Now that pension surplus has a direct impact on a corporation’s capital structure, and potentially on its cost of capital, the valuation of the pension liability is more important than ever. In the absence of a standardized notion of market interest rates, the corporate treasurer has fairly wide latitude in choosing a pension liability valuation technique. The incentive will be to select a technique that minimizes the liabilities. The “market value” of the liabilities may thus differ from the actual projected liabilities, and future benefits may be jeopardized. Furthermore, comparability across firms, from accounting, valuation and security analysis viewpoints, will be reduced if different firms measure their pension liabilities differently.
To lend consistency to pension liability valuation, some consensus about the appropriate term structure model would be desirable. When used to value pension liabilities, a term structure model does not have to adhere closely to actual yields, which contain premiums for an array of features not relevant to the liabilities. What is important is that the model adhere to accepted economic theory. A two-stage modified regression model that controls for individual bond features exhibits a close fit to actual Treasury yield data while behaving in accordance with economic theory. In particular, the model allows for flattening of yields in the long run and the smooth convergence of spot and forward rates, indicating that it will give consistent and accurate results for discounting purposes.
