Interest Rate for Normal Cost Calculation

[Guest Bob_DB]

Suppose you have a DB plan for a small, privately held company (10 employees), with funding of the plan based on individual aggregate approach (i.e., funding each year is equal to the sum of the normal costs for all employees). The employees have anywhere from 10 to 40 years until retirement.

My question is: how does the actuary go about picking the interest rate (pre- and post-retirement) to use in calculating the normal cost? Are there regulations or guidelines published anywhere? Is the rate typically based on some margin above long-term treasuries, corporate bond rates, etc.? Is a single rate always used for all employees or can the rates vary depending on the lenght of time to retirement for each employee?

Any insight as to how actuaries think about this would be appreciated. Thanks.

[SoCalActuary]

Here's my thinking:

The rate needs to be acceptable to the IRS, so generally within a two point range around the current long term interest rates available.

The rate needs to anticipate the investment methods of the trustees, some of whom are risk takers and others are worried about loss. The risk takers will have a wider range, and generally a higher interest rate for the long term. The risk averse will probably go with short term cash type investments, so their interest rate should reflect the rates on the investments in their portfolio, such as 1 point below the 30 year treasury rates.

If the portfolio has had a dramatic unrealized gain or loss, the assets may be mis-valued, especially if I know the market has changed dramatically since the valuation date. Examples were in October 1987 (when I raised rates) and in March 2001 (when I lowered my assumptions). Thus my interest assumption may be changed to consider the long term value of the investments.

Now for an editorial:

With the proposed new funding rules, the flexibility I have had will now be gone, and it will make things worse for my clients. The yield curve is a valid measure of a stable population with predictable demographics. Most of my clients are small businesses with retirement savings needs that are not stable and predictable, because employee turnover or life-changing events for the business owner are not always planned ahead. If you ask me whether a 55 year old owner will retire at age 65 and take a lifetime annuity, I doubt there is a 25% chance it will happen as planned. If you ask that same business owner about their projected sales, salaries, staffing and profits for the next ten years, the probability of meeting that target as planned is also very low. Statisticians would say the beta coefficient is very high between expected and actual employee longevity.

[Blinky the 3-eyed Fish]

I have a little different spin on the topic. The criteria of all the assumptions made in the valuation, including interest rates, is they have to be reasonable at the time of the valuation, not before and not after. The ultimate judge of what is reasonable in this case is the IRS.

I don't hold that a 2-point range of current interest rate nor trends in past performance of assets or the overall trends in the stock market are necessarily a judge of what is reasonable because they are not a judge of the future. They are merely pieces of the puzzle to determine what is reasonable.

Now the long and short of it in reality is that if you choose an interest rate between 5-8%, you are highly unlikely to be challenged. I wasn't around for the small plan audits, but I hear that didn't go well for the IRS when they did challenge many 5% assumptions as being too low.

[Guest Bob_DB]

Thanks.

Could you tell me what rates you used for year-end 2001, 2002, 2003, and 2004 (pre-retirement and post-retirement)? Thanks.

[Blinky the 3-eyed Fish]

There is no one size fits all. It would entirely depend on the client. Going to the reasonable factor, you wouldn't necessarily pick the same interest rate for a client invested solely in Treasury Bonds versus one in growth stocks.

[Guest DBtech]

So what's worth more? A million dollars worth or Treasury Bonds or a miilion dollars worth of growth stocks? It seems the answer isn't self-evident to a pension actuary.

[WDIK]

So what's worth more?  A million dollars worth or Treasury Bonds or a miilion dollars worth of growth stocks?  It seems the answer isn't self-evident to a pension actuary.

Obviously the trick is determining what each will be worth 10 or 20 years from now. Please share any insight you have in this regard.

[Blinky the 3-eyed Fish]

I don't think DBtech understands the concept yet feels he has such an advanced understanding only known to him that he needs to make a rude comment. Are you MoeHoward2 in disguise?

DB if you are funding for a benefit in future years it matter how much your current investment will grow. How much your current investment will grow depends on what it is invested in.

[david rigby]

Most of this discussion is correct, but insufficient.

It is not enough to merely look at the assets (current or expected). Recall that (under ERISA) the plan sponsor is responsible for selecting the funding method, and the EA is responsible for selecting actuarial assumptions, in that order. For example, if the sponsor selects a method that the actuary believes will provide contributions that are too low, the actuary must then select assumptions that will provide for adequate funding of the plan.

Please see: http://benefitslink.com/boards/index.php?showtopic=23357

[Blinky the 3-eyed Fish]

The reality of that situation is the day the plan sponsor of all but a very large plan picks the funding method is the day I walk on land.

[AndyH]

Acquire a 412(i) for your top heavy company and declare yourself a QSLOB apart from your peon employees and your funding method and asset return (-) and coverage issues are all solved. And I know first hand board participants who do such designs.

