oversight

Private Pensions: Process Needed to Monitor the Mandated Interest Rate for Pension Calculations

Published by the Government Accountability Office on 2003-02-27.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to Congressional Requesters




February 2003
                PRIVATE PENSIONS

                Process Needed to
                Monitor the Mandated
                Interest Rate for
                Pension Calculations




GAO-03-313
                                               February 2003


                                               PRIVATE PENSIONS

                                               Process Needed to Monitor the Mandated
Highlights of GAO-03-313, a report to          Interest Rate for Pension Calculations
Congressional Requesters




Employers with defined benefit                 GAO analysis indicates the Congress intended that the interest rates used in
plans have expressed concern that              current liability and lump-sum calculations should reflect the interest rate
low interest rates were affecting              underlying group annuity prices and not be vulnerable to manipulation by
the reasonableness of their pension            interested parties. In 1987, 30-year Treasury bond rates appeared to have
calculations used to determine                 both of these characteristics. However, the Department of the Treasury
funding requirements under the
Employee Retirement and Income
                                               stopped issuing new 30-year Treasury bonds in 2001.
Security Act of 1974 (ERISA).
ERISA requires employers to use a              Actuaries and other pension experts have proposed a number of alternative
variation of the 30-year Treasury              interest rates, including alternatives based on interest rates set in various
bond rate for these calculations;              credit markets—including composite rates for long-term Treasury securities,
however, in 2001 Treasury stopped              long-term high-quality corporate bond indices, 30-year rates on securities
issuing the 30-year bond. This                 issued by government-sponsored enterprises, such as Fannie Mae, 30-year
report provides information on                 interest rate swap rates—and PBGC interest rate factors based on surveys of
(1) what characteristics of an                 insurance company group annuity purchase rates. Each alternative has
interest rate make it suitable for             attributes that may make it more or less suitable as an interest rate for the
determining current liability and              calculation of current liabilities, PBGC premiums, and lump-sum amounts.
lump-sum amounts; (2) what
alternatives to the current rate
                                               Additionally, the relationship of any interest rate to the underlying group
might be considered; and (3) how               annuity purchase rates may change over time and, unless the relationship is
using an alternative rate might                periodically evaluated, the Congress may be unable to appropriately respond
affect plan participants, employers,           to those changes.
and the Pension Benefit Guaranty
Corporation (PBGC).                            If the alternative interest rate selected to replace the current statutory rate
                                               immediately results in a higher interest rate level, which is likely, it would
                                               generally lower participant lump-sum amounts, lower minimum employer
                                               funding requirements, and reduce PBGC premium revenue. However, if the
GAO is not recommending                        alternative interest rate produces a lower interest rate level, plan
executive action. However, in order            participants would generally receive larger lump sums, some employers
to allow the Congress an
                                               would need to increase contributions to their plans, and PBGC may
opportunity to respond
expeditiously to changes in interest           experience an increase in revenue.
rates that might affect the                    Effect of a 1-Percentage Point Increase in the Interest Rate on the Funded Percentage of a
reasonableness of defined benefit              Hypothetical Defined Benefit Plan with a Typical Participant Distribution
pension calculations, the Congress             Funded percentage
may wish to consider providing the             100
                                                                      90.9
cognizant regulatory agencies (the              90
                                                80     80.0
Department of the Treasury, PBGC,
and the Department of Labor) the                70
                                                60
authority to jointly adjust the rate
                                                50
within certain boundaries as
                                                40
specified under the law.
                                                30
                                                20
                                                10
                                                 0
www.gao.gov/cgi-bin/getrpt?GAO-03-313.                   5                 6   C           D           E            F           G           H
                                                     Interest rate (percent)
To view the full report, including the scope   Source: GAO calculations.
and methodology, click on the link above.
For more information, contact Barbara          Note: At 90 percent funded and above for current liability, the plan is not subject to the deficit
Bovbjerg at (202) 512-7215 or                  reduction contribution, which is the portion of the minimum funding requirements that uses the
bovbjergb@gao.gov.                             30-year Treasury rate.
Contents


Letter                                                                                      1
               Results in Brief                                                            4
               Background                                                                  6
               Interest Rate Should Reflect Group Annuity Purchase Rates                  10
               Alternative Interest Rates Have Advantages and Disadvantages
                  Compared with Treasury Bond Rates                                       14
               Alternatives Likely to Decrease Lump-Sum Payments, Employer
                  Contributions, and PBGC Revenue                                         26
               Conclusions                                                                31
               Matters for Congressional Consideration                                    32
               Agency Comments                                                            33

Appendix I     Scope and Methodology                                                       35



Appendix II    Group Annuity Purchase Rate Would Be Affected by
               Cash Flow Projection and Yield Curve at Termination 36
               Cash Flows Vary by Plan                                                    36
               Group Annuity Purchase Rates Would Vary with the Yield Curve               37

Appendix III   Comments from the Department of Treasury                                    41



Table
               Table 1: Characteristics of Proposed Alternatives that Affect Their
                        Suitability as an Interest Rate for Pension Calculations          15


Figures
               Figure 1: Interest Rates and Weighted Average Rates on 30-Year
                        Treasury Bonds and Highest and Lowest Allowable
                        Interest Rates for Current Liability Calculations, 1987 to
                        2002                                                              10
               Figure 2: Annual Long-Term Applicable Federal Rate and 30-Year
                        Treasury Bond Rate, 1987 to 2002                                  17
               Figure 3: Long-Term, High-Quality Corporate Bond and 30-Year
                        Treasury Bond Rates, 1987 to 2002                                 19




               Page i                                       GAO-03-313 Mandated Interest Rate
Figure 4: PBGC Interest Rate Factors and 30-Year Treasury Bond
         Rates, 1987 to 2002                                                              24
Figure 5: Thirty-Year Treasury Bond Rates and Proposed
         Alternative Interest Rates, 1994 to 2002                                         27
Figure 6: Percent Change in Lump Sums for Participants Retiring in
         40 Years or Less for an Interest Rate Increase from
         5 Percent to 6 Percent                                                           28
Figure 7: Effect of a 1-Percentage Point Increase in the Interest
         Rate on the Funded Percentage of a Hypothetical Plan
         with a Typical Participant Distribution                                          30
Figure 8: Projected Cash Flow for Sample Defined Benefit Plan for
         the First 40 Years after Plan Termination                                        36
Figure 9: Yield Curves for On-the-Run and Zero-Coupon Treasury
         Securities as of February 6, 2003                                                38




Abbreviations

ACLI              American Council of Life Insurers
ERISA             Employee Retirement Income Security Act of 1974
FNMA              Federal National Mortgage Association
GSE               government-sponsored enterprises
IRC               Internal Revenue Code
IRS               Internal Revenue Service
LIBOR             London Interbank Offer Rate
PBGC              Pension Benefit Guaranty Corporation


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Page ii                                              GAO-03-313 Mandated Interest Rate
United States General Accounting Office
Washington, DC 20548




                                   February 27, 2003

                                   The Honorable George Miller
                                   Ranking Minority Member
                                   Committee on Education and the
                                    Workforce
                                   House of Representatives

                                   The Honorable Robert Andrews
                                   Ranking Minority Member
                                   Subcommittee on Employer-Employee
                                    Relations
                                   Committee on Education and the Workforce
                                   House of Representatives

                                   In 2001, groups representing employers with defined benefit plans
                                   expressed concern that low interest rates were affecting the
                                   reasonableness of their pension calculations.1 Under the Employee
                                   Retirement Income Security Act of 1974 (ERISA), as amended, and the
                                   Internal Revenue Code (IRC), these calculations affect how much
                                   employers are allowed or required to contribute to their pension plans,
                                   how much employers must pay to the Pension Benefit Guaranty
                                   Corporation (PBGC) for federal insurance of the benefits promised by the
                                   plan,2 and how much plan participants receive when pension benefits are
                                   distributed in a lump sum.3 When making such calculations, the laws


                                   1
                                    Under defined benefit plans, formulas set by the employer determine employee benefits.
                                   Defined benefit plan formulas vary widely, but benefits are frequently based on participant
                                   pay and years of employment. Because defined benefit plans promise to make payments in
                                   the future, employers must use present value calculations to estimate the current value of
                                   promised benefits. Present value calculations reflect the time value of money—that a dollar
                                   in the future is worth less than a dollar today, because the dollar today can be invested and
                                   earn interest. The calculation requires an assumption about the interest rate, which reflects
                                   how much could be earned from investing today’s dollars.
                                   2
                                    PBGC is a federal corporation created by ERISA to insure pension benefits, up to certain
                                   limits set by law, of participants in most qualified defined benefit pension plans. PBGC
                                   takes over defined benefit plans that are terminated with insufficient assets to pay the
                                   benefits to which participants are entitled.
                                   3
                                    Generally, defined benefit plan participants receive benefits in periodic payments, called
                                   “annuities,” starting at retirement and ending at the beneficiary’s death. However, under
                                   certain circumstances, defined benefit plans may provide all promised benefits in a single
                                   lump-sum payment.



