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Does a Discount Rate Rule Ensure a Pension Plan Can Pay Promised Benefits without Excessive Asset Accumulation?

Author

Listed:
  • Landon, Stuart

    () (University of Alberta, Department of Economics)

  • Smith, Constance

    () (University of Alberta, Department of Economics)

Abstract

The choice of discount rate makes a substantial difference to the magnitude of the assets required to ensure a pension plan is fully funded. Finance theory suggests that the discount rate should equal the default-free rate, but pension plan administrators argue for a rate equal to the long run return on plan assets. We evaluate the ability of a fully funded pension plan to meet its promised benefit payments when the plan's liabilities are determined using different discount rate-setting rules. To account for the uncertainty of the return to plan assets and future benefit payments, we employ Monte Carlo techniques and estimates using U.S. data. Due to the volatility of pension fund asset returns and payouts, to generate a high probability of meeting promised pension payments, a plan must use a discount rate that leads, on average, to the accumulation of significant assets in excess of those required to cover promised benefits. The better performing rules are a function of economic variables, such as the return on government bonds or the inflation rate. Two rules that yield a relatively high probability that pension obligations can be met, combined with the relatively low accumulation of excess assets, set the discount rate equal to a proxy for the corporate bond yield or an inflation forecast plus 3 percent. These rates are greater than the default free rate, but lower than the return on the plan portfolio.

Suggested Citation

  • Landon, Stuart & Smith, Constance, 2018. "Does a Discount Rate Rule Ensure a Pension Plan Can Pay Promised Benefits without Excessive Asset Accumulation?," Working Papers 2018-1, University of Alberta, Department of Economics.
  • Handle: RePEc:ris:albaec:2018_001
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    File URL: https://sites.ualberta.ca/~econwps/2018/wp2018-01.pdf
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    References listed on IDEAS

    as
    1. Bucciol, Alessandro & Beetsma, Roel M. W. J., 2011. "Consequences for welfare and pension buffers of alternative methods of discounting future pensions," Journal of Pension Economics and Finance, Cambridge University Press, vol. 10(03), pages 389-415, July.
    2. Brown, Jeffrey R. & Pennacchi, George G., 2016. "Discounting pension liabilities: funding versus value," Journal of Pension Economics and Finance, Cambridge University Press, vol. 15(03), pages 254-284, July.
    3. Jeffrey R. Brown & David W. Wilcox, 2009. "Discounting State and Local Pension Liabilities," American Economic Review, American Economic Association, vol. 99(2), pages 538-542, May.
    4. Robert Novy‐Marx & Joshua Rauh, 2011. "Public Pension Promises: How Big Are They and What Are They Worth?," Journal of Finance, American Finance Association, vol. 66(4), pages 1211-1249, August.
    5. Freeman, Mark, 2013. "Pension Plan Solvency and Extreme Market Movements: A Regime Switching Approach ‐ Abstract of the Leeds discussion," British Actuarial Journal, Cambridge University Press, vol. 18(03), pages 681-694, September.
    6. Abourashchi, Niloufar & Clacher, Iain & Hillier, David & Freeman, Mark & Kemp, Malcolm & Zhang, Qi, 2013. "Pension Plan Solvency and Extreme Market Movements: A Regime Switching Approach – Funding Report for the Actuarial Profession," British Actuarial Journal, Cambridge University Press, vol. 18(03), pages 676-680, September.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Pension plans; discount rate; pension sustainability; defined benefit pension; policy rules;

    JEL classification:

    • H55 - Public Economics - - National Government Expenditures and Related Policies - - - Social Security and Public Pensions
    • H75 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Government: Health, Education, and Welfare
    • H83 - Public Economics - - Miscellaneous Issues - - - Public Administration
    • J26 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Retirement; Retirement Policies
    • J32 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Nonwage Labor Costs and Benefits; Retirement Plans; Private Pensions

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