Discount rate in Pension

CFA Level II FRA
#1

I did a few questions on the effect of decreasing the discount rate in this chapter and it seems that by decreasing the discount rate, both PBO *AND* pension cost will increase.

I understand the first one (PBO) will increase becasue the denominator is getting smaller. HOwever I don’t get the second part, because pension cost includes service cost, net interest expense/income and remeasurement. The second term (net interest expense/income) = discount rate x net pension liability/asset. So if the discound rate is lower, I would think net interest expense/income is lower, and this term dominates the other two terms in pension cost, hence pension cost will decrease, rather than increase.

Can someone please correct me if I’m wrong?

Thanks in advance.

#2

  1. Service cost will also be higher - as service cost is PV of all the incremental benefits earned during the current year (when discount rate is lower, PV is higher).

  2. Interest cost is actually higher is most cases (except in case of mature plans) even though the discount rate is lower. This is because the PBO that you are multiplying the discount rate with will now be much higher. The effect on PBO is compounded over many years while interest cost is only for a single year (and hence the exception for mature plans). Under IFRS, the plan assets would not change due to change in discount rate - while PBO would.

#3

Nice answer, thank you!