Answer to Problem 15, in FRA, Pensions, page 254: “A lower discount rate will increase the defined benefit obligation and increase the interest cost component of the periodic pension cost (the increase in the obligation will, in most cases, more than offset the decrease in the discount rate).” A lower discount rate does not increase the interest cost component, it reduces it, which will make NI higher, so answer should be A as well. Their jusitifcation that lower discount rate increases the DBO is correct, but that should not impact earnings. My understanding of interest cost is that it is interest rate * beginning DBO. Any thoughts?
interest cost is int rate * beg PBO. But the combined effects here still decrease NI. Sorry i don’t have anything better than that
I thought of this issue. The actuarial assumption have no meaning as far as NI is concerned. Irrespective of assumptions we can contribute to your pensions a set fixed amount and the Funded status reflects any increase or decrease in overall pension plan status.
My main argument is the statement explaining the answer, i.e., “A lower discount rate will increase the defined benefit obligation and increase the interest cost component of the periodic pension cost (the increase in the obligation will, in most cases, more than offset the decrease in the discount rate).” … is not correct, because impact on earnings is related to pension expense, not DBO balance. Since pension expense is lower with a lower discount rate, NI is higher.
If the discount rate goes down, the service portion of the PBO will go up. The interest rate component is now increased by this higher PBO amount and offset a little by the lower discount rate. Hence why the statement says the increase in the obligation will more than offset the decrease in the discount rate.
Here is what they are not saying in their explanation…or at least I didn’t get it the first time. Yes, interest cost will decrease because of the lower DR, and that will reduce P.E., and yes DBO will increase, and that has nothing to do with earnings. However, the decreased DR will *increase* the current service cost in the P.E. formula, which increases P.E. and lowers NI. Oh, boy.
If you lower the discount rate, you increase the PBO. What it says in the book is this: Larger PBO * Smaller Discount Rate > Smaller PBO * Larger Discount Rate Therefore lowering the discount rate will increase interest expense. It’s counterintuitive but makes sense after running through it a time or two.
Read my reply above if you really want to understand this well.
Interest cost = PBO * Discount rate. The int cost goes up simply because the increase of PBO is large enough to offset the effect of a decreasing discount rate. Have I made it clear?
no.
Zeal, you’re correct, and yes, you made it clear.