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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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). 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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). 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. 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). 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. 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. 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.

Summary: 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. 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. GAO is not making any recommendations in this report.