                                   Page 1                                                GAO-03-313 Mandated Interest Rate
    require that employers use interest rates on 30-year Treasury bonds, or
    interest rates that are based on 30-year Treasury bond rates. Specifically,
    the laws require employers to use

•   an interest rate from within a permissible range of a 4-year weighted
    average of 30-year Treasury bond rates to calculate a plan’s total liability,
    termed the plan’s current liability, and to use that calculation to assess its
    funding level.4 If plans are funded below certain thresholds as defined in
    the IRC, employers are to determine minimum contribution amounts on
    the basis of those assessments.5 If a plan is fully funded as defined in the
    law, employers are precluded from making additional tax-deductible
    contributions to the plan.6




    4
     In 1987, a permissible range meant a rate of interest that was not more than 10 percent
    above, and not more than 10 percent below, the weighted average of the rates of interest on
    30-year Treasury bond securities during the 4-year period ending on the last day before the
    beginning of the plan year. The weighted average rate is calculated as the average yield
    over 48 months with rates for the most recent 12 months weighted by 4, the second most
    recent 12 months weighted by 3, the third most recent 12 months weighted by 2, and the
    fourth weighted by 1. The top of the permissible range was gradually reduced by 1 percent
    per year beginning with the 1995 plan year to not more than 5 percent above the weighted
    average rate effective for plan years beginning in 1999. The top of the permissible range
    was temporarily increased to 20 percent above the weighted average rate for 2002 and
    2003. A plan’s total liability is calculated for benefits earned through the valuation date.
    5
     Under the special minimum funding rule, a single-employer plan sponsored by an
    employer with more than 100 employees in defined benefit plans is subject to a deficit
    reduction contribution for a plan year if the value of the plan’s assets is less than 90 percent
    of its current liability. However, a plan is not subject to the deficit reduction contribution if
    (1) the value of plan assets is at least 80 percent of current liability and (2) the value of the
    plan assets was at least 90 percent of current liability for each of the 2 immediately
    preceding years or each of the second and third immediately preceding years. See 26 U.S.C.
    412(l).
    6
     The full funding limit is generally defined as the excess, if any, of (1) the lesser of (a) the
    accrued liability under the plan, including normal cost, or (b) 170 percent of the plan’s
    current liability, over the value of the plan’s assets. Additionally, the full-funding limit is
    never below the excess, if any, of 90 percent of a plan’s current liability over the value of
    the plan’s assets. See 26 U.S.C. 404(a)(1) and 26 U.S.C. 412(c)(7). Current and accrued
    liability differ in that current liability is limited to benefits that participants and
    beneficiaries have accrued to date, while accrued liability is generally based on projected
    benefits. This current liability full-funding limit was originally 150 percent of current
    liability but started being phased out in 1999. It will be repealed for plan years beginning in
    2004 and thereafter. Even if a plan’s assets are at the full-funding limit, the employer can
    contribute and deduct the amount, if any, to bring assets up to 100 percent of current
    liability.




    Page 2                                                   GAO-03-313 Mandated Interest Rate
•   the interest rate on 30-year Treasury bonds to assess a plan’s funding level
    and, if required, pay an additional premium, termed the variable-rate
    premium, to PBGC for federal insurance of their plan’s benefits.7
•   the interest rate on 30-year Treasury bonds to determine the minimum and
    maximum values of lump-sum distributions, and whether a benefit can be
    distributed as a lump sum without a participant’s consent.8 When
    determining the minimum lump-sum distribution payable, the 30-year
    Treasury rate is the highest rate that an employer can use in making the
    calculation.

    Generally, the interest rates specified in the law were intended, within
    certain parameters, to reflect the price an insurance company would
    charge to take responsibility for the plan’s pension payments.9 The price
    that insurance companies would charge employers for this service reflects
    current interest rates, the expected mortality and retirement rates of
    participants for the plans they are considering, and the insurance
    companies’ expected expenses and required profit. These factors may be
    expressed as a single rate, called the group annuity purchase rate, which is
    the interest rate underlying the actual group annuity price. In the late
    1990s, when fewer 30-year Treasury bonds were issued and economic
    conditions increased demand for the bonds, the 30-year Treasury rate
    diverged from other long-term interest rates, an indication that it also may
    have diverged from group annuity purchase rates. In 2001, Treasury
    stopped issuing these bonds altogether, and in March 2002, the Congress
    enacted temporary measures to alleviate employer concerns that low
    interest rates on the remaining 30-year Treasury bonds were affecting the




    7
     An additional premium is required if the plan has unfunded vested benefits using a
    statutorily specified interest rate.
    8
     Under IRC, if a participant ceases to be employed by the employer maintaining the plan,
    the plan may distribute the participant’s benefit as a lump sum without the consent of the
    participant, if the present value of the benefit does not exceed a specified amount
    (currently $5,000). Internal Revenue Service regulations provide plans with various options
    for specifying the 30-year Treasury bond interest rate to be used under the plan, such as the
    period for which the interest rate will remain constant and the use of averaging.
    9
     For example, by placing limits on the range of rates that employers might use as an
    interest rate for calculating current liabilities, the Congress effectively prevented
    employers from choosing a rate that reflects insurance company prices should it result in
    an interest rate outside the permissible range.




    Page 3                                                GAO-03-313 Mandated Interest Rate
                   reasonableness of the interest rate for employer pension calculations.10 To
                   help the Congress decide what, if any, additional measure to take, you
                   asked us to determine: (1) what characteristics of an interest rate would
                   make it suitable for determining current liability and lump-sum amounts;
                   (2) what alternatives to the current interest rate might be considered; and
                   (3) how using an alternative rate might affect plan participants, employers,
                   and PBGC.

                   To determine the characteristics of a suitable interest rate, we reviewed
                   pension laws and their legislative history with respect to the calculation of
                   current liability and lump-sum amounts. We also interviewed Labor,
                   Treasury, and PBGC officials who might play a role in assessing alternative
                   interest rates. To identify and examine the advantages and disadvantages
                   of potential alternative interest rates, we interviewed representatives and
                   reviewed documents from a number of government, actuarial, pension
                   plan sponsor, and investment entities. We also compared rates and other
                   market statistics for suggested alternative debt securities with rates for
                   30-year Treasury bonds from 1987 to 2002. To determine how alternative
                   rates might affect employers, plan participants, and PBGC, we created
                   hypothetical examples, based on discussions with actuaries and pension
                   consultants, in which we tested the effect of changes in rate levels on
                   current liabilities and lump-sum payments. We did not assess alternative
                   methods for specifying interest rates. For example, we did not assess
                   whether the interest rate for current liability calculations should be
                   specified as a 4-year weighted average or current market rate. Our scope
                   and methodology is explained more fully in appendix I.


                   Our analysis of the law and related congressional documents, and
Results in Brief   discussions with PBGC and Treasury officials, indicate 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. In 1987,
                   30-year Treasury bond rates appeared to have both of these
                   characteristics. While group annuity purchases are private transactions
                   and information about actual group annuity rates is not available, several


                   10
                     The Job Creation and Worker Assistance Act of 2002 expanded the permissible range of
                   the statutory interest rate for current liability calculations for plan years beginning after
                   December 31, 2001, and before January 1, 2004. Similarly, the act increased the statutory
                   interest rate for PBGC variable-rate premium calculations for plan years beginning during
                   the same time period. See section 405 of P.L. 107-147, Mar. 9, 2002.




                   Page 4                                                  GAO-03-313 Mandated Interest Rate
actuaries said that, in 1987, 30-year Treasury bond rates appeared to be
reasonably close to actual group annuity purchase rates. Additionally,
30-year Treasury bonds were actively traded in large markets, which
meant that interested parties could not easily manipulate their rates. Also,
federal agencies collected and compiled trade information for Treasury
securities and published their rates, which provided further assurance that
rates could not be manipulated.

Actuaries and other pension experts have proposed a number of
alternative interest rates for pension calculations. Most alternatives were
based on interest rates set in various credit markets—including composite
rates for long-term Treasury securities; long-term, high-quality corporate
bond indices; 30-year rates on securities issued by government-sponsored
enterprises (GSEs), such as Fannie Mae; and 30-year interest rate swap
rates. One alternative, PBGC interest rate factors, was based on surveys of
insurance company group annuity purchase rates. Each alternative has
characteristics that may make it more or less suitable as an interest rate
for current liability and lump-sum calculations. During periods of financial
uncertainty, for example, Treasury rates’ proximity to group annuity
purchase rates might be adversely affected if investors’ demand for risk-
free securities increases, causing Treasury rates to decline relative to
other long-term rates. On the other hand, the market is well established
and Treasury debt has the backing of the federal government, and,
therefore, its rates may be considered more trustworthy than other
alternatives. In contrast, insurance companies offering group annuities
tend to invest their premium income in corporate debt rather than in other
securities, and have a similar credit rating to GSEs and interest rate swap
rates. Therefore, rates on these securities might better track changes in
group annuity purchase rates, but private rates might be perceived to be
more vulnerable to manipulation or more complex than Treasury rates.
The PBGC interest rate factors were specifically developed to
approximate group annuity purchase rates. However, PBGC interest rate
factors are based on confidential surveys, and PBGC’s rate calculations
are not published or independently verified, which might make them more
vulnerable to manipulation than other alternatives. For any of the market-
based interest rates, the relationship to group annuity purchase rates may
change over time. Unless the relationship is periodically evaluated, the
Congress may be unable to appropriately respond to those changes.

