The first approach—the “assumed-return approach”— bases the discount rate on a long-term assumed average rate of return on  the pension plan’s assets (which includes expected long-term stock  market returns to the extent plan assets are so invested, and which, in  recent years, and as employed by U.S. public plan sponsors, often would  produce discount rates between 7 and 8 percent). The use of  a 25-year historical average results in current discount rates that are  significantly in excess of current or recent interest rates on high  quality bonds. Defined Benefit Systems in Selected Other Countries

The discount rate approaches and regulatory structure governing pension  plans in Canada, the Netherlands, and the United Kingdom differ in  various ways from those in the United States. Discount Rates for Sponsors of Public Sector Plans and Private Sector Multiemployer Plans Differ from Those of Private Sector Single- Employer Plans, Resulting in Different Incentives for Both and, for the Former, Higher Reported Funded Ratios and Lower Reported Costs

Public and private sector DB pension plans are subject to different rules  and guidance regarding discount rates. Under FASB  standards, plan sponsors are required to discount using “settlement  rates,”---which can be based on the discount rates implicit in the current  prices of annuity contracts, such as PBGC’s rates, but can also be based  on current high quality bond rates, which plan sponsors generally do--- while plans are required to discount using best-estimate assumed rates of  return. At this  difference in discount rates, the present value of a benefit payment due in  15 years for a private sector single-employer plan sponsor for financial  reporting would be almost 50 percent higher than for a comparable public   Some experts (including those on the GASB) view  sector plan sponsor.differences between public sector and private sector single-employer  discounting approaches as appropriate because they see public plans as  going concerns that can best estimate their pension costs using very  long-term assumed returns as their discount rate. Some experts said that the assumed-return approach could incentivize  public plan sponsors to invest in riskier assets because doing so can  increase the assumed-return discount rate, thereby lowering reported  liabilities and reducing funding requirements. Experts Identified a Variety of Considerations for Setting Discount Rate Policy and Many Saw Value in Plan Sponsors Reporting Multiple Measures

For many of the experts we interviewed, the appropriate discount rate to  use depends on the purpose of the measurement. There are at least five key purposes for which one might  determine a discounted value of future benefits: (1) determining the  required or recommended amount that the plan sponsor should contribute  into the plan; (2) reporting plan liabilities to shareholders, taxpayers, plan  participants, or other stakeholders, such as for financial reporting; (3)  determining the amount needed to terminate a plan, settle a portion of  plan liabilities, or to guarantee or minimize risk on pensions earned to  date; (4) expressing the value of participants’ benefits (for example, in  putting a value on their total compensation); and (5) determining optional   Several  lump sum amounts payable to participants in lieu of an annuity.experts with whom we spoke also indicated that their views on the  appropriateness of different rates for different purposes of the  measurement vary between public and private plans. A number of  experts emphasized transparency or comparability considerations in  setting the discount rate and many supported the reporting of multiple  measures of liability using different discount rates. Third, actual returns for any particular plan would  also depend on plan characteristics and cash flows. However, in those cases where these other  countries use assumed returns, or some allowance for assumed  returns—for example, one of the two Canadian measures, the rate for  Dutch recovery plans, and the U.K.’s plan-specific approach—these  assumed returns tend to be lower than assumed returns currently used by  U.S. public plans. The practices of  selected foreign countries—notably, Canada, the Netherlands, and the  United Kingdom—may provide insight into ways that other pension  systems discount liabilities, applying a variety of approaches to  discounting, with significant government oversight, and generally using  lower discount rates than U.S. assumed returns. Key contributors to this report are found in appendix V.

