The Disaggregated Discount Rate - A Catalyst for De-Risking

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Hypothetical Scenario: A plan sponsor would like to reduce some degree of pension investment risk, or more accurately, dampen the volatility of their plan’s funded status through the principles of Liability Driven Investing (LDI). However, this sponsor continues to maintain an uncomfortable level of equity market and other investment risk in their pension holdings primarily because they can’t stomach the associated increase in pension expense generally required by U.S. GAAP accounting rules.

In the brief example that follows, we offer a simple illustration of how sponsors can potentially utilize a rapidly emerging accounting trend to mitigate the P&L impact of pension investment de-risking. While the efficacy of this approach will vary by plan, some sponsors may find this technique to be effective in making pension investment de-risking a more palatable proposition to those internal or external stakeholders who may otherwise be opposed.

Background and Purpose: Beginning in 2015 and accelerating greatly into 2016, a number of defined benefit pension plan sponsors have adopted a new method of calculating pension expense.1 While the details of the approach are rather technical, the implications of the change are relatively straightforward. The purpose of this article is in no way to comprehensively explain the intricacies or the potential variations of the accounting method, which have been addressed by other publications. Rather, the goal of this article is to offer a simple example of the accounting implications of adopting a plain vanilla version of the new method, and to illustrate how this change can be strategically implemented in tandem with a shift to a more conservative strategic asset allocation. As will be shown, the pension expense consequences should be diminished as a result of the coupling.

The new accounting method involves disaggregating the (historically singular) discount rate into three separate discount rates, one each for 1) Pension Benefit Obligation (PBO), 2) Service Cost, and 3) Interest Cost. Resisting the urge to elaborate, let’s simply refer to
this discount rate disaggregation as the Full Yield Curve Method, and for the purpose of the example in this article, let’s assume that the key outcome of changing to this method is a lower Interest Cost (though Service Cost is likely to be reduced as well). It is worth noting that a shift to this method should have no bearing on the PBO, and therefore the resulting (Gain)/Loss will be impacted, as the balancing item in the PBO reconciliation. The assumed directional impact on the components of a hypothetical 2017 PBO reconciliation from changing to the Full Yield Curve Method for that year’s accounting is illustrated below.

So what is the connection between this new methodology (which clearly relates primarily
to plan liabilities) and the riskiness of the plan’s investment portfolio (which clearly relates
primarily to plan assets)?

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