In DB plans, formulas set by the employer determine employee benefits. DB plan formulas vary widely, but benefits are frequently based on participant pay and years of service, and typically paid upon retirement as a lifetime annuity, or periodic payments until death. Because DB plans promise to make payments in the future and because tax-qualified DB plans must be funded, employers must use present value calculations to estimate the current value of promised benefits. The calculations require making assumptions about factors that affect the amount and timing of benefit payments, such as an employee’s retirement age and expected mortality, and about the expected return on plan assets, expressed in the form of an interest rate. The present value of accrued benefits calculated using mandated assumptions is known as a plan’s “current liability.” Current liability provides an estimate of the amount of assets a plan needs today to pay for accrued benefits. The Employee Retirement Income Security Act of 1974 (ERISA), and several amendments to the law since its passage, established minimum funding requirements for sponsors of pension plans in order to try to ensure that plans have enough assets to pay promised benefits. Compliance with the minimum funding requirements is recorded through the plan’s funding standard account (FSA). The FSA tracks events that affect the financial health of a plan during that plan year: credits, which reflect improvements to the plan’s assets, such as contributions, amortized experience gains, and interest; and charges, which reflect an increase in the plan’s financial requirements, such as the plan’s normal cost and amortized charges such as the initial actuarial liability, experience losses, and increases in a plan’s benefit formula. ERISA and the Internal Revenue Code (IRC) prescribe rules regarding the assumptions that sponsors must use to measure plan liabilities and assets. For example, for plan years 2004 and 2005, the IRC specifies that the interest rate used to calculate a plan’s current liability must fall within 90 to 100 percent of the weighted average of the rate on an index of long-term investment-grade corporate bonds during the 4-year period ending on the last day before the beginning of the plan year. Similarly, rules dictate that sponsors report an “actuarial” value of assets that must be based on reasonable assumptions and must take into account the assets’ market value. This value may differ in any given year, within a specified range, from the current market value of plan assets, which plans also report. While different methodologies and assumptions will change a plan’s reported assets and liabilities, sponsors eventually must pay the amount of benefits promised; if the assumptions used to compute current liability differ from the plan’s actual experience, current liability will differ from the amount of assets actually needed to pay benefits. Funding rules generally presume that the plan and the sponsor are ongoing entities, and plans do not necessarily have to maintain an asset level equal to current liabilities every year. However, the funding rules include certain mechanisms that are intended to keep plans from becoming too underfunded. One such mechanism is the AFC, introduced by the Omnibus Budget Reconciliation Act of 1987 (OBRA ‘87). The AFC requires sponsors of plans with more than 100 participants that have become underfunded to a prescribed level to make additional plan contributions in order to prevent funding levels from falling too low. With some exceptions, plans with an actuarial value of assets below 90 percent of current liabilities are affected by the AFC rules. In addition to setting funding rules, ERISA established PBGC to guarantee the payment of the pension benefits of participants, subject to certain limits, in the event that the plan could not. Under ERISA, the termination of a single-employer DB plan may result in an insurance claim with the single-employer program if the plan has insufficient assets to pay all benefits accrued under the plan up to the date of plan termination. PBGC may pay only a portion of a participant’s accrued benefit because ERISA places limits on the PBGC benefit guarantee. For example, PBGC generally does not guarantee benefits above a certain amount, currently $45,614 annually per participant at age 65. Additionally, benefit increases arising from plan amendments in the 5 years immediately preceding plan termination are not fully guaranteed, although PBGC will pay a portion of these increases. Further, PBGC’s benefit guarantee amount is limited to the monthly straight life annuity benefit the participant would receive if she were to commence the annuity at the plan’s normal retirement age. Sponsors of PBGC-insured DB plans pay annual premiums to PBGC for their coverage. Premiums have two components: a per participant charge paid by all sponsors (currently $19 per participant) and a “variable-rate” premium that some underfunded plans pay based on the level of unfunded benefits. The recent decline of PBGC’s single-employer program has occurred in the context of the long-term stagnation of the DB system. The number of PBGC-insured plans has decreased steadily from approximately 110,000 in 1987 to about 29,000 in 2004. While the number of total participants in PBGC-insured single-employer plans has grown