will match group annuity  purchase rates.
Various calculations can be applied to any interest rate to make it more  suitable for its intended use.  For example, each of the alternatives could  be specified as: (1) a single monthly interest rate, which is currently the  case for lump-sum calculations; (2) a corridor of interest rates around the   4-year weighted average of a monthly rate, which is currently the case for  current liability calculations; or (3) a yield curve. According to several  actuaries and others, specifying the alternative as a yield curve, instead of  a single rate or corridor of rates around a weighted average rate, would  have advantages and disadvantages.  For example, specifying a yield curve  might enable each plan to more closely approximate its group annuity  purchase rate, but doing so might increase the difficulty of plan  calculations and could prove relatively costly for small plans.
subsections: section_title: Long-Term Treasury Securities
paragraphs: The Department of the Treasury continues to construct rates for long-term  bonds that could be used as a basis for selecting interest rates for current  liability and lump-sum calculations. For example, the Treasury  Department constructs a rate, called the long-term applicable federal rate,  which approximates Treasury’s borrowing costs for securities with  maturities exceeding 9 years. IRS publishes applicable federal rates.  Figure 2 compares the long-term applicable federal and 30-year Treasury  bond rates from 1987 to 2002. As can be seen, the differences between the  two rates are generally less than 50 basis points.
According to actuaries, insurance companies typically place group annuity  premiums in fixed-income investments that have a higher rate of return  than 30-year Treasury bonds. Treasury rates are lower than rates for other  fixed-income investments of the same maturity because Treasury bonds  have a lower credit risk. The proximity of Treasury bond rates to group  annuity purchase rates may vary with changes in investor attitudes about  credit risk. During periods of financial uncertainty, for example, investors  may have a sharply heightened desire for safety, often referred to as a  “flight to quality,” which could cause Treasury rates to decline relative to  rates for other securities. Some investment analysts believe that one such  period began toward the end of the 1990s.
Despite concerns that long-term Treasury bond rates may not track closely  with group annuity purchase rates during periods of financial uncertainty,  Treasury bond rates retain some characteristics that may continue to  make them a desirable interest rate. The government constructs the rates,  and they are based on trades in large, active, and highly visible markets.  For example, debt securities markets have shifted to the 10-year Treasury  note to serve some of the same long-term benchmark functions as the   30-year Treasury bond has served in the past.
section_title: Long-Term High-Quality Corporate Bond Index Rates
paragraphs: Various financial investment firms construct indices of interest rates for  long-term, high-quality corporate bonds, which are debt securities with  maturity of 10 years or more issued by companies with relatively low  credit risk. Figure 3 compares interest rates for the highest-quality  corporate debt (bonds rated Aaa by Moody’s Investor Services), high- quality corporate debt (bonds rated Aa), and 30-year Treasury bonds for  the period 1987 to 2002. As can be seen, corporate bonds with a Aa rating  have higher interest rates than corporate bonds with a Aaa rating and   30-year Treasury bonds.
Several actuaries and plan sponsor groups have suggested using one or  more indices for long-term, high-quality corporate bond rates as the basis  of an interest rate, while others suggest that these indices require  adjustments before they can be used. Because insurance companies tend  to invest in long-term corporate debt, these rates may track changes in  group annuity purchase rates. An industry representative said that an  unadjusted average of the indices would reflect insurance company  expenses and other group annuity pricing factors because insurance  companies typically achieve a higher rate of return on investment than is  indicated by high-quality corporate bond rates. For example, investing in  lower-quality bonds and private loans might achieve a higher rate of return  than investing in high-quality corporate bonds. According to some  actuaries, however, the indices would need to be adjusted for insurance  company expenses and other factors before they would reflect the level of  group annuity purchase rates. For example, a study for the Society of  Actuaries said that a long-term corporate bond index rate minus 70 basis  points would reasonably approximate group annuity purchase rates.  However, the ERISA Industry Committee recommended using an average  of corporate bond indices published by four firms as the interest rate  without such an adjustment. Some actuaries and other pension experts  have suggested that rates on some corporate bond indices might also need  to be adjusted to make allowances for certain options before the rates  would reflect the level of group annuity purchase rates. For example,  corporate bonds are typically “callable,” meaning that the issuer can recall  a bond before its maturity date. Because this creates some uncertainty to  the holder of a corporate bond, this may also increase corporate bond  rates relative to group annuity purchase rates.
