Pension Plan Valuation: Views on Using Multiple Measures to Offer a More Complete Financial Picture
Published: 2014-09-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Defined benefit plans use interest rates to “discount,” or determine the current value, of estimated future benefits. Experts in the United States have disagreed on both the approach that should be taken by plans to determine a discount rate and the appropriate rate to be used. Different discount rates can create large differences in the valuation of a plan's obligations, which in turn can lead various stakeholders to draw different conclusions about a plan's health, the value of a plan's benefits, and the contributions required to fund them.
As requested, GAO examined different approaches used to determine the discount rate. This report addresses (1) the significance of differences in approaches used to determine discount rates among public and private plans; (2) purposes for measuring the value of a plan's future benefits and key considerations for determining discount rate policy; and (3) approaches selected countries have taken to choose discount rates.
For this review, GAO analyzed provisions in relevant federal laws and regulations, as well as financial reporting and actuarial standards. GAO also reviewed relevant literature and interviewed experts, including experts in Canada, the Netherlands, and the United Kingdom—countries with significant defined benefit systems. In addition, GAO modeled hypothetical pension investment portfolios and cash flows to calculate average investment returns using available historical data.
section_title: What GAO Found
paragraphs: Public and private sector defined benefit pension plans are subject to different rules and guidance regarding discount rates—interest rates used to determine the current value of estimated future benefit payments. These differences can result in significant implications:
Sponsors of public sector plans generally use discount rates using a long-term assumed average rate of return on plan assets. This approach results in reported obligations that generally appear lower than those of comparable private sector single-employer plans. Some experts believe this approach may encourage public plans to invest in riskier assets, which can increase the assumed return and thereby lower estimated obligations and plan contributions. Other experts believe this approach helps to maintain more predictable and lower costs. Private sector multiemployer plans generally use an assumed rate of return for funding purposes.
Sponsors of private sector single-employer pension plans use bond-based discount rates, which are generally lower than assumed rates of return, for financial reporting of their plans' liabilities. Experts believe this approach may encourage plans to invest in less risky assets, particularly high-quality bonds, to make pension costs less volatile, but it may increase current reported costs. Funding requirements for these plans are tied to historical interest rates, which can reduce funding compared to measures based on more recent interest rates.
Experts identified at least five purposes for measuring the value of future benefits where discount rates are used, including determining sponsor contributions, reporting plan liabilities to stakeholders, determining the amount needed to secure benefits, measuring the value of employee benefits, and determining lump sum settlement amounts. They also identified a variety of considerations in setting discount rate policy, including cost, risk, fairness, sustainability, transparency, and comparability. To address trade-offs among these varied and sometimes competing purposes and considerations, many experts saw value in reporting multiple measures of plan obligations, using different discount rates. Some experts also regarded assumed returns used by U.S. public plans as too high under current market conditions.
Selected countries we examined reported that they apply a variety of approaches to discounting. Canada requires determination of multiple measures of plan obligations, based on both assumed returns and high-quality bond rates and annuity prices. The Netherlands requires that plan obligations be measured based on market interest rates, but allows the use of assumed returns for determining plan contributions or developing recovery plans. In the United Kingdom, discount rates are determined on a plan-specific basis and can include some allowance for assumed returns in excess of high-quality bond rates, depending on plan characteristics and the strength of the sponsor. To the extent that plans in these countries use long-term assumed rates of return, they are generally lower than the 7.5 to 8 percent used by many U.S. public plans under recent market conditions. Experts GAO interviewed in these countries described a greater degree of government oversight which might help explain their use of lower assumed returns.
section_title: What GAO Recommends
paragraphs: GAO is not making any recommendations in this report.

section_title: Letter
paragraphs: Traditional defined benefit (DB) plans remain an essential source of  retirement income, with tens of millions of Americans relying on them for  retirement security. As of 2011, state and local government sector DB  plans covered over 28 million participants, many of whom were not  eligible for Social Security, and private sector DB plans covered more  than 40 million Americans. However, DB plans have faced a number of  challenges, including the lingering effects from the 2008 stock market  downturn; the implications of lower interest rates for the cost of financing  retirement benefits; increased longevity of plan participants; and the  possibility of a need for higher contributions to these plans. For some  public plans, these challenges have been compounded by some plan  sponsors not making recommended plan contributions or granting benefit   For  increases during more favorable economic environments in the past.private plans, these challenges have occurred in the context of a long  decline in the portion of private sector workers covered by such plans.  While many plans have weathered these challenges, they have raised  questions about the ability of some DB plans to provide adequate benefits  to current workers and retirees in the future.
At the same time, experts sharply disagree on which approach should be  taken to calculate these plans’ estimated obligations for benefits promised  to workers and retirees, referred to in this report as liabilities regardless of  the purpose of the measurement (e.g., funding, financial reporting, or  Employee Retirement Income Security Act (ERISA) reporting). More  specifically, a major source of disagreement relates to how projected  future benefit payments should be discounted—or valued—in today’s  dollars. Discounting is based on the concept that $1 payable in the future  (e.g., in 1 year) is worth less than $1 payable today because the dollar  payable today can be invested and grow with interest over that year. One  approach to discounting future benefits—the “assumed-return  approach”—uses a discount rate based on a long-term assumed average  rate of return on the pension plan’s assets, typically a mix that includes  substantial portions of stocks and bonds. A second approach—the “bond- based approach”—uses a discount rate based on market prices for  bonds, annuities, or other alternatives that are deemed to have certain  characteristics that are similar to pension promises. In many instances, a  bond-based approach produces a lower discount rate, and therefore  higher estimates of pension liabilities, than the assumed-return approach,  particularly given recent bond market conditions and current U.S. practice  in setting assumed-return discount rates.
The discounting approach used can have a significant effect on the  calculated pension obligations. For example, for a typical pension plan,  the liability calculated using a 4 percent discount rate (a rate close to what  would be produced in recent years under certain bond-based  approaches, with little or no averaging or “smoothing”) could be more  than 80 percent higher than the liability calculated using an 8 percent  discount rate (a rate commonly used under the assumed-return approach  in recent years). In addition, the appropriate discount rate can vary  depending on the purpose of the measurement (see later discussion).  These differences in approach to the valuations of a plan’s liabilities can  lead stakeholders and sponsors to draw very different conclusions about  an individual plan’s financial health, the value of the plan’s promised  benefits, the contributions required to fund those benefits, the appropriate  investment strategy, and perceptions about the health of the defined  benefit “system” as a whole.
As requested, GAO examined the differences of opinion concerning  discount rates for pension plan valuations and funding. This report  addresses the following three questions:  1.  What is the significance of the differences in discounting approaches  used by public versus private pension plans?  2.  What are the purposes for measuring the value of a plan’s future  benefits and key considerations for determining plan discount rate  policy?  3.  What approaches have select countries taken to choose discount  rates?
To address our objectives, we interviewed experts, including actuaries,  economists, and other pension experts, who represent diverse points of  view and a variety of organizations and constituencies. We also reviewed  relevant literature on pension discount rates. In addition, we also  reviewed relevant provisions in the Internal Revenue Code, the Employee  Retirement Income Security Act (ERISA) as amended, relevant federal  regulations, and relevant accounting standards, specifically the  Governmental Accounting Standards issued by the Governmental  Accounting Standards Board (GASB), the Financial Accounting  Standards issued by the Financial Accounting Standards Board (FASB),  the International Financial Reporting Standards issued by the  International Accounting Standards Board (IASB), and relevant actuarial  standards of practices issued by the Actuarial Standards Board. We also  modeled different hypothetical pension investment portfolios and cash  flows and calculated average investment returns using available historical  data. Lastly, we reviewed approaches used in other countries by selecting  three countries with relatively substantial DB coverage and ongoing  discount rate discussions—Canada, the Netherlands, and the United  Kingdom (U.K.)—and spoke to experts from these countries. We did not  conduct an independent legal analysis to verify the information these  international experts provided about the laws, regulations, or policies of  the foreign countries selected for this study. Instead, we relied on  appropriate secondary sources, interviews with relevant experts, and  other sources to support our work.
We conducted this performance audit from December 2012 to September  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: The U.S. Retirement System and Defined Benefit Plans
paragraphs: Employers sponsor two broad categories of pension plans: (1) defined  benefit plans (DB)—in which employers generally maintain a fund to  provide a specified level of monthly retirement income based on a formula  specified in the plan—or (2) defined contribution plans (DC)—in which  retirement income is based on employer and employee contributions and  the performance of investments in individual employee accounts.
Historically, DB benefits have typically been paid as a lifetime annuity  (although lump sum options have increased in prevalence). Properly- funded DB plans can shield participants from numerous risks that  participants face in DC plans, including eligible employees not enrolling in  the plan; employees enrolling but contributing amounts likely to be  insufficient, together with other sources of retirement income, to provide  adequate overall retirement income; “leakage” of plan assets through  withdrawals for purposes other than retirement; investment risks; and the  “longevity risk” of outliving one’s savings. Participants in DC plans must  save a sufficient amount through contributions and investment returns to  meet future retirement needs, and must adequately manage both the  “accumulation phase” of building up assets prior to retirement and the  “decumulation phase” of spending down assets during retirement. On the  other hand, while DB plans can shield participants from numerous risks,  they can sometimes be less advantageous than DC plans for workers  who change employers one or more times before retirement.
There are several major DB-plan sectors in the United States: (1) “public  plans,” which cover state and local government employees; (2) private  sector single-employer plans; (3) private sector multiemployer plans,  which generally cover union employees who work for participating  employers in a particular trade or industry; and (4) nonqualified plans,  which do not meet the applicable requirements for tax-qualification under  the Internal Revenue Code and are typically maintained by employers  primarily for the purpose of providing deferred compensation for select  groups of management or highly-compensated employees. We will  not discuss nonqualified plans in this report because sponsors of such  plans typically do not have to satisfy laws and regulations requiring a  minimum level of benefits or contributions.
For most private sector single-employer and multiemployer pension  plans, the Pension Benefit Guaranty Corporation (PBGC) insures plan  benefits, up to certain statutory limits, under separate insurance programs  for these two types of plans. PBGC was established under ERISA to insure the pension benefits of participants in qualified DB plans and pay  participants up to the statutory limits, should their plans be terminated  with insufficient funds or become insolvent. The statutory limits on  insured benefits are much lower for multiemployer plans than for single- employer plans. In recent years, PBGC has faced large net  accumulated deficits coupled with future risks posed by plan sponsors  and their plans that have threatened its solvency. PBGC recently  reported that while its single-employer program is likely to remain in net  deficit over the next 10 years, some improvement is projected. However,  there is significant variation in projected results under PBGC’s single- employer Pension Insurance Modeling System, with a worsening of the  financial position of the single-employer program also possible. In  contrast, the financial status of some multiemployer plans is deteriorating.  PBGC reports that the insurance fund for its multiemployer program is  more likely than not to be exhausted within the next 8 years, and 90  percent likely to be exhausted by 2025, which would result in benefits for  participants in insolvent plans being cut to a small fraction of current  guarantees. PBGC uses a discount rate assumption, discussed later,  to determine the present value of projected future pension benefits to be  paid to the participants of single-employer plans it has taken over, and the  present value of projected financial assistance payments to multiemployer  plans.
In the public sector, DB plans still provide primary pension benefits for  most state and local government workers. In contrast, DB plan coverage  in the private sector has declined as these employers continued to shift  away from sponsoring DB plans toward sponsoring DC plans. About 78  percent of state and local government employees participated in DB plans  in 2013, compared with only 16 percent of private sector employees. few states offer DC or other types of plans as the primary retirement  plan.
For the same period, there were about 19 million state and local government employees  and over 106 million private sector employees. See U.S. Department of Labor, U.S.  Bureau of Labor Statistics, National Compensation Survey: Employee Benefits in the  United States, March 2013 (Washington, D.C.: Sept. 2013).
