This question is in fact No. 81 for the 1st practice exam. Carson believes that the discount rate will be 7% as opposed to 8% in the pervious year, if he is right, is this going to increase or decrease 1) PBO 2) Pension Cost? I got the first part right, but 2nd part wrong. Anybody can answer the question plus some hints?
Lower discount rate increases PBO and (usually) increases Pension cost
if discount rate decrease from 8 to 7; PBO increase and Pension expense will also increase
Pension Expense = SVC Cost + Interest Cost - Expected REturn Plan Assets + Ammort Lower discount rate will Increase SVC Cost, decrease Interest Cost The increase in SVC cost will almost always dominate the decrease in interest cost.
Yep, just think of discounting at a lower rate. Increases numerator. Most definitely increases p-expense and PBO.
So reduce the interest rate will reduce interest expense for sure. Basically, we use a lower interest number to multiply a potentially ‘huge’ number. On the other hand, how much it will increase service cost is a ‘one-year’ effect. I can easily come up with a counter example. But I shall stop doing so. I’d better follow CFAI instead of being a smart ass.
For the test, all that matters is the CFAI way.
How about increase in the discount rate from 7% to 8%? It’s tricky
Reduces PBO, Reduces SVC cost, Increases Int Cost, overall pension expense is lower.
Not necessarily always
Actually, when interest rate increases Interest cost will usually decrease as well (lower PBO*higher Int Rate). The exception is with mature pension plans. The change in interest rate won’t have as large of an impact on the PBO, and the interest cost (and pension expense) could be higher.