Interest rates are key assumptions in calculating the present value of promised future pension benefits. When interest rates are lower, more money is needed today to finance future benefits because it will earn less income when invested. At a 6-percent interest rate, for example, a promise to pay $1.00 per year for the next 30 years has a present value of about $14. If the interest rate is reduced to 1.0 percent, however, the present value of $1.00 per year for the next 30 years increases to about $26 because the $26, when invested, will earn the relatively small income associated with a 1-percent interest rate. Therefore, lower interest rate assumptions result in higher current liability and lump-sum amounts. The interest rate appropriate for measuring the present value of a plan’s pension liabilities may differ depending on a number of factors, including the purpose of the measurement. For example, the interest rate appropriate for measuring the present value of a plan’s pension liabilities on an ongoing basis may reflect the assumed rate of return that the plan is expected to achieve on the investment of its assets. On the other hand, the interest rate appropriate for measuring the present value of that same plan’s pension liabilities at plan termination may reflect interest rates implicit in annuity purchase rates. Before ERISA, few rules governed the funding of defined benefit plans, and there were no guarantees that participants would receive promised benefits. When the pension plan of a major automobile manufacturer failed in the 1960s, for example, thousands of defined benefit plan participants lost their pensions. As part of ERISA, the Congress established PBGC to pay pension benefits in the event that an employer could not. In addition to establishing PBGC, ERISA and IRC require employers to make minimum contributions to under-funded plans and prevent employers from making tax-deductible contributions to plans exceeding specified funding limits. “. . . the determination of whether an interest rate is reasonable depends on the cost of purchasing an annuity sufficient to satisfy current liability. The interest rate is to be a reasonable estimate of the interest rate used to determine the cost of such annuity, assuming that the cost only reflected the present value of the payments under the annuity (i.e., and did not reflect the seller’s profit, administrative expenses, etc.). For example, if an annuity costs $1,100, the cost of $1,100 is considered to be the present value of the payments under the annuity for purposes of the interest rate rule, even though $100 of the $1,100 represents the seller’s administrative expenses and profit. In making the determination with respect to the interest rate . . . other factors and assumptions (e.g., mortality) are to be individually reasonable.” In 1987, the range of permissible interest rates was from 10-percent below to 10-percent above the weighted average 30-year Treasury bond rate. In 1994, IRC was amended to reduce the upper limit of the permissible range of interest rates from 10 percent to 5 percent above weighted average rate. The House Report accompanying the bill stated that the 1987 legislation was intended to address the chronic under-funding of pension plans that had persisted since passage of ERISA. However, when measuring current liability, plans could decrease contributions by choosing an interest rate at the high end of the range. According to the report, the highest allowable interest rate was reduced to 105 percent to minimize a plan’s ability to decrease its current liability through the choice of interest rates. Additionally, in 1994, IRC was amended to require that employers determine the minimum value of certain optional forms of benefit, such as lump sums, using an interest rate no higher than the interest rate for 30-year Treasury bonds. To prevent employers from exceeding the maximum lump-sum payment specified by law, IRC also required employers to use an interest rate no lower than 30-year Treasury bond rates when calculating lump sums for certain highly paid employees. The Congress enacted the amendment for a number of reasons, including to ensure that rates for determining lump-sum payments better reflected prices in the insurance annuity market. Figure 1 shows, for 1987 to 2002, the range of allowable rates for current liability calculations and the allowable interest rates for lump-sum calculations. In November 2002, for example, the interest rate for 30-year Treasury bonds was 4.96 percent. That month, the 4-year weighted average rate for 30-year Treasury bonds was 5.58 percent, and the range of allowable interest rates for current liability calculations was 5.02 percent to 6.70 percent. Our analysis of the law and related congressional documents, and discussions with PBGC and Treasury officials, indicates that the interest rates used in current liability and lump-sum calculations were to have two characteristics. They were to: (1) reflect group annuity purchase rates and (2) not be vulnerable to manipulation by interested parties. Because actual group annuity purchase rates are unknown, the Congress specified rates to regulate an employer’s selection of an interest rate. While 30-year Treasury rates may have been close to group annuity purchase rates in 1987, PBGC was not aware of any available studies that documented that proximity. Officials said that, in addition to their possible proximity to group annuity purchase rates, the