Social Security taxes on these earnings.pension benefits for such noncovered employees are generally higher  than for employees covered by Social Security, and employee and  employer contributions are generally higher as well. Also, unlike private  sector employees with DB plans, state and local government employees  generally contribute to their DB plans.
As a result, employer-provided  ERISA established minimum standards for pension plans in the private  sector and, through the Internal Revenue Code, provides extensive rules  on the federal tax effects of transactions associated with employee  benefit plans. ERISA protects the interests of employee benefit plan  participants and their beneficiaries by requiring the disclosure of financial  and other information concerning the plan, establishing standards of  conduct for plan fiduciaries, and providing for appropriate remedies and  access to the federal courts, among other things. Since its enactment in  1974, ERISA has been amended many times, including by the Pension  Protection Act of 2006 (PPA), which changed minimum funding standards  for private sector single-employer defined benefit pension plans by,  among other things, changing the measurement of a plan’s funding target  (including the discount rate used) and shortening the period of time over  which the funding target should be attained. Minimum funding standard  provisions have since been further revised by subsequent legislation.  PPA also included provisions requiring private sector multiemployer plans  in poor financial shape to take action to improve their financial condition  over the long term.
The federal government has not imposed the same funding and reporting  requirements on state and local government pension plans as it has on  private sector pension plans. State and local government plans are  specifically exempted from ERISA funding requirements, in part, because  of the presumption that state and local governments can rely on their  taxing power to pay for DB plan benefits. These plans are also not  insured by the PBGC as private DB plans are. However, in order for  participants to receive preferential tax treatment (that is, for contributions  and investment earnings to be tax-deferred), state and local government  pension plans must comply with certain requirements of the Internal  Revenue Code.
State and local governments also follow different standards than the  private sector for financial reporting. The accounting standards for  financial reporting by public and private sector pension plan sponsors are  promulgated by two independent organizations. For the public sector, the  GASB has been designated by the American Institute of Certified Public  Accountants as the accounting standard-setter to establish generally  accepted accounting principles for U.S. state and local governmental  entities. GASB’s standards are not federal laws or regulations and GASB  does not have enforcement authority. However, compliance with its  standards is required through laws of some individual states and is  integrated into the audit process, whereby auditors render opinions on the  fair presentation of state and local governments’ financial statements in  accordance with generally accepted accounting principles. For the private  sector, the FASB has been designated by the American Institute of  Certified Public Accountants as the accounting standard-setter to  establish generally accepted accounting principles for nongovernmental  entities. Those standards are officially recognized as “generally accepted”  for the purposes of federal securities laws by the Securities and  Exchange Commission (SEC), and companies registered with the SEC  are required to comply with those standards in preparing financial  statements filed with the SEC.
In addition to the standards above, actuarial standards of practice are  promulgated by the Actuarial Standards Board, whose mission is to  identify what an actuary should consider, document, and disclose when  performing an actuarial assignment. Actuaries work with plans to develop  economic and demographic assumptions.
section_title: The Discount Rate and Liability Calculations
paragraphs: For DB pension plans, the discount rate is used in converting projected  future benefits into their “present value” and is an integral part of  estimating a plan’s liabilities. A pension liability generally includes two  pieces: (1) the present value of all projected future benefits for current  retirees, as well as for former employees not yet retired but who have a  vested right to a future pension, plus (2) the present value of a portion of  the projected future benefits for current employees, based on their service  to date (with each additional year of service adding to the liability, such  that approximately the full cost of benefits is accrued when employees  reach retirement). The increase in the liability that arises from an  additional year of employee service is called the “normal cost,” which can  also be thought of as the pension cost attributable to employees’ work in  a single year. Both the liability and the normal cost depend on the  discount rate, as they both represent the present value of some portion of  future benefits. The higher the discount rate, the lower the plan’s estimate  of its liability and normal cost (see fig. 1). In addition, the further into the  future that the projected benefit payments occur, the more pronounced is  the effect of the discount rate, because it is applied over a greater number  of years. As a result, a pension liability for current workers is typically  more sensitive to changes in the discount rate than is a pension liability  for retirees.
section_title: Approaches to Determining the Discount Rate
paragraphs: Methods for determining a plan’s discount rate can be categorized into  two primary approaches—the assumed-return and bond-based  approaches. The first approach—the “assumed-return approach”— bases the discount rate on a long-term assumed average rate of return on  the pension plan’s assets (which includes expected long-term stock  market returns to the extent plan assets are so invested, and which, in  recent years, and as employed by U.S. public plan sponsors, often would  produce discount rates between 7 and 8 percent). Under this  approach, the discount rate depends on the allocation of plan assets. For  example, a reallocation of plan assets into fewer bonds and more stocks  can increase the discount rate and reduce the measurement of plan  liabilities. Under this approach, the discount rate also depends on  estimates of what future investment returns the plan will earn on its  assets; more optimistic estimates produce higher discount rates and  lower plan liabilities. The assumed-return approach is based in part on  the premise that pension plans are long-term enterprises that can  weather fluctuations in financial markets, and that the estimated long-term  average cost of financing plan benefits, based on the plan’s asset  allocation, provides the most relevant measure of plan costs.
The second approach—the “bond-based approach”—uses a discount rate  based on market prices for bonds, annuities, or other alternatives that are  deemed to have certain characteristics similar to pension promises,  instead of estimates of future returns. The bond-based approach is premised on the theory that pension benefits are “bond-like,” in that they  constitute promises to make specific payments in the future, and should  be similarly valued. Under this approach, the discount rate is independent  of the allocation of plan assets. The relevant bond “quality” (e.g., AAA- rated, AA-rated, etc.) can depend on the specific purpose of the liability  measurement, which can result in rates that vary considerably. There are  at least five variations of bond-based approaches that are in use or have  been proposed.
Interest Rates on High-Quality Corporate Bonds: This method is  typically used by private sector single-employer plan sponsors for  financial reporting under FASB standards.
Historical Averages of High-Quality Corporate Bond Interest  Rates: This “smoothing” approach is allowed for funding purposes for  private sector single-employer plan sponsors under amendments to  ERISA and PPA, which allowed discount rates based on a 2-year  average of high-quality corporate bond rates. This 2-year smoothing  was lengthened to 25-year smoothing by the Moving Ahead for  Progress in the 21st Century Act (MAP-21), tying discount rates to a  25-year historical average (see table 1 in the next section). The use of  a 25-year historical average results in current discount rates that are  significantly in excess of current or recent interest rates on high  quality bonds.
Risk-Free Interest Rates: Another variation is to use risk-free interest  rates (e.g., Treasury rates). A panel commissioned by the Society of  Actuaries recommended that public plans disclose an additional  liability measurement using this method, and at least one public plan  currently discloses such a supplemental measure. A liability based  on risk-free interest rates can be thought of as approximating the  amount of money that would be needed to come close to protecting  the payment of future benefits from investment risk. Demographic risk  would still remain, such as the risk of life expectancy improving faster  than expected.
Matching Bond Credit Quality with Estimated Riskiness of the  Pension Promise: Under this variation, as advocated by some  financial economists for certain purposes, as discussed later, the  bond credit quality could be chosen to match the estimated riskiness  of the pension promise.
Annuity Settlement Rates: This fifth variation is the method used by  PBGC for its financial reporting of its deficit.be considered a bond-based approach as it is based on estimated  market prices for annuities, which are influenced by, and will vary   This method can also  with, market interest rates. A liability based on an annuity settlement  rate is the estimated market value of the amount of money that is  required to fully insure the payment of future benefits against both  economic and demographic risks. As a result, a settlement liability  can be significantly greater than a liability calculated using high-quality  bond rates. PBGC officials stated that this often leads to unpleasant  surprises when a plan terminates, whereby a plan that was thought by  plan participants to be overfunded turns out to be underfunded. The  remainder of this report focuses mainly on the discount rates used by  plan sponsors and trustees.
Because bond interest rates are currently at historic lows (see fig. 2), and  because plans’ assumed returns have not declined commensurately,  bond-based approaches today that use little or no smoothing are likely to   produce discount rates that are much lower than current assumed  returns.
section_title: Defined Benefit Systems in Selected Other Countries
paragraphs: The discount rate approaches and regulatory structure governing pension  plans in Canada, the Netherlands, and the United Kingdom differ in  various ways from those in the United States. As in the United States,  most Canadian defined benefit plans—both public and private—are  prefunded, according to Canadian experts with whom we spoke.  Additionally, they noted that most plans are regulated at the provincial  level, although some plans, such as those of federally regulated  employers such as banks, telecommunications companies, and inter- provincial transportation companies, are regulated by a separate federal  regulator. Nonetheless, the regulatory principles are generally similar  across all regulators, according to experts. There is no national pension  insurance program in Canada. In the Netherlands, De Nederlandsche  Bank (DNB) regulates pension discount rates. An official told us that  there are no regulatory distinctions among public, private, or  multiemployer defined benefit plans in the Netherlands. They also noted  that pension plans in the Netherlands are separate legal entities from plan  sponsors, and there is no pension insurance program in place. Benefit  amounts can vary with plan investment performance and plan funded  status. In the United Kingdom, private sector defined benefit plans are  prefunded and public sector plans generally are not. The Pensions  Regulator is the regulating entity for private pension plans and a national  pension insurance program is administered by the Pension Protection  Fund. Plans have trustees who are autonomous from the sponsoring  employers. The trustees and employers negotiate in setting plan policies,  with assumptions and approaches subject to a risk-based process of  review by the Pensions Regulator. According to experts, the Pensions  Regulator uses what it calls a Scheme Specific Funding framework for  evaluating funding requirements. Discounting practices for DB pension  plans in Canada, the Netherlands, and the United Kingdom are discussed  later in this report, and a summary of these countries’ DB regulatory  requirements and discounting approaches can be found in appendix IV.
For financial reporting purposes, private sector plan sponsors in these  countries often follow the accounting standards promulgated by the IASB.  Plan sponsors in the United Kingdom will often follow the local U.K.  accounting standards promulgated by the Financial Reporting Council  (FRC) or the IASB standards. IASB and FRC standards take an approach  to the discount rate that is broadly similar to that in FASB standards.
section_title: Discount Rates for Sponsors of Public Sector Plans and Private Sector Multiemployer Plans Differ from Those of Private Sector Single- Employer Plans, Resulting in Different Incentives for Both and, for the Former, Higher Reported Funded Ratios and Lower Reported Costs
paragraphs: Public and private sector DB pension plans are subject to different rules  and guidance regarding discount rates. For purposes of both funding and  financial reporting, public plan sponsors generally use an assumed-return  approach, while private sector single-employer plan sponsors use a bond- based approach for financial reporting purposes, but currently are allowed  a 25-year smoothing option that is generally in use for funding  purposes. Private sector multiemployer plans generally use an  assumed-return approach for funding purposes, but also calculate an  additional liability measure under ERISA based on an average of  Treasury bond rates, while standards related to discounting for  accounting purposes are typically not applicable to participating  employers in these plans. These various rules and guidance result in  considerable variation in the discount rates that are currently in use. The  result is discount rates that are generally highest for public plans and for  funding private sector multiemployer plans, followed by discount rates for  funding private sector single-employer plans (under the interest rate path  of the past 25 years). The lowest discount rates among U.S. plans are for  financial reporting by sponsors of private sector single-employer plans  and for the additional liability calculated by multiemployer plans.
