What is a correct discount rate in pension calculations?

Some background information on the discussion on pension plans and discount rates. Choosing the correct discount rate in calculation pension liabilities is not an easy task and a task that brings public responsibility.

Interest rates in the European area are close to zero because the ECB holds its benchmark refinancing rate at zero since March 2016, see table below:

Low-interest rates play a critical role in calculating pension plan obligations. Specifically, the interest rates on high-quality corporate bonds are used to determine the plan’s expected risk-free return in the future – a metric known as the “discount rate”. If the discount rate decreases, a pension plan needs more assets today in order to be sure it can generate sufficient investment returns to pay a projected amount of benefits in the future.

Therefore, today’s low discount rate places a burden on pension plans. Corporate executives believe this burden is unfair: they argue that the current low rates do not truly reflect expected risk-free returns, but rather the policy measures taken by central banks.

Some governments have eased this burden by dictating higher discount rates (which is supported by the above table, in ten years two years were below the discount rate (expected rate of return) applied to pension obligations in a Canadian pension fund all other years were significantly higher!). In June 2012, Denmark and Sweden took direct approaches, setting floors or specific values for the discount rates applicable to certain obligations. Nevertheless, it is unclear what an accurate discount rate should be. A less contrived approach would be to use actual interest rates, averaged over several years. The US recently (August 2012!) took this step: Congress allowed corporations to use a discount rate based on high-quality bond yields averaged over 25 years, instead of an average over two years as under the previous rules.

Why does all this matter? Because some anti-pension ideologues have started attacking the discount rate used by public pension plans as a way to attack pensions. Chief among them is Stanford economist Josh Rauh. For years, Rauh has promoted the idea that public pension plans are using an assumed discount rate that is too high. He wants them to use a rate that is much lower. The reason you should care is because if the assumed discount rate is lowered, then it makes pensions appear to be more expensive because you are assuming that the pension fund will earn less money over time, meaning more money needs to be contributed now for the pension benefits that will be paid out in, say, 30 years.

The problem with Rauh’s projections is that he is wrong. In 2010, he famously predicted that Philadelphia’s municipal pension system would be bankrupt in five years. However, six years later, Philadelphia’s pension system is still paying out benefits. He also predicted that Louisiana’s pension system would reach “funding exhaustion” by 2017, but Louisiana’s public employee pension system has improved its funded status over the past several years and has increased the number of assets in the system. This is consistent with the experience of most public pension plans as they have recovered from the economic crisis.

Over the long term, public pensions have met, or exceeded their investment target goals. They will experience year-to-year fluctuations, but over 25-30 years, the plans will usually meet their goals. In fact, one study found that the 25-year median investment return for public pension plans was 8.3 percent, higher than the assumed investment return. By using an interest rate that is unreasonably low, Rauh is creating the impression that pension funds are far worse off than they are. His so-called studies are then picked up and passed off as evidence in the political arena to justify closing pension funds down.

So setting the discount rate is quite an important issue!!!

IAS 19 does not allow the financial statement preparer to determine its discount rate with reference to plan-asset returns. Instead, it prescribes that the discount rate must be determined with reference to market yields on high-quality corporate bonds, or where there is no deep market in such bonds, by reference to market yields on government bonds. While the yield on high-quality corporate bonds would be marginally higher than on government bonds, it would still be significantly lower than the expected return on plan assets.

IAS 19 also has additional disclosure requirements for actuarial assumptions such as the discount rate. For example, IAS 19 requires the preparer to disclose a sensitivity analysis for each significant actuarial assumption as at the end of the reporting period, showing how the benefit obligation would have been affected by changes in the relevant assumptions that were reasonably possible at the time.

A sensitivity analysis at least would give readers information on how actuarial assumptions such as the discount rate could impact a company’s pension obligations. Just an example, a decrease of 25 basis points across all discount rates used by a Canadian pension plan would cause the consolidated accrued benefit obligation to increase by about $4 billion as at March 31, 2016.

Used the Financial Times analysis by Robert Pozen and Theresa Hamacher AUGUST 19,2012, see

https://www.ft.com/content/b5e7a3bc-e133-11e1-9c72-00144feab49a

and from the National Public Pension Coalition:

https://protectpensions.org/2016/04/19/discount-rate-matter/

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