Interest Rates and Pension

Interest Rates and Pension Plans The strength of private retirement plans must be maintained in the upcoming years due to the increasing number of Baby Boomers who will be retiring in the United States. Many retired Americans rely on private pensions and employer-sponsored retirement savings as a secondary source of income in addition to Social Security (Brinner 131). In addition, because the human life expectancy has increased dramatically over recent years, it is very important that policymakers encourage the growth of employer-sponsored retirement plans (Hungerford et al. 13).

Defined benefit plans are employer-provided retirement plans that provide a guaranteed retirement income (Blomquist and Wijkander 32). The employer typically assumes all of the investment risk and the benefits are guaranteed by the Pension Benefit Guaranty Corporation. In the United States alone, there are approximately 50,000 defined benefit plans that cover about 23 million workers (Hungerford et al. 16) History of Discount Rates Over the years, Congress has adjusted the appropriate discount rate in order to address specific problems as they arose.

From 1987 to 2002, the law required that defined benefit pension plans use a weighted 4-year average of the returns of the 30-year U.S. Treasury bond rate as their discount rate for determining funding adequacy. Under the 1987 law, plans were allowed to use any number between 90-110% of that rate. The spread between 90-110% was intended to allow the pension plan a slight amount of flexibility in its calculations. In 1994, Congress narrowed this range to 90-105% of that weighted average.

This discount rate is also used to determine lump-sum benefits for workers who want a one-time payment instead of a monthly check (Hungerford et al. 20). On April 9, 2004 Congress passed the Pension Funding Equity Act of 2004, and the President signed it into law on April 10, 2004. This Act replaces the 30-year Treasury bond interest rate assumption with a composite of long-term corporate bond rates for the years 2004 and 2005.

The replacement of the 30-year Treasury rate for the determination of pension liabilities and other calculations is an issue of great importance for sponsors of defined benefit plans. On October 31, 2001, following a three-year program of buying back 30-year bonds, the Treasury Department announced that it would stop issuing the bonds. Shortly after, the Job Creation and Worker Assistance Act of 2002 increased the range of permissible interest rates for determining contributions and premiums for under-funded pension plans to 120% of the current 30-year Treasury rate.

However, the Job Creation and Worker Assistance Act expired on December 31, 2003. The U.S. Chamber of Commerce assumes that a composite corporate bond rate is the appropriate replacement for the 30-year Treasury rate because it is a realistic interest rate assumption that reflects both the long-term rates actually earned by pension plans and the annuity rates charged to terminating pension plans. The Chamber is currently working towards legislation that will permanently replace the 30-year Treasury bond interest rate assumption with a composite corporate bond rate.

Some corporations have proposed that Congress substitute a longer-term corporate bond rate for the 30-year Treasury rate. Since corporate bonds do not have the full faith and credit of the United States behind them, they have higher interest rates. Using those higher interest rates would sharply reduce the amount of money that a pension plan must have on hand to avoid being underfunded while still protecting the funding status of the plan. The funding of a defined benefit pension plan is measured using a discount rate.

A plan is assumed to be fully-funded if the current assets are expected to grow at a certain interest rate until the resulting level of assets equals the total amount of pension payments that the plan promises in the future. For example, if a fund will owe $1,000 in 30 years and assumes that its assets will earn an average of 5% per year after inflation, it must have $231 today in order to be fully funded. In other words, invested at a 5% interest rate, $231 will grow to $1,000 in 30 years.

The discount interest rate used to measure a plan's funding is important. If a plan assumes that assets will grow at a rate of 7% per year instead of 5%, only $131 is needed today to be considered fully funded vs. The $231 it would need if it used a 5% rate. On the other hand, if a plan uses a discount rate of only 3%, then $412 must be on hand today to be considered fully-funded. The discount rate has no direct relationship to the earnings of a pension plan's investments.

Although the law requires that plans make prudent investments, these investments may change over time and are strongly affected by short-term swings in.