Rev. Rul. 63-11

The Internal Revenue Service has been requested to state its position with respect to the acceptability of various methods of valuing assets, and the proper interest rate to be used in valuing liabilities, for the purpose of computing costs in determining the limitations on deductions for employer contributions to self-insured employee pension plans, or plans funded by means of a deposit administration type of group annuity, under section 404(a) of the Internal Revenue Code of 1954.

As a general rule, any asset valuation basis will be considered acceptable for the purpose of estimating costs of a trusteed pension plan for use in determining one of the limits referred to in section 404(a) of the Code, provided (a) it is followed consistently, and (b) it results in costs which are reasonable within the meaning of section 1.404(a)-3(b) of the Income Tax Regulations. Thus, subject to these qualifications, either the fair market value or the cost of fund assets (other than bonds which are not in default) may be used as a basis for valuation in the determination of the limitations under section 404(a) of the Code. For bonds not in default, either cost or amortized value may be used. However, asset valuation bases, such as the lower of cost or market for individual securities or classes of securities, or cost less a reserve for market fluctuations, are not acceptable.

Section 1.404(a)-3(b) of the regulations provides that in no event shall costs for the purpose of section 404(a)(1) of the Code exceed costs based on assumptions and methods which are reasonable in view of the provisions and coverage of the plan, the funding medium, reasonable expectations as to the effects of mortality and interest, reasonable and adequate regard for other factors such as withdrawal and deferred retirement (whether or not discounted) which can be expected to reduce costs materially, reasonable expenses of operation, and all other relevant conditions and circumstances.

Further, an employer's contribution to a pension trust fund would not be deductible to the extent that the assets of the plan valued on an acceptable basis already exceed the employer's accrued liability.

The estimated cost of benefits under a pension plan depends to a considerable extent on the interest estimated to be earned on the plan's funds in future years. The assumption of an unreasonably low interest rate would not be consistent with section 1.404(a)-3(b) of the regulations and would result in the inflation of estimated costs so as to include a contingency fund for which deductions are not allowable under section 404(a) of the Code.

The acceptability of any specific interest assumption depends on the degree of conservatism involved in the other cost assumptions, such as those dealing with mortality and withdrawals of employees without vested rights in benefits. Where the mortality table assumed is not less conservative than the Annuity Table for 1949 (a-1949 Table), or the 1937 Standard Annuity Table with a one year set-back in age, or the Group Annuity Table for 1951 (GA-1951 Table) with a one year set-back in age, or the GA-1960 Table without set-back (the GA-1951 Table projected to 1960), there would appear to be no justification, under present investment conditions, for assuming an interest rate less than three and one-half percent.

However, it should be emphasized that, for the purpose of determining deductible limits, it is not essential that each individual assumption used be reasonable. It is merely required that the combination of all assumptions produces reasonable results. Where there is little or no vesting prior to retirement, withdrawals will generally have a substantial effect on actual costs. This factor should be taken into account to the extent necessary to produce cost estimates which are reasonable in relation to actual costs.

In the case of a trusteed plan or a plan of the deposit administration type of group annuity, the interest and other assumptions to be used in estimating costs as a basis for deduction under section 404(a) of the Code should not be so conservative as to anticipate for a long period of years the most unfavorable experience likely to arise at any time in the future, nor should they be as conservative as the assumptions used by insurers to calculate premiums for guaranteed benefits. Rather, in order to satisfy the requirement that the cost be reasonable and necessary, the assumptions must be consistent with reasonable expectations as to average future experience.

Thus, a minimum guaranteed rate of interest applicable during the accumulation period in a deposit administration type of group annuity contract will generally not be considered reasonable if that rate is substantially below the actual average interest rate credited by the insurer during recent years. Under normal circumstances, the most reasonable assumption as to future yields for a particular trust will be in line with the actual average yield over a recent period of years, since the future trend of yields may depend upon the type of investments in a particular trust; for this purpose, the actual average yield should be determined in a manner consistent with the method adopted for valuing assets.

After a plan has been in effect for a period of five years or so, the reasonableness of the original assumptions will be indicated by the amounts of gains which have occurred. Usually, a change to less conservative assumptions would not be required for the purpose of determining deductible limits unless there has been a consistent pattern of substantial gains over a period of years from sources which would be likely to recur in the future.