Table 1 summarizes these laws, standards, and rules for different plan  types. Different laws and standards also specify different actuarial cost  methods and give different names to the resulting liability measures. See  appendix II for more details. In addition, both FASB and GASB have  differences in their requirements applicable to financial reporting by  pension plan sponsors (and participating employers in the case of  multiemployer plans) and financial reporting by the pension plans  themselves. Under GASB standards, the discount rate requirements are  the same for both plan sponsor and plan financial reporting. Under FASB  standards, plan sponsors are required to discount using “settlement  rates,”---which can be based on the discount rates implicit in the current  prices of annuity contracts, such as PBGC’s rates, but can also be based  on current high quality bond rates, which plan sponsors generally do--- while plans are required to discount using best-estimate assumed rates of  return. With regard to U.S. financial reporting requirements, the focus of  this report is on requirements applicable to plan sponsors and  participating employers, not financial reporting by the plans themselves.
Public plans and private sector multiemployer plans generally report  higher funded ratios, and their liabilities generally appear lower, than  those of comparable private sector single-employer plans because these  plans currently use very different discount rate approaches, leading to  potentially large differences in funded ratios and reported liabilities. This  difference is because public plan sponsors’ and multiemployer plans’  discount rates are determined largely using an assumed-return approach,  which generally produces higher discount rates. As such, this  approach generally produces lower liabilities than variations of bond- based approaches with little or no smoothing (which often produces lower  discount rates), as used by private sector single-employer plan sponsors  for financial reporting purposes. For example, Mercer, a retirement  industry consultant, estimated that at the end of 2013 an average private  sector single-employer plan sponsor would have a discount rate of 4.88  percent for FASB reporting. According to the National Association of  State Retirement Administrators, however, public plan sponsors assumed  a return of 7.72 percent on average as of December 2013. At this  difference in discount rates, the present value of a benefit payment due in  15 years for a private sector single-employer plan sponsor for financial  reporting would be almost 50 percent higher than for a comparable public   Some experts (including those on the GASB) view  sector plan sponsor.differences between public sector and private sector single-employer  discounting approaches as appropriate because they see public plans as  going concerns that can best estimate their pension costs using very  long-term assumed returns as their discount rate. There are other  experts, however, who disagree with this viewpoint or see value in both  types of measures. See the next section for a discussion of various  considerations underlying different views on discount rate policy.
Bond-based discount rates can vary considerably, and may not always  result in significantly lower discount rates than assumed-returns. In  practice, there are variations of the bond-based approach that can result  in discount rates that do not, to varying degrees, reflect current or recent  market rates. These approaches have been implemented or proposed in  order to provide stability for funding or financial reporting purposes but  can have the effect of obscuring any measure of a market value of the  liability (i.e., a connection to current market prices). For funding  purposes under ERISA as amended by the PPA, but prior to the MAP-21  amendments, private sector single-employer plan sponsors who elected  to use 2-year smoothing of interest rates based on high-quality corporate  bonds would have used, in December 2013, Treasury-prescribed  discount rates of 1.28 percent for benefit payments due in less than 5  years, 4.05 percent for payments due between 5 and 20 years, and 5.07  percent for payments due in 20 years or more. This simplified three- segment yield curve was adjusted up by MAP-21, with its boundaries tied  to 25-year smoothing, to minimum rates of 4.94 percent, 6.15 percent,  and 6.76 percent respectively, for the same month (see app. II for more  details). In contrast, PBGC interest rate factors at December 30, 2013  were 3.00 percent for benefit payments within the first 20 years and 3.31  percent for payments beyond 20 years. At these discount rates, the  present value of a benefit payment due in 15 years for a private sector  single-employer plan under ERISA (MAP-21) segment rates would be  closer to the value determined under the average 7.72 percent assumed  return used by public plans than to the annuity settlement rate used by  PBGC.
Table 2 summarizes the preceding findings with regard to public and  private sector discount rates.
In addition to the discount rate, the actuarial cost method used to allocate  retirement costs among employees’ work years can affect the size of a  pension plan’s liability. Public sector plan sponsors typically use  actuarial cost methods that assign higher liabilities to younger workers as  compared to the cost methods private sector single-employer plan  sponsors use. As discussed in appendix II, the cost methods typically  used by public plan sponsors tend to somewhat increase the liability  relative to the cost methods used by private sector single-employer plan  sponsors. However, this effect is often greatly offset by the effect of the  differences in discount rates determined between the bond-based and  assumed-return approaches.
These different funding and financial reporting requirements for setting  discount rates for different types of plans also result in differing amounts  of discretion that plan sponsors can use in setting their discount rates. Of  the GASB, ERISA, and FASB requirements with respect to discount  rates, GASB standards and ERISA’s multiemployer funding standards  leave the most room for judgment, because, for example, estimated long- term average rates of return on pension plan investments in equities are  judgments rather than observable data, and such estimates can vary  significantly even among experts. This stands in contrast to ERISA’s  single-employer standards and FASB standards (for plan sponsors) which  allow less discretion.
Some experts said that the assumed-return approach could incentivize  public plan sponsors to invest in riskier assets because doing so can  increase the assumed-return discount rate, thereby lowering reported  liabilities and reducing funding requirements. In addition, some experts  said that some public plan sponsors have sometimes inverted the  recommended practice of first determining plan asset allocation—based  on an assessment of investment goals and the amount of risk that can be  taken on—and then deriving a discount rate based on an assumed long- term average return for that mix of assets. Instead, these experts said  that some plan sponsors have set a target discount rate and then asked  the plan’s investment team to develop an asset allocation to support it.  Other experts stated that this practice does not occur. In a related way,  some experts said that the assumed-return approach has led some public  plan sponsors to issue pension obligation bonds.bonds could help state and local governments improve plan funding, the  increased capital into the pension fund is derived from the apparent  arbitrage opportunity created for the plan sponsor by taking on more debt  outside the plan. The use of an assumed-return discount rate allows the  plan sponsor to capitalize on the difference between the assumed return  on the invested assets and the interest rate on the pension obligation  bonds, essentially taking credit for the assumed returns before actually  achieving them. The use of pension obligation bonds effectively allows  plan sponsors to invest on “margin,” or borrow money to invest in risky  While issuing such  assets. This strategy comes with increased risk and is only successful if  the sponsor’s pension assets actually do appreciate at a higher rate than  the rate at which the plan sponsor borrowed.
Some experts told us that it is also possible that a plan’s discount rate  approach could influence future benefit levels. At the most basic level, the  cost of benefits typically will appear lower using an assumed-return  discount rate than using a bond-based discount rate, perhaps leading to  compensation packages that are weighted toward more retirement  benefits or to larger overall compensation packages. Further, some  experts expressed concern that sponsors of plans that have earned more  than the assumed return, such as in a bull market, have given this extra  return to participants as a benefit increase, but that benefits would not be  cut at the same rate during periods of low returns. To the extent this  occurs, it would mean that an assumed-return discount rate would need  to be lowered, or the plan liability increased in some other manner, to  reflect the fact that future bull-market gains would not be fully available to  offset future bear market losses. On the other hand, many public plans  have reduced some aspect of their benefit structure in recent years in  response to low returns on assets.
In contrast to the investment incentives that public plan sponsors (and  multiemployer plans) may face, the use of a bond-based discount rate for  private sector single-employer plan sponsors can create an incentive to  invest in bonds to make pension contributions more predictable or  financial reporting results less volatile. For plans using bond-based discount rates (with little or no smoothing), liability values will fluctuate  with changes in market interest rates. A bond-based investment policy  can be used so that plan asset values will move in tandem with liability  values as interest rates fluctuate. The greater the match between a plan’s  investment assets and the amount and timing of its projected benefit  payments, the more stable the plan’s funded status will be. However,  holding bonds means forgoing potentially higher returns from equities.  Thus, the more that a plan matches assets to liabilities by purchasing  similar-duration low-risk bonds, the more expensive the plan may become  to fund, which may provide a countervailing disincentive to invest more in  bonds.
Additional incentive effects are discussed in the next section.
section_title: Experts Identified a Variety of Considerations for Setting Discount Rate Policy and Many Saw Value in Plan Sponsors Reporting Multiple Measures
paragraphs: For many of the experts we interviewed, the appropriate discount rate to  use depends on the purpose of the measurement. Regardless of whether  they believed the appropriate discount rate to use depends on the  purpose of the measurement, all experts we interviewed pointed to  various considerations that influenced their views on discount rate policy.  Many of these experts supported reporting multiple liability measures and  some said assumed-return rates may be too high.
subsections: section_title: For Many Experts, the Appropriate Discount Rate to Use Depends on the Purpose of the Measurement
paragraphs: The discount rate used can vary depending on the purpose of the  measurement. There are at least five key purposes for which one might  determine a discounted value of future benefits: (1) determining the  required or recommended amount that the plan sponsor should contribute  into the plan; (2) reporting plan liabilities to shareholders, taxpayers, plan  participants, or other stakeholders, such as for financial reporting; (3)  determining the amount needed to terminate a plan, settle a portion of  plan liabilities, or to guarantee or minimize risk on pensions earned to  date; (4) expressing the value of participants’ benefits (for example, in  putting a value on their total compensation); and (5) determining optional   Several  lump sum amounts payable to participants in lieu of an annuity.experts with whom we spoke also indicated that their views on the  appropriateness of different rates for different purposes of the  measurement vary between public and private plans. The discussions  with these experts were focused on setting future policy and not  necessarily related to laws, standards, and practices that currently apply  to plans in the United States.
subsections: section_title: Determining Sponsor Contributions into a Plan (Funding)
paragraphs: As a plan will ultimately pay benefits out of contributions into the plan and  investment earnings on those contributions, some experts said a measure  of a plan’s liability based on an assumed return can be thought of as a  best estimate of the assets a plan believes it needs to have on hand to  fulfill its promises. Experts told us that an assumed-return approach can  be useful in determining this amount, as well as for estimating a plan  sponsor’s most likely stream of future contributions into the plan. Some  experts referred to this measurement purpose as “funding” or “budgeting,”  as distinct from “accounting” or “financial reporting.” For funding  purposes, public plan sponsors typically calculate a liability using an  assumed-return discount rate, but there are no federal laws that require  them to do so. In contrast, for funding purposes, private sector single- employer plan sponsors must follow ERISA standards for discounting to  determine their minimum required contribution. Under ERISA, private  sector single-employer plan sponsors use a bond-based discount rate to  determine a minimum required contribution, while private sector  multiemployer plans generally employ an assumed-return approach to  determine this required contribution. Private sector single-employer  plans include most private sector plans and about three-quarters of  private sector plan participants.
section_title: Reporting Liabilities to Stakeholders (Financial Reporting or Other Reports)
paragraphs: Another purpose for using a discount rate is in calculating and then  reporting liabilities to shareholders, taxpayers, plan participants,  regulators, or other stakeholders, such as in annual funding notices, or  financial or actuarial reports. For example, participants in private sector  plans receive information on the health of their plan through the Annual  Funding Notice, which reports plan funded status based on funding  measures under ERISA. For single-employer plans, MAP-21 requires that  this Annual Funding Notice report the plan’s funded status both before  and after MAP-21’s 25-year smoothing of interest rates. The Annual  Funding Notice can show a funded status that is higher than it would be  on a PBGC basis under current market conditions. All publicly-traded  companies follow FASB accounting standards for reporting pension  liabilities to shareholders and other users, which allows investors to  compare different companies’ pension liabilities along with other financial  data. For this purpose, most private sector sponsors of single-employer  plans use bond-based discount rates based on high-quality (AA-rated)  bonds. In contrast, for public plans, the discount rate approach  prescribed in GASB standards requires discounting that is closer to an  assumed-return basis in most cases.approaches for financial reporting suggested that the bond quality should   Some proponents of bond-based  vary with the riskiness of the benefit promise. For example, a pension  benefit promise that was deemed to be at risk—perhaps because of some  combination of an underfunded plan and a weak plan sponsor—might be  discounted at a B-rated bond rate, to reflect the risk of non-payment of  the benefit promise, whereas a strong, well funded pension promise by a  financially strong sponsor might be discounted at a AAA-rated bond rate.  This would result in a weaker sponsor reporting a lower liability than a  strong sponsor with a comparable plan.
section_title: Determining Funding Amount Needed to Terminate Plan or Guarantee or Minimize Risk on Pensions Earned to Date (Solvency)
paragraphs: To determine the amount needed to terminate a plan or to guarantee  pensions to date—a “solvency measure”—the discount rate, such as the  interest rate factors used by PBGC, would typically be based on the price  an insurance company would charge to take over the obligation. In a  standard ERISA plan termination, the plan would purchase annuities from  an insurance company and transfer the liability to it. also be used to determine how much it would cost to guarantee pensions  at any given moment, even if the plan was not terminated. Solvency  measures typically exceed the liability measure disclosed under financial  reporting standards. As a result, a plan could be insolvent if it needed to  terminate, even if it appeared fully funded on a financial reporting basis  (or on an ERISA basis). For an ongoing plan, a liability could also be  calculated using Treasury bond rates, as a measure of the plan assets  that would be needed to minimize investment risk in the ongoing plan,  while retaining demographic risk, without transferring the obligations to an  insurance company.
