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

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