[Guest Ned Ryerson]

How dare you call me out in front of everyone like that. But it wasn't a QSLOB I declared, but rather I declared my peons slobs that didn't deserve my mighty pension, full of life insurance like Bonds is full of steriods. I should celebrate my ingenuity with a bottle of Dom.

[AndyH]

Your vocabulative wit is impressive.

[SoCalActuary]

To Bob DB You might get a better answer if you can tell us your perspective.

Actuary in training?

Regulator?

Accountant?

TPA?

The Treasury has suggested their new proposed funding methods, including use of a zero-coupon bond yield curve. This method is not used by small plans, but may be used by some larger plans, as well as the PBGC for certain plans they take over.

Small plan actuaries (and possibly large plan actuaries as well) have commented that the proposed approach is inflexible, and unrelated to the expected investment performance of the trust assets. Generally an interest rate is selected for the period of accumulation of contributions (pre-retirement) and a separate rate for post-retirement interest while benefits are in pay status. Some actuaries tie these two assumptions to the current market yields of long term investments available to the general public. Others tie the rates to the expected yield on the investments in place, as for example a rate of 3% for fully insured plans.

[SRM]

My question is: how does the actuary go about picking the interest rate (pre- and post-retirement) to use in calculating the normal cost? Are there regulations or guidelines published anywhere?

Any insight as to how actuaries think about this would be appreciated. Thanks.

Bob DB,

The Academy of Actuaries Pension Practice Council has issued a Practice Note titled "Selecting and Documenting Investment Return Assumptions". This might provide some insight into one method utilized to select a reasonable interest rate assumption.

AAA Pension Practice Note

[Guest Bob_DB]

Thanks for all of the feedback.

In response to one question, my perspective is that of a plan participant. This is a bit complicated, but I'll try to explain.

In calculating my normal cost for plan years ending Dec-01 and Dec-02, the enrolled actuary used a rate of 6.0% for both pre- and post-retirement. This did not seem all that unreasonable given that long-term treasuries were about 5-5.5% at the time.

However, for the plan year ending Dec-03, the actuary reduced the rates to 4.5% pre-retirement and 5.5% post-retirement despite the fact that long-term treasuries remained at about 5%. And, for the plan year ending Dec-04, the actuary used 5.0% and 5.5% even though long-term treasuries remained around 5%.

This reduction in the assumed interest rates significantly increased my normal cost. The complicated part is why the normal cost matters to me as a plan participant. Without getting into the details, any increase in my normal cost leads to a reduction in my cash compensation.

The plan assets were invested roughly as follows: 50% equity (mutual funds), 10% bonds, and 40% cash.

I do not see how assuming a rate that is below long-term treasuries can be reasonable under any circumstance (assuming that the plan is going to be continued indefinitely). Moreover, given that over a reasonably long-term equities are in all likelihood going to outperform treasuries, even assuming a rate slightly above long-term treasures (as was done in 2001-2002) is not appropriate given the mix of investments chosen by the fund manager.

Again, thank for the feedback.

[Blinky the 3-eyed Fish]

So it appears you are one of the higher-ups in your company and your overall compensation package dictates that you take home less pay and instead receive a defined benefit accrual.

I would completely disagree with how the costs are being allocated to people if they are being based on normal cost. Because a person's normal cost, like you have discovered, is tied to funding assumptions and not to actuarial equivalents nor 417(e), it can easily be incongruous to what you will eventually be paid from the plan. These situations are very tricky. You might want to invest in an actuarial analysis to determine how this arrangement is working for you.

It looks like your questions relate to these prior question, eh Bob? Well upon further review, it looks like this whole arrangement has been an ongoing source of questions.

http://benefitslink.com/boards/index.php?s...opic=27279&st=0

[Effen]

Your problem is that you (or someone) tied your compensation to the plan's normal cost. The plan's normal cost is based on the funding method and the actuarial assumptions used. It is for plan funding and NOT benefit payments. The ultimate benefit you receive may have little relationship to your historical normal costs. Even using individual aggregate funding methods, the normal cost is still calculated in the "aggregate".

Your ultimate benefit will be based on the plan document. If your plan provides a lump sum, the lump sum will be based on the document provisions at the time of payment. By using 5.5% for funding the actuary is trying to anticipate the rates that will be in effect when it will be paid. Congress may change the law in the next few years or interest rates may rise or fall. Lets say 4 years from now you terminate and lump sum rates are at 6.5%. The fact the normal cost was based on 5.5% is meaningless. You will get the 6.5% lump sum which will be less than the 5.5% lump sum. The reverse is also true if lump sum rates stay below 5.5%. You could end up with more than the 5.5% lump sum.