Plans can also offer participants lump sums that are based on IRS-published rates for  high-quality corporate bonds.
section_title: Expressing Value of Benefits as Part of Compensation (Valuing Benefits)
paragraphs: A plan sponsor, or both management and labor in a collective bargaining  process, that wants to assess the value of retirement benefits as part of  employees’ total compensation must decide how to discount future  benefits to today’s dollars, among other assumptions. All proponents of a  bond-based approach with whom we spoke advocated that approach for  this purpose, so that pension benefits would be valued in a manner  consistent with similar future financial promises (i.e., based on bonds with  a similar level of risk of nonpayment). In contrast, most proponents of an  assumed-return approach with whom we spoke advocate that approach  for this purpose so that pension benefits would be valued in a manner  consistent with a plan sponsor’s long-term budgeting estimates.
section_title: Determining Lump Sum Amounts in Plans That Offer a Lump Sum Option in Lieu of an Annuity
paragraphs: Some plans offer a lump sum as an optional form of payment at  retirement or termination of employment, as an ongoing plan feature.  Some sponsors of plans that did not previously provide for a lump sum  option have recently amended their plans to offer one-time lump sum  payout options to retirees and other former employees as a settlement of  the plan’s remaining pension obligation to those plan participants.  Converting monthly annuity or lifetime benefit streams into a lump sum  amount requires a discount rate, among other assumptions. The Internal  Revenue Code requires that a lump sum offer be at least as large as that  determined using bond-based discount rates (in particular, prescribed  high-quality corporate bond yields, along with other prescribed  assumptions).
section_title: Various Considerations Influenced Experts’ Views on Discount Rate Policy
paragraphs: Regardless of whether they believed the appropriate discount rate to use  depends on the purpose of the measurement, all experts we interviewed  pointed to at least one among six considerations that influenced their  views on discount rate policy. These considerations can present trade- offs in setting discount rate policy and can be grouped into issues related  to cost and risks, fairness and sustainability, and transparency. (See table  3 for a summary of these considerations). In terms of costs and risks,  some experts identify tradeoffs between two competing goals: having  level and predictable costs versus being certain that plans will ultimately  have sufficient funds to ensure benefit security for plan participants and  minimizing risks to other stakeholders, including the entity sponsoring the  plan, shareholders and PBGC in the case of a private sector plan, and  taxpayers and beneficiaries of public services in the case of a public plan.  Some experts also said that it could be useful to account for plan and  sponsor characteristics in setting discount rates for funding purposes.  Plan and sponsor characteristics could include the size of the plan  relative to the size of the plan sponsor, the maturity of the plan, and the  strength of the plan sponsor. In terms of issues of fairness and  sustainability, experts disagreed on whether an assumed-return or bond- based approach to discounting would best ensure intergenerational equity  for bearing the cost of these plans, and would best promote system  sustainability. Additionally, experts who support the use of only the bond- based approach or both approaches identified transparency and  comparability as important considerations for setting discount rate policy,  but they disagreed as to whether these considerations suggested using  an assumed-return or bond-based discount rate. Lastly, many experts  cited financial economic theory as an important consideration in setting  discount rate policy based on market valuation principles. Other experts  argued that this theory is not relevant to public plans because as “going- concerns” with very long time horizons, they do not have significant risk of  plan termination; according to these experts, discounting based on long- term assumed-return expectations is a best estimate of long-term plan  costs for public plans.
Level and predictability of costs refers to the level of certainty a  sponsor has that its pension costs will be affordable and stable from  year to year. Reported costs based on bond rates will typically be  higher than reported costs based on assumed rates of return, but  depending on asset allocation and amortization periods. Experts  also noted that liabilities based on point-in-time bond-market rates will  fluctuate as interest rates rise and fall, causing costs to be  unpredictable compared to costs based on assumed long-term  returns, which tend to be more stable than bond interest rates  because they are based on very long-term expectations. Some of  these experts suggested smoothing discount rates by averaging bond  rates over a number of years in order to make costs more predictable,  as used by most private single-employer plan sponsors under ERISA  provisions. Other experts preferred that, if smoothing were to be done,  that costs be smoothed directly rather than smoothing discount  rates. For funding purposes, private sector single-employer plan  sponsors generally use a smoothing approach to discount rates, but  for financial reporting, they do not.
Benefit security and risks to stakeholders are the risks that a plan will  be unable to pay promised benefits to plan participants or will present  serious financial challenges to other stakeholders, including the entity  sponsoring the plan, shareholders and PBGC, and PBGC premium  payers in the case of a private sector plan, and taxpayers and  beneficiaries of public services in the case of a public plan. In the  private sector, some companies fail and sometimes entire industries  decline. While participants in single-employer plans have PBGC  protection, it is limited, and participants sometimes lose a portion of  their benefits. Participants in multiemployer plans face greater risks:  as noted earlier, their PBGC benefit limits are much lower, and PBGC  projects that its multiemployer insurance program is itself likely to  become insolvent within the next decade without further action. While  states cannot and local governments usually do not go out of  business and have the option to raise tax revenue or reduce services  to pay for underfunded benefits, some local governments have  entered into bankruptcy and some participants in public plans have  lost some current benefits or anticipated future growth in benefits.
Benefit losses can be particularly challenging for those public sector  participants who are not covered by Social Security. Some experts  told us that using an assumed-return discount rate could obscure the  risk that a plan could ultimately be unable to pay for benefits, and/or a  sponsor may be unable or unwilling to make necessary additional  contributions, even though the plan might appear fully funded on a  given date using an assumed return discount rate. For example, a  plan could be insolvent if it needed to terminate, even if it was fully  funded using an assumed-return discount rate or a bond-based rate  with significant smoothing, because the cost to actually buy out the  pension benefits or transfer them to another party could be much  higher than the liability using an assumed return. Another risk to  using the assumed-return approach cited by some experts is that a  plan’s assets could fail to grow at the assumed return, which would  require higher-than-expected contributions or future reductions in  benefits. The associated risks to participants would depend on how  well the sponsor could use other financial resources to make up  funding shortfalls and pay benefits. Due to these risks, according to  some experts, using a discount rate that is lower than an assumed- return rate—whether a bond-based rate (with little or no smoothing) or  something in between an assumed-return rate and a bond-based  rate—can be viewed as a lower-risk approach than a pure assumed- return approach. Specifically, because the discount rates would be  more conservative, sponsors would have to put more money into the  plan to be fully funded, which would provide a cushion against the  possibility of actual returns falling short of those assumed and being  inadequate to pay for future benefits.
Plan and plan sponsor characteristics, such as the size of the plan  relative to the size of the plan sponsor, the maturity of the plan, and  the strength of the plan sponsor may be key factors in determining an  appropriate discount rate, particularly for funding purposes. Two  supporters of the assumed-return approach for some purposes said  that weak plan sponsors with uncertain futures might need to be more  conservative in setting a discount rate because the sponsor might not  be able to make up the difference (through higher future contributions)  if plan investments perform poorly. Based on interviews with  experts, we identified the following key plan and sponsor  characteristics to consider in setting the discount rate:  1.  The size of the plan relative to the size of the plan sponsor, since a  small sponsor with a large plan may be less able to cope with  assumed returns that fail to materialize. The size of a plan sponsor  could be measured by metrics such as revenue or market  capitalization for a corporation or revenue or tax base for a state or  local government.  2.  The maturity of the plan, since an aging plan with few new participants  will wind down over a shorter time horizon. Such a plan will have less  time to recover if it does not meet investment expectations.  3.  The strength of the plan sponsor, since a sponsor with strong revenue  projections is better positioned to take risks with funding or investment  policy or with its discount rate approach.
These characteristics can change over time. Indeed, it is not uncommon  for a plan’s demographics to mature over time, for a plan to grow in size  relative to the size of the plan sponsor over time, or for once-healthy plan  sponsors to become financially strained. Related to this is that risks to  plans and plan sponsors are “correlated,” meaning that a market  downturn may both decrease the value of plan assets and weaken the  financial health of the plan sponsor at the same time. These risks are also  considerations in setting a discount rate.
subsections: section_title: Fairness and Sustainability Considerations
paragraphs: Intergenerational equity is the issue of whether current and future  generations bear fair amounts of cost and risk. In general, a principle  of public finance is that each generation should pay for the services it  receives, and that borrowing should be for capital projects that benefit  people over a long period of time. Experts disagreed on how to best  design the discount rate to achieve the goal of intergenerational  equity. Some experts stated that using an assumed-return approach  passes uncompensated risk to future generations. Others had an  opposing view that using a bond-based approach charges current  generations in excess of a best estimate of the funds that would  ultimately be needed for future pension benefits, which would pass  surplus assets to future generations.
System sustainability refers to whether public or private sponsors will  want to continue to provide DB pension plans under one or the other  discount rate regime. Several experts attributed historical declines in  private sector DB coverage to bond-based discount rate policies that  created too much volatility in reported DB liabilities, along with  increases in reported costs. These experts noted that DB plans are  often replaced by DC plans that shift risks onto participants, who, in  the view of two experts, are less equipped to bear them than are plan  sponsors. Another expert noted an incongruity between the fact that  bond-based discount rates create an incentive for DB plans to move  out of the stock market and into bonds, whereas the standard  recommendation for DC participants is to invest in a mix of stocks and  bonds (with the particular mix varying by age). Some experts argued  that DB plans, particularly public plans, can and should take on some  amount of investment risk, which could reduce long-term costs.  Others said that the discount rate should be an assumed return to be  consistent with plan investment practices. Other experts argued the  opposite, that assumed-return discount rates lead to poor risk  management practices—such as taking on too much investment risk  or increasing benefits when plans appear overfunded. In this view,  such practices could lead to funding shortfalls and crises that  undermine system sustainability. One such expert argued that DB  pension plans should be operated more like insurance companies in  their risk management practices.
section_title: Transparency and Comparability
paragraphs: Transparency and comparability refers to providing sufficient  information for users of financial data to understand a pension plan’s  financial position and to make comparisons across plans. A number of  experts emphasized transparency or comparability considerations in  setting the discount rate and many supported the reporting of multiple  measures of liability using different discount rates. While some  proponents of an assumed-return approach stated that multiple  measures of liability would be confusing for stakeholders in the public  plan environment, other experts were often concerned that one  measure of liability reported at a single discount rate could not provide  enough information for pension plan stakeholders to make informed  decisions. For example, one expert compared using a single discount  rate to driving across the country with only a single gauge—fuel,  speed, or temperature.
section_title: Many Experts Supported Reporting Multiple Liability Measures; Some Said Assumed-Return Rates May Be Too High
paragraphs: Nearly half of the experts we interviewed supported the use of multiple  measures for valuing pension plan obligations. Some experts saw value  in reporting a bond-based liability in addition to an assumed-return liability  because of various concerns about asset allocation. To the extent the  same actuarial cost method is used, the difference between the two  liabilities would represent: (1) a measure of the long-term reduction in  cost that a plan thinks it can achieve through investments that outperform  a low-risk rate and (2) the amount of investment risk a plan takes on  relative to a low-risk funding target. Additionally, many experts stated that  reporting multiple measures of liabilities would be useful in providing  transparency. Some experts felt that more complete information for all  key stakeholders would be an improvement over currently available  information, while others said that reporting liabilities based on multiple  discount rates would provide fuller transparency into a plan’s finances  than using a single rate. Some experts also took the view that public  plans providing liabilities at both a bond-based and assumed-return  discount rate could provide a broader range of information to plans and  employers to guide plan policies, and could potentially provide a useful  check on the assumed-return measurement. At least one large public  plan voluntarily provides multiple measures of liability using different  discounting approaches (as well as multiple actuarial cost methods). The  plan discloses a number of estimates of liability based on low-risk bond  rates as well as estimates of liability using assumed returns. It also  provides a narrative explaining what the different numbers represent.  As noted earlier, while multiemployer plans generally use an assumed- return approach for funding purposes, they also calculate an additional  liability measure under ERISA based on a 4-year weighted average of  Treasury bond rates. Experts had differing views on the significance of  this “current liability” calculation.
