Page 112 of Schweser (FRA - Pensions) states that
For mature plans, a higher discount rate might increase the interest costs.
I cannot understand how this is ever possible - maybe we need a magician here?
A higher discount rate will always increase interest costs.
Taken in context, the increase in interest expense might offset the savings of a lower PBO in a mature plan.
Interest cost = net pension liability or asset * interest rate.
The net pension liability/asset is the funded status, if overfunded, we will have a gain. If underfunded, we will have an expense.
higher discount rate always decreases NPV.
lets say the plan consists of one retiree aged 90, actuarially he is expected to die in 4 years.
so if you pay him $100/yr then the obligation is $400. Next year, he is 91 and actuarailly he expected to live 3.7 more years.
so you paid out $100, but your obligation went up to $370, not $300 as expected.
I think that is what schweser is talking about, something to keep in mind but not worry about.
This makes a lot of sense to me - sorry if this was obvious I’m ok with all other parts but accounts is a diff ball game.
So it’s down the actual payout vs acturial expectation I guess?
they are talking about a mature plan - which means the Accumulated Plan Liabilities (on which you pay interest costs) are at a high already. When the rate increases - the amount that would get added to the accumulated plan liabilities itself WOULD become lower - however since you are paying interest on the already high accumulated liabilities at the same rate - that would be high.
and this is from the point of view of the Company paying out the pension benefits, not from the recipients’ point of view.
A higher discount rate will increase total interest costs (over the working life of the employee), but often will reduce the interest cost in the early years.
please explain s2000 - I see six different approaches to the question on this thread…
When discount rates increase -> PBO is reduced -> THis reduction more than offsets the impact of increased rate at which we compute the interest cost.
Hence, for non mature plans increase in discount rates = decrease in costs.
So I don’t see how what MrSmart said is rght
My original question relates to mature plans
Open up Excel.
In cell C3, put =10000000/1.07^20. If you format it as currency, you’ll see $2,584,190.03. That’s the present value of a $10 million pension obligation 20 years from today, discounted at _ 7% _ per year.
In cell F3, put =10000000/1.08^20. If you format it as currency, you’ll see $2,145,482.07. That’s the present value of a $10 million pension obligation 20 years from today, discounted at _ 8% _ per year.
So, the total interest expense over the next 20 years will by higher when discounted at 8% than at 7%, as you would expect.
In cell D3, put =C3*0.07. If you format it as currency, you’ll see $180,893.30. That’s the interest the first year at _ 7% _ per year.
In cell G3, put =F3*0.08. If you format it as currency, you’ll see $171,638.57. That’s the interest the first year at _ 8% _ per year.
So, although the total interest will be higher when discounted at 8% than at 7%, the first year’s interest is higher at 7% than at 8%. In fact, the interest is higher at 7% for the first 6 years; starting in year 7, the 8% interest is higher.
^
Gotchya! Now that explanation deserves a round of applause - or I deserve a kick on the backside for missing this simple thing.
Thank you very much!
My pleasure.