The three different methodologies for calculating the present value of a pension use different interest rates and apply those interest rates to different life years of the participant. In general, higher interest rates translate into lower present values; lower interest rates translate into higher present values. Because each method applies the interest rates differently, however, comparing the present value outcomes of the different methods is more complicated than simply scanning to see if the interest rates are relatively higher or lower.
The IRC method as of February 2020 produces the lowest present values, but this has not always been the case. (See Example 2, below, in which the GATT method in 2010 produced a lower present value.)
For pensions close to payout status or already in payout status, the PBGC (4022) method as of February 2020 produces the highest present values. If the pension will not start for many (e.g., 20) years, the GATT method will produce the highest present values. (See Example 1)
The GATT method is the simplest in the way it uses interest rates. It uses the 30-year treasury rate—a rate determined daily by financial markets–to discount all the years after the determination date (the present value “as of” date). “GATT” is an acronym for “General Agreement on Tariffs and Trade”, an international trade agreement.
The PBGC (ERISA 4022) method uses up to 4 different interest rates, an Immediate rate and 3 Deferred Annuities rates. The 3 Deferred Annuities interest rates are used to discount the time period before pension benefits begin. Interest rate #3 (i3) is used to discount for the 7 years immediately before pension benefits begin. Interest rate #2 (i2) is used to discount the years from 15 years before pension benefits begin until 7 years before pension benefits begin. Interest rate #1 (i1) is used to discount all years until 15 years before pension benefits begin. This differentiation between periods is not that meaningful because interest rates #1, #2, and #3 have all been an identical 4% since August 2001. The Immediate interest rate is used to discount all years after the pension benefits begin. The PBGC immediate interest rate has ranged from 3% in May 2010 to 0% in March 2020.
“PBGC” stands for “Pension Benefit Guaranty Corporation.” The PBGC is a federally chartered corporation created by the 1974 ERISA to regulate and stabilize private pension plans. There is another PBGC methodology–based on ERISA Section 4044–which is not yet available in this calculator (I am still debugging it). It uses one discount interest rate for the first 20 or 25 years and then a second interest rate for discounting subsequent years.
The IRC method uses three different interest rates: First Segment, Second Segment, and Third Segment. The discount interest applied to a particular payment depends on the window of time during which the payment is made. Unlike the PBGC methodology, there is no distinction between discount interest rate for the period before retirement and the period after retirement. The only thing that matters is the time window during which the payment is made. The First Segment interest rate is used to discount benefit payments made during the first five years after payments begin. The Second Segment interest rate is used to discount payments made during the period from 6 to 20 years after pension benefits begin. The Third Segment rate is used to discount payments made more than 20 years after pension benefits begin. “IRC” stands for “Internal Revenue Code”. IRC rates are published by the IRS.
Example 1: Comparison of three methods for December 2019 present value calculations
The following chart compares the present values calculated using the three different methodologies. It assumes a female who plans to retire at age 65 with a monthly benefit of $4,000. In the first row, the female is a 40-year-old at the determination date, so she will not begin collecting benefits for 25 years. In the second row, the female is a 60-year-old and will begin collecting benefits in 5 years.
The determination date is December 1, 2019, and the GATT (30-year treasury: 2.28%), IRC Segment Rates (2.03%, 3.06%, 3.59%), and PBGC rates (Immediate: .25%, i1: 4%, i2: 4%, i3: 4%) are drawn from that date.
|December 2019||GATT Method (2.28%)||PBGC Method (.25%; 4%)||IRC Method (2.03%, 3.06%, 3.59%)|
As the chart shows, the IRC Methodology yields significantly lower present values than the other two methods in this case.
The relationship between GATT and PBGC outcomes is more complicated.
In the chart above, the GATT rate gives a higher present value for a pension that will not start paying benefits until many years into the future, while the PBGC method gives a higher present value for a pension that will begin to pay benefits in the near future.
This is because the PBGC rate is relatively high (4%) for the “deferral” period—the years before pension benefits begin—and relatively low (.25%) for the pay-out period, when pension benefits are received. The GATT rate (2.28%), in contrast, stays the same across the deferral and pay-out years. The high PBGC rate for the long, 25-year deferral period for the 40-year-old results in a lower present value in this case.
If the deferral period is long, the GATT method (given low 30-year treasury rates in 2019-20) will give a relatively higher present value than the PBGC method. If the deferral period is short, the PBGC method (with its very low “immediate” interest rate) will give a higher present value than the GATT method.
For pensions in, or very close to, payout status, the PBGC method will give high present values. The March 2020 PBGC “Immediate” rate is 0%, which means that if a pension is already in payout status, the payments would not be discounted for interest at all. They would only be discounted for mortality. This will result in extremely high present values for pensions in payout status at a young age, e.g., pensions taken by some law enforcement workers, firefighters, or prison guards in their 40’s or 50’s.
Example 2: Comparison of three methods using December 2010 interest rates
The following chart is the same as the chart, above, from Example 1, but Example 2 uses interest rates from a different date. Comparing the two charts shows how shifting interest rates affect the present values differently for different methods. The interest rates from December 2010: GATT (30-year treasury: 4.41%), IRC Segment Rates (2.96%, 4.91%, 5.68%), and PBGC rates (Immediate: 2.25%, i1: 4%, i2: 4%, i3: 4%).
|December 2010||GATT Method (4.41%)||PBGC Method (2.25%; 4%)||IRC Method (2.96%, 4.91%, 5.68%)|
|40-year-old female||$205,108||$283, 821||$173,925|
All values in the Example 2 (2010) chart are lower than the corresponding values in Example 1 (2019) chart, because interest rates were higher in 2010 than in 2019. Higher interest rates translate into lower present values.
The IRC method gives the lowest present value for the 40-year-old female in Example 2, just as it did in Example 1.
In contrast to Example 1, the GATT method in Example 2 gives a lower present value that PBGC. This is because the 2010 GATT interest rate (4.41%) is higher than both PBGC rates.
For a 60-year-old, the results are also different from Example 1. In Example 2, the GATT method gives a slightly lower present value than the IRC method. This is because the IRC First Segment rate (2.96%) is so much lower than the GATT rate.
This low IRC First Segment rate is applied to benefits from age 65 to 70, which are the years that the recipient is most likely to collect (based on mortality). The moderate Second Segment rate (4.91%) is applied to years 71 to 85, when there is a declining chance of collecting benefits (because of mortality). The high Third Segment rate (5.68%) only applies to years after age 85. It is not likely that benefits will be collected for many years after age 85. Thus, the high Third Segment interest rate will have very little effect on the present value of the pension.
High rates translate into lower present values, but the highest IRC rate here (5.68%) is only applied to years when there is a low chance of being alive. That is why the IRC method yields a slightly higher present value than the GATT method in this case.