In contrast to experts favoring multiple measures, nearly a quarter of the  experts we interviewed argued that only a bond-based approach should  be used to value plan obligations while nearly a third of the experts we  interviewed favored use of only the assumed-return approach. For  example, some advocates of each of the assumed-return and bond- based approaches did not see value in the other approach, and as noted  earlier, some even saw potential damage. Some experts who saw the  bond-based approach as the only correct approach for all purposes,  argued that including a liability based on an assumed-return approach is  incorrect based on economic theory and could result in lower  contributions, higher benefits, or riskier investment strategies. Some  advocates of using only the assumed-return approach argued that  including a liability based on a bond-based approach is irrelevant for  public plans. One expert noted that requiring public plans to report a  bond-based measure could result in pressure to fund to this much higher  measure, and two experts said requiring state and local governments to  fund their plans using a bond-based measure could put pressure on them  to change their pension plans from DB to DC. Some of these experts  felt that more extensive risk analysis and disclosure, using techniques  such as stochastic modeling and stress testing, would provide more  useful and relevant information than the addition of a bond-base liability  measure.
Nevertheless, some of the experts who principally advocate for one  particular approach also said that they could see value in multiple  measures. Some experts who principally support a bond-based approach  thought that if a plan were trying to earn returns in excess of low-risk  bonds, reporting a funding target based on the assumed-return measure  could be worthwhile. Some experts did not think that plans should attempt  to earn a risk premium, and therefore, their assumed rate of return would  be the same as the bond-based rate, since the plan would only invest in  low-risk bonds. Some advocates of the assumed-return approach for at  least some purposes said that reporting multiple measures could provide  informational value. Figure 3 illustrates some of these lines of  argument.
According to some experts, even within the assumed-return discount rate  framework, the returns assumed by public plans have been too high.  More specifically the assumed return among most public plans surveyed  in 2013 was between 7.5 to 8 percent.return discount rates are currently too optimistic, and a few said it would  be difficult to achieve such returns given current market conditions.  Further, some experts cited current interest rates, which are historically  very low, as indicative of lower expectations for future returns. In contrast,  two experts were more optimistic about future returns, including one  expert who cited an analysis of price-to-earnings ratios on stocks as  indicating potential for strong long-term future returns. Two experts noted  that public plans’ assumed returns have been declining. One of these  experts said this decline indicates that the system is making necessary  self-corrections. The other expert viewed the discount rate reductions as  too small and too gradual.
Some experts we spoke to cited the historical returns of assets in a  typical pension plan portfolio as evidence for the appropriateness of  assuming a rate of return of around 8 percent. Some experts have cited,  for example, the average level of historical returns over particular periods  or the distribution of returns over rolling long-term historical periods, such  as all possible 30-year periods for which there is good return data.  However, by themselves, historical returns have limited usefulness in  resolving disagreements over the appropriate discount rate. We modeled  returns on typical pension portfolios over past periods, but identified  numerous challenges with using historical data to generate or support an  assumed-return assumption. First, analysis of returns on overlapping  rolling historical periods has significant statistical limitations. Second,  historical returns vary with the time period used in the analysis.  Furthermore, future return expectations will depend in part on current  economic variables that may not be consistent with any particular  historical time period. Third, actual returns for any particular plan would  also depend on plan characteristics and cash flows. Lastly, investment  returns and plan benefit levels are not independent variables. Details of  our analysis, and its limitations, can be found in appendix III.
section_title: Selected Countries Apply a Variety of Approaches to Discounting and Use Lower Assumed Returns Than U.S. Public Plans
subsections: section_title: Selected Countries Apply a Variety of Approaches to Discounting
paragraphs: As discussed, a plan has an unfunded liability or is underfunded when its liabilities are  greater than assets, so that the funded ratio is less than 100 percent. The amount of the  unfunded liability is equal to the excess of liabilities over assets. conservative (i.e., lower) discount rate at or close to government bond  yields often used for benefits of retired workers as compared to some  assumed return in excess of high-quality bond yields used for current  workers. The precise discount rate that can be reasonably justified by a  plan depends on the strength of its sponsor. The regulator uses a risk- based approach that considers plan and sponsor characteristics to  determine the reasonability of the discount rate and other plan  assumptions.
Canadian experts said that private sector Canadian plans use two liability  measurements to determine minimum required contributions: (1) a  solvency-liability measurement based on an assumption of plan  termination, using bond-based discount rates, and (2) a going-concern  liability measurement generally based on an assumed return (and  typically with projections of future salary increases). The minimum  contribution requirement is based on the larger of two different  “amortization” calculations, one to pay down the unfunded solvency  liability, the other to pay down the unfunded going-concern liability. The  two measurements reflect the dual goals of solvency and long-term  returns. The required solvency measure reflects, in part, the absence of a  pension insurance program. The solvency measure generally consists  of two parts: an amount for plan participants who would be assumed to  take a lump sum upon plan termination, and an amount for plan  participants who would be assumed to take an annuity upon plan  termination. Lump sum values are calculated in accordance with  Canadian Institute of Actuaries standards, which specify discount rates  based on a formula tied to Canadian government bond rates plus a  spread. For participants assumed to take an annuity, the solvency  measure reflects the market prices insurers charge for immediate and  deferred annuities. As noted earlier, using annuity prices can be  considered a bond-based approach since such prices are influenced by,  and will vary with, market interest rates. These annuity discount rates  ranged from about 3.6 to 4.0 percent as of December 2013.
Given the recent low interest-rate environment in Canada, private plans  have generally had to fund to the more conservative solvency calculation.  Experts also told us that a number of Canadian regulators have extended  temporary solvency funding relief to some private sector single-employer  plans following low valuations of their asset portfolios resulting from the  2008 market decline.
In contrast, experts told us that most Canadian public plans and some  multiemployer plans are generally exempted from the solvency  assessment for funding or have been granted temporary solvency funding  relief. Experts told us that because these plans are considered going- concerns, they are allowed to make contributions based solely on an  assumed-return discount rate. This is similar in concept to practices for  such plans in the United States, though the actual levels of assumed- return assumptions differ between the two countries, as discussed later in  this section.require that a (bond-based) solvency liability be calculated and provided   However, Canadian Institute of Actuaries standards  by all plans, including public and multiemployer plans. An expert told us   that this Canadian Institute of Actuaries requirement is not a public  disclosure requirement; rather the information is provided only to plan  sponsors, plan members, and regulators. Nonetheless, it stands in  contrast to U.S. practice, where such a bond-based measure of liability is  generally not provided by public plans.
subsections: section_title: The Netherlands
paragraphs: In the Netherlands, plan liabilities are measured using a bond-based  approach. Benefits projected to be paid within the next 20 years are  discounted using a 3-month average of a market interest rate curve.  For benefits projected to be paid beyond 20 years, rates are extrapolated  from the market interest rate curve to approach a predetermined rate, set  at a fixed rate of 4.2 percent by an independent commission and  introduced by De Nederlandsche Bank (DNB) in September 2012. A  Dutch official told us that an independent commission has recently issued  an advisory on the determination of this rate. In the future, the fixed level  of 4.2 percent will be replaced by a 10-year moving average of the 20- year forward rate.
An official noted that the Netherlands bases a plan’s funding target on the  riskiness of the plan’s asset allocation. Plans are subject to a base  funding target of 105 percent of the plan’s liability, which protects nominal  accrued benefits, and a risk-adjusted target based on the riskiness of a  plan’s asset allocation. Plans must fund to these risk-adjusted funding  targets, which increase as a plan’s asset allocation gets riskier in order to  provide a buffer or provide a financial cushion to protect against  investment risk.where, under the assumed-return approach used by U.S. public plan  sponsors and private sector multiemployer plans, the funding target  (which is the liability) decreases as a plan’s asset allocation gets riskier.
This is in contrast to the dynamic in the United States  For determining minimum required contributions, plans may use either  market interest rates, a 10-year moving average of market interest rates,  or assumed returns. The option to use an average of market interest rates  or assumed returns provides plans with some ability to avoid sharp  fluctuations in minimum required contributions. However, the funding  target would still be the risk-adjusted target based on the bond-based  liability. For future projections of assets and liabilities, plans may use  assumed returns. Similarly, plans that become underfunded must submit  a recovery plan to the regulator but are allowed to use an assumed return  to project their ability to close the funding deficit. However, in developing  assumed returns, the maximum expectations that can be used are  regulated. Currently, the maximum acceptable assumed return on the  equity portion of the portfolio, as established by an independent  commission as of December 2013, is 7 percent (the overall assumed  return would also reflect the other asset classes in the portfolio). The recovery plan details specific measures that will enable a plan to return to  fully-funded status within the allotted time.
section_title: The United Kingdom
paragraphs: U.K. experts told us that under the U.K.’s Scheme Specific Funding  framework, discount rates used by private plans for funding purposes are  plan-specific and may incorporate elements of either or both of the bond- based and assumed-return approaches. In setting their discount rate or  rates, plans can choose to apply the bond-based, assumed-return, or a  combination of approaches, which is then subject to a risk-based  regulatory review by the regulator. urges plans to consider the ability of the sponsor to assume risks of plan  underfunding resulting from their discount rate and other plan  assumptions. The weaker the sponsor relative to the plan, the more  prudent should be the plan’s strategy and approach to the discount rate  (and other assumptions). A weak sponsor may find it prudent to take less  risk than a strong sponsor and use a discount rate that assumes lower  returns.
The relevant regulation states that “the rates of interest used to discount future  payments of benefits must be chosen prudently, taking into account either or both–(i) the  yield on assets held by the scheme to fund future benefits and the anticipated future  investment returns, and (ii) the market redemption yields on government or other high- quality bonds.” other plan assumptions to determine if any appear to be too high or  inappropriate given plan risks and sponsor strength. The regulator  cautions plan trustees in published guidance to regularly assess sponsor  strength because it may fluctuate significantly over relatively short periods  of time. As part of its evaluation, the regulator also compares the size of  the plan relative to the size of the plan sponsor. The regulator then  conducts risk-based assessments to determine which plans may require  additional scrutiny.
Plans are required to be fully funded or they must set up a recovery plan,  which guides funding decisions until the deficit is eliminated and is  overseen by the regulator. According to an official from the U.K. Pensions  Regulator, plans operating under a recovery plan may assume a higher  return over the recovery period than the discount rate used to calculate  the plan’s liability, provided that the recovery plan return assumption is  justified by the investment strategy. The same official also told us that  about 75 percent of plans were in recovery status as of June 2013.