Corporate bond indices have properties that make them difficult to  manipulate, but the corporate bond market may not be as liquid and  transparent as the Treasury bond market. While the investment-grade  corporate bond market is very large overall, with over $700 billion in  issuance in 2001 and an estimated $4 trillion in outstanding value as of the  third quarter of 2002, the market is segmented by differences in credit  quality and issuer characteristics and, therefore, is less liquid than a large  unsegmented market such as the market for Treasury securities.  Additionally, interest rates for specific corporate bonds are based on  quotes by traders, who usually estimate the current trading value of a bond  and quote a rate based on its spread versus a comparable Treasury  security. However, information on which to base corporate bond quotes is  expected to become more widely available through a National Association  of Security Dealer’s reporting system, which was launched in July 2002  and reports many large recent transactions. The new system may not  alleviate all transparency concerns. Some financial experts said that  corporate bonds are not as highly traded as other debt securities, which  means that recent trades are often not available to verify current market  conditions and rates.
Certain corporate bond indices also have unique characteristics and  complexities that could affect their suitability as an interest rate.  Corporate bond indices are put together by private financial companies,  which then compute an interest rate for the index based on underlying  interest rates of the component bonds. Financial companies differ in how  publicly they share information on which bonds they include in an index,  how they weight component interest rates, and other factors and  calculations that influence the published rate. Further, the reliability of the  corporate indices can be affected by the reliability of the data source— actual transactions, quotes, or estimates of values or yields—on which  they are based.
section_title: Thirty-Year Rates on GSE Securities
paragraphs: Thirty-year rates on securities issued by GSEs are rates on bonds used to  finance home ownership and other public policy goals. GSEs are private  corporations, such as Federal National Mortgage Association (also known  as Fannie Mae), that have the implicit backing of the U.S. government. In  1998, Fannie Mae began issuing debt through its benchmark program,  which is intended to be high-quality, noncallable, actively traded debt.  Fannie Mae attempts to issue benchmark debt periodically and in large  amounts, similar to how Treasury issued 30-year bonds in the past.
Several pension experts have suggested using 30-year Fannie Mae bond  rates as the basis for the interest rate. Because GSE securities have  received a credit rating comparable to, or higher than, the credit rating of  the insurance companies that offer group annuities, GSE rates may  approximate group annuity purchase rates. GSE-issued debt is generally of  the highest credit quality but not considered credit-risk free like Treasury  securities. Therefore, GSE rates would typically be expected to fall  between Treasury rates and high-quality corporate rates of comparable  maturity.
Fannie Mae benchmark 30-year bond rates have properties that indicate a  low likelihood that interested parties could manipulate them, but the  securities have a relatively small market and relatively low trading activity  compared with the Treasury and corporate bond markets. Outstanding  volume of 30-year Fannie Mae benchmark debt was $14.9 billion as of  December 2002, which was significantly less than the $589 billion in  outstanding Treasury bonds as of November 30, 2002, and $4 trillion in  outstanding long-term corporate bonds. According to Federal Reserve data  of market transactions by primary dealers, trading in long-term GSE debt,  which includes securities besides Fannie Mae benchmark debt, has been  approximately $1.1 billion per day in 2002, which is much less than long- term Treasury securities. According to some experts, GSE debt is  expected to continue to grow. With regard to transparency, Fannie Mae  has also recently increased the availability of information on trades  underlying the rates on its securities, which should increase rate  transparency.
