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The Discount Rate Debate and Its Implications for Defined Benefit Pensions

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Abstract

Since defined benefit (DB) pensions are guaranteed, they are often priced using risk-free interest rates. This paper shows how time diversification limits the cost of guarantying DB pensions to no more than the required cash contributions to pay for outgo, which can be significantly cheaper than the risk-free interest rate approach. The discrepancy can be explained by the incompleteness of financial markets for pensions and hence the breach of Ross s (1976) arbitrage-free conditions to price DB benefits using interest rates. Given the current negative interest rates, it is optimal to hold more equity so that the increased risk can be mitigated by cash contributions, a higher funding ratio and long investment horizon. The above findings are applied to the Universities Superannuation Scheme, the largest privately funded DB scheme in the UK. Overlooking the role of cash contributions in mitigating risks is identified as the main reason for the scheme s deficits.

Suggested Citation

  • Woon K. Wong, 2018. "The Discount Rate Debate and Its Implications for Defined Benefit Pensions," Cardiff Economics Working Papers E2018/22, Cardiff University, Cardiff Business School, Economics Section.
  • Handle: RePEc:cdf:wpaper:2018/22
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    Cited by:

    1. Rostami-Tabar, Bahman & Ali, Mohammad M. & Hong, Tao & Hyndman, Rob J. & Porter, Michael D. & Syntetos, Aris, 2022. "Forecasting for social good," International Journal of Forecasting, Elsevier, vol. 38(3), pages 1245-1257.
    2. Jackie Grant, 2024. "The UK Universities Superannuation Scheme valuations 2014-2023: gilt yield dependence, self-sufficiency and metrics," Papers 2403.08811, arXiv.org, revised Apr 2024.

    More about this item

    Keywords

    pension; defined benefit; time diversification; de-risking; USS;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G3 - Financial Economics - - Corporate Finance and Governance

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