Discount rate for PBO discount, liability, confusion, game

ASSet_MANagemen

Kinda late in the game to be fuzzy about this central concept, but....

If the discount rate for PBO decreases the, PV of pension liabilities increases. Given this inverse relationship between dicount rate and liability amount, why does the discount rate become the starting point for required return of a pension plan (book 2 page 363 first para)

My confusion is consider a case where the discount rate used by plan actuaries keep going down and we use that lowering rate as required return for plan assets, the liabilities will keep increasing and assets will keep using a lower required return!?

Perhaps I have been assuming incorrect parallel between "crediting rate" of a insurance company and the PBO "discount rate" used by Pension sponsor



Edited 1 time(s). Last edit at Sunday, May 22, 2011 at 03:16PM by jbaphna.

Windjam

The discount rate of liabilities is the minimum required rate of return to fund the ALM assuming assets = or > than liabilities. Plans that have above average risk tolerance (surplus, young working life etc.) may seek a higher return objective to lower future pension contributions or increase benefits to participants. Look for statements such as required return + 2% etc.

pennyless

Thanks Paraguay....just to recap--

Liabilities discount rate (usually a risk free, long term bond yield) is the *minimum* the assets need to earn. If the plan lowers the discount rate used, it implies the liability PBO increases and the assets should correspondingly try to lower risk taking.

Could you please contrast "crediting rates" of an insurance company with the "discount rate" used for PBO by Pension sponsor?

strikethree

If you are forced to lower the discount rate then first thing is you generally need to do is add assets via a contribution.

The new amount of assets now has a lower required rate of return but again brings up the decision to take more risk than benchmark (liability) and pursue a higher rate of return or the same risk as benchmark and immunize the portfolio.

Credited rates of an insurance company is an opposite concept but has the same effect on required rates of return. If credited rates are decreased the asset pool doesn't have to produce as high a rate of return to meet the liability. Think of credited rates as a payout of $5 for 5%, $4 per 4% etc per $100. Lowering the credited rates decreases the amount of payout. The payout of a Defined Benefit is defined for perpetuity, you are changing the discount factor for the payments. Insurance credited rates act as an offset to this problem as the rates are variable based on the asset portfolio so a lower expected return on the asset side lowers the credited rates (assuming there is no floor). Generally barring very specific statements. Required return for insurance should be "Earn positive spread to contractual liabilities, commensurate with claims paying ability being paramount" whereas pension has a discount rate that should be followed unless specific provisions allow the company to take more risk.

dyga

I should preface this with the idea that the IPS is a long-term document. Insurance companies sell multitudes of products on a daily basis and would require changing the IPS almost daily for the required return.

The CFAi will have to either give a statement that is fairly obvious as to what the return requirement for insurance is or go with positive spread to liabilities.



Edited 1 time(s). Last edit at Sunday, May 22, 2011 at 04:24PM by Paraguay.