Return requirement for DB plan

CFA Level III
#1

This is 2012 past paper. Question asks to calculate the return requirement for the Defined benefit pension plan given: - Discount rate applied to determine the PV of plan liabilities = 5% - Expected average annual inflation rate = 1.25%

Can someone please explain further why we don’t include inflation in the return requirement?. E.g. why is return not (1.05)x(1.0125).

Answer says: the minimum return requirement for the Plan is 5% because this is the rate that is used to calculate the present value of liabilities. (Note that the expected future liabilities already incorporate expected inflation-related adjustments to benefits for Plan participants.

#2

I guess because the inflation rate is already embedded in the 5% discount rate.

#3

“Discount rate applied to determine the PV”

Why change it?

#4

But how do we know that inflation is already embedded in the 5% discount rate?

#5

Read my post.

#6
#7

Good…good…let the hate flow through you.

#DarthVadar

#8

Can someone please explain further why inflation is already embedded in the 5% discount rate used to calculate plan liabilities?

#9

That’s how actuaries calculate the discount rate.

#trustme

#10

Because it is a nominal discount rate.

#11

Because it’s said 5% includes the inflation,

that’s not systematically the case though.

#12

Ding ding ding ding ding

#13

But the information in the vignette only says: “The Discount rate applied to determine the present value of the Plan’s liabilities: 5.0%” There is no mention that this is a nominal discount rate?

#14

I posted something above from the text - which possibly got missed in the rest of the folk’s comments.

Plan status: fully funded – also GIVEN IN THE VIGNETTE!

Statement from BOOK: for a fully funded pension plan, the portfolio manager should determine the return requirement beginning with the discount rate used to calculate the present value of plan liabilities.

and this from, the guideline…

(Note that expected future liabilities already incorporate expected inflation-related adjustments to benefits for Plan participants.) Aquiline may consider earning a return in excess of the 5% required minimum. Achieving a higher return would reduce the probability of a future funding deficit and the need to make additional contributions.

#15

But the vignette makes no mention of inflation. The answer, as you pointed out, says that expected future liablities already incorporate inflation-related adjustments, but how do we know this from the vignette? Can someone please further explain why we don’t add inflation in the DB return requirement when they mention “Discount rate applied to determine the PV of plan liabilities = 5%”

#16

You cannot argue both ways. Read the puzzle (vignette) carefully.

At the very top they state

* Discount rate applied to determine the present value of the Plan’s liabilities: 5.0% • Expected average annual inflation rate: 1.25%

also

Plan status: fully funded

They ask you afterwards to determine what the return requirement would be…

You are supposed to use the fact that a) plan is fully funded, therefore discount at the discount rate applied to determine PV of plan liabilities = 5% is the required rate of return.

If you went ahead and added 1.25% and said 6.25% - you lost points PERIOD.

The fact that you still state = plan made no mention of inflation - but they did give you inflation - to throw you off.

In Level III - you will find these “so called” inconsistencies - and a majority of candidates - self included - fall for them, time after time. That is also a given fact. You do not need to know that when plan is fully funded - you DO NOT ADD INFLATION… If you pointed that out … and ding…ding…ding … that is what you were supposed to do - you got the 4 points for writing 1 sentence … else you got 0.

#17

So if it wasnt fully funded you would add inflation?

#18

Is this as simple as the retirees receive inflation-adjusted pension payments and therefore the inflation assumption is embedded into discount rate?

Also, I dont know if “You do not need to know that when plan is fully funded - you DO NOT ADD INFLATION.” is accurate. Haven’t seen a mention of that in the curriculum.

#19

People here make it seem harder than it is.

The discount rate used to find the PV of any asset/liability is a nominal discount rate. Adding inflation to it is useless.

Now if the payments were real, and the discount rate did not include inflation, then guess what, adding inflation is still useless.

#20

So is the discount rate used to find the PV of any asset/liability always a nominal discount rate? Hence why we don’t need to add inflation to the return requirement?