Once upon a time, corporate pension plans were ruled by actuaries. Then inflation rose. Markets became more volatile. Pension reporting requirements changed. And, most importantly, pension assets grew, and grew, and grew. The importance of pension plans became evident even to the corporate managers. But when they turned their acquisitive eyes to the pension reports the actuaries gave them, they were astonished: The figures—for pension liabilities, in particular—seemed to have little to do with economic reality. It was decreed that, henceforth, pension liabilities had to abide by the laws of the marketplace.
Arriving at “best estimate” assumptions for calculating the economic value of pension liabilities is simplified by using currently obtainable market discount rates to estimate the present value of the benefit payments. Current government bond rates tell us what discount rate to use over the next 20 years; this will cover almost all current pensioners. But what of active plan members, whose payments may extend out 65 years?
Obviously, some assumptions must be made about the discount rate 20 to 65 years into the future, and current economic conditions have little to tell us about what this rate should be. Fortunately, because of the effects of discounting to present value, it turns out that this rate, whatever its value, will have relatively little effect on the total present value of pension obligations. In fact, 70 to 90 per cent of this value will be determined by the known market discount rate. Of course, this also means that the present value of pension benefits, hence corporate contribution rates, will be very sensitive to changes in observed discount rates. But, after all, this was the intention from the start—to arrive at best estimates that reflect (changing) economic conditions.