U.K. discount rates for funding purposes frequently differ between the  retired and current worker portions of the plan populations. The projected  benefits of retired plan participants are frequently discounted largely with  reference to U.K. government bond rates, known as “gilts,” and to  corporate bond rates. The projected benefits of current workers (and  deferred members) are frequently discounted at gilt rates plus 2 to 3  percent for the period up to retirement. Generally, this practice  acknowledges that the benefits of retirees should be discounted at a more  conservative rate than the benefits of current workers, for whom more  time is available to make up for any adverse plan experience, according  to officials. As discussed, the precise discount rate used—be it based  on government bond yields or varying levels of assumed returns in  excess of bond yields—is plan-specific and depends on the strength of  the sponsor, subject to a risk-based review by the regulator. Currently,  the net result of this plan-specific approach is discount rates of gilt rates  plus 0.8 to 1.3 percent. For plans in recovery, the average overall  discount rate has ranged in recent years from 4.3 to 5.7 percent.
As noted earlier, public plans in the United Kingdom are generally  financed on a pay-as-you-go basis, with plan benefits paid out of tax  revenue. Public plan sponsors make contributions to a notional pension  account that are calculated based on a discounted measure of the plan’s  liabilities. The discount rate used for this purpose is 3 percent above the  U.K. Consumer Prices Index.
section_title: U.S. Public Plans Generally Use Higher Discount Rates Than Plans in Selected Countries
paragraphs: When determining their liabilities, U.S. public plans generally use higher  discount rates than plans use in Canada, the Netherlands, and the United  Kingdom. In the United States, it is common for public plans to use a 7.5  to 8 percent long-term assumed rate of return. Experts told us that  Canadian public plans generally use funding discount rates, using the  assumed-return approach, of about 6 percent or lower, and that Canadian  private plans use similar assumed-return rates for their going-concern  valuations, and even lower rates—under current market conditions—for  their solvency valuations. According to a Dutch official, the funding  discount rates used in the Netherlands, using a bond-based approach,  depend on the duration of plan liabilities and can fluctuate with the market  but cannot currently exceed 4.2 percent, unless amended by the Dutch  independent commission. In the United Kingdom, funding discount  rates used by private plans in recovery have most recently been about  4.3 percent, with the average excess return assumed over  conventional 20 year gilts at about 1 percent. In addition, discount rates  for financial reporting purposes under International Accounting Standards  Board (IASB) and Financial Reporting Council (FRC) standards (and  FASB in the U.S.) are all bond-based and lower than U.S. public plan  discount rates.
Some of the differences in discount rates between the United States and  these countries are accounted for by differing approaches to determining  these rates. Bond-based discount rates generally will be lower than  assumed-return discount rates under current and most market conditions.  U.S. public plans use an assumed-return approach for funding and  accounting purposes. In contrast, the Dutch discount rate, one of the  two Canadian funding measures, and the IASB, FRC, and FASB discount  rates are all bond-based. However, in those cases where these other  countries use assumed returns, or some allowance for assumed  returns—for example, one of the two Canadian measures, the rate for  Dutch recovery plans, and the U.K.’s plan-specific approach—these  assumed returns tend to be lower than assumed returns currently used by  U.S. public plans.
One potential explanation for differences in the discount rates is the  greater degree of government oversight in Canada, the Netherlands, and  the United Kingdom, where experts said regulators routinely scrutinize  discount rates. Unlike for public plans in the United States, Canadian  pension regulators’ authority to reject an actuarial report allows them to  implicitly set the boundaries for reasonable assumptions. One expert  stated that Canadian provincial regulators’ scrutiny “sets the tone” even  for plans that are not subject to solvency measurements. Another expert  said that in some jurisdictions, the regulator explicitly tells plans the  acceptable range of discount rates to use. In addition, another expert  told us that while Canadian Institute of Actuaries standards state that  assumed returns should be best estimates unless otherwise required by  the circumstances of the calculation, many regulators have sent notices  to plans under their jurisdiction that margins for adverse deviation are  needed. The overall acceptable net assumption tends to vary across  provincial and federal regulators but, as discussed, is generally not higher  than about 6 percent, under recent and current conditions. In the  Netherlands, De Nederlandsche Bank’s use of prescribed bond-based  discount rates obviates the need for explicit scrutiny of the discount rate  assumption. However, plans are allowed to make assumed-return  assumptions for recovery plans, and for this purpose an independent  commission sets a ceiling on the maximum acceptable assumed return  on the equity portion of plan assets. In the United Kingdom, the Pensions  Regulator has legal powers to ensure that the discount rate and other  plan assumptions are prudent given plan risks and sponsor strength.
Differences in discount rates also arise from variations in the regulatory  framework of each country, which reflect different views among  governments and regulators on the most appropriate way to protect DB  pension benefits for plans under their jurisdiction. Experts told us that  under the Canadian two-measurement funding standard, private plans  have less incentive to be overaggressive with their assumed-return  assumption used for the going-concern measurement because they must  generally fund their plan using a bond-based solvency measurement,  which is currently the higher of the two measures. The Netherlands’  adherence to market interest valuation of accrued benefits through use of  a bond-based approach to discounting for all plans is the most  conservative among the countries we studied and, consequently, results  in generally the lowest discount rates. As for the United Kingdom, the  discretion to determine a discount rate approach under the Scheme  Specific Funding framework necessitates negotiation among plan  sponsors, trustees, and advisors, and may involve the regulator. This  process facilitates a system of checks and balances that help to ensure  that reasonable plan assumptions, including the discount rate, are used,  experts said.
section_title: Concluding Observations
paragraphs: Although our report illustrates the differences of opinion over pension  discount rates, we found one significant area where there is some, but not  universal, room for agreement. Specifically, many experts supported  providing multiple measures of liabilities for different purposes to provide  a more complete picture of pension plan finances. The practices of  selected foreign countries—notably, Canada, the Netherlands, and the  United Kingdom—may provide insight into ways that other pension  systems discount liabilities, applying a variety of approaches to  discounting, with significant government oversight, and generally using  lower discount rates than U.S. assumed returns.
In general, as in many aspects of pension plan finances, additional  transparency and information about discount rates and their impact can  be useful. There may be value in providing multiple measures of liability  and cost, using both assumed-return and bond-based discount rates— carefully labeled to describe their purpose (e.g., with some measures,  such as funding targets, not even necessarily labeled “liabilities”)—and  with explanations of what these measures do and do not represent. The  measurements resulting from these different discount rate approaches  can ultimately improve the understanding, management, and governance  of the finances of pension plans. In short, there may be value in having  multiple liability measures to arrive at funding, benefit, and investment  policies that will better balance risks and rewards to plan participants and  all other stakeholders.
Despite the challenges that many plans currently face, traditional DB  plans in the public and private sector continue to play an important role in  American retirement security. This is especially true in the public sector  where many current workers and retirees do not participate in Social  Security and may rely on these pensions as their primary source of  retirement income. Policy options to address these plans’ challenges may  be addressed by fostering the use of appropriate liability measurements  and discount rate assumptions and increased transparency concerning  their financial health. However, any such options should also be sensitive  to the crucial need to ensure that benefits remain adequate to current and  future retirees and their families.
section_title: Agency Comments
paragraphs: We provided officials from the Department of the Treasury and the  Pension Benefit Guaranty Corporation with a draft of this report. They  provided technical comments that we incorporated, as appropriate. In  addition, we provided officials from the Financial Accounting Standards  Board and the Governmental Accounting Standards Board with a draft of  this report. They provided technical comments that we incorporated, as  appropriate. We also provided select experts and officials from the  countries we reviewed with portions of the draft report that addressed  aspects of the pension funds in their jurisdictions. We incorporated their  technical comments, as appropriate, as well.
As arranged with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from the  date of this letter. At that time, we will send copies of this report to  appropriate congressional committees, the Secretary of the Treasury, the  Director of the Pension Benefit Guaranty Corporation, and other  interested parties. In addition, this report will be available at no charge on  GAO’s website at http://www.gao.gov.
If you have any questions about this report, please contact Charles  Jeszeck at (202) 512-7215 or jeszeckc@gao.gov or Frank Todisco at  (202) 512-2700 or todiscof@gao.gov. Mr. Todisco meets the qualification  standards of the American Academy of Actuaries to address the actuarial  issues contained in this report. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are found in appendix V.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: To analyze differences of opinion concerning discount rates for pension  plan valuations and funding, GAO examined (1) the significance of the  differences in discounting approaches used by public versus private  sector pension plans; (2) the purposes for measuring the value of a plan’s  future benefits and key considerations for determining plan discount rate  policy; (3) the approaches select countries have taken to choose discount  rates. This appendix provides an account of the information and  methodology we used to answer these questions.
To address our objectives, we spoke with experts, including actuaries,  economists, and other pension experts, from a variety of organizations  and constituencies who represent diverse points of views regarding  discount rates. These experts’ opinions cover a wide range of views on  the appropriate way to set discount rates. We examined relevant literature  on pension discount rates. We also reviewed relevant provisions in the  Internal Revenue Code and the Employee Retirement Income Security  Act, as amended; relevant federal regulations; relevant pension  accounting standards issued by the Governmental Accounting Standards  Board, Financial Accounting Standards Board, and the International  Accounting Standards Board; and relevant actuarial standards of practice  issued by the Actuarial Standards Board.
For our analysis of historical returns and their implications, we spoke to  experts and reviewed historical data on bond and stock returns as tracked  using historical data from 1926 to 2012 in the Ibbotson Stocks, Bonds,  Bills, and Inflation Historical Yearbook. We calculated average annual  time-weighted geometric and arithmetic returns for various asset  allocations and over various time periods within the 1926 to 2012 period.  We also developed two stylized pension plans—a growing plan and a  maturing plan—for which we calculated dollar-weighted returns over each  of the three consecutive 29-year periods from 1926 to 2012.
A growing plan is characterized by contributions into the plan exceeding  benefit payments out of the plan. The ratio of cash in to cash out is set at  10 to 1 for the entire 29-year period. The ratio of contributions relative to  total plan assets starts at about 40 percent in year 1 and declines to  about 2 percent in year 29. A maturing plan is characterized by  decreasing contributions relative to benefit payments, with benefit  payments beginning to outpace contributions during the middle years of  the 29-year period and continuing to increase relative to contributions for  the remainder of the analysis period. The ratio of cash in to cash out  starts at 3 to 1 in year 1 and ends at 0.65 in year 29. The cash in to cash  out ratios for the intervening years (from 2 through 28) are determined  through linear interpolation. The ratio of contributions relative to total plan  assets start at about 43 percent in year 1 and declines to between 6 and  14 percent in year 29, depending on the period. These plans were  provided as illustrative examples of how the dollar-weighted return of a  particular plan can differ from a time-weighted return.
To examine other countries’ approaches, we asked experts to identify  countries with significant defined benefit systems and active controversies  with regard to discount rates. Ultimately, we chose to examine Canada,  the Netherlands, and the United Kingdom. These countries are not meant  to be a representative sample of international practice; rather, they  represent countries with contrasting approaches to discounting and  ongoing discussions about the appropriate rate of discount. We spoke to  experts in these countries and reviewed publicly-available documents.  We did not conduct an independent legal analysis to verify the information  provided about the laws, regulations, or policies of the foreign countries  selected for this study. Instead, we relied on appropriate secondary  sources, interviews with relevant officials, and other sources to  summarize each country’s approach to discounting pension liabilities. We  also provided select experts and officials from the countries we reviewed  with portions of the draft report that addressed aspects of the pension  funds in their jurisdictions. We incorporated their technical comments, as  appropriate, as well.
section_title: Appendix II: Additional Information on Laws, Standards, and Practices for Determining Discount Rates for U.S. Defined Benefit Plans
paragraphs: As discussed in the background, discount rate guidelines and practices  for U.S. DB pension plans and plan sponsors differ for funding and  financial reporting purposes, and for different plan types: public sector  plans, private sector single-employer plans, and private sector  multiemployer plans. As discussed, for both funding and financial  reporting, sponsors of private sector single-employer plans generally use  a bond-based approach, while sponsors of public plans generally use an  assumed-return approach; private sector multiemployer plans generally  use an assumed-return approach for funding, but also calculate an  additional liability measure under ERISA based on an average of  Treasury bond rates, while participating employers usually do not have to  report a liability for financial reporting. However, the different plan sectors  have unique guidelines and practices for arriving at a final discount rate  for different purposes.
