Discount Rate Choice for Pension Liabilities

A pension liability is a promise to pay retirees a stream of cash for decades — but a promise to pay $1 in 25 years is worth less today than $1 in 5 years, so any honest valuation has to discount those future payments back to a present value. The rate used to do that discounting is not a minor technical footnote: because pension cash flows stretch 30 or 40 years into the future, even a small change in the discount rate compounds into a very large change in the reported liability, which is why the choice of rate is one of the most fought-over numbers in pension accounting.

Which rate, and why it matters which one

Different accounting and regulatory regimes prescribe different rates. Corporate accounting standards (like US GAAP or IFRS) typically require discounting at a high-quality corporate bond yield, on the logic that this reflects the rate at which the company could theoretically settle the obligation by buying bonds that match the payment schedule. Some regulatory or funding regimes instead prescribe a rate closer to the risk-free government bond yield, on the more conservative logic that a promised pension payment shouldn't be discounted at a rate that assumes a company's own credit risk (why should a weaker company get to report a smaller liability just because its own bonds yield more?). A public-sector or multiemployer plan might instead use a long-term expected-return-on-assets assumption, discounting the liability at whatever rate the fund's own equity-heavy portfolio is expected to earn — a choice that critics argue understates the true liability, because it discounts a fixed, low-risk promise using a rate that only makes sense for risky assets.

Because the liability is a long-dated stream of fixed payments, it behaves like a very long-duration bond: its present value is highly sensitive to the discount rate, in exactly the way a 30-year zero-coupon bond's price is far more sensitive to yield changes than a 2-year bond's.

For example, a stream of pension payments with a present value of $1 billion at a 5% discount rate could be worth roughly $1.2 billion at a 4% discount rate — a 20% swing in the reported liability from a one-percentage-point change in the assumed rate, with nothing about the actual promised payments having changed at all.