Schweser vol 2 page 195 figure 5 second column: “discount rate up: interest cost down, pension expense decrease.” I really couldn’t understand this. Coz intuitively, when discount rate goes up, the interest expense is the PBO times interest rate which be higher than when interest rate is low. if the PBO is very big, the increase of interest can offset any service cost. How to understand this? The interest cost should goes up usually?
the fact that discount rate goes up decreases PBO the decrease of PBO is more important weights more, than an increase in the interest rate
The rate that you multiply the PBO by to get the interest expense will go up. However this will (most often) be more than offset by the decrease in the PBO due to the increase in discount rate. Only in very mature plans is it more likely that the there will be an increased in interest costs.
when the interest rate goes up, your PV of PBO calculated will go down - so your interest cost will be based on a LOWER PBO and HIGHER INTEREST RATE. This net amount is usually smaller than the service cost which goes down when interest rates rise. Thus overall the interest rate increase will decrease pension expense…
the discount rate has two offsetting effects: 1) it decreases the interest cost by reducing the % multiplied by the PV(PBO) 2) reduces PV(PBO) however, the net effect is usually and almost always is that the total pension expense goes down. in very rare occasions, where the pension is mature, a reduction in interest would increase PBO.
Usif Wrote: ------------------------------------------------------- > the discount rate has two offsetting effects: > > 1) it decreases the interest cost by reducing the > % multiplied by the PV(PBO) > 2) reduces PV(PBO) > > however, the net effect is usually and almost > always is that the total pension expense goes > down. in very rare occasions, where the pension is > mature, a reduction in interest would increase > PBO. An INCREASED discount rate increases the % that is multiplied by the PBO. But, the PBO will be smaller and the smaller PBO will dominate unless the plan is very aged.
I got this wrong for on my last Schweser test. I gave the book the double barrelled middle finger and “Scruuuuuu You.”
But i still couldn’t understand. PBO(t) = PBO(t-1) + PBO(t-1) * interest + service cost + actuarial gain/loss … My question here is that : 1 ) Will change in interest affect PBO(t-1) or it will only affect the current yr service cost and the interest cost? 2) If 1) is true then if the pension has been run for 10 yrs, the base of PBO(t-1) should be pretty huge and the interest generated should be much more than the decrease in service cost due to the interest rate increase. Is it true?
I think I understand your question… You want to know if last year’s PBO (the value that we calculate interest expense with) is changed retroactively due to a change in the discount rate?? I know that service cost for this year will be lower due to an increase in the discount rate since the future cashflows are discounted more heavily. I don’t THINK the PBO for last year changes retroactively which would make me assume the interest costs would actually be higher…lol
To answer pencil, I think PBO changes retroactively through the actuarial gains/losses… if the discount rate increases by 1%, PBO will decrease by 1% * duration. If duration > 1 (which is 99% likely unless you’ve just started the plan), the cumulative effect of the increased interest rate on a decreased PBO will lead to a decreased interest cost… That’s how I understand things.