Multiemployer plans have a choice of actuarial cost methods under ERISA for  determining the accrued liability on which minimum required contributions are primarily  based. Multiemployer plans also disclose, on Schedule MB of Form 5500, two liability  measures based on the unit credit actuarial cost method: an accrued liability using the  plan’s assumed return discount rate, and a measure called the current liability using a  discount rate based on a 4-year weighted average of 30-year Treasury rates. use the entry age actuarial cost method. Using this method, a worker’s  service and salary are both projected to retirement to estimate a projected  benefit. The cost of this benefit is allocated over the worker’s entire  service (both past and projected future) as a level percentage of his or  her salary (for plans whose benefit formula is tied to salary levels). The  accrued liability is the value of these allocated costs accumulated up to  the point of the worker’s service to date. The resulting liability measure is  simply called the total pension liability. For active workers, holding  actuarial assumptions constant, an entry age normal accrued liability  (GASB method) will typically be somewhat higher than a projected unit  credit accrued liability (FASB method), which in turn will typically be  somewhat higher (for benefit formulas tied to salary levels) than a unit  credit accrued liability (ERISA method). For plan participants who are  already retired or terminated employment, these three methods produce  the same liability.
In addition, the different funding and financial reporting requirements for  setting discount rates for different types of plans also result in differing  amounts of discretion that plan sponsors can use in setting their discount  rates. Of the GASB, ERISA, and FASB requirements with respect to  discount rates, GASB standards and ERISA’s multiemployer funding  standards leave the most room for judgment, because, for example,  estimated long-term average rates of return on pension plan investments  in equities are judgments rather than observable data, and such  estimates can vary significantly even among experts. This stands in  contrast to ERISA’s single-employer standards and FASB standards (for  plan sponsors) which allow less discretion. Table 5 summarizes  differences in the laws, standards, and practices that govern discount rate  approaches across plan types in the United States.
subsections: section_title: GASB Standards
paragraphs: Recently revised GASB standards prescribe a “blended approach” to  determining pension discount rates for financial reporting by public plan  sponsors, with implementation required by fiscal years beginning after  June 15, 2014. Under the new GASB standard, plan sponsors would use  an assumed-return approach to the extent they project that current  assets, assumed returns, and future contributions for current members  will be sufficient to provide for benefits; for any projected shortfalls, public  plan sponsors would use 20-year, tax-exempt general obligation  municipal bond interest rates with an average rating of AA/Aa or higher.  Thus, for some plans the composite discount rate will be a hybrid of the  assumed-return approach and bond-based approach. Industry experts  have indicated that, on average, the composite discount rate is likely to  be closer to the assumed-return rate for two reasons: many plans have  contribution policies which, combined with current plan assets, are likely  to be projected to cover projected benefit payments, so that the blended  discount rate will be the same as the assumed-return discount rate; and  for those plans where there is a projected insufficiency, the bond-based  approach would only apply to a portion of plan liabilities.
section_title: ERISA Requirements
paragraphs: With regard to the rates they use to discount benefits, single-employer  sponsors are generally required to use a bond-based approach to  determine the minimum required contribution. However, within this  framework, these sponsors have options which can result in  measurements of plan liabilities that may not be closely tied to current  market conditions. Plan sponsors are given the option of using a full yield  curve approach, which matches projected benefit payments to high- quality corporate bond interest rates averaged over a current month, so  that under this option, the measurement of plan liabilities would be tied to  current or recent market conditions. A plan choosing this approach would  discount a benefit payment due in 10 years at the yield curve rate as  published by Treasury for year 10. However, single-employer plan  sponsors may also elect to discount using a simplified three-segment  yield curve published by Treasury, with the three different segment  interest rates applicable to benefit payments due in less than 5 years, 5 to  20 years, and 20 years or more. These segment rates are based on a 2- year average of bond rates and also cannot be higher or lower than  maximum and minimum segment rates as set in law in 2012 as part of the  Moving Ahead for Progress in the 21st Century Act (MAP-21). The MAP- 21 maximum and minimum apply to plans that use the segment rate  approach, and are based on long-term (25-year) bond averages. MAP- 21’s effect on discount rates is designed to be temporary. Because  average interest rates over the past 25 years are significantly higher than  more recent market rates, the MAP-21 changes had the effect of  significantly increasing ERISA discount rates over what they would  otherwise have been, thereby lowering measurements of plan liabilities  and reducing minimum funding requirements.
Under the bond-based approach used by private sector single-employer  pension plans under ERISA (as well as common practice under FASB), a  single pension plan will use different discount rates to calculate the  present value of benefits that will be paid out at different points in the  future. This means that different plans can end up with very different  average rates of discount depending on the age of the plan’s participants.  In contrast, a public plan using an assumed rate of return would typically  discount all future benefit payments at the same assumed return.  Because the assumed return is based on asset allocation, the rates will  vary depending on how a plan allocates its assets. This is an example of  how the bond-based approach determines discount rates based on  characteristics of a plan’s liabilities, whereas the assumed-return  approach determines discount rates based on characteristics of the  assets being used to finance the liabilities. As discussed, under ERISA,  private sector multiemployer plans generally discount using an assumed  rate of return for funding purposes. However, these plans also calculate a  liability based on a bond-based discount rate under ERISA, which can  sometimes affect the timing of minimum required contributions and is also  used in the calculation of the maximum deductible contribution. Experts  had differing views of the significance of the reporting of this measure.
section_title: FASB Standards
paragraphs: FASB financial reporting standards are separate from ERISA funding  standards but plan sponsors also typically use high-quality corporate  bond rates to compute liabilities, with some key differences. The  corporate bond rates that plan sponsors use to satisfy FASB standards  are snapshots of market interest rates on the measurement date,  producing liabilities based on current market interest rates. This approach  is different from discount rates based on ERISA segment rates, which are  averages of past and present rates. Also, FASB standards allow  companies to select a hypothetical matching bond portfolio, or a yield  curve (extrapolated for projected benefits with long durations), rather than  rely on one particular set of published rates (such as those produced by  Treasury for ERISA). Also, unlike the ERISA funding target, which is  based on worker’s service and salary to date, FASB requires companies  to report a projected benefit obligation, which for pension benefit formulas  based on compensation includes an assumption of future benefit growth  due to salary increases.
section_title: Appendix III: Historical Returns and the Discount Rate
subsections: section_title: Challenges with Analysis of Historical Returns
paragraphs: Even though some experts we spoke to cited the historical returns of  assets in a typical pension plan portfolio as evidence for the  appropriateness of assuming a rate of return of around 8 percent, we  found several challenges with using historical data to generate or support  an assumed-return assumption. First, reliance on returns during  overlapping rolling historical periods has significant statistical limitations.  Second, historical returns vary with the time period used in the analysis.  Furthermore, future return expectations will depend in part on current  economic variables that may not be consistent with any particular  historical time period. Third, actual returns for any particular plan would  also depend on plan characteristics and cash flows. Fourth, investment  returns and plan benefit levels are not independent variables. Also, the  potential use of historical returns is only relevant within the context of an  assumed-return approach to discounting because a bond-based  approach relies on observable market prices for bonds, annuities, or other  alternatives.
subsections: section_title: Rolling Period Historical Returns Present Statistical Challenges
paragraphs: Other experts argue that, on the contrary, investment risk in risky assets such as equities  increases in magnitude the longer the time horizon. the 1926 to 2012 period.conclusions about investment risk over 30-year periods solely from this  historical record.
section_title: Past Returns Depend on the Time Period Used in the Analysis, and Future Returns Depend on Current Economic Variables
paragraphs: In analyzing the 1926-2012 historical period, modeled returns vary with  particular subsets of years during this historical period and with the  assumed allocation of plan assets. For the entirety of this 87-year  historical period, we found that a static portfolio allocation of 60 percent in  equities and 40 percent in corporate bonds (“60/40 portfolio”), rebalanced  annually and with no intervening net cash flows, would have achieved an   However, when “trailing returns”  8.9 percent annualized nominal return. (i.e., returns for the years leading up to the current year) are used to  examine historical capital market performance, the historical time period  chosen can greatly affect return expectations. For example, as figure 4  shows, for the same 60/40 portfolio, the annualized nominal returns are  6.5 percent over the past 15 years, 10.9 percent over the past 30 years,  9.3 percent over the past 50 years, 8.7 percent over the past 85 years,  and again, 8.9 percent over the past 87 years. Even to the extent that  such information can be informative as to future expectations, it is not  clear how to assign relative credibility between the more recent and the  more distant past.
Unless otherwise noted, the returns in this section are all geometric means rather than  arithmetic means. See discussion at end of this section.
section_title: Returns Also Depend on Plan Characteristics and Cash Flows
paragraphs: Another challenge to drawing conclusions from historical returns is that  any approach may not reflect the cash flow patterns of an actual pension  plan. Historical return statistics are often “time-weighted” averages,  meaning that they reflect average returns over some time period that are  independent of the order in which those historical returns occurred. Time- weighted returns do not vary across plans. Of more relevance to an  actual pension plan is its “dollar-weighted” average return, which reflects  the plan’s cash flow pattern. For example, consider a 10-year period in  which returns average 10 percent annually for the first 5 years and 2  percent annually for the second 5 years, for a 10-year average of 6  percent annually, which is the time-weighted average return. However,  for a growing pension plan that has net cash inflows (contributions paid in  exceeding benefits paid out) during this period, the returns in the second  half of the period may be more important than the returns in the first half  of the period, because there may be more money at stake in the second  half of the period. Consequently, if a growing plan experiences  decreasing rates of return, the plan’s dollar-weighted average return may  be less than the time-weighted average.
To apply this concept to our historical return analysis, we developed two  hypothetical pension plans—a growing plan and a maturing plan.  Each  of these hypothetical plans generated a unique cash flow pattern that  broadly reflected its plan characteristics and certain assumptions about  the plans. We divided the 87-year period from 1926 to 2012 into three  discrete 29-year periods.dollar-weighted returns for each period based on plan assets invested in  various investment portfolio allocations using historical return data.
For each hypothetical plan, we calculated  Our analysis shows that for a 60/40 investment portfolio allocation to  stocks and corporate bonds, the dollar-weighted returns of our  hypothetical plans can differ significantly from time-weighted returns. The  hypothetical growing plan outperformed the time-weighted average in two  of the three 29-year historical periods, while the maturing plan  underperformed the time-weighted average in all three periods. As figure  5 shows, the hypothetical growing plan would return nearly one  percentage point above the time-weighted average return for the period  from 1926 to 1954 and almost a quarter of a percentage point above the  time-weighted return for the period from 1955 to 1983, but the maturing  plan would return nearly 1.25 percent below the time-weighted average  return for the period from 1984 to 2012.