If the alternative interest rate selected to replace the current rate results
immediately in a higher rate level, which is likely, it would generally lower
participant lump-sum amounts, lower minimum employer funding
requirements, and reduce PBGC premium revenue. A higher interest rate


Page 5                                       GAO-03-313 Mandated Interest Rate
             lowers each of these amounts because it increases the value of today’s
             dollars, relative to future dollars, and therefore fewer of today’s dollars
             should be needed to pay benefits in the future. However, if the alternative
             interest rate produces a lower rate level, plan participants would receive
             larger lump sums, some employers would need to increase contributions
             to their plans, and PBGC may experience an increase in revenue. The
             magnitude of these effects would depend on the characteristics of the plan
             and its participants and how the rate is specified in the law. For example,
             if the rate were to increase and a high percentage of the participants in the
             plan were far from the plan’s normal retirement age, the percentage
             decrease in employer contributions would be greater than if the
             participants were closer to retirement or already retired. Additionally, if
             the Congress specifies the interest rate differently for current liability and
             lump-sum calculations, as is currently the case, the magnitude of the
             impact on each could differ.

             Because the choice of the statutory interest rate has important
             implications for federal revenue, employer cash flow, and participant
             retirement income, this report contains matters for congressional
             consideration concerning the ability of the Congress to respond
             expeditiously to changes that may affect the relationship between the
             interest rate and group annuity purchase rates.


             Interest rates are key assumptions in calculating the present value of
Background   promised future pension benefits.11 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


             11
               Other important assumptions in estimating the value of plan benefits include the mortality
             and retirement rates for plan participants because those rates determine the expectation
             that each future benefit payment will be made and the expected starting date of benefit
             payments, respectively.




             Page 6                                                GAO-03-313 Mandated Interest Rate
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.12 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.13

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.14

Subsequently, concerns were raised about the potential claims that PBGC
might face from the termination of plans that had insufficient assets to pay
promised benefits. In an effort to improve plan funding and protect PBGC,
IRC funding rules were amended in 1987 to require that employers show
they were accumulating sufficient funds should they need to terminate
their plan and contract with an insurance company to take responsibility
for future pension payments. The 1987 amendment required that
employers calculate each plan’s current liability as the sum of the present
values of each participant’s accrued benefits,15 and to calculate the present


12
 Recently, a number of issues have been raised concerning the interest rate that should be
used for measuring pension liabilities. See, for example, Lawrence N. Bader and Jeremy
Gold, Reinventing Pension Actuarial Science, The Pension Forum, Society of Actuaries,
(Schaumberg, IL, forthcoming) at http://www.soa.org/sections/reinventing_pension.pdf.
13
 Selection of Economic Assumptions for Measuring Pension Obligations, Actuarial
Standard of Practice Number 27, Actuarial Standards Board, Dec. 1996.
14
 Employers are generally subject to an excise tax for failure to make required
contributions or for making contributions in excess of the greater of the maximum
deductible amount or the ERISA full-funding limit.
15
  Accrued benefits are benefits that plan participants have earned based on past service.
Accrued benefits may be vested, in which case plan participants have a nonforfeitable right
to them, or nonvested, in which case participants have not yet completed qualification
requirements for the benefits. In a voluntary plan termination, participants become fully
vested in their accrued benefits.



Page 7                                               GAO-03-313 Mandated Interest Rate
values as if the plan were to terminate at the end of the plan year. To make
this calculation, the amendment stated that the interest rate used under
the plan shall be: “consistent with the assumptions which reflect the
purchase rates which would be used by insurance companies to satisfy the
liabilities under the plan.”16 The law also stated that the selected interest
rate must be within a specified range of a weighted average of interest
rates on 30-year Treasury bonds. The Conference Committee report
accompanying the amendment stated, however, that the specified range
was not intended to be a “safe harbor” with respect to whether the interest
rate is reasonable. The report stated:

“. . . 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.,
                                                  17
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.18 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.19 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.



16
 Section 9307(e)(1)(5)(B)(iii)(II) of P.L. 100-203, Dec. 22, 1987.
17
 Omnibus Budget Reconciliation Act of 1987, Conference Report to Accompany H.R. 3545,
House of Representatives Report 100-495 at 846 and 868, Dec. 21, 1987.
18
 The amendment phased in the change in the upper limit to 105 percent over several years.
19
 Retirement Protection Act of 1994, House Report No. 103-632(II), Aug. 26, 1994.



Page 8                                                   GAO-03-313 Mandated Interest Rate
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,20 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.21

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.




20
 The maximum lump sum cannot exceed the present value of the maximum annual benefit
permitted by IRC (for a participant retiring at age 65 in 2003, the lesser of $160,000 a year
or 100 percent of the participant’s average compensation for the high 3 years).
21
 In addition to changing the required interest rate to 30-year Treasury bond rates, the
amendment required employers to use a mortality table based on the prevailing
commissioners standard table used to determine reserves for group annuity contracts. See
Section No. 767, P.L. 103-465, Dec. 08, 1994, and H.R. Rep. No. 632(II), Aug. 26, 1994.




Page 9                                                 GAO-03-313 Mandated Interest Rate
Figure 1: Interest Rates and Weighted Average Rates on 30-Year Treasury Bonds and Highest and Lowest Allowable Interest
Rates for Current Liability Calculations, 1987 to 2002
Interest rate (percent)
11

10

 9

 8

 7

 6

 5

 4




0
Jan-87      Jan-88     Jan-89      Jan-90   Jan-91   Jan-92   Jan-93   Jan-94    Jan-95     Jan-96   Jan-97   Jan-98   Jan-99   Jan-00   Jan-01   Jan-02

                                                                  Interest rate
                                                                  Lowest rate
                                                                  Highest rate
                                                                  4-year weighted average
Source: Federal Reserve Board and IRS.

                                                        Note: In 2002, IRC was amended to increase the highest allowable rate to 120 percent of the 4-year
                                                        weighted average.



                                                        Our analysis of the law and related congressional documents, and
Interest Rate Should                                    discussions with PBGC and Treasury officials, indicates that the interest
Reflect Group                                           rates used in current liability and lump-sum calculations were to have two
                                                        characteristics. They were to: (1) reflect group annuity purchase rates and
Annuity Purchase                                        (2) not be vulnerable to manipulation by interested parties. Because actual
Rates                                                   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



                                                        Page 10                                                        GAO-03-313 Mandated Interest Rate
                             interested parties. However, the Department of the Treasury stopped
                             issuing new 30-year Treasury bonds in 2001.


Information on Actual        Information needed to determine actual group annuity purchase rates is
Group Annuity Purchase       not available because annuity purchases are private transactions between
Rates Is Not Available       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.22 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.23(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




                             22
                               Insurance companies may be able to achieve a somewhat higher rate of return than
                             indicated by publicly traded securities, at a given credit risk, by lending money privately
                             and holding investments to maturity.
                             23
                               Projected cash flows are the expected payments to retired and nonretired participants
                             taking into account their expected mortality and adjusted for the expected commencement
                             dates for nonretired participants. A yield curve shows how current interest rates vary with
                             the term to maturity of securities that would be used to finance the cash flow.




                             Page 11                                                GAO-03-313 Mandated Interest Rate
    population, with some adjustments to account for future potential
    improvements in mortality.24
•   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.25
    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.




    24
     According to a survey of insurance companies for a Society of Actuaries research project,
    all companies adjusted their mortality by projection to the current date, and most
    companies projected future improvement. Surveys indicate that insurance companies use
    several mortality tables, including the 1994 Group Annuity Reserving and 1994 Group
    Annuity Mortality tables. See Victor Modugno, "30-Year Treasury Rates and Defined Benefit
    Plans," in 30-Year Treasury Rates and Defined Benefit Plans, a special report
    commissioned by the Society of Actuaries (2001),
    www.soa.org/sections/pension_research.html (downloaded Dec. 12, 2002), 3. See also
    Ryan Labs, Inc., "Pension Financial Management and Valuation Discount Rates," in 30-Year
    Treasury Rates and Defined Benefit Plans, a special report commissioned by the Society
    of Actuaries (2001), www.soa.org/sections/pension_research.html (downloaded Dec. 12,
    2002), 27.
    25
     Insurance company actuaries said that variations in plan provisions and insurance
    company assumptions with respect to early retirement and ancillary benefits may preclude
    an accurate determination of actual group annuity purchase rates, even if the buy-out price
    and basic plan information were disclosed. They also said, however, that a periodic survey
    of insurance company assumptions could be useful in assessing the designated interest
    rate.




    Page 12                                              GAO-03-313 Mandated Interest Rate
Thirty-Year Treasury          Thirty-year Treasury bonds had several desirable characteristics when
Bonds Had Desirable           they were selected to approximate group annuity purchase rates in 1987.
Characteristics, but Are No   For example, the American Academy of Actuaries said that in 1987, the
                              30-year Treasury bond rate plus 0.3 percentage points (30 basis points26)
Longer Issued                 would have replicated group annuity purchase rates.27 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.




                              26
                               A basis point is one-hundredth of a percent.
                              27
                                Jon Parks and Ron Gebhardtsbauer, Alternatives to the 30-Year Treasury Rate, a public
                              statement by the Pension Practice Council of the American Academy of Actuaries (July 27,
                              2002), www.actuary.org/pdf/pension/rate_17july02.pdf (downloaded Dec. 12, 2002), 8.