Congress adopted 30-year Treasury bond rates as the basis for interest rates because they could not be easily manipulated by interested parties. In this regard, Treasury bonds were actively traded in large markets and interest rate data for them were available from government sources, which helped ensure that the rates accurately represented market conditions and could not be easily manipulated by interested parties. However, the Department of the Treasury stopped issuing new 30-year Treasury bonds in 2001. Information needed to determine actual group annuity purchase rates is not available because annuity purchases are private transactions between insurance companies and employers who terminate their pension plan. To terminate a defined benefit plan, an employer determines the benefits that have been earned by each participant up to the time of plan termination and purchases a single-premium group annuity contract from an insurance company, under which the insurance company guarantees to pay the accrued benefits when they are due. The insurance company determines the employer’s premium by analyzing participant demographics and making assumptions about a number of variables, including: Interest rates. The assumed interest rate is used to determine the present value of projected benefit payments and costs at the annuity purchase date. Rates reflect current market rates for the securities in which the company is likely to invest the premium paid by the plan: generally fixed income securities, such as corporate bonds and mortgage- backed securities, with a relatively low credit risk. Interest rate assumptions may vary according to a number of factors at plan termination, including the projected cash flow of the plan and the yield curve on relevant securities. (See app. II.) Interest rates are adjusted to produce the insurer’s target level of capital requirements and profits from the annuity. Mortality rates. The assumed mortality rate reflects death rates associated with known or assumed characteristics of the participant population, with some adjustments to account for future potential improvements in mortality. Administrative expenses, taxes, and other costs. Administrative expenses for annuities include the cost of setting up accounts and tracking payments. Many insurers assume a flat rate for each annuitant in pricing some administrative expenses, such as account set-up charges. Some insurers reduce their interest rate assumption to account for those expenses. Information about insurance company assumptions, or premium payments and projected benefits, would be needed to estimate actual group annuity purchase rates; however, this information is often not available publicly. For example, employers who decide to terminate their pension plans typically contact a broker or consultant who then solicits bids for a group annuity contract from qualified insurance companies. Insurance companies bid on the contract through the broker or consultant. Negotiations or an auction may take place, which may further affect the price. Insurance companies typically do not disclose assumptions made during this process. Thirty-year Treasury bonds had several desirable characteristics when they were selected to approximate group annuity purchase rates in 1987. For example, the American Academy of Actuaries said that in 1987, the 30-year Treasury bond rate plus 0.3 percentage points (30 basis points) would have replicated group annuity purchase rates. This would indicate that the difference between the rate of return on 30-year Treasury bonds and the typical insurance company investment (such as long-term, high- quality corporate bonds) approximated the expenses and other annuity pricing factors that insurance companies would consider. The extent to which 30-year Treasury bond rates maintained their proximity to group annuity purchase rates would depend upon how closely Treasury rates continued to approximate insurance company investment rates of return, after adjusting them for expected administrative expenses and other annuity pricing factors. Additionally, policymakers said that 30-year Treasury bond rates were selected as the interest rate in 1987 in part because interested parties could not easily manipulate Treasury rates. Two characteristics of 30-year Treasury bonds that would indicate their rates could not be easily manipulated were their “transparency” and “liquidity.” Thirty-year Treasury bond rates were transparent. For a rate to be transparent, information about it must be widely available and frequently updated. The Federal Reserve Board of Governors, using data provided by the Department of the Treasury, published information on 30-year Treasury rates. The Department of the Treasury constructed 30-year Treasury bond rates using data collected from private vendors and reviewed and compiled by the Federal Reserve Bank of New York. Thirty-year Treasury bonds were liquid. For a bond to be liquid, the market in which it is traded must be large and active so that isolated events or erratic behavior by a single market participant are unlikely to have a major effect on market prices. According to a senior market analyst, the 30-year Treasury bond market in 1987 was likely the deepest and most liquid market in low risk 30-year bonds in the world. While 30-year Treasury bonds had several favorable characteristics when they were selected to approximate group annuity purchase rates, their issuance has since been suspended.