section_title: Thirty-Year Interest Rate Swaps Rate
paragraphs: Thirty-year interest rate swap rates are fixed rates in a contract between  two parties, one of whom agrees to make fixed interest payments based on  a specified amount of money in exchange for interest payments based on  variable short-term rates on the same specified amount of money for the  duration of the contract. For example, one party might agree to pay a   5 percent annual fixed rate on $1 million every year for the next 30 years in  exchange for receiving a published 3-month interest rate that changes  periodically for the next 30 years on the same $1 million. The 30-year swap  rate in this case would equal 5 percent, and the predominant 30-year swap  rate should move up and down with the expected level of short-term  interest rates over the next 30 years. The “notional” amount of money   ($1 million in the example) does not typically change hands between the  counter parties in a swaps contract, and unlike most other fixed-income  markets, interest-rate swaps do not involve the issuance of debt. By  entering into a swap contract, the party that agreed to make fixed interest  rate payments can help offset potential risk from variable-rate debt that it  issues by making fixed interest payments in exchange for variable-rate  payments. The variable-rate payments that it receives under the agreement  can then be used to pay its debt holders. If interest rates go up, the debt  issuer pays higher debt service payments but also receives higher interest  payments from the swap agreement.
Several pension experts have considered using 30-year interest rate swap  rates as the basis for current liability and lump-sum calculations. Interest- rate swaps contracts are generally perceived to contain low credit risk for  two reasons. First, the two parties involved in the contract typically have  high credit ratings. Second, swap contracts typically use the London  Interbank Offer Rate (LIBOR) as the floating rate, and the LIBOR has a low  credit risk. The overall credit quality underlying LIBOR-based, interest-rate  swap rates is likely comparable to that of high-quality corporate bonds.  However, unlike some corporate bonds, swaps are not callable, so their  rates would not need to be adjusted for such options and typically would  be expected to fall below those on high-quality corporate bonds of similar  maturity. The credit rating of insurance companies in the group annuity  market is generally Aa or better. Interest rate swaps might give an  accurate indication of an insurance company’s cost of borrowing funds.
The interest rate swap market has characteristics that likely protect rates  from potential manipulation. The swap market is considered to be very  active, although the trading volume and amount outstanding for longer  maturity interest rate swaps are believed to be low, relative to shorter  maturities. The Federal Reserve Board publishes 30-year interest rate  swap rates daily based on a private survey of quotes on new contracts  offered by 16 large swaps dealers, and quotes on swaps contracts are  updated throughout the day and visible via subscription services. A unique  advantage of using swaps as an interest rate is that swaps do not require  the issuance of debt; rather, swap rates reflect contracts between two  parties. Because new contracts are produced every day, it is easier to  update 30-year swap rates than other rates involving the issuing of debt,  which happens only periodically. The international swaps market  represents the largest of the alternatives considered, with an outstanding  dollar-denominated value of swaps contracts estimated at approximately  $20 trillion, with many new transactions conducted between parties every  day. However, some experts have expressed concern about using the   30-year interest rate swaps because the swaps market is relatively new and  the outstanding trading volume of 30-year interest rate swaps is believed  to be much lower than for shorter maturity contracts.
section_title: PBGC Interest Rate Factors
paragraphs: Of all the alternative rates, PBGC’s interest rate factors have the most  direct connection to group annuity purchase rates. Figure 4 shows that the  proximity of PBGC interest rate factors to 30-year Treasury bond rates  varied from 1987 through 2002.
PBGC interest rate factors are based on surveys of insurance companies  conducted by the American Council of Life Insurers (ACLI) for PBGC and  IRS. The survey asks insurers to provide the net annuity price for annuity  contracts for plan terminations. PBGC develops interest rate factors,  similar to interest rates, from the survey results, which are adjusted to the  end of the year using an average of the Moody’s Corporate Bond Indices  for Aa and A-rated corporate bonds for the last 5 trading days of the  month. The adjusted interest rate factors are published in mid-December  for use in January. The interest rate factors are then further adjusted each  subsequent month of the year on the basis of the average of the Moody’s  bond indices. According to PBGC, the interest rate factors, when used  along with the mortality table specified in PBGC regulations, reflect the  rate at which pension sponsors could have settled their liabilities, not  including administrative expenses, in the market for single-premium  nonparticipating group annuities issued by private insurers. Although  PBGC interest rate factors do not consider the insurers’ administrative  expenses, a May 2000 American Academy of Actuaries study of the PBGC  interest rate factors found that they overstated termination liability by a  relatively small amount, averaging 3 percent to 4 percent. The study  characterized PBGC factors as mildly conservative.