Many experts cited examples of pension plans for which benefit formulas  were increased following periods of robust investment returns. We have  also seen examples in more recent years of benefit formulas being  decreased in financially distressed plans. These examples indicate that  investment returns and benefit levels have not been independent  variables. If plan benefits have been more flexible in this way on the  upside than the downside—an empirical question—it would mean that  some historical investment returns effectively went towards net benefit  increases rather than supporting previously existing benefit promises.  This is another reason for caution in looking to historical returns to  support a particular discount rate.
section_title: Geometric Versus Arithmetic Means
paragraphs: In calculating average annual historical returns, either of two types of  time-weighted (i.e., plan-independent) average annual returns can be  measured—geometric average return or arithmetic average return. For  returns that vary from year to year, the geometric average will always be  less than an arithmetic average. Figure 6 shows the differences in these two types of average returns for a 60/40 investment portfolio allocated to  stocks and corporate bonds calculated for various trailing periods.
As a simplified but illustrative example, consider a two-year historical  period where the return is positive 100 percent in year one and negative  50 percent in year two. One dollar invested at the start of this period will  grow to 2 dollars at the end of year one and then fall back to 1 dollar at  the end of year two, for a total net return of zero over the 2-year period.  The geometric average return is zero. The arithmetic average return is  positive 25 percent (100 percent minus 50 percent, divided by 2).
Experts we spoke with disagreed about whether a forward-looking  assumed-return assumption should reflect a geometric average  expectation or an arithmetic average expectation. Conceptually, a  geometric assumption reflects a median expectation (with a 50 percent  chance that actual investment performance will be above or below the  assumption) while an arithmetic assumption reflects a mean (average)  expectation (with a greater than 50 percent chance that actual investment  performance will fall short of the assumption).
section_title: Appendix IV: Key Features of Discount Rate Practices in Canada, the Netherlands, and the United Kingdom
subsections: section_title: At a glance
subsections: section_title: • As of 2011, 38 percent of
paragraphs: Canadian employees were  covered under a registered  pension plan in Canada.  Of those, 74 percent or nearly 4.5  million Canadians were  participants in defined benefit  plans, with an aggregate market  value of assets of about 1.1 trillion  Canadian dollars.
Defined benefit plans are generally  regulated at the provincial level,  with some regulated by a separate  federal regulator, so policies can  vary by province and the federal  level. Most defined benefit plans,  both public and private, are  prefunded.
With the exception of Ontario  province, which has pension  insurance that insures a nominal  benefit of up to one thousand  Canadian dollars per month, there  is no pension insurance program  in Canada. been exempted from the solvency assessment for funding purposes,  or have been granted temporary solvency funding relief, as they are  considered going-concerns. These plans make contributions based on  an assumed-return discount rate. However, these plans must also  provide a solvency-based liability measure to plan sponsors, plans  members, and regulators.
The bond-based rates used in the solvency assessment reflect a  combination of (i) a formula tied to Canadian government bond rates  plus a spread intended to approximate the results that would be  obtained from discounting using a full yield curve based on highly  rated provincial bonds (for participants who would be assumed to take  a lump sum), and (ii) the market prices insurers charge for immediate  and deferred annuities (for participants who would be assumed to take  an annuity).
Funding requirements and discounting approaches (cont.)
Although the assumed-return rate used in the going-concern  assessment is similar in concept to the approach applied by public  sector plans and private sector multiemployer plans in the U.S., the  return assumptions differ between the two countries, with assumed  returns in Canada typically at 6 percent or lower, reflecting both lower  best-estimates of assumed returns and, in some cases, the  subtraction of a margin for adverse deviation.
For financial reporting purposes, private sector plan sponsors in  Canada often follow the accounting standards promulgated by the  International Accounting Standards Board (IASB).
Regulator and regulatory principles
At the federal level, the Office of the Superintendent of Financial  Institutions (OSFI) regulates and supervises private pension plans in  federally regulated areas of employment, such as banking,  telecommunications and inter-provincial transportation. Each province  has its own regulatory body for pension plans under its jurisdiction.  The majority of registered defined benefit pension plans are under the  jurisdiction of either the regulator in Ontario, Quebec, or with the OSFI.
Regulatory principles are generally similar across all regulators,  whether provincial or federal.
Generally, provincially-regulated plans are assessed once every three  years, while federally-regulated plans and plans registered with the  Québec regulator are assessed annually.
Canadian regulators have the authority to reject an actuarial report  which allows them to implicitly set boundaries for reasonable  assumptions.
section_title: At a glance
paragraphs: Funding requirements and discounting approaches
All plans discount their liabilities using a bond-based approach.
In 2013, defined benefit plans  accounted for 78 percent of all  retirement plans in the  Netherlands. Participants in those  plans represented nearly 93  percent of all active pension plan  participants.
With regard to the discount rate,  the regulator makes no regulatory  distinctions between public,  private, or multiemployer defined  benefit pension plans.
Pension plans are separate legal  entities from plan sponsors and  there is no pension insurance  program.
Plan benefits can vary with  investment performance and  funded status. base funding target of 105 percent using prescribed market interest  rates. Plans can attempt to provide inflation indexed benefits by  investing in riskier asset portfolios. Inflation indexed benefits are  granted only to the extent they are supported by actual investment  returns. However, base funding targets are also “risk-adjusted,”  meaning the base funding target is increased the riskier the plan’s  asset allocation, in order to provide a buffer against investment risk.  An official told us that a common asset allocation of 50 percent equity,  40 percent bond, and 10 percent real estate would require a plan to be  120 percent funded, based on a 2.5 percent probability of shortfall in a  1-year horizon.
For determining minimum required contributions, plans may use either  market interest rates, a 10-year moving average of market interest  rates, or assumed returns.  However, the funding target would still be  the risk-adjusted target based on the bond-based liability.
For future projections of assets and liabilities, plans may use assumed  returns.
Plans in recovery are allowed to assume investment returns based on  plan asset allocation to project reaching funding targets within the  recovery period.
Funding requirements and discounting approaches (cont.)
Plans with funded ratios less than the 105 percent base funding target  must submit a recovery plan to return to full funding within 3 years.  Nominal accrued benefits can be reduced for plans that do not achieve  the base funding target within this allotted time. Plans with funded  ratios less than the risk-adjusted funding target (specific to the plan’s  asset allocation) must reduce or eliminate inflation-indexation and  submit a recovery plan to return to this funding target within 15 years.
For financial reporting purposes, private sector plan sponsors in the  Netherlands often follow the accounting standards promulgated by the  International Accounting Standards Board (IASB).
Regulator and regulatory principles
De Nederlandsche Bank (DNB) examines the financial position of  pension funds and regulates discount rates. The Netherlands Authority  for the Financial Markets monitors market conduct relating to pension  funds’ obligations to provide information to members.
The DNB publishes discount rates on a monthly basis.
Pension plans must submit quarterly and annual reports to the DNB.
When using assumed returns, the maximum expectations that can be  used are regulated. Currently, the maximum acceptable assumed  return on the equity portion of the portfolio, as established by an  independent commission, is 7 percent (the overall assumed return  would also reflect the other asset classes in the portfolio).
section_title: At a glance
paragraphs: In 2012, participation in workplace  pension plans was at 46  percent. 91 percent of public  sector employees with workplace  pensions had a defined benefit  plan while 26 percent of private  sector employees with workplace  pensions were in such plans.  Overall, the proportion of  employees with defined benefit  pension plans continued to fall,  with 28 percent of employees  participating in such plans in 2012,  compared with 46 percent in 1997. benefit pension plans must use beyond the requirements that actuarial  valuations must use an accrued benefit method, assets must be at  market value, and economic and actuarial assumptions must be  chosen prudently based on circumstances specific to the plan.   Regulations specifically allow plans to use either a bond-based,  assumed-return, or a combination of both approaches to determine its  discount rate for funding purposes.
Under U.K.’s Scheme Specific Funding framework, discount rates  used by private plans for funding purposes are plan-specific and may  incorporate elements of both the bond-based and assumed-return  approaches. employer sponsor to support the plan, known as the “employer  covenant,” in plan assumptions. A strong sponsor can have some  justification for using a somewhat higher discount rate, but the  regulator cautions plan trustees to regularly assess sponsor strength  because it may be subject to significant variation over relatively short  periods of time. Conversely, a weak sponsor may find it prudent to  take less risk and use a discount rate that assumes lower returns  above safe bond yields. autonomous from the sponsoring  employer. Trustees and employers  negotiate in setting plan policies,  with assumptions, including the  discount rate, and methods subject  to a risk-based review by the  Pensions Regulator.
Discount rates for funding purposes frequently differ between the  retired and current worker portions of the plan populations. The  projected benefits of retired plan participants are frequently discounted  largely with reference to U.K. government bond rates, known as “gilts,”  and to corporate bond rates. The projected benefits of current workers  (and deferred members) are frequently discounted at gilt rates plus 2  to 3 percent for the period up to retirement.
A national pension insurance  program administered by the  Pension Protection Fund (PPF)  provides compensation to  members of eligible, largely private  sector defined benefit pension  plans when there is a qualifying  insolvency event in relation to the  employer, and where there are  insufficient assets in the pension  plan to cover the PPF level of  compensation.
Plans under recovery are allowed to assume a higher return, over the  recovery period, than the discount rate used to calculate the plan’s  liability.
For financial reporting purposes, private-sector plan sponsors in the  United Kingdom often follow accounting standards promulgated by the  local Financial Reporting Council (FRC) or the International  Accounting Standards Board (IASB). FRC and IASB standards take  an approach to the discount rate that is broadly similar to FASB in the  United States.
The regulation states that “the rates of interest used to discount future payments of benefits must be  chosen prudently, taking into account either or both–(i) the yield on assets held by the scheme to fund  future benefits and the anticipated future investment returns, and (ii) the market redemption yields on  government or other high-quality bonds.”  Accounting standards developed by the FRC are contained in Financial Reporting Standards,  referred to as FRS.
Regulator and regulatory principles
The Pensions Regulator is responsible for regulating work-based  pension plans, which includes occupational defined benefit and  defined contribution plans as well as certain aspects of work-based  personal pensions. It has the authority to oversee the administration of  these plans and contributions made to them based on its objective to  protect the benefits under occupational pension plans of, or in respect  to, members of such plans.
Private plan sponsors must prepare actuarial valuations on at least a  triennial basis (provided they also produce annual updates-–otherwise  they have to do annual valuations). Plans in deficit, and which have  therefore prepared a recovery plan, must submit details of the  recovery plan and valuation to the regulator. Plans in surplus must  submit details of their valuation along with their regular plan data  updates. The regulator conducts a risk-based assessment to  determine if additional scrutiny or actions are necessary.
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Kimberly Granger (Assistant  Director), David Lin (Analyst-in-Charge), Amy Buck, and Aron Szapiro  made key contributions to this report. Also contributing to this report were  James Bennett, Susan Bernstein, Kenneth Bombara, David Chrisinger,  Robert Dacey, Michael Hoffman, Gene Kuehneman Jr., Kathy Leslie,  Ashley McCall, Sheila McCoy, Nhi Nguyen, Susan Offutt, Max Sawicky,  Margie Shields, Roger Thomas, Kate van Gelder, and Amber Yancey- Carroll.
section_title: Related GAO Products
paragraphs: Private Pensions: Timely Action Needed to Address Impending  Multiemployer Plan Insolvencies. GAO-13-240. Washington, D.C.: March  28, 2013.
State and Local Government Pension Plans: Economic Downturn Spurs  Efforts to Address Costs and Sustainability. GAO-12-322. Washington,  D.C.: March 2, 2012.
State and Local Government Pension Plans: Governance Practices and  Long-term Investment Strategies Have Evolved Gradually as Plans Take  On Increased Investment Risk. GAO-10-754. Washington, D.C.: August  24, 2010.
State and Local Government Retiree Benefits: Current Status of Benefit  Structures, Protections, and Fiscal Outlook for Funding Future Costs.  GAO-07-1156. Washington D.C.: September 24, 2007.