approximately 25 percent since 1980, the percentage of participants who are active workers has declined from 78 percent in 1980 to 50 percent in 2002. Unless something reverses these trends, PBGC may have a shrinking plan and participant base to support the program in the future. From 1995 to 2002, while most of the 100 largest plans had sufficient assets to cover their plan liabilities, many did not. Furthermore, because of leeway in the actuarial methodology and assumptions sponsors can use to measure plan assets and liabilities, underfunding may actually have been more severe and widespread than reported at the end of the period. Because of flexible funding rules permitting the use of accounting credits other than cash contributions to satisfy minimum funding obligations, on average 62.5 of the 100 largest plans each year received no cash contributions from their sponsors. Although as a group, funding levels among the 100 largest plans were reasonably stable and strong from 1996 to 2000, by 2002, more than half of the largest plans were underfunded (see fig. 1). Two factors in the deterioration of many plans’ finances were the decline in stock prices and prevailing interest rates. From 2000 to 2002, stock prices declined sharply each year, causing a decline in the value of many plans’ pension assets. In addition, over the sample period, 30-year Treasury bond rates, which served as the benchmark for the rate used by plans to calculate pension liabilities, generally fell steadily, raising current liabilities. The combination of lower asset values and higher pension liabilities had a serious, adverse effect on overall DB plan funding levels. Accurate measurement of a plan’s liabilities and assets is central to the sponsor’s ability to maintain assets sufficient to pay promised benefits, as well as to the transparency of a plan’s financial health. Because many plans chose allowable actuarial assumptions and asset valuation methods that may have altered their reported liabilities and assets relative to market levels, it is possible that funding over our sample period was actually worse than reported for a number of reasons. These include the use of above-market rates to calculate current liabilities and actuarial measurement of plan assets that differ from market values. Reported current liabilities are calculated using a weighted average of rates from the 4-year period before the plan year. While this allows sponsors to smooth fluctuations in liabilities that sharp swings in interest rates would cause, thereby reducing volatility in minimum funding requirements, it also reduces the accuracy of liability measurement because the rate anchoring reported liabilities is likely to differ from current market values. To the extent that the smoothed rate used to calculate current liabilities exceeds current rates, the 4-year smoothing could reduce reported liabilities relative to those calculated at current market values. Further, rules allowed sponsors to measure liabilities using a rate above the 4-year weighted average. The 4-year weighted average of the reference 30-year Treasury bond rate exceeded the current market rate in 76 percent of time in the months between 1995 and 2002, and the highest allowable rate for calculating current liabilities exceeded the current rate in 98 percent of those months. Sponsors of the plans in our sample chose the highest allowable interest rate to value their current liabilities 62 percent of the time from 1995 to 2002. For example, an interest rate 1 percentage point higher than the statutorily required interest rate would decrease the reported value of a typical plan’s current liability by around 10 percentage points. As with liabilities, the actuarial value of assets used for funding may also differ from current market values. Under the IRC, actuarial asset values cannot be consistently above or below market, but in a given year may be anywhere from 80 to 120 percent of market asset levels. Among the plans we examined, on average each year, 86 percent reported a different value for actuarial and market assets. On average, using the market value instead of the actuarial value of assets would have raised reported funding levels by 6.5 percent each year. However, while the market value exceeded the actuarial value of assets during the late 1990s, when plan funding was generally strong, in the weaker funding year of 2002 market assets dipped below actuarial assets. In 2001 and 2002, calculating plan funding levels using market assets would have greatly increased the number of plans below 90 percent funded each year. A similar calculation for 2002 would have drastically increased the number of large plans below 80 percent funded, from 6 to 24. Thus, we see some evidence that using actuarial asset values lowered the volatility of reported funding levels relative to those using market asset values. However, the use of the actuarial value of assets also may have disguised plans’ funded status as their financial condition worsened. Two large plans that terminated in 2002 illustrate the potential effects of discrepancies between reported and actual funding. The Bethlehem Steel Corporation in 2002 reported that its plan was 85.2 percent funded on a current liability basis; yet, the plan terminated later that year with assets of less than half of the value of promised benefits.