Interest In Pension Values In Divorce
By: Marvin Snyder
One of the fundamental assumptions in the valuation of pensions in divorce when the pension involved is in a defined benefit pension plan is the interest rate or rates to be used. First it must be understood that present values and interest rates are in an inverse relationship. When one goes up the other goes down. If interest rates increase then present values decrease. The change in value is not proportional to the change in the interest rate however. Values are very sensitive to interest rate changes, but while the direction of the change is known, the quantity cannot be predicted. Only a full valuation can tell the result of changing interest rates.
Rules of thumb, while interesting, are not of help in estimating pension values. For example, there is a rule for approximating the time it takes to double a sum of money, given the interest rate. A crude version of the rule is to divide the number 72 by the interest rate as a whole number. Examples: at 6%, money doubles in 12 years; at 8% it takes 9 years. A more precise version is to divide 69 by the interest rate, but that is a more difficult mental feat.
The interest that we deal with is compound interest, as opposed to simple interest, and is expressed as an annual yield. In compound interest, the funds accumulate with investment growth on the original principal as well as on the accumulating interest.
There are available tables with an almost limitless range of interest rates, drawn to the finest degree of accuracy, with miniscule gradations between rates, such as, 7.58333% or 8.33333%. Computer programs are capable of calculating any interest rate with extreme accuracy. But, what is the practical use of such fine tuning? When arguments turn on the use of, say, 6.00% versus 11.00%, the number of decimals is not important.
A common source of interest rates for pension values is the Pension Benefit Guaranty Corporation (PBGC). PBGC has published 21 sets of rates, from a low of 6.00% to a high of 11.00%, graded by 1/4% intervals. For the past several months the primary rate has been 7.50%. For June 1990 it has been changed to 7.75%.
But the construction of the PBGC rates is not simple. There are four interest rates included in every PBGC set. There is the primary rate, also known as the immediate rate, which serves to identify the set. This is the interest rate that prevails at and after retirement. Prior to retirement, the rates are graded down for the first seven years, then the next eight years, then all years thereafter. There is no one single interest rate in the PBGC rates.
The complex construction of the PBGC rates enables the rates to serve their purpose very well: to reflect the cost of annuities.