Interest & Rate Standards
Pension valuators use either the GATT or PBGC interest rates. There are arguments for either. The GATT rate is based on the 30 Treasury bond interest rate, and has been the interest specified in IRC code for pension plans until recently. This interest rate was used both for calculation of pension plan liabilities and also for minimum present value calculation of lump sums payable to individuals.
The PBGC interest rate is based upon a survey of interest rates used by private insurance companies in pricing annuities. When an insurance company prices a single premium deferred annuity, company actuaries present value the annuity using a standard mortality table and prevailing interest rates. The PBGC interest rate is based upon a survey of these interest rates across a number of insurance companies.
Since the purpose of calculating a present value of a pension in a divorce case is to asses the market value of the pension (what it is worth), the PBGC interest rate is reasonable. However, the pension in divorce valuator is working with a pension offered by a plan, not an annuity offered by a life insurance company. In the rare case where the pension is paid out as a lump sum, the plan must use an interest rate no greater than that specified in Section 417(e)(3) of the IRC code, not the PBGC rate. Thus, there is also a rationale for using the rate specified in the IRC code.
As seen in the graph below, note that there is no mathematical bias between the GATT and the PBGC interest rate. Bias, in the mathematical sense, means that one rate is consistently lower or higher than the other. They have crossed at several points, and are currently very close.
Interest Rate (In Percent)
However, Congress has recently passed legislation making the IRC interest rate significantly lower than the PBGC interest rate, introducing a mathematical bias.
The rationale for this has been to create relief for private pension plans, many of which have had severe funding problems over the last few years. As can be seen by reviewing the Pension Tutorial on the PAC website, the higher the interest rate, the lower the present value of the pension. Thus, Congress has moved to using an interest rate in the IRC code based on the blended yield of corporate bonds with maturities of 20 years or greater. Since corporate bonds have a higher risk than Government bonds, the yield (interest rate) is higher. Thus, moving to the new interest rate will lower the pension plans Current Liability, which in turn reduces the plans contribution requirements.
The Current Liability of a plan is essentially the plans currently accrued obligation to the existing participants. However, for calculating an individuals cash out in the case where the terminated employee is paid out in a lump sum, the rate specified under IRC 417(e)(3) will not be changed, for 2004 and 2005. The situation is in flux, because this bill is a 2 year stopgap measure only. In fact, the next round of legislation is likely to address the IRC 417(e) (3) interest rate for lump sums, adopting an interest rate closer to the corporate bond rate. Thus, it is possible that individual lump sums will be calculated with the corporate bond rate in the near future.
Since the corporate bond rate has been specifically chosen by Congress to lower the present value, the rate will be mathematically biased, compared to the PBGC rate.
Remember that the purpose of the pension valuation is to obtain a fair market value for the pension. The PBGC rate reflects the market interest rate. On the other hand, in the rare case that the pension is paid out as a lump sum, the plan must use the IRC rate, which may be very different from, and lower than, the PBGC interest rate, in the near future.
Because of the complexity of these issues, PACs policy is to offer both the PBGC and IRC interest rates. We encourage you to use both interest rates. That is why the fee for the second interest rate is discounted. Both versions can be made available for court presentation.