                              Page 13                                             GAO-03-313 Mandated Interest Rate
                       While 30-year Treasury bonds had several favorable characteristics when
                       they were selected to approximate group annuity purchase rates, their
                       issuance has since been suspended. The 30-year Treasury bond rates that
                       are currently used as an interest rate for pension calculations are
                       published by the Internal Revenue Service (IRS) based on rates for the last
                       30-year Treasury bonds, which were issued in February 2001.


                       Actuaries and others have proposed a number of alternatives that could be
Alternative Interest   used to control the selection of interest rates for current liability and
Rates Have             lump-sum calculations, including (1) interest rates set in credit markets for
                       various securities, such as long-term Treasury securities; long-term, high-
Advantages and         quality corporate bonds; 30-year GSE bonds; and 30-year interest rate
Disadvantages          swaps; and (2) PBGC interest rate factors based on surveys of insurance
                       company group annuity purchase rates. As shown in table 1, each
Compared with          alternative has characteristics that affect its likelihood of approximating
Treasury Bond Rates    group annuity purchase rates over time and its potential vulnerability to
                       manipulation. For example, the closer an alternative’s interest rate levels
                       match the net return on investment of insurance companies offering group
                       annuities, the more likely that alternative will match group annuity
                       purchase rates. Similarly, the closer the underlying credit rating of an
                       alternative matches that of an insurance company offering group
                       annuities, the more likely that alternative will match group annuity
                       purchase rates.




                       Page 14                                      GAO-03-313 Mandated Interest Rate
Table 1: Characteristics of Proposed Alternatives that Affect Their Suitability as an Interest Rate for Pension Calculations

                                                 Interest rates determined by credit markets
                        Long-term           Long-term, high-
                        Treasury            quality corporate                                       30-year interest rate  PBGC interest
 Feature                securities          bonds                   30-year GSE securities          swaps                  rate factors
 Closeness of           During periods of   While insurance         Credit rating comparable        Comparable credit      Study indicates
 relationship to        financial           companies are           to or higher than               rating and not callable.
                                                                                                                           rate levels were
 group annuity          uncertainty, may    believed to invest      insurance companies that                               close for some
 purchase rates,        fall below group    largely in corporate    offer group annuities.                                 plans between
 based on               annuity purchase    bonds, may need to                                                             1994 and 1997.
 insurance              rates because of    deduct for expenses                                                            Constructed
 company                increased           and profit.                                                                    from surveys of
 investments or         demand for                                                                                         insurance
 credit rating          Treasury                                                                                           companies’
                        securities.                                                                                        group annuity
                                                                                                                           purchase rates,
                                                                                                                           but includes
                                                                                                                           information
                                                                                                                           from only two
                                                                                                                           surveys
                                                                                                                           annually.
 Vulnerability to       Government rate,    Large market overall,     Market has perceived          Very large, active     Rates based on
 manipulation           based on highly     but different issuing     backing of federal            market, with rates     confidential
                        visible trading     companies, quality,       government.                   based on daily survey survey and
                        data in well-       and cash structures       Effort by Federal National    of rates offered on    market
                        established,        segment market.           Mortgage Association          new contracts.         representation
                        active market.      New reporting system      (Fannie Mae) to increase      However, concern       of respondents
                                            likely to increase        availability of information   about low market       is unknown.
                                            availability of trading   underlying rates.             volume at long         PBGC
                                            data, but rates based     Current market for Fannie     maturities.            calculations are
                                            more on price             Mae benchmark debt not        Relatively new market, not published
                                            estimates than on         very large or well traded.    perhaps more difficult or
                                            trades.                                                 to understand.         independently
                                                                                                                           verified.
Source: GAO analysis.


                                               Various calculations can be applied to any interest rate to make it more
                                               suitable for its intended use. For example, each of the alternatives could
                                               be specified as: (1) a single monthly interest rate, which is currently the
                                               case for lump-sum calculations; (2) a corridor of interest rates around the
                                               4-year weighted average of a monthly rate, which is currently the case for
                                               current liability calculations; or (3) a yield curve. According to several
                                               actuaries and others, specifying the alternative as a yield curve, instead of
                                               a single rate or corridor of rates around a weighted average rate, would
                                               have advantages and disadvantages. For example, specifying a yield curve
                                               might enable each plan to more closely approximate its group annuity
                                               purchase rate, but doing so might increase the difficulty of plan
                                               calculations and could prove relatively costly for small plans.




                                               Page 15                                                   GAO-03-313 Mandated Interest Rate
Long-Term Treasury   The Department of the Treasury continues to construct rates for long-term
Securities           bonds that could be used as a basis for selecting interest rates for current
                     liability and lump-sum calculations. For example, the Treasury
                     Department constructs a rate, called the long-term applicable federal rate,
                     which approximates Treasury’s borrowing costs for securities with
                     maturities exceeding 9 years. IRS publishes applicable federal rates.
                     Figure 2 compares the long-term applicable federal and 30-year Treasury
                     bond rates from 1987 to 2002. As can be seen, the differences between the
                     two rates are generally less than 50 basis points.




                     Page 16                                     GAO-03-313 Mandated Interest Rate
Figure 2: Annual Long-Term Applicable Federal Rate and 30-Year Treasury Bond Rate, 1987 to 2002

Interest rate (percent)
10


 9


 8


 7


 6


 5




 0
Jan-87      Jan-88      Jan-89      Jan-90     Jan-91      Jan-92      Jan-93      Jan-94     Jan-95    Jan-96   Jan-97   Jan-98    Jan-99   Jan-00   Jan-01   Jan-02

                                                                             Long-term applicable federal rate
                                                                             30-year Treasury bond rate
Source: Department of the Treasury and Federal Reserve Board of Governors.



                                                               According to actuaries, insurance companies typically place group annuity
                                                               premiums in fixed-income investments that have a higher rate of return
                                                               than 30-year Treasury bonds. Treasury rates are lower than rates for other
                                                               fixed-income investments of the same maturity because Treasury bonds
                                                               have a lower credit risk.28 The proximity of Treasury bond rates to group
                                                               annuity purchase rates may vary with changes in investor attitudes about
                                                               credit risk. During periods of financial uncertainty, for example, investors
                                                               may have a sharply heightened desire for safety, often referred to as a
                                                               “flight to quality,” which could cause Treasury rates to decline relative to
                                                               rates for other securities. Some investment analysts believe that one such
                                                               period began toward the end of the 1990s.

                                                               Despite concerns that long-term Treasury bond rates may not track closely
                                                               with group annuity purchase rates during periods of financial uncertainty,
                                                               Treasury bond rates retain some characteristics that may continue to
                                                               make them a desirable interest rate. The government constructs the rates,



                                                               28
                                                                Credit risk is the potential that borrowers will be delinquent or default on their
                                                               obligations.




                                                               Page 17                                                             GAO-03-313 Mandated Interest Rate
                         and they are based on trades in large, active, and highly visible markets.
                         For example, debt securities markets have shifted to the 10-year Treasury
                         note to serve some of the same long-term benchmark functions as the
                         30-year Treasury bond has served in the past.


Long-Term High-Quality   Various financial investment firms construct indices of interest rates for
Corporate Bond Index     long-term, high-quality corporate bonds, which are debt securities with
Rates                    maturity of 10 years or more issued by companies with relatively low
                         credit risk.29 Figure 3 compares interest rates for the highest-quality
                         corporate debt (bonds rated Aaa by Moody’s Investor Services), high-
                         quality corporate debt (bonds rated Aa), and 30-year Treasury bonds for
                         the period 1987 to 2002. As can be seen, corporate bonds with a Aa rating
                         have higher interest rates than corporate bonds with a Aaa rating and
                         30-year Treasury bonds.




                         29
                          Companies that issue debt typically have a “credit rating” based on an assessment of its
                         probability of making promised payments. A number of companies, including Moody’s and
                         Standard & Poor’s, issue widely accepted credit ratings of different companies.




                         Page 18                                              GAO-03-313 Mandated Interest Rate
Figure 3: Long-Term, High-Quality Corporate Bond and 30-Year Treasury Bond Rates, 1987 to 2002

Interest rate (percent)
11


10


 9


 8


 7


 6


 5




 0
Jan-87      Jan-88      Jan-89      Jan-90     Jan-91      Jan-92      Jan-93    Jan-94    Jan-95    Jan-96   Jan-97   Jan-98    Jan-99   Jan-00   Jan-01   Jan-02

                                                                            Long-term, Aa-rated bonds
                                                                            Long-term, Aaa-rated bonds
                                                                            30-year Treasury bonds
Source: Moody's Investor Services and Federal Reserve Board of Governors.



                                                                Several actuaries and plan sponsor groups have suggested using one or
                                                                more indices for long-term, high-quality corporate bond rates as the basis
                                                                of an interest rate, while others suggest that these indices require
                                                                adjustments before they can be used. Because insurance companies tend
                                                                to invest in long-term corporate debt, these rates may track changes in
                                                                group annuity purchase rates. An industry representative said that an
                                                                unadjusted average of the indices would reflect insurance company
                                                                expenses and other group annuity pricing factors because insurance
                                                                companies typically achieve a higher rate of return on investment than is
                                                                indicated by high-quality corporate bond rates. For example, investing in
                                                                lower-quality bonds and private loans might achieve a higher rate of return
                                                                than investing in high-quality corporate bonds. According to some
                                                                actuaries, however, the indices would need to be adjusted for insurance
                                                                company expenses and other factors before they would reflect the level of
                                                                group annuity purchase rates. For example, a study for the Society of
                                                                Actuaries said that a long-term corporate bond index rate minus 70 basis




                                                                Page 19                                                         GAO-03-313 Mandated Interest Rate
points would reasonably approximate group annuity purchase rates.30
However, the ERISA Industry Committee recommended using an average
of corporate bond indices published by four firms as the interest rate
without such an adjustment. Some actuaries and other pension experts
have suggested that rates on some corporate bond indices might also need
to be adjusted to make allowances for certain options before the rates
would reflect the level of group annuity purchase rates. For example,
corporate bonds are typically “callable,” meaning that the issuer can recall
a bond before its maturity date. Because this creates some uncertainty to
the holder of a corporate bond, this may also increase corporate bond
rates relative to group annuity purchase rates.

