Defined Benefit Insights
Interest Rates and DB Plans
Vanguard Strategic Retirement Consulting | Winter 2012
Evan Inglis, chief actuary
Why are interest rates significant for defined benefit plans?
A defined benefit plan promises to make payments in the future to its participants. Any promise to make
a payment in the future has a value today based on the time value of money. A payment today is worth
more than a promise to make a payment next year.
A promise to make a pension payment in the future is not that different from a promise by a homeowner
to make a mortgage payment, or a promise by a company or a government to make a payment on its bonds.
A pension plan sponsor can be viewed as having borrowed current wages from its employees (just like borrowing
from investors by issuing a bond). The plan sponsor promises to pay back those borrowed wages in the form
of pension payments and the value of those payments today (the “present value”) is calculated with interest rates.
What factors impact the level of interest rates?
Interest rates change based on multiple factors, including, for example, Federal Reserve decisions and expected
inflation. As interest rates change, the present value of a pension-payment promise changes correspondingly.
A significant factor is the length of time until the promised payment is made. Usually, the longer the period
until the payment needs to be made, the higher the interest rate will be.
Another important factor is the level of certainty that the payment will be made. If there is uncertainty about
the ability of the borrower (the plan sponsor) to make a payment, then the rate of interest will be higher.
A higher interest rate is a way for the borrower to compensate the lender for the lack of certainty about
actually getting paid back.
Why does the present value go up when interest rates go down?
When lower yields are used to calculate a present value, the present value is bigger. To see why, imagine
that a friend owes you $100 next year. If you can earn 6% interest in a secure account (savings account, CD,
or Treasury bills) then you’d be willing to accept about $94 today instead of the $100 next year. Your friend
could also take $94 and put it in such an account and know he or she would have $100 next year to pay you.
Thus the $100 promise to pay next year is worth $94 today. However, if the secure account only paid 5%,
you’d ask for about $95 today from your friend to settle the promise to you. The interest rate went down
from 6% to 5%, which caused the present value of your friend’s promise to increase from $94 to $95.
When interest rates go down, present values go up, and vice versa.
What kinds of interest rates are used to value pension plan obligations?
For most purposes*, interest rates on high-quality corporate bonds are used to measure pension obligations.
The basic idea is that pension promises are highly certain to be paid and high-quality corporate bond payments
are highly certain to be paid. Since interest rates vary by length of time until the payment is promised, a pension
plan must use many different rates to value the payments promised for each different year in the future.
Often these many rates are boiled down into a single rate called the “effective discount rate.”
Pension promises—otherwise known as “obligations” or “liabilities”—are valued slightly differently depending
on the purpose. The two main reasons for calculating the value of pension payments are to determine contribution
amounts under PPA rules—that is, the “funding target”—and for accounting purposes—that is, to determine
the “Projected Benefit Obligation” or “PBO” (see DB Insights: Corporate pension accounting—The basics). Note
that in this DB Insights we do not describe how pension liabilities for government pension plans are calculated
(see DB Insights: Government (public) pension plans).
Other reasons for using interest rates to value pension payment promises are shown below.
Rate
PPA 24-month average segment rates
Purpose
PPA funding target
for determining contributions
Explanation
PPA allows plan sponsors to use an average
rate to reduce volatility in their contribution
requirements. These rates are presented as
three segments: for payments due from 0 to 5
years, for payments due from 5 to 20 years,
and for payments further away than 20 years.
PPA 30-day average yield curve rates
(“spot rates”)
PPA funding target for determining
contributions
An alternative to the 24-month average rates
is individual rates for every year along the yield
curve. This alternative is normally elected
by plans that have adopted liability-driven
investment (LDI) strategies because the
financial markets value bonds based on
spot interest rates (see the DB Insights
on liability-driven investment strategies).
PPA 30-day average segment rates
•
etermining underfunding for PBGC
D
variable-rate premiums
•
C alculating lump-sum amounts
for participant payments
•
T he variable premium rate is taken from
the 30-day average just before the start
of the plan year.
•
T he lump-sum rate is usually set once a year
and is selected from one of the five months
just before the beginning of the plan year.*
30-year Treasury rate
Calculating lump-sum amounts
for participants under pre-PPA rules
Under pre-PPA rules, 30-year Treasury rates
defined the minimum level of the lump-sum
amount equivalent to the annuity benefit
that a participant earned. This rule is being
phased out by 2012 and replaced with the
30-day average segment rates noted above.
Accounting: AA corporate bond
Calculating the PBO for recognition
on the balance sheet and calculation
of pension expense for the income
statement
Usually a single rate is determined by
analyzing the individual rates applicable
at different points in time (“along the yield
curve”) when pension payments are due
and converting them into a single
equivalent rate.
*Plan sponsors may use an average of rates during the five-month period and may select the rate more often than annually, if desired.
How Vanguard can help
Defined benefit plans can enhance the effectiveness of an employer’s retirement program, but they must be
designed thoughtfully and managed carefully. Vanguard can help employers with DB plan design and investment
strategies. We offer:
Consultative guidance to help you get the most out of the DB plan in your retirement program.
Investment products that allow pension plans to implement any investment strategy.
• Expert analysis and asset-liability modeling to help you determine appropriate asset allocations.
• Professional plan administration through state-of-the-art technology and processes.
•
•
For more information, please contact your Vanguard representative.
Vanguard Strategic Retirement Consulting (SRC) is a valuable resource that can help both defined contribution
and defined benefit plan sponsors optimize their plan design, develop fiduciary best practices, and achieve
regulatory compliance. The strategies developed by SRC consultants are grounded in expert analysis of broadbased data and are informed by Vanguard’s highly respected research teams, including the Vanguard Center
for Retirement Research.
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