This is also a huge oversimplification. There are many other factors that need to be considered, but the lesson is that the accumulation of normal cost can be dramatically different from the value of the actual benefit paid.

[No Name]

Well said, Effen.

[david rigby]

I agree with Blinky and Effen. But I wonder if Bob_DB has the facts correct. Is compensation reduced by Normal Cost, no matter how calculated? Might there already be some "definition" or parameters that assist in this determination? Even if this does not pan out, perhaps Bob_DB could point out (to whomever) that such offset should not be adjusted for changes in actuarial assumptions.

[Guest Bob_DB]

Yes, I recognize that there is no relationship between the normal cost and my benefit prior to retirement and that the compensation system is messed up. I discussed that only to explain why I, as a plan participant, care about the normal cost calculation. For current purposes, I wanted to set that aside and just focus on the normal cost calculation itself.

In particular, I wanted to focus on the interest rate used in the calculation. Is there any way that using 4.5% pre-retirement and 5.5% post-retirement as of December 2003 can be reasonable given the mix of plan investments (roughly 50% equity (mutual funds), 10% bonds, and 40% cash)?

Thanks.

[Blinky the 3-eyed Fish]

Is there any way it's reasonable? Absolutely, it is certainly possible.

Is it reasonable? Not nearly enough information to tell nor am I the judge and jury on that one.

[Effen]

Part of the actuary’s professional responsibility is to define "reasonable" for the given situation. Other actuaries my have other opinions, but the signing actuary bears the responsibility. Also, unless you are the owner and/or plan sponsor, the actuary is probably not going to change the assumptions based on your suggestion no matter how much ammunition you provide. Hopefully the employer understands what and why the actuary is doing what he/she is doing. It would similar to asking the auditor to change a statement in the financial report because it might impact the stock price. The actuary is supposed to be independent.

Do I think 4.5% could be reasonable? Sure, it could be.

What do you think a reasonable rate of return for the mutual funds? (What kind of mutual funds are they? Blue chip? Long term, short term, value, balanced, growth, etc..) Lets just say we expect them to earn 7%. Now, is 4% reasonable for the bonds? How about 2% for the cash. Put all that together and you get 4.7% (.50*.07+.1*.04+.4*.02) Again, oversimplified, but I think you get the idea.

[david rigby]

...which gets to the issue of "what does reasonable mean"? As actuaries already know, any assumption will likely have a range of reasonable answers.

I agree that 4.5% might be reasonable. However, it also may be possible to construct a set of parameters which create a reasonable range (for example) of 5% to 7%. If so, does that mean 4.5% might be described as "unreasonable"? (Maybe.)

So much depends on the other parameters, plan design, investment mix, etc. No assumption should be evaluated entirely in a vacuum. Let's bring that back to the situation at hand: if the underlying investment return assumption was changed, it would be appropriate to look at other assumptions simultaneously. ("Look at" means "evaluate". It does not mean "change".)

[Guest penman]

Bob,

Your post on 4/8 metions assuming the plan goes on indefinitely. Is that a good assumption, or is the plan designed to benefit an individual or select individuals that are closer to retirement age? If the plan is going to terminate upon the retirement of a given individual, the life expectency of the plan should be considered in determining the interest assumption.

[AndyH]

....and the relationship between the normal cost and the ultimate benefit itself. Your benefit, for example, might be frontloaded over the first x years (e.g. the interval of the owner from plan inception to retirement) but your normal cost calculation might cost out that benefit over your longer interval to normal retirement age. In that case, you may win because your normal cost might accumulate to much less than your benefit.

My point is you should hire somebody to examine the entire picture, not just a small facet of it.

[Effen]

Andy makes very good points.

[rcline46]

Bob DB did not mention if the plan also had turnover, disability, or mortality discounts. If so they also enter into the mix of interest rate assumptions.

As poor Bob DB is finding out, everything affects the assumptions.

[Guest Bob_DB]

Thanks again.

I wanted to follow up on a couple of things:

(1) Suppose you had a small firm where virtually all of the business was generated by one person. Suppose that person was expected to retire in 5 years at which point the firm would almost certainly fold and the pension plan would be terminated. In that case, would it be appropriate to calculate the normal cost for younger employees assuming that the plan were to be continued until their normal retirement date (e.g., 20 years)? If not, what would you do?

(2) Suppose it was known that the pension plan was to be terminated in a year. In that case, same questions as in (1).

(3) Suppose the actuary used an interest rate in calculating the normal cost that everybody believed was unreasonably low (say 0% or -10% or whatever). Further, the company contribution to the plan was equal to the sum of the normal costs for all employees and the company wrote off the full contribution for tax purposes. What would a concerned citizen do? For example, should the IRS be alerted? If so, what would the IRS do (e.g., disallow tax write-offs)? Are there other agencies to which this should be reported?

Thanks.