Corporate bond indices have properties that make them difficult to
manipulate, but the corporate bond market may not be as liquid and
transparent as the Treasury bond market. While the investment-grade
corporate bond market is very large overall, with over $700 billion in
issuance in 2001 and an estimated $4 trillion in outstanding value as of the
third quarter of 2002, the market is segmented by differences in credit
quality and issuer characteristics and, therefore, is less liquid than a large
unsegmented market such as the market for Treasury securities.
Additionally, interest rates for specific corporate bonds are based on
quotes by traders, who usually estimate the current trading value of a bond
and quote a rate based on its spread versus a comparable Treasury
security. However, information on which to base corporate bond quotes is
expected to become more widely available through a National Association
of Security Dealer’s reporting system, which was launched in July 2002
and reports many large recent transactions. The new system may not
alleviate all transparency concerns. Some financial experts said that
corporate bonds are not as highly traded as other debt securities, which
means that recent trades are often not available to verify current market
conditions and rates.

Certain corporate bond indices also have unique characteristics and
complexities that could affect their suitability as an interest rate.
Corporate bond indices are put together by private financial companies,
which then compute an interest rate for the index based on underlying


30
 The study used the 30-year Bloomberg A3 index of industrial bonds for the analysis. See
Victor Modugno, 30-Year Treasury Rates, 6. According to the American Academy of
Actuaries, the Bloomberg A3 index rate is close to the rate for Moody’s Aa-rated bonds
because it is option adjusted. For example, the rates are adjusted to eliminate the call
provision. See Parks and Gebhardtsbauer, Alternatives, 4.




Page 20                                             GAO-03-313 Mandated Interest Rate
                           interest rates of the component bonds. Financial companies differ in how
                           publicly they share information on which bonds they include in an index,
                           how they weight component interest rates, and other factors and
                           calculations that influence the published rate. Further, the reliability of the
                           corporate indices can be affected by the reliability of the data source—
                           actual transactions, quotes, or estimates of values or yields—on which
                           they are based.


Thirty-Year Rates on GSE   Thirty-year rates on securities issued by GSEs are rates on bonds used to
Securities                 finance home ownership and other public policy goals. GSEs are private
                           corporations, such as Federal National Mortgage Association (also known
                           as Fannie Mae), that have the implicit backing of the U.S. government. In
                           1998, Fannie Mae began issuing debt through its benchmark program,
                           which is intended to be high-quality, noncallable, actively traded debt.
                           Fannie Mae attempts to issue benchmark debt periodically and in large
                           amounts, similar to how Treasury issued 30-year bonds in the past.

                           Several pension experts have suggested using 30-year Fannie Mae bond
                           rates as the basis for the interest rate. Because GSE securities have
                           received a credit rating comparable to, or higher than, the credit rating of
                           the insurance companies that offer group annuities, GSE rates may
                           approximate group annuity purchase rates. GSE-issued debt is generally of
                           the highest credit quality but not considered credit-risk free like Treasury
                           securities. Therefore, GSE rates would typically be expected to fall
                           between Treasury rates and high-quality corporate rates of comparable
                           maturity.

                           Fannie Mae benchmark 30-year bond rates have properties that indicate a
                           low likelihood that interested parties could manipulate them, but the
                           securities have a relatively small market and relatively low trading activity
                           compared with the Treasury and corporate bond markets. Outstanding
                           volume of 30-year Fannie Mae benchmark debt was $14.9 billion as of
                           December 2002, which was significantly less than the $589 billion in
                           outstanding Treasury bonds as of November 30, 2002, and $4 trillion in
                           outstanding long-term corporate bonds. According to Federal Reserve data
                           of market transactions by primary dealers, trading in long-term GSE debt,
                           which includes securities besides Fannie Mae benchmark debt, has been
                           approximately $1.1 billion per day in 2002, which is much less than long-
                           term Treasury securities. According to some experts, GSE debt is
                           expected to continue to grow. With regard to transparency, Fannie Mae
                           has also recently increased the availability of information on trades



                           Page 21                                       GAO-03-313 Mandated Interest Rate
                            underlying the rates on its securities, which should increase rate
                            transparency.


Thirty-Year Interest Rate   Thirty-year interest rate swap rates are fixed rates in a contract between
Swaps Rate                  two parties, one of whom agrees to make fixed interest payments based on
                            a specified amount of money in exchange for interest payments based on
                            variable short-term rates on the same specified amount of money for the
                            duration of the contract. For example, one party might agree to pay a
                            5 percent annual fixed rate on $1 million every year for the next 30 years in
                            exchange for receiving a published 3-month interest rate that changes
                            periodically for the next 30 years on the same $1 million. The 30-year swap
                            rate in this case would equal 5 percent, and the predominant 30-year swap
                            rate should move up and down with the expected level of short-term
                            interest rates over the next 30 years. The “notional” amount of money
                            ($1 million in the example) does not typically change hands between the
                            counter parties in a swaps contract, and unlike most other fixed-income
                            markets, interest-rate swaps do not involve the issuance of debt. By
                            entering into a swap contract, the party that agreed to make fixed interest
                            rate payments can help offset potential risk from variable-rate debt that it
                            issues by making fixed interest payments in exchange for variable-rate
                            payments. The variable-rate payments that it receives under the agreement
                            can then be used to pay its debt holders. If interest rates go up, the debt
                            issuer pays higher debt service payments but also receives higher interest
                            payments from the swap agreement.

                            Several pension experts have considered using 30-year interest rate swap
                            rates as the basis for current liability and lump-sum calculations. Interest-
                            rate swaps contracts are generally perceived to contain low credit risk for
                            two reasons. First, the two parties involved in the contract typically have
                            high credit ratings. Second, swap contracts typically use the London
                            Interbank Offer Rate (LIBOR) as the floating rate, and the LIBOR has a low
                            credit risk. The overall credit quality underlying LIBOR-based, interest-rate
                            swap rates is likely comparable to that of high-quality corporate bonds.
                            However, unlike some corporate bonds, swaps are not callable, so their
                            rates would not need to be adjusted for such options and typically would
                            be expected to fall below those on high-quality corporate bonds of similar
                            maturity. The credit rating of insurance companies in the group annuity
                            market is generally Aa or better. Interest rate swaps might give an
                            accurate indication of an insurance company’s cost of borrowing funds.

                            The interest rate swap market has characteristics that likely protect rates
                            from potential manipulation. The swap market is considered to be very


                            Page 22                                      GAO-03-313 Mandated Interest Rate
                     active, although the trading volume and amount outstanding for longer
                     maturity interest rate swaps are believed to be low, relative to shorter
                     maturities. The Federal Reserve Board publishes 30-year interest rate
                     swap rates daily based on a private survey of quotes on new contracts
                     offered by 16 large swaps dealers, and quotes on swaps contracts are
                     updated throughout the day and visible via subscription services. A unique
                     advantage of using swaps as an interest rate is that swaps do not require
                     the issuance of debt; rather, swap rates reflect contracts between two
                     parties. Because new contracts are produced every day, it is easier to
                     update 30-year swap rates than other rates involving the issuing of debt,
                     which happens only periodically. The international swaps market
                     represents the largest of the alternatives considered, with an outstanding
                     dollar-denominated value of swaps contracts estimated at approximately
                     $20 trillion, with many new transactions conducted between parties every
                     day. However, some experts have expressed concern about using the
                     30-year interest rate swaps because the swaps market is relatively new and
                     the outstanding trading volume of 30-year interest rate swaps is believed
                     to be much lower than for shorter maturity contracts.


PBGC Interest Rate   Of all the alternative rates, PBGC’s interest rate factors have the most
Factors              direct connection to group annuity purchase rates. Figure 4 shows that the
                     proximity of PBGC interest rate factors to 30-year Treasury bond rates
                     varied from 1987 through 2002.




                     Page 23                                    GAO-03-313 Mandated Interest Rate
Figure 4: PBGC Interest Rate Factors and 30-Year Treasury Bond Rates, 1987 to 2002

Interest rate (percent)
10


 9


 8


 7


 6


 5




 0
Jan-87      Jan-88     Jan-89     Jan-90     Jan-91    Jan-92   Jan-93    Jan-94    Jan-95   Jan-96   Jan-97    Jan-98    Jan-99   Jan-00   Jan-01    Jan-02

                                                                    PBGC factors
                                                                    30-year Treasury yield
Source: PBGC and Federal Reserve Board of Governors.

