How can the lower PBO and high discount rate increase pension expense?

From Schweser: “There are two offsetting effects. A higher discount rate will decrease the PBO, but the product of the lower PBO and the higher discount rate will usually result in lower interest cost (makes sense). In mature plans where interest cost is high relative to service cost, interest cost may actually increase because the PBO declines only slightly. This occurs because the product of the slightly lower PBO and the higher discount rate now result in a higher interest cost. (Huh?) In fact, the increase in the interest cost may be large enough, in rare cases, to completely offset the lower current service cost and actually increase pension expense.” Can some one explain this to me in understandable terms? -Richard

Great question and the CFAI texts one has one line on this. I think it just has to do with the time remaining till payout of the obligation…since there isn’t a lot of time left for the increase in the Discount Rate to have an impact, it may increase the interest costs which is based off of DR*PBO at beginning of year.

In a mature plan – lots of people have already made it into the plan. a change of discount rate would reduce the corresponding PBO (due to service cost) only slightly. but the corresponding interest cost on the high PBO (since it is based on the older beginning balance of PBO and the older discount rate as well) would be high. So Service Cost change would be low, interest cost change would be high. this is what they mean. at least get the concept - that even though interest cost reduces - the reduction is a. marginal. b. change in interest cost happens 1 year later - when the new PBO and the new discount rate kick in. the exact numbers - whether change in the PBO (reduction due to service cost) is more, or change in interest cost is more - all depends on numbers. But in the general scenario - interest cost is usually lower than PBO - so it will reduce PBO – not end up offsetting that reduction in service cost = increase in interest cost.

I think what they’re getting at is that the increase in interest cost (because it’s a function of the size of the PBO which is going to be relatively large in a mature plan) is going to dwarf the savings from the service cost. So it’s like if you raise the discount rate by 1% and it saves you a $1 on service cost given your assumptions. If your PBO is a very unmature $10 you’re ahead of the game because your 1 savings only costs an extra .10 in interest cost but if your PBO is a very mature $1,000 then you just spent $10 to save $1.