FAQ 909: Effective Interest Rate Calculations

Problem: We ran a PPA valuation about a month ago. We made a minor data change and reran calculations. Why did the effective interest rate change?

Solution: The effective interest rate is calculated using an iterative approach. For example, if the funding tiered rates are 4.75%, 5.18% & 5.92% for a single person plan with the person one year from retirement, the effective rate might be 5.38%. That's the single rate at which the annuity substitution rule calculates the closest result to the funding target using the three segment rates. To verify the effective rate, you can enter the effective rate in all three MIN segment rate fields on the Funding \ PPAFASMP screen and run Calculations > Valuation, making sure that the 'Calculate Effective Interest Rate (EIR)' checkbox is unchecked. You should get the same funding target (or very close). Example for a one-participant plan: EXAMPLE No 415 limits apply - refer to FAQ 787 - Funding to Lump Sum Limited by 415 for calculation details when 415 limits do apply Attained Age: 61 NRA: 62 Benefit: 625.00 AE APR@62 using 5.5% interest and GA2002U mortality - 145.471 Segment rate for discounting - 1st segment rate - 4.75% PVF Deferred Annuity Age 61 starting 62 using 4.75%, 5.18%, 5.92% Segment Rates with RP22C U Mortality - 148.0874 a) Present value of the actuarial equivalent lump sum: 625.00 x 145.471 / (1.0475)^1 = 86,797 b) Present value of the benefit using annuity substitution: 625.00 x 148.0874 = 92,555 The funding target is the greater of a) and b), 92,555 The effective interest rate calculated by the system is 5.38%. Using 5.38% in all 3 MIN PPA Minimum rate fields produces a funding target of 92,570. Using 5.37% in all 3 MIN PPA Minimum rate fields produces a funding target of 92,666. Using 5.39% in all 3 MIN PPA Minimum rate fields produces a funding target of 92,474. Since 5.38% produces the closest funding target to 92,555, it is the effective interest rate.