                                                          Note: PBGC interest rate factors have been set back 2 months because published rates reflect
                                                          interest rates approximately 2 months earlier. Additionally, PBGC factors from 1987 to 1993 were
                                                          adjusted by PBGC to reflect the same mortality table that was used to determine the factors after
                                                          1993. Also, PBGC publishes two factors, one for the first 20 years to 25 years of a valuation period,
                                                          and another for the remaining years. The figure shows factors for the first part of the valuation period.


                                                          PBGC interest rate factors are based on surveys of insurance companies
                                                          conducted by the American Council of Life Insurers (ACLI) for PBGC and
                                                          IRS.31 The survey asks insurers to provide the net annuity price for annuity
                                                          contracts for plan terminations. PBGC develops interest rate factors,
                                                          similar to interest rates, from the survey results, which are adjusted to the
                                                          end of the year using an average of the Moody’s Corporate Bond Indices
                                                          for Aa and A-rated corporate bonds for the last 5 trading days of the
                                                          month. The adjusted interest rate factors are published in mid-December
                                                          for use in January. The interest rate factors are then further adjusted each
                                                          subsequent month of the year on the basis of the average of the Moody’s
                                                          bond indices. According to PBGC, the interest rate factors, when used




                                                          31
                                                           ACLI conducts four surveys annually. PBGC interest rate factors are based on an average
                                                          of the surveys conducted in June and September.




                                                          Page 24                                                        GAO-03-313 Mandated Interest Rate
along with the mortality table specified in PBGC regulations,32 reflect the
rate at which pension sponsors could have settled their liabilities, not
including administrative expenses, in the market for single-premium
nonparticipating group annuities issued by private insurers. Although
PBGC interest rate factors do not consider the insurers’ administrative
expenses, a May 2000 American Academy of Actuaries study of the PBGC
interest rate factors found that they overstated termination liability by a
relatively small amount, averaging 3 percent to 4 percent.33 The study
characterized PBGC factors as mildly conservative.

Despite its seeming desirability as a statutory rate because of its direct
connection to group annuity purchase rates, PBGC’s interest rate factors
may be more vulnerable to manipulation than other alternatives because
they are not based on interest rates determined by the credit market and
are less transparent. The identity of insurance companies surveyed and
included in PBGC factors is not known, raising ambiguity about the extent
to which the PBGC interest rate factors reflect the current broad market
for group annuities. Additionally, PBGC calculations are not reported or
independently reviewed. However, an insurance company representative
said that insurance companies participating in the survey would likely
agree to have that participation reported, and a PBGC official said that
PBGC would not object to an independent review of its methodology for
developing the interest rates.




32
  29 C.F.R. 4044.53 specifies the use of the 1983 Group Annuity Mortality Table for PBGC
valuations of current liability, which under current rules is the same table specified by the
IRS for current liability calculations. However, IRS has initiated the process to change the
table. See IRS Announcement 2000-7, which was published February 7, 2000. An IRS
actuary said that the effort is still in process with no estimated completion date. According
to PBGC, changing the mortality table on which the factors are based would alter them. An
official said, for example, that basing the factors on the mortality table that PBGC used in
preparing its 2002 financial report would change them by 60 basis points.
33
  Marilyn M. Oliver and Gregory S. Schlappich, PBGC Plan Termination Cost Study,
American Academy of Actuaries, May 4, 2000.The study examined actual plan terminations,
which mostly occurred between 1994 and 1997. Available data did not cover very large plan
terminations and the study cautioned that no conclusions should be drawn with respect to
them.




Page 25                                               GAO-03-313 Mandated Interest Rate
                         If the alternative results immediately in a higher allowable interest rate,
Alternatives Likely to   which is likely for the alternatives we reviewed, using the higher rate
Decrease Lump-Sum        would generally decrease minimum allowable lump-sum amounts34 and
                         increase the number of participants whose benefit could potentially be
Payments, Employer       distributed as a lump sum without their consent, decrease minimum and
Contributions, and       maximum employer contributions, and decrease PBGC revenue. The
                         present value of a participant's benefit and related contribution and
PBGC Revenue             premium requirements would decrease because a higher interest rate
                         increases the value of today’s dollars, relative to future dollars, and
                         therefore fewer of today’s dollars should be needed to pay benefits in the
                         future. However, if the alternative produces a lower interest rate, plan
                         participants would receive larger lump sums, employers would need to
                         increase contributions to their plans, and PBGC may experience an
                         increase in revenue.

                         The magnitude of these effects on lump sums, plan funding, and PBGC
                         premiums would depend on the characteristics of the plan and its
                         participants and how the rate is specified in the law. Additionally, if the
                         Congress specifies the interest rate differently for current liability and
                         lump-sum calculations, as is currently the case, the magnitude of the
                         impact on each could differ. Furthermore, the effect on current liability
                         and lump-sum calculations could be phased in over a period of time. In
                         1994, for example, the law phased in the reduction in the upper limit on
                         interest rates for current liability calculations from 110 percent to
                         105 percent over a 5-year period. Additionally, requiring the use of an
                         updated mortality table for current liability calculations might partially
                         offset the effect that a higher interest rate would have on current liability
                         calculations.35

                         During the period from January 1994 to July 2002, the monthly long-term
                         corporate bond rates, GSE rates, and 30-year interest rate swap rates, were
                         generally greater than the 30-year Treasury bond rate; the PBGC estimated
                         rate was below the 30-year Treasury bond rate in the mid-1990s but was
                         higher than the 30-year Treasury bond rate after 1998. As shown in figure


                         34
                          A change to a higher statutory interest rate would not decrease minimum lump-sum
                         amounts for participants in plans that use an interest rate below the rate on 30-year
                         Treasury bonds for calculating lump-sum amounts.
                         35
                           More recent mortality tables take into consideration increased expected longevity due to
                         advances in medical diagnostics and treatment and therefore have the effect of increasing
                         current liability valuations because the valuation will have to be made with the assumption
                         that the promised monthly benefit will be paid over a longer period of time.




                         Page 26                                               GAO-03-313 Mandated Interest Rate
                                                                5, each rate’s relationship to the 30-year Treasury rate has changed over
                                                                time.

Figure 5: Thirty-Year Treasury Bond Rates and Proposed Alternative Interest Rates, 1994 to 2002

Interest rate (percent)
10


 9


 8


 7


 6


 5




 0
 Jan-94               Jan-95               Jan-96               Jan-97              Jan-98               Jan-99               Jan-00              Jan-01     Jan-02

                                                                           Long-term Aa corporate bonds
                                                                           30-year FannieMae bonds
                                                                           PBGC factor
                                                                           30-year interest rate swaps
                                                                           30-year Treasury bonds
Source: PBGC, Federal Reserve Board of Governors, Moody's Investors Service, Federal National Mortgage Association (Fannie Mae), and Bloomberg.




Use of Higher Interest                                          Figure 6 shows that the effect of a change in the interest rate used to
Rates Would Decrease                                            calculate lump sums is greater for participants further away from
Lump-Sum Amounts                                                retirement than for participants near retirement. The figure shows, for
                                                                example, that a 1-percentage point increase in the interest rate from
                                                                5 percent to 6 percent would result in an 8 percent decrease in the lump
                                                                sums of participants expected to retire almost immediately. On the other
                                                                hand, that same 1-percentage point increase in the interest rate would
                                                                result in a 36 percent decrease in the lump sums of participants expected
                                                                to retire in 40 years.




                                                                Page 27                                                                    GAO-03-313 Mandated Interest Rate
Figure 6: Percent Change in Lump Sums for Participants Retiring in 40 Years or
Less for an Interest Rate Increase from 5 Percent to 6 Percent

Percent change in lump sum
  0


 -5


-10


-15


-20


-25


-30


-35


-40
      0             5             10     15    20        25         30         35        40
      Number of years until retirement
Source: American Academy of Actuaries.

Note: GAO and American Academy of Actuaries analysis using the 1994 Group Annuity Reserving
table mortality data.


Reducing the dollar amount of each lump-sum distribution by using a
higher interest rate may affect the number of employers that offer a lump-
sum distribution and the number of participants electing to take a lump-
sum distribution. Many employers already offer a lump-sum provision in
their plans; however, if the rate used to calculate lump-sum distribution
amounts were to increase, reducing the amount of each distribution, more
employers may adopt lump-sum provisions in their plans in order to
reduce costs. However, fewer participants might elect a lump-sum
distribution if the value of such payments were to decline relative to the
participant’s annuity benefit.

Reducing the calculated present value of each participant’s benefit would
also increase the number of participants whose benefit may be distributed
by the plan as a lump sum without their consent. An increase in the
assumed interest rate would cause the present values of some benefits,
which are currently above the $5,000 limit for nondiscretionary
distribution as a lump sum, to be reduced to the point that they fall below
that limit.



Page 28                                                GAO-03-313 Mandated Interest Rate
Use of Higher Interest   Because a higher interest rate would make plans appear better funded
Rates May Decrease       relative to current liabilities than they were before, employer
Employer Contributions   contributions and PBGC revenue may decrease. For each 1-percentage
                         point change in the interest rate, estimated current liabilities of a pension
and PBGC Revenue         plan would change by 12 percent to 15 percent.36 Such a change may lower
                         or eliminate the minimum employer contribution, referred to as the deficit
                         reduction contribution, required by the IRC.37 Therefore, plans with a
                         typical distribution of participants would see their liabilities reduced by
                         12 percent to 15 percent from a 1-percentage point increase in the interest
                         rate. Figure 7 shows plans that were 80 percent funded would become
                         more than 90 percent funded and would no longer have to make a deficit
                         reduction contribution.




