Effect of changing discount rate on PBO and Pension Cost

CFA Level II
#1

SPOILER ALERT - Schweser Mock 2

Question 81: Based on Carson’s projection that the discount rate will go from 8% to 7%, what are the likely effects on the PBO and the pension cost.

I get why the PBO would increase, but I’m confused about why the pension cost would increase.

Isn’t one of the main pension cost components (PBO * r), therefore if r goes down, then the cost goes down?

Or is it because since PBO went down, the decrease in PBO is the dominant factor? Is this the reason?

#2

This is correct. The PBO is usually so large that the increase from reducing the discount rate would be so big that interest cost would also wind up increasing. You’re right to think that the interest cost should fall because of the reduced interest rate, holding PBO constant, but you can’t hold PBO constant when changing the discount rate - it impacts it directly.

The only situation I’ve come across where this wouldn’t occur is if the plan is a mature one.

#3

maybe you should think service cost - as rate decrease service cost increase ==> pension cost increases as well.

#4

Thanks guys.

One more question. It mention in the text about the exception to this rule being the plan being mature (as pointed out by cgottuso). What exactly defines a “mature” plan? What does that mean exactly? Does that just mean that all the employees in the plan are about to retire or have already retired?

#5

I would suggest you follow your gut on exam day - you’re almost there. It means that there are more employees near retirement than there are young employees.

#6

Yeah, looks like I answered all my own questions. Guess it’s a good thing.

Thanks for your help mate.