Despite its seeming desirability as a statutory rate because of its direct  connection to group annuity purchase rates, PBGC’s interest rate factors  may be more vulnerable to manipulation than other alternatives because  they are not based on interest rates determined by the credit market and  are less transparent. The identity of insurance companies surveyed and  included in PBGC factors is not known, raising ambiguity about the extent  to which the PBGC interest rate factors reflect the current broad market  for group annuities. Additionally, PBGC calculations are not reported or  independently reviewed. However, an insurance company representative  said that insurance companies participating in the survey would likely  agree to have that participation reported, and a PBGC official said that  PBGC would not object to an independent review of its methodology for  developing the interest rates.
section_title: Alternatives Likely to Decrease Lump-Sum Payments, Employer Contributions, and PBGC Revenue
paragraphs: If the alternative results immediately in a higher allowable interest rate,  which is likely for the alternatives we reviewed, using the higher rate  would generally decrease minimum allowable lump-sum amounts and  increase the number of participants whose benefit could potentially be  distributed as a lump sum without their consent, decrease minimum and  maximum employer contributions, and decrease PBGC revenue. The  present value of a participant's benefit and related contribution and  premium requirements would decrease because a higher interest rate  increases the value of today’s dollars, relative to future dollars, and  therefore fewer of today’s dollars should be needed to pay benefits in the  future. However, if the alternative produces a lower interest rate, plan  participants would receive larger lump sums, employers would need to  increase contributions to their plans, and PBGC may experience an  increase in revenue.
The magnitude of these effects on lump sums, plan funding, and PBGC  premiums would depend on the characteristics of the plan and its  participants and how the rate is specified in the law. Additionally, if the  Congress specifies the interest rate differently for current liability and  lump-sum calculations, as is currently the case, the magnitude of the  impact on each could differ. Furthermore, the effect on current liability  and lump-sum calculations could be phased in over a period of time. In  1994, for example, the law phased in the reduction in the upper limit on  interest rates for current liability calculations from 110 percent to   105 percent over a 5-year period. Additionally, requiring the use of an  updated mortality table for current liability calculations might partially  offset the effect that a higher interest rate would have on current liability  calculations.
During the period from January 1994 to July 2002, the monthly long-term  corporate bond rates, GSE rates, and 30-year interest rate swap rates, were  generally greater than the 30-year Treasury bond rate; the PBGC estimated  rate was below the 30-year Treasury bond rate in the mid-1990s but was  higher than the 30-year Treasury bond rate after 1998. As shown in figure  5, each rate’s relationship to the 30-year Treasury rate has changed over  time.
subsections: section_title: Use of Higher Interest Rates Would Decrease Lump-Sum Amounts
paragraphs: Figure 6 shows that the effect of a change in the interest rate used to  calculate lump sums is greater for participants further away from  retirement than for participants near retirement.  The figure shows, for  example, that a 1-percentage point increase in the interest rate from   5 percent to 6 percent would result in an 8 percent decrease in the lump  sums of participants expected to retire almost immediately.  On the other  hand, that same 1-percentage point increase in the interest rate would  result in a 36 percent decrease in the lump sums of participants expected  to retire in 40 years.
Reducing the dollar amount of each lump-sum distribution by using a  higher interest rate may affect the number of employers that offer a lump- sum distribution and the number of participants electing to take a lump- sum distribution. Many employers already offer a lump-sum provision in  their plans; however, if the rate used to calculate lump-sum distribution  amounts were to increase, reducing the amount of each distribution, more  employers may adopt lump-sum provisions in their plans in order to  reduce costs. However, fewer participants might elect a lump-sum  distribution if the value of such payments were to decline relative to the  participant’s annuity benefit.
Reducing the calculated present value of each participant’s benefit would  also increase the number of participants whose benefit may be distributed  by the plan as a lump sum without their consent. An increase in the  assumed interest rate would cause the present values of some benefits,  which are currently above the $5,000 limit for nondiscretionary  distribution as a lump sum, to be reduced to the point that they fall below  that limit.
section_title: Use of Higher Interest Rates May Decrease Employer Contributions and PBGC Revenue
paragraphs: Because a higher interest rate would make plans appear better funded  relative to current liabilities than they were before, employer  contributions and PBGC revenue may decrease. For each 1-percentage  point change in the interest rate, estimated current liabilities of a pension  plan would change by 12 percent to 15 percent. Such a change may lower  or eliminate the minimum employer contribution, referred to as the deficit  reduction contribution, required by the IRC. Therefore, plans with a  typical distribution of participants would see their liabilities reduced by   12 percent to 15 percent from a 1-percentage point increase in the interest  rate. Figure 7 shows plans that were 80 percent funded would become  more than 90 percent funded and would no longer have to make a deficit  reduction contribution.