                         36
                          This assumes a typical distribution of participants by age and other relevant factors, such
                         as number of years until retirement and years of service. See Parks and Gebhardtsbauer,
                         Alternatives, 6. The magnitude of an increase or decrease in plan liabilities associated with
                         a given change in discount rates would depend on the demographic and other
                         characteristics of each plan. Essentially, the percentage change in liabilities, for a given
                         change in the discount rate, would be greater for plans and plan participants with a
                         majority of their benefit payments in the distant future (younger participants far from
                         retirement) than for those plans with a majority of their payments in the near term (older
                         participants close to or already in retirement).
                         37
                           The IRC requires that plans with a funded percentage below 90 percent be subject to the
                         deficit reduction contribution. However, plans that are between 80 percent and 90 percent
                         funded are exempted from the deficit reduction contribution as long as the funded
                         percentage in 2 consecutive years out of the prior 3 years were at or above 90 percent.




                         Page 29                                                GAO-03-313 Mandated Interest Rate
Figure 7: Effect of a 1-Percentage Point Increase in the Interest Rate on the Funded
Percentage of a Hypothetical Plan with a Typical Participant Distribution

Funded percentage
100
                         90.9
 90
           80.0
 80

 70

 60

 50

 40

 30

 20

 10

     0
            5               6      C         D            E           F           G            H
         Interest rate (percent)
Source: GAO calculations.


Note: At 90-percent funded and above for current liability, the plan is not subject to the deficit
reduction contribution, which is the portion of the minimum funding requirements that uses the
30-year Treasury rate. A 12-percent reduction in liabilities, resulting in a 10.9-percent increase in the
funded percentage is assumed for illustrative purposes.


A higher interest rate would also decrease allowable employer
contributions for plans at the full funding limit. The IRC imposes full
funding limitations that limit tax-deductible contributions under certain
circumstances in order to prevent employers from contributing more to
their plan than is necessary to cover promised future benefits. The full
funding limitations established in 1987 and 1994, also known respectively
as the 150-percent current liability limitation38 and the 90-percent current
liability limitation, are required to be computed using the 30-year Treasury
rate. If the rate with which they are required to be computed were to
increase, more plans would be subject to the full funding limitation and,
therefore, fewer would be allowed to make additional contributions.



38
 The current liability full-funding limit established in 1987 was originally 150 percent of
current liability but started being phased out in 1999. It will be repealed for plan years
beginning in 2004 and thereafter.




Page 30                                                       GAO-03-313 Mandated Interest Rate
              Employer premium payments to PBGC would decrease with the use of a
              higher interest rate because their plans’ current liabilities would become
              better funded. Generally, ERISA requires plans with assets that are less
              than the value of their accrued vested benefits to pay an additional
              premium, termed the variable-rate premium.39 Assuming an increase in the
              interest rate, some plans would no longer be subject to the variable-rate
              premium because the reduction in their current liabilities would cause
              them to reach the full funding limit and therefore become exempt from the
              payment. Plans still subject to the variable-rate premium would pay less
              because their current liabilities would become better funded.


              The choice of an interest rate has important implications for federal
Conclusions   revenue, employer cash flow, and participant retirement income. A single
              percentage point increase in the interest rate would reduce a typical
              pension plan’s current liabilities by 12 percent to 15 percent, depending on
              participant demographics. Rules for using current liability calculations to
              determine minimum contributions, full funding limits, and PBGC
              premiums are extremely complex. However, in general, with an increase in
              the interest rate, some under-funded plans would become adequately
              funded, some plans would reach full funding limits, and additional plans
              would avoid variable-rate premiums. Additionally, the minimum allowable
              value of the lump-sum equivalent of a participant’s annuity benefit would
              decline. The magnitude of the decline would depend on the participant’s
              age and proximity to the plan’s normal retirement age.

              Each alternative has characteristics that may make it more or less
              appropriate as an interest rate. To the extent that policymakers continue
              to want the interest rate tied to group annuity purchase rates, the PBGC
              interest rate factors have the most direct connection to the group annuity
              market. Other than the survey conducted for PBGC, no mechanism exists
              to collect information on actual group annuity purchase rates. Although
              the PBGC interest rate factors may track group annuity purchase rates


              39
                Variable-rate premiums are calculated on the basis of a plan’s unfunded current liabilities,
              taking into account only vested benefits discounted using 100 percent of the 30-year
              Treasury rate for the month preceding the beginning of the premium payment year. Under
              the Job Creation and Worker Assistance Act of 2002, the percentage of the 30-year Treasury
              rate for variable-rate premium calculation purposes was temporarily increased from
              85 percent to 100 percent for plan years beginning in 2002 and 2003. In 2004, under current
              law, it will revert to its former 85 percent of the 30-year Treasury rate until such time as the
              Secretary of the Treasury specifies a new mortality table for calculating current liabilities
              at which time it is scheduled to go back up to 100 percent of the 30-year rate.




              Page 31                                                 GAO-03-313 Mandated Interest Rate
                more closely than other rates do, the PBGC interest rate factors are less
                transparent than market-determined alternatives. Long-term market rates,
                such as corporate bond indices, may track changes in group annuity rates
                over time, but they are less directly connected to group annuity rates and
                their proximity to group annuity rates is uncertain. In addition, an interest
                rate based on some long-term market rates, such as corporate bond
                indices, may need to be adjusted downward to better reflect the level of
                group annuity purchase rates.

                Finally, the suitability of any interest rate used is likely to change over
                time and, unless some entity is given the responsibility for monitoring its
                relationship to group annuity purchase rates, the Congress and pension
                plans regulatory agencies will have difficulty determining when changes
                are needed. The Congress has made several ad hoc adjustments to the
                mandatory interest rate for pension calculations and can continue to make
                changes to the rate through the legislative process. Given the significant
                technical issues associated with such decisions as well as the time it takes
                to enact such a legislative change, the Congress could decide to delegate
                this authority to the executive branch and establish a process to monitor
                the mandatory rate. This would provide an opportunity for needed
                adjustments to the rate to occur in a timelier manner. We are offering
                suggestions to the Congress on a possible process for adjusting the
                mandatory rate as well as a way to periodically monitor the rate over time.


                To improve the timeliness of adjustments to the mandatory interest rate
Matters for     for pension calculations, the Congress should consider establishing a
Congressional   process for regulatory adjustments of the rate. The Congress should
                consider providing the cognizant regulatory agencies—Labor, Treasury,
Consideration   and PBGC—the authority under ERISA to jointly adjust the rate within
                certain boundaries as specified under the law.

                This could be done by the Congress establishing an interagency committee
                to adjust, with the input of key stakeholders, including plan sponsors,
                labor unions, actuaries and others, the mandatory interest rate. This could
                be a transparent process consistent with the Administrative Procedures
                Act. Under this option, the Congress could either require that the
                Committee’s adjustments to the mandated interest rate obtain
                congressional approval and be enacted into law or it could provide for
                congressional review and disapproval. The disapproval role could be
                similar to the role the Congress provides for itself under the Congressional
                Review Act. Under the act, federal regulations are held for 60 days to give
                the Congress the opportunity to pass a resolution of disapproval. This


                Page 32                                      GAO-03-313 Mandated Interest Rate
                  process provides the advantages of allowing for more timely adjustments
                  to the interest rate if needed and providing the Congress with the
                  opportunity to intervene if it so chooses without requiring direct
                  congressional involvement for the adjustments to take effect.

                  Whether the Congress decides to maintain its current role in setting and
                  adjusting the mandatory interest rate or delegates this authority to the
                  executive branch, it should consider establishing a process to better
                  monitor changes to the rate in relation to group annuity purchase rates. If
                  the Congress selects one of the market-based rates as the new mandatory
                  rate, it should consider amending ERISA to require the cognizant
                  regulatory agencies to (1) periodically evaluate the relationship between
                  the rate and the group annuity purchase rates and report to the Congress
                  and (2) provide comments about how any changes to the mandated
                  interest rate they would recommend would likely affect federal revenue,
                  employer pension contributions, plan funding levels, and participants’
                  lump-sum benefits. This would provide the Congress and the regulatory
                  agencies an opportunity to respond in a timely manner to changes that
                  might affect the relationship between the market-based rate and the group
                  annuity purchase rate.

                  Alternatively, if the Congress decides to select the PBGC interest rate
                  factors as the mandatory interest rate, it should consider requiring an
                  independent review to validate PBGC’s methodology and calculations for
                  developing the factors and require PBGC to publish its methodology, both
                  before they are selected as the mandated interest rate and periodically
                  thereafter.


                  We provided a draft of this report to Labor, Treasury, and PBGC. The
Agency Comments   agencies jointly provided written comments, which appear in appendix III.
                  They generally agreed with our findings and conclusions and noted that
                  our report will help interested parties better evaluate possible alternatives
                  to the 30-year Treasury rate. They also provided technical comments,
                  which we incorporated as appropriate.


                  We are sending copies of this report to the Secretary of Labor, the
                  Secretary of the Treasury, the Secretary of Commerce, and the Executive
                  Director of the Pension Benefit Guaranty Corporation, appropriate
                  congressional committees, and other interested parties. We will also make
                  copies available to others on request. In addition, the report will be
                  available at no charge on GAO’s Web site at http://www.gao.gov.


