Reading 20: challenge problems #19 about the defined-benefit pension plan
The answer says: The discount rate is increasing, but the inflation rate is decreasing. There is usually a direct relationship between the discount rate and the infliation rate.
Why?
Normally, when inflation rate increases, employees’ compensation is expected to be increased as well. Similarly, as inflation rate raises, I think the pension expense shall be increased too. Therefore the discount rate should decrease, which means there is an inverse relationship between the discount rate and the inflation rate.
when inflation rate increases - the general interest rate (which is the discount rate) in the environment usually also increases. (That is what they mean).
but potentially you have a situation where the inflation rate is increasing - while the rate at which the employees compensation is discounted to arrive at the PBO liability - is decreasing (which would mean that the PBO liability is INCREASING - when discount rate decreases - the PBO Liability increases). If the discount rate increases in actuality the PBO Liability would decrease - due to the discount rate being on the denominator.