Choosing CL Interest Rate

[David MacLennan]

I was wondering how actuaries on the boards here choose the CL interest rates used in the valuation for a particular client, in relationship to the other funding assumptions, and other factors. As we all know, the choice can have a dollar impact on PBGC covered clients, via the ACM on Schedule A.

[Guest Keith N]

I have heard the IRS state it this way on several occasions:

1) If your funding rate is within the corridor, then use the funding rate

2) If your funding rate is greater than the highest rate in the corridor, then you should use the highest rate

3) If you funding rate is lower than the lowest rate, then use the lowest rate

[david rigby]

They may have said that but it might be inconsistent.

Q&A 20 from the 1990 Gray Book:

OBRA Funding

In determining Current Liability for 1989 plan year minimum and maximum contributions, will any rate within the corridor described in IRS Notice 88-73 (subject to the 8% floor specified IRS Notice 88-31) be deemed to satisfy the annuity purchase rate requirement?

RESPONSE

In accordance with recent IRS Notice 90-11, any rate within the corridor of 7.92% and 9.68% inclusive, is acceptable as the annuity purchase rate for a 1989 calendar plan year. The 8% floor is no longer applicable.

[Blinky the 3-eyed Fish]

I choose a rate that best fits each client's situation. There is a range available to use, so I feel that any rate within that range is acceptable without another source of justification.

[Guest Keith N]

Blinky,

Do you change from one year to the next? For example, if the client has good year wants higher contribution do you lower the rate to create higher contribution? What if they follow their good year with a bad year; do you raise the rate to reduce the contribution? Do you really "choose a rate that best fits each client's situation" on a year by year basis?

Isn't the "current liability rate selection method" part of your overall funding method?

[MGB]

Keith N.,

I have specifically posed this question separately to both Jim Holland and Marty Pippins in the past year. Both emphatically stated that there is complete discretion in choosing anything within the range.

I challenged them on the issue of the CL rate needing to be set to the funding rate if the funding rate is within the corridor, which IS THE RULE in the law, no ifs, ands, or buts about it. Both stated the IRS doesn't require anyone to stick to that rule anymore. I asked them to issue some type of guidance stating that. They said they don't plan to and that I shouldn't worry about it.

[Blinky the 3-eyed Fish]

MGB, can you give a cite for that rule in the law?

Keith, being a small plan actuary, the choice in currently liability interest rates has in the past not affected funding for the most part, but rather the PBGC premium or the need for late quarterly contributions in the next year. However, with the changes in 404(a)(1)(D) effective for 2002, there is that potential now for a small plan to have funding significantly affected by the rate chosen. While I would feel justified in having that interest rate change up and down year to year, I don't believe it would be appropriate to set the rate to the low end of the range to hike up the contribution in many of my situations. The chances of producing an overfunded plan would increase too dramatically.

[David MacLennan]

Thanks everyone for the comments.

This is a bit of a tangent, but has anyone noticed the counterintuitive result that the variable rate premium can sometimes be reduced by lowering the CL interest rate? I haven't done the analysis, but apparently this can happen because of the way the PBGC Alternative Calculation Method tries to extrapolate present value of vested benefits under the PBGC interest rate from the prior year Sch B CL info, and perhaps because in my case the owner has reached NRA and is getting half the vested benefits. Before I would have assumed the higher interest rate would give the lowest premium payment under the ACM.

[MGB]

Blinky,

The linkage requires a discussion of the OBRA'87 rate under 412(b)(5) along with the RPA'94 rate under 412(l)(7) and how they are linked to the ERISA funding rate under 412(b)(5).

The structure of 412(b)(5) starts with (A), "In General." This sets one interest rate for the funding standard account which is used to determine costs. Then, in (B), "Required Change of Interest Rate," they set up a condition that, if met, you need to change the interest rate defined under (A) for purposes of current liability (i.e., you don't get to skip or ignore (A), it is the first step). In (B)(i), it states ("For purposes of determining a plan's current liability....") "If any rate of interest used under the plan to determine cost is not within the permissible range, the plan shall establish a new rate of interest..." This does not say that current liability is calculated as anything within the permissible range. It only says that if the rate under (A) (the accrued liability rate and, thus, the current liability rate) is outside of the permissible range, then you set the current liability rate to be a different rate that is within the range. The logical reverse of this statement implies that if the rate in (A) is within the permissible range, then the current liability rate is the rate under (A), which is also the accrued liability rate. There is nothing in this language that allows you to choose a different current liability rate if the accrued liability rate is within the permissible range.

Just to add some more background other than the law (the above provisions came from OBRA'87), here is the language from the Conference Committee Report on OBRA '87:

"House Bill: If any rate used under the plan is not within the permissible range, then the plan generally is required to establish a new interest rate that is within the permissible range."

"Senate Amendment: The Senate amendment uses the term "current liability" instead of the term "termination liability" as under the House bill, but the substance of the two terms is the same. For purposes of calculating current liability under the amendment, the interest rate is the rate used for calculating costs under the plan. If such rate is not within the permissible range, however, then for this purpose the plan is required to establish a new interest rate that is within the permissible range..."

"Conference Agreement: The conference agreement follows the House bill (using the term "current liability" rather than "termination liability"), with certain modifications. The conference agreement follows the rule under the Senate amendment with respect to the interest rate to be used in determining current liability, with certain modifications. Under the conference agreement, for this purpose, the interest rate is generally the rate determined under the plan's assumptions. However, notwithstanding the plan's assumptions, the interest rate is required to be within...." "No rate outside the specified corridor is permitted under any circumstances. Also, the specified corridor is not intended to be a safe harbor with respect to whether an interest rate is reasonable. The Secretary is authorized to adjust a rate within the corridor to the extent that it is unreasonable under the rules applicable to actuarial assumptions."

In 412(l)(7)©(i)(I), it states that the RPA'94 current liability shall be calculated using, "the rate of interest used under subsection (b)(5)" and then describes the effect of being adjusted if you are at the limit of the range. (b)(5) is where both the accrued liability rate and the OBRA'87 rates are. Prior to the previous statement, it says "The rate of interest used to determine current liability under this subsection..." and the question is whether or not that phrase limits the reference to (b)(5) as being only the current liability rate instead of all rates under (b)(5). This should include the accrued liability rate, not just the current liability rate. If they only wanted to point to the current liability rate under (b)(5), they should have stated "(b)(5)(B)", rather than referencing (b)(5).

Even if you limit the reference to only point to the OBRA'87 current liability rate, the way (b)(5) works (discussion above) is that the OBRA'87 current liability rate IS the accrued liability funding rate, unless that would put it outside the allowable range. If it is outside the range, then that is the only time the OBRA'87 rate should be different from the accrued liability rate. Then, the next step is to coordinate these with 412(l)(7).

(BUT, as I stated earlier, Holland and Pippins have rewritten the law in their minds and disregard this.)

[Blinky the 3-eyed Fish]

Wow, that's a lot to digest.

David, yes, I have noticed that. Unless the bulk of the liabilities are with younger participants, the conversion under the ACM yields a greater variable rate premium with the higher interest rate. It is only with the younger participants that the higher interest rate is beneficial because of the effect the high RPA rate has in lowering their liabilities enough to overcome the ACM adjustment. When running my valuations, I have been looking at RPA CL at both the high and low interest rates to see how that affects the premium.

One other note if anyone is interesed, running the numbers for a 2002 calendar year plan with a retirement age of 65, a participant 51-52 years old would yield roughly the same liability for PBGC purposes under the ACM method whether the low end of the range was used (5.14%) or the high end (6.85%).