CFA® Program Curriculum, Volume 2, page 73 The firm discloses three assumptions used in its pension calculations: the discount rate, the rate of compensation growth, and the expected return on plan assets.
The discount rate is the interest rate used to compute the present value of the benefit
obligation and the current service cost component of periodic pension cost. The discount rate is not the risk-free rate. Rather, it is based on interest rates of high quality fixed income investments with a maturity profile similar to the future obligation. The discount rate assumption affects the PBO as well as periodic pension cost.
The rate of compensation growth is the average annual rate by which employee
compensation is expected to increase over time. The rate of compensation growth affects both the PBO and periodic pension cost.
The expected return on plan assets is the assumed long-term rate of return on the plan’s investments. Recall that the expected return reduces periodic pension cost in P&L and the differences between the expected return and actual return are deferred. Also, recall that expected return is assumed only under U.S. GAAP. Under IFRS, it is always equal to the discount rate.
Firms can improve reported results by increasing the discount rate, reducing the
compensation growth rate, or (under U.S. GAAP) increasing the expected return on plan assets.
Increasing the discount rate will:
Reduce present values; hence, PBO is lower. A lower PBO improves the funded status of the plan.
Usually results in lower total periodic pension cost because of lower current service cost. Recall that current service cost is a present value calculation; thus, an increase in the discount rate reduces the present value of a future sum.
Usually reduce interest cost (beginning PBO × the discount rate) unless the plan is mature. Note that beginning PBO is reduced when the discount rate increases. For a nonmature plan this decrease more than offsets the impact of the increased rate at which we compute the interest cost.
Decreasing the compensation growth rate will:
Reduce future benefit payments; hence, PBO is lower. A lower PBO improves the funded status of the plan.
Reduce current service cost and lower interest cost; thus, total periodic pension cost will decrease.
Increasing the expected return on plan assets (under U.S. GAAP) will:
Reduce periodic pension cost reported in P&L (but will leave the total periodic pension cost unchanged).
Not affect the benefit obligation or the funded status of the plan.
Figure 14.3 summarizes the effects of changes in these assumptions on the PBO.
Figure 14.3: Effect of Changing Pension Assumptions on Balance Sheet Liability and Periodic Pension Cost
Effect on… Increase
Discount Rate
Decrease Rate of Compensation Growth
Increase Expected Rate of Return Balance sheet
liability Decrease Decrease No effect
Total periodic
pension cost Decrease* Decrease No effect
Periodic pension cost in P&L
Decrease* Decrease Decrease**
*For mature plans, a higher discount rate might increase interest costs. In rare cases, interest cost will increase by enough to offset the decrease in the current service cost, and periodic pension cost will increase.
**Under U.S. GAAP only. Not applicable under IFRS.
The assumptions are similar for other post-employment benefits except the compensation growth rate is replaced by a health care inflation rate. Generally, the presumption is the inflation rate will taper off and eventually become constant. This constant rate is known as the ultimate health care trend rate.
All else equal, firms can reduce the post-employment benefit obligation and periodic expense by decreasing the near term health care inflation rate, by decreasing the ultimate health care
trend rate, or by reducing the time needed to reach the ultimate health care trend rate.
Analysts must compare the pension and other post-employment benefit assumptions over time and across firms to assess the quality of earnings. Earnings quality deals with the conservatism of management’s financial reporting assumptions.
In addition, analysts should consider whether the assumptions are internally consistent. For example, the discount rate and compensation growth rate should reflect a consistent view of inflation. Under U.S. GAAP, the assumed expected rate of return should be consistent with plan’s asset allocation. If the assumptions are inconsistent, the firm may be manipulating the financial statements by using aggressive assumptions.
MODULE QUIZ 14.5
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1. Which of the following statements best describes the impact of an increase in the discount rate on PBO and periodic pension cost reported in P&L of a defined-benefit retirement plan covering a relatively young workforce?
A. Decrease the PBO and increase periodic pension cost reported in P&L.
B. Decrease the PBO and decrease periodic pension cost reported in P&L.
C. Increase the PBO and decrease periodic pension cost reported in P&L.
2. Under U.S. GAAP, all else equal, which of the following statements best describes the impact of an increase in the expected return on plan assets?
A. Increase in plan assets and decrease in periodic pension cost reported in P&L.
B. Decrease in PBO and increase in service cost.
C. Increase in net income.
Use the following information to answer Questions 3 and 4.
You have just been hired as the controller at Vincent, Inc. Vincent has a defined-benefit retirement plan for its employees. The firm has a relatively young workforce with a low percentage of retirees. Your first task is to analyze the effects of changing assumptions on different variables used to calculate certain pension amounts.
3. Which of the following best describes the impact of an increase in the compensation growth rate?
A. Retained earnings are lower.
B. PBO is lower.
C. The plan assets are higher.
4. All else equal, a decrease in the discount rate will most likely have what impact on the funded status?
A. Increase.
B. Decrease.
C. No effect.
5. SCP Incorporated disclosed the following information related to its defined-benefit pension plan:
2016 2015 2014
Discount rate 4.4% 4.3% 4.1%
Expected return on assets 5.2% 4.9% 4.9%
Expected salary growth rate 3.1% 3.1% 3.1%
Actual inflation rate 2.3% 2.5% 2.6%
Allocation of plan assets:
Debt investments 40.0% 30.0% 30.0%
Equity investments 60.0% 70.0% 70.0%
SCP’s pension assumptions are internally consistent with regard to:
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A. inflation expectations but not asset returns.
B. asset returns but not inflation expectations.
C. neither asset returns nor inflation expectations.