A higher interest rate would also decrease allowable employer  contributions for plans at the full funding limit. The IRC imposes full  funding limitations that limit tax-deductible contributions under certain  circumstances in order to prevent employers from contributing more to  their plan than is necessary to cover promised future benefits. The full  funding limitations established in 1987 and 1994, also known respectively  as the 150-percent current liability limitation and the 90-percent current  liability limitation, are required to be computed using the 30-year Treasury  rate. If the rate with which they are required to be computed were to  increase, more plans would be subject to the full funding limitation and,  therefore, fewer would be allowed to make additional contributions.
Employer premium payments to PBGC would decrease with the use of a  higher interest rate because their plans’ current liabilities would become  better funded. Generally, ERISA requires plans with assets that are less  than the value of their accrued vested benefits to pay an additional  premium, termed the variable-rate premium. Assuming an increase in the  interest rate, some plans would no longer be subject to the variable-rate  premium because the reduction in their current liabilities would cause  them to reach the full funding limit and therefore become exempt from the  payment. Plans still subject to the variable-rate premium would pay less  because their current liabilities would become better funded.
section_title: Conclusions
paragraphs: The choice of an interest rate has important implications for federal  revenue, employer cash flow, and participant retirement income. A single  percentage point increase in the interest rate would reduce a typical  pension plan’s current liabilities by 12 percent to 15 percent, depending on  participant demographics. Rules for using current liability calculations to  determine minimum contributions, full funding limits, and PBGC  premiums are extremely complex. However, in general, with an increase in  the interest rate, some under-funded plans would become adequately  funded, some plans would reach full funding limits, and additional plans  would avoid variable-rate premiums. Additionally, the minimum allowable  value of the lump-sum equivalent of a participant’s annuity benefit would  decline. The magnitude of the decline would depend on the participant’s  age and proximity to the plan’s normal retirement age.
Each alternative has characteristics that may make it more or less  appropriate as an interest rate. To the extent that policymakers continue  to want the interest rate tied to group annuity purchase rates, the PBGC  interest rate factors have the most direct connection to the group annuity  market. Other than the survey conducted for PBGC, no mechanism exists  to collect information on actual group annuity purchase rates. Although  the PBGC interest rate factors may track group annuity purchase rates  more closely than other rates do, the PBGC interest rate factors are less  transparent than market-determined alternatives. Long-term market rates,  such as corporate bond indices, may track changes in group annuity rates  over time, but they are less directly connected to group annuity rates and  their proximity to group annuity rates is uncertain. In addition, an interest  rate based on some long-term market rates, such as corporate bond  indices, may need to be adjusted downward to better reflect the level of  group annuity purchase rates.
Finally, the suitability of any interest rate used is likely to change over  time and, unless some entity is given the responsibility for monitoring its  relationship to group annuity purchase rates, the Congress and pension  plans regulatory agencies will have difficulty determining when changes  are needed. The Congress has made several ad hoc adjustments to the  mandatory interest rate for pension calculations and can continue to make  changes to the rate through the legislative process. Given the significant  technical issues associated with such decisions as well as the time it takes  to enact such a legislative change, the Congress could decide to delegate  this authority to the executive branch and establish a process to monitor  the mandatory rate. This would provide an opportunity for needed  adjustments to the rate to occur in a timelier manner. We are offering  suggestions to the Congress on a possible process for adjusting the  mandatory rate as well as a way to periodically monitor the rate over time.
section_title: Matters for Congressional Consideration
paragraphs: To improve the timeliness of adjustments to the mandatory interest rate  for pension calculations, the Congress should consider establishing a  process for regulatory adjustments of the rate. The Congress should  consider providing the cognizant regulatory agencies—Labor, Treasury,  and PBGC—the authority under ERISA to jointly adjust the rate within  certain boundaries as specified under the law.
