Is inflation accounted for in the discount rate that equates a DB plan’s assets and liabilities? i.e.: when setting a minimum return objective, its just the discount rate and inflation should not be added anymore? I feel like it might be a stupid question, but for some reason it feels counterintuitive.
do not add inflation, it is encompassed within the discount rate
Depends on the funded status of the plan.
-If the plan is fully funded, use only the discount rate. Inflation is incorporated in the liabilities, so no need to add it.
-If the plan is underfunded, you need to beat the discount rate for the plan to return to a fully funded status. So adding the inflation component might be reasonable here.
-If the plan is overfunded, you have a much higher return target than the discount rate.
Underfunding and inflation are different things. The discount rate itself incorporates any inflation-adjustment since that is part of the liability cash flow values, see AM 2012 6A. Then comes the question if this rate is sufficient yes or no given the funded status. If fully funded, minimum is discount rate, if underfunded and desire to grow surplus it’s discount rate plus some extra return but that has nothing to do with inflation.
If your plan is underfunded and you want your plan to be fully funded, your return on the asset portfolio has to exceed your discount rate. So you may increase your discount rate by the inflation rate as a return target. Or not?!
Correct but inflation is not an input for that. The key here is that the effect of inflation is already incorporated in the discount rate if we’re talking about inflation indexed liabilities. The amount by which you increase the discount rate is simply a TVM problem where you solve for I/Y. If you’re at 90% funding it may be +2%, at 95% +1% etc.
Example: assets 90, liabilities 100, discount rate of liabilities is 3%. How much return is required to grow to funded status in one year? In one year liabilities are 103. So N = 1, PV = 90, FV = 103, solve for I/Y = 14.44 so that’s an additional return of 11.44. No inflation required here.
You will fly to the moon on Saturday;]
pensions are my forte