                  Page 33                                      GAO-03-313 Mandated Interest Rate
If you have any questions concerning this report, please contact me at
(202) 512-7215 or George A. Scott at (202) 512-5932. Other major
contributors include Daniel F. Alspaugh, Joseph Applebaum,
Kenneth J. Bombara, Mark M. Glickman, Michael P. Morris,
Corinna Nicolaou, John M. Schaefer, and Roger J. Thomas.




Barbara D. Bovbjerg
Director, Education, Workforce
 and Income Security Issues




Page 34                                     GAO-03-313 Mandated Interest Rate
             Appendix I: Scope and Methodology
Appendix I: Scope and Methodology


             To determine the characteristics of a suitable interest rate, we reviewed
             pension laws and their legislative history with respect to the calculation of
             current liability and lump-sum amounts. We also interviewed officials at
             the Pension Benefit Guaranty Corporation (PBGC) and other
             policymakers who played a role in assessing alternative interest rates. We
             obtained information about group annuity pricing, and the availability of
             information about group annuity purchase rates, from representatives of
             the American Academy of Actuaries, the American Council of Life
             Insurers, the National Association of Insurance Commissioners, and
             insurance companies.

             To identify and examine the advantages and disadvantages of potential
             alternative interest rates, we interviewed representatives and reviewed
             documents from a number of government, pension plan sponsor, and
             investment entities, including PBGC, the Department of the Treasury, and
             Department of Labor. We also compared rates and other market statistics
             for suggested alternative debt securities with rates for 30-year Treasury
             bonds from 1987 to 2002. We discussed transparency, rate construction,
             and liquidity issues for the alternatives with economists at the Department
             of the Treasury and the Federal Reserve and with financial experts at the
             Bond Market Association, Federal National Mortgage Association, and
             pension plan consultants.

             To determine how alternative rates might affect employers, plan
             participants, and PBGC, we created hypothetical examples in which we
             tested the effect of changes in rate levels on current liabilities and lump-
             sum payments. We designed the hypothetical examples based on
             discussions with several actuaries and pension consultants, including
             PBGC and the American Society of Pension Actuaries. Additionally, in
             order to better understand the possible effects of a rate change on
             employers and plan participants, we spoke with several organizations that
             represent their interests. In order to better understand the implications of
             a change in the interest rate on PBGC, we spoke with PBGC, Department
             of Labor, Internal Revenue Service, and the Department of the Treasury.




             Page 35                                      GAO-03-313 Mandated Interest Rate
                     Appendix II: Group Annuity Purchase Rate
Appendix II: Group Annuity Purchase Rate
                     Would Be Affected by Cash Flow Projection
                     and Yield Curve at Termination


Would Be Affected by Cash Flow Projection
and Yield Curve at Termination
                     Group annuity purchase rates would vary among plans depending on the
                     pattern of each plan's projected cash flows over time and the yield curve
                     at the time the plan is terminated.


                     Figure 8 shows the projected cash flow over a 40-year period for a sample
Cash Flows Vary by   plan at termination. The figure shows that, in the early years, payments to
Plan                 inactive participants of the sample plan, primarily current retirees,
                     constitute a majority of total cash flow. In later years, however, payments
                     to active participants make up the majority of total cash flow as current
                     employees retire.

                     Figure 8: Projected Cash Flow for Sample Defined Benefit Plan for the First 40
                     Years after Plan Termination

                     Cash flow (dollars in millions)
                     4.0


                     3.5


                     3.0


                     2.5


                     2.0


                     1.5


                     1.0


                     0.5


                     0.0
                           1           5            9            13           17           21           25           29        33   37
                           Number of years

                                      Inactive participants
                                      Active participants
                                      Total annual benefits
                     Sources: Victor J. Modugno, ‘Terminal Funding’, Transactions of the Society of Actuaries, 1986 Vol. 38.

                     Note: Inactive participants are primarily current retirees, but also includes some terminated-vested
                     participants.


                     All else being equal, the projected cash flows of plans with a larger
                     percentage of retirees at termination than the sample plan would be more
                     heavily weighted toward the early years, and the cash flows of plans with a
                     larger percentage of active participants at termination would be more
                     heavily weighted toward the later years.


                     Page 36                                                                        GAO-03-313 Mandated Interest Rate
                       Appendix II: Group Annuity Purchase Rate
                       Would Be Affected by Cash Flow Projection
                       and Yield Curve at Termination




                       Surveys of insurance company group annuity pricing practices performed
Group Annuity          as part of two studies for the Society of Actuaries indicate that insurance
Purchase Rates Would   companies use different methods to price group annuity products.1 In
                       general, these methods may be described with respect to yield curves,
Vary with the Yield    which may be constructed for various types of securities, including
Curve                  Treasury securities, corporate bonds, and mortgages. Figure 9 shows, for
                       example, two of the better know yield curves, the yield curves for on-the-
                       run Treasury securities and zero-coupon Treasury securities, as of
                       February 6, 2003.2 The yield for on-the-run securities reflects interest rates
                       for securities that make semiannual interest payments before they mature,
                       followed by a final payment of interest and principal at maturity. The yield
                       for zero-coupon securities reflects interest rates, called spot rates, for
                       securities that make a single payment at maturity.




                       1
                       Modugno, 30-Year Treasury Rates, 4-7. Ryan Labs, Inc., 30-Year Treasury Rates, 37-38.
                       2
                        On-the-run securities are the most recently issued government securities at each maturity
                       point.




                       Page 37                                              GAO-03-313 Mandated Interest Rate
Appendix II: Group Annuity Purchase Rate
Would Be Affected by Cash Flow Projection
and Yield Curve at Termination




Figure 9: Yield Curves for On-the-Run and Zero-Coupon Treasury Securities as of
February 6, 2003

Percentage yield
6



5



4



3



2



1



0
    0.5             5.0               9.5     14.0           18.5           23.0           27.5
     Term to maturity (in years)

              Zero-coupon securities
              On-the-run coupon securities
Source: Department of the Treasury.


Note: Treasury constructed the curve for zero-coupon securities, often referred to as Separate
Trading of Registered Interest and Principal of Securities (STRIPS), from the yield on on-the-run
securities. According to a Treasury official, spot rates constructed from the yield for on-the-run
securities may differ from actual market rates on STRIPS.


In figure 9, interest rates for the on-the-run securities that make coupon
payments are lower than rates for zero-coupon securities, at the same
maturity. This reflects the fact that coupon yields are a blend of zero-
coupon spot rates, and the term structure of spot rates on February 6,
2003, was upward sloping.3

To determine the present value of plan cash flows using a zero-coupon
yield curve, the spot rates at various maturities may be used as the interest
rates for calculating the present value of cash flows at the corresponding




3
 Bruce Tuckman, Fixed Income Securities: Tools for Today's Market, John Wiley & Sons,
Inc., (New York, 1995).




Page 38                                                      GAO-03-313 Mandated Interest Rate
Appendix II: Group Annuity Purchase Rate
Would Be Affected by Cash Flow Projection
and Yield Curve at Termination




points in time.4 For example, the spot rate at a 10-year maturity might be
used to calculate the present value of a cash flow at 10 years because the
timing of the single payment from the security would match the timing of
the cash flow by the plan.

In using a yield curve based on securities that make payments prior to
maturity, maturity is inadequate for deciding which interest rate should be
used to calculate the present value of a given cash flow because the
security's interim interest payments must be considered. In these cases, a
concept called “duration” may be used to select a single interest rate for all
cash flows in the present value calculation. Duration measures the
average time that it takes for a security to make all interest and principal
payments, or a pension plan to make all benefit payments, with the time
until each payment weighted by its present value as a percentage of the
total present value of all payments. The total present value of a security's
payments is its market price and the total present value of a plan's benefit
payments is its current liabilities. An interest rate is selected for plan
present value calculations from the yield curve that results in the same
duration for the security and plan's cash flow.

Duration is a measure of the sensitivity of a security's price, a lump sum,
or a pension plan's current liability to changes in the interest rates used to
calculate them. For example, actuaries estimate that the duration of the
liabilities for pension plans with a “typical” distribution of participants is
between 12 years and 15 years.5 Durations of 12 years and 15 years
indicate that a 1-percentage point increase in the interest rate used to




4
 Spot rates may need to be converted from semiannual compounded rates, the convention
used in U.S. fixed-income markets, to annual rates, the convention used by actuaries to
specify interest rates for employee benefit plan liabilities.
5
Treasury officials believe that the maturity structure of many large plans is shorter than
what has been described by other actuaries as typical, and that, moreover, for all plans, the
maturity structure has become shorter over the last two decades.




Page 39                                                GAO-03-313 Mandated Interest Rate
Appendix II: Group Annuity Purchase Rate
Would Be Affected by Cash Flow Projection
and Yield Curve at Termination




calculate a plan's liabilities would decrease those liabilities by roughly
12 percent and 15 percent, respectively. In February 2003, the duration of
the 30-year Treasury bond issued in February 2001 was about 15 years.




Page 40                                     GAO-03-313 Mandated Interest Rate
              Appendix III: Comments from the Department
Appendix III: Comments from the
              of Treasury



Department of Treasury




(130140)
              Page 41                                      GAO-03-313 Mandated Interest Rate
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