This could be done by the Congress establishing an interagency committee  to adjust, with the input of key stakeholders, including plan sponsors,  labor unions, actuaries and others, the mandatory interest rate. This could  be a transparent process consistent with the Administrative Procedures  Act. Under this option, the Congress could either require that the  Committee’s adjustments to the mandated interest rate obtain  congressional approval and be enacted into law or it could provide for  congressional review and disapproval. The disapproval role could be  similar to the role the Congress provides for itself under the Congressional  Review Act. Under the act, federal regulations are held for 60 days to give  the Congress the opportunity to pass a resolution of disapproval. This  process provides the advantages of allowing for more timely adjustments  to the interest rate if needed and providing the Congress with the  opportunity to intervene if it so chooses without requiring direct  congressional involvement for the adjustments to take effect.
Whether the Congress decides to maintain its current role in setting and  adjusting the mandatory interest rate or delegates this authority to the  executive branch, it should consider establishing a process to better  monitor changes to the rate in relation to group annuity purchase rates. If  the Congress selects one of the market-based rates as the new mandatory  rate, it should consider amending ERISA to require the cognizant  regulatory agencies to (1) periodically evaluate the relationship between  the rate and the group annuity purchase rates and report to the Congress  and (2) provide comments about how any changes to the mandated  interest rate they would recommend would likely affect federal revenue,  employer pension contributions, plan funding levels, and participants’  lump-sum benefits. This would provide the Congress and the regulatory  agencies an opportunity to respond in a timely manner to changes that  might affect the relationship between the market-based rate and the group  annuity purchase rate.
Alternatively, if the Congress decides to select the PBGC interest rate  factors as the mandatory interest rate, it should consider requiring an  independent review to validate PBGC’s methodology and calculations for  developing the factors and require PBGC to publish its methodology, both  before they are selected as the mandated interest rate and periodically  thereafter.
section_title: Agency Comments
paragraphs: We provided a draft of this report to Labor, Treasury, and PBGC.  The  agencies jointly provided written comments, which appear in appendix III.   They generally agreed with our findings and conclusions and noted that  our report will help interested parties better evaluate possible alternatives  to the 30-year Treasury rate.  They also provided technical comments,  which we incorporated as appropriate.
We are sending copies of this report to the Secretary of Labor, the  Secretary of the Treasury, the Secretary of Commerce, and the Executive  Director of the Pension Benefit Guaranty Corporation, appropriate  congressional committees, and other interested parties. We will also make  copies available to others on request. In addition, the report will be  available at no charge on GAO’s Web site at http://www.gao.gov.
If you have any questions concerning this report, please contact me at  (202) 512-7215 or George A. Scott at (202) 512-5932. Other major  contributors include Daniel F. Alspaugh, Joseph Applebaum,   Kenneth J. Bombara, Mark M. Glickman, Michael P. Morris,   Corinna Nicolaou, John M. Schaefer, and Roger J. Thomas.
section_title: Appendix I: Scope and Methodology
paragraphs: To determine the characteristics of a suitable interest rate, we reviewed  pension laws and their legislative history with respect to the calculation of  current liability and lump-sum amounts. We also interviewed officials at  the Pension Benefit Guaranty Corporation (PBGC) and other  policymakers who played a role in assessing alternative interest rates. We  obtained information about group annuity pricing, and the availability of  information about group annuity purchase rates, from representatives of  the American Academy of Actuaries, the American Council of Life  Insurers, the National Association of Insurance Commissioners, and  insurance companies.
To identify and examine the advantages and disadvantages of potential  alternative interest rates, we interviewed representatives and reviewed  documents from a number of government, pension plan sponsor, and  investment entities, including PBGC, the Department of the Treasury, and  Department of Labor. We also compared rates and other market statistics  for suggested alternative debt securities with rates for 30-year Treasury  bonds from 1987 to 2002. We discussed transparency, rate construction,  and liquidity issues for the alternatives with economists at the Department  of the Treasury and the Federal Reserve and with financial experts at the  Bond Market Association, Federal National Mortgage Association, and  pension plan consultants.
