Understanding Discount Rates for Pension Obligations

The brief from the American Academy of Actuaries, “Measuring Pension Obligations,” starts out by explaining that pension obligations can refer to the estimated payments made to pension plan participants. The present value of this obligation to participants is then expressed as a single amount to be paid on a specific date.

This present value, explains the brief, is dependent upon the discount rate. The discount rate is defined as the interest rate used to bring future cash flows to the present to account for the time value of money. The brief looks at two approaches for selecting discount rates—those that are market based and those that are based on expected returns. 

The brief defines a market-based approach as one that uses a discount rate based on observable data from financial markets. An approach based on expected returns, on the other hand, is defined as using a discount rate based on the estimated return of a pension plan’s investment portfolio.

Delving deeper, the brief looks at solvency value, which is a measurement used under the market-based approach. This measurement determines an amount that a pension plan needs to invest in default-free securities to provide the benefits with certainty. The brief also discusses budget value, a measurement used under the return-based approach. This measurement determines an amount that will be sufficient to provide benefits if the portfolio earns the expected returns on assets.

The difference between these two values represents the gain that the plan sponsor anticipates by taking on risk in a diversified portfolio.

According to the authors of the brief, “The difference between the solvency value and the budget value provides insight in to the risk and potential rewards of the diversified portfolio.” The authors also explore related scenarios, which include plan sponsors using return-seeking assets in a diversified portfolio, as well as plans using a contingent asset similar to a call option.

The full issue brief can be downloaded here.