Appendix I: Objectives, Scope, and Methodology

To analyze differences of opinion concerning discount rates for pension  plan valuations and funding, GAO examined (1) the significance of the  differences in discounting approaches used by public versus private  sector pension plans; (2) the purposes for measuring the value of a plan’s  future benefits and key considerations for determining plan discount rate  policy; (3) the approaches select countries have taken to choose discount  rates. We examined relevant literature  on pension discount rates. We spoke to  experts in these countries and reviewed publicly-available documents. ERISA Requirements

With regard to the rates they use to discount benefits, single-employer  sponsors are generally required to use a bond-based approach to  determine the minimum required contribution. However, within this  framework, these sponsors have options which can result in  measurements of plan liabilities that may not be closely tied to current  market conditions. As discussed, under ERISA,  private sector multiemployer plans generally discount using an assumed  rate of return for funding purposes. base funding target of 105 percent using prescribed market interest  rates.
Why GAO Did This Study

Defined benefit plans use interest rates to “discount,” or determine the current value, of estimated future benefits. Experts in the United States have disagreed on both the approach that should be taken by plans to determine a discount rate and the appropriate rate to be used. Different discount rates can create large differences in the valuation of a plan's obligations, which in turn can lead various stakeholders to draw different conclusions about a plan's health, the value of a plan's benefits, and the contributions required to fund them.
As requested, GAO examined different approaches used to determine the discount rate. This report addresses (1) the significance of differences in approaches used to determine discount rates among public and private plans; (2) purposes for measuring the value of a plan's future benefits and key considerations for determining discount rate policy; and (3) approaches selected countries have taken to choose discount rates.
For this review, GAO analyzed provisions in relevant federal laws and regulations, as well as financial reporting and actuarial standards. GAO also reviewed relevant literature and interviewed experts, including experts in Canada, the Netherlands, and the United Kingdom—countries with significant defined benefit systems. In addition, GAO modeled hypothetical pension investment portfolios and cash flows to calculate average investment returns using available historical data.

What GAO Found

Public and private sector defined benefit pension plans are subject to different rules and guidance regarding discount rates—interest rates used to determine the current value of estimated future benefit payments. These differences can result in significant implications:
Sponsors of public sector plans generally use discount rates using a long-term assumed average rate of return on plan assets. This approach results in reported obligations that generally appear lower than those of comparable private sector single-employer plans. Some experts believe this approach may encourage public plans to invest in riskier assets, which can increase the assumed return and thereby lower estimated obligations and plan contributions. Other experts believe this approach helps to maintain more predictable and lower costs. Private sector multiemployer plans generally use an assumed rate of return for funding purposes.
Sponsors of private sector single-employer pension plans use bond-based discount rates, which are generally lower than assumed rates of return, for financial reporting of their plans' liabilities. Experts believe this approach may encourage plans to invest in less risky assets, particularly high-quality bonds, to make pension costs less volatile, but it may increase current reported costs. Funding requirements for these plans are tied to historical interest rates, which can reduce funding compared to measures based on more recent interest rates.
Experts identified at least five purposes for measuring the value of future benefits where discount rates are used, including determining sponsor contributions, reporting plan liabilities to stakeholders, determining the amount needed to secure benefits, measuring the value of employee benefits, and determining lump sum settlement amounts. They also identified a variety of considerations in setting discount rate policy, including cost, risk, fairness, sustainability, transparency, and comparability. To address trade-offs among these varied and sometimes competing purposes and considerations, many experts saw value in reporting multiple measures of plan obligations, using different discount rates. Some experts also regarded assumed returns used by U.S. public plans as too high under current market conditions.
Selected countries we examined reported that they apply a variety of approaches to discounting. Canada requires determination of multiple measures of plan obligations, based on both assumed returns and high-quality bond rates and annuity prices. The Netherlands requires that plan obligations be measured based on market interest rates, but allows the use of assumed returns for determining plan contributions or developing recovery plans. In the United Kingdom, discount rates are determined on a plan-specific basis and can include some allowance for assumed returns in excess of high-quality bond rates, depending on plan characteristics and the strength of the sponsor. To the extent that plans in these countries use long-term assumed rates of return, they are generally lower than the 7.5 to 8 percent used by many U.S. public plans under recent market conditions. Experts GAO interviewed in these countries described a greater degree of government oversight which might help explain their use of lower assumed returns.

What GAO Recommends

GAO is not making any recommendations in this report.