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Old 10-28-2015, 03:43 PM
cmmh1990 cmmh1990 is offline
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Default Discount Rate in ASC-715

For determining the discount rate under ASC-715, a common approach is to match liability cash flows with high-quality corporate bonds, then determine the effective discount rate based on the yield of those bonds. In reading FAS-157 (paragraph C47), I thought it was interesting that some accountants argue that the credit rating of the bonds used to match cash flows should be based on the credit rating of the plan sponsor. In other words, a company whose financial situation is shaky would use a discount rate based on corporate bonds of similarly shaky corporations. I don't quite understand how this is fair, so any guidance is appreciated.

My thoughts: For one, this approach would let struggling companies value their benefit obligations at a higher discount rate (since they're basing it off of lower-quality bonds, which have higher yields). Secondly, this approach seems to argue that since the plan sponsor has a low credit rating, the benefit obligations might not be met (if we're using a high discount rate to determine liability, there must be an additional risk, so as to eliminate arbitrage opportunity). But a company's overall financial well-being isn't necessarily telling of its pension plan's well-being (i.e. there could be a company with a small, frozen, well-funded pension plan, while at the same time be unable to pay its debts to other lenders, thus having a low credit rating).

Any opinions or clarifications are welcome. Thank you!

Last edited by cmmh1990; 10-29-2015 at 06:24 PM..
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Old 10-28-2015, 04:20 PM
Jeremy Gold Jeremy Gold is offline
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This is a good set of questions that you ask.

It depends on what discipline you want to apply. I believe that a straightforward read of ASC-715 (FAS 157, FAS 87) is that you should use high quality corporate bonds regardless of the company's creditworthiness.

If you want the best economic reasoning (and what I think the accounting should say, but doesn't), then you should consider both the company credit and the fundedness of the plan. In effect you have a collateralized debt of the corporation (the plan funds are the collateral since they must, in an ERISA plan, be used first to pay benefits). A very well-funded plan sponsored by a weak sponsor might imply a near default-free discount rate, especially if benefits are frozen and the plan assets are well-matched to the liabilities and the plan is overfunded. An unfunded plan, e,g, a SERP, might also be discounted at nearly default-free rates if the plan sponsor is very creditworthy (think NY Life for example).

In the second case, we are relying on the company's credit; in the first case on the collateral. If both are weak, then a higher discount rate is appropriate even though this leads to a lower liability. If we marked corporate bonds to market, then the bonds of an Aaa company would create a greater liability than the bonds of a Bb company, i.e., a higher discount rate for the bonds of the weaker company.

If we were talking about unfunded plans, then it might be appropriate to use the sponsor's credit rating and this would be fair across companies.

If, however, we were talking funding, rather than financial reporting, and we want to know how well-funded a plan is or, in theory, how we should fund it, then default-free rates would apply. I inserted "in theory" because PPA, due to a technical error in testimony and to political forces, inserted default premiums into the funding valuation for ERISA plans. Tsk, tsk. This was exasperated by MAP-21, then by HAFTA which extended MAP-21, and now by the latest budget agreement which extends HAFTA.
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Old 10-29-2015, 06:03 PM
zeus1233 zeus1233 is offline
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It could be considered "fair" in the sense that other debt of the corporation is being valued at that sort of market-based rate reflecting the company's credit rating. Pensions are just another form of debt. To add on to what Jeremy is saying, I can see a logical distinction between the portion of the obligation which can be satisfied with current assets and the portion that cannot be satisfied. The unfunded portion of the plan is debt of the company. Using a cost of debt consistent with that company's credit rating may be reasonable. The funded portion is different since assets exist solely to pay benefits, and the discount rate for that should reflect the lower risk.

Think about the interest rate a bank charges you for a mortgage vs. what you would pay for debt that has no collateral asset behind it. The interest rate is very different because the risk (and likelihood of payment) is different.

I've seen a multiemployer plan calculation which reflects a split discount rate approach in the past (although the mechanics of the calculation weren't the same as what is described above)

FWIW there is SEC guidance that AA quality bonds are what should be used under US GAAP, so there really isn't a choice here for public companies

Last edited by zeus1233; 10-29-2015 at 06:06 PM..
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Old 10-29-2015, 06:41 PM
cmmh1990 cmmh1990 is offline
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Thank you for the input. I think I'm starting to understand the argument for using a discount rate based on the sponsor's credit rating. When you break it down into who is borrowing money (sponsor) and who's lending money (participants), it makes sense that the lender would charge a higher interest rate if the borrower's financial situation is murky.

The main thing that trips me up is the use of the ASC-715 val itself. Unlike the typical lending/borrowing scenario, an increased discount rate doesn't help out the lender; these guys are still getting their benefit payments at the same time. If anything, it seems to help out the borrower. The borrower gets to lower its PBO by using a higher discount rate.
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Old 10-29-2015, 08:24 PM
zeus1233 zeus1233 is offline
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It's not about "helping" or "hurting" it's about reflecting the economic reality associated with the plan.

Think of it this way - if participants could "sell" the obligation as debt to another organization, what price would they get? If I sell a bond with fixed payments in the future, the market value of that security is going vary with the credit worthiness of the underlying counterparty as there is a higher risk that the payments are never made.

Of course, if one wanted to go down this road, one could also point out the fact that at least a portion of the payments are "insured" through the PBGC for a US qualified pension plan, which complicates this even further.
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Old 10-30-2015, 12:55 PM
cmmh1990 cmmh1990 is offline
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Ok thank you, that helps me understand. And as you (Zeus) stated earlier, the SEC guidelines clearly say that AA bonds should be used as the basis for determining the discount rate; so I probably won't have to worry about this too much. Anyway, it piqued my curiosity, thanks for the input and explanation.
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