To determine how alternative rates might affect employers, plan  participants, and PBGC, we created hypothetical examples in which we  tested the effect of changes in rate levels on current liabilities and lump- sum payments. We designed the hypothetical examples based on  discussions with several actuaries and pension consultants, including  PBGC and the American Society of Pension Actuaries. Additionally, in  order to better understand the possible effects of a rate change on  employers and plan participants, we spoke with several organizations that  represent their interests. In order to better understand the implications of  a change in the interest rate on PBGC, we spoke with PBGC, Department  of Labor, Internal Revenue Service, and the Department of the Treasury.
section_title: Appendix II: Group Annuity Purchase Rate Would Be Affected by Cash Flow Projection and Yield Curve at Termination
paragraphs: Group annuity purchase rates would vary among plans depending on the  pattern of each plan's projected cash flows over time and the yield curve  at the time the plan is terminated.
subsections: section_title: Cash Flows Vary by Plan
paragraphs: Figure 8 shows the projected cash flow over a 40-year period for a sample  plan at termination.  The figure shows that, in the early years, payments to  inactive participants of the sample plan, primarily current retirees,  constitute a majority of total cash flow.  In later years, however, payments  to active participants make up the majority of total cash flow as current  employees retire.
All else being equal, the projected cash flows of plans with a larger  percentage of retirees at termination than the sample plan would be more  heavily weighted toward the early years, and the cash flows of plans with a  larger percentage of active participants at termination would be more  heavily weighted toward the later years.
section_title: Group Annuity Purchase Rates Would Vary with the Yield Curve
paragraphs: Surveys of insurance company group annuity pricing practices performed  as part of two studies for the Society of Actuaries indicate that insurance  companies use different methods to price group annuity products.  In  general, these methods may be described with respect to yield curves,  which may be constructed for various types of securities, including  Treasury securities, corporate bonds, and mortgages.  Figure 9 shows, for  example, two of the better know yield curves, the yield curves for on-the- run Treasury securities and zero-coupon Treasury securities, as of  February 6, 2003.  The yield for on-the-run securities reflects interest rates  for securities that make semiannual interest payments before they mature,  followed by a final payment of interest and principal at maturity.  The yield  for zero-coupon securities reflects interest rates, called spot rates, for  securities that make a single payment at maturity.
In figure 9, interest rates for the on-the-run securities that make coupon  payments are lower than rates for zero-coupon securities, at the same  maturity.  This reflects the fact that coupon yields are a blend of zero- coupon spot rates, and the term structure of spot rates on February 6,  2003, was upward sloping.
To determine the present value of plan cash flows using a zero-coupon  yield curve, the spot rates at various maturities may be used as the interest  rates for calculating the present value of cash flows at the corresponding  points in time.  For example, the spot rate at a 10-year maturity might be  used to calculate the present value of a cash flow at 10 years because the  timing of the single payment from the security would match the timing of  the cash flow by the plan.
In using a yield curve based on securities that make payments prior to  maturity, maturity is inadequate for deciding which interest rate should be  used to calculate the present value of a given cash flow because the  security's interim interest payments must be considered.  In these cases, a  concept called “duration” may be used to select a single interest rate for all  cash flows in the present value calculation.  Duration measures the  average time that it takes for a security to make all interest and principal  payments, or a pension plan to make all benefit payments, with the time  until each payment weighted by its present value as a percentage of the  total present value of all payments.  The total present value of a security's  payments is its market price and the total present value of a plan's benefit  payments is its current liabilities.  An interest rate is selected for plan  present value calculations from the yield curve that results in the same  duration for the security and plan's cash flow.
Duration is a measure of the sensitivity of a security's price, a lump sum,  or a pension plan's current liability to changes in the interest rates used to  calculate them.  For example, actuaries estimate that the duration of the  liabilities for pension plans with a “typical” distribution of participants is  between 12 years and 15 years.  Durations of 12 years and 15 years  indicate that a 1-percentage point increase in the interest rate used to   calculate a plan's liabilities would decrease those liabilities by roughly   12 percent and 15 percent, respectively.  In February 2003, the duration of  the 30-year Treasury bond issued in February 2001 was about 15 years.
section_title: Appendix III: Comments from the Department of Treasury