Understanding Pension Liabilities: A Closer Examination of Discount Rates

Abstract

The discount rate represents a critical choice in accounting for corporate defined-benefit pension plans due to the long-term nature of pension liabilities. U.S. GAAP and IFRS mandate the AA corporate bond rate. Their requirement is subject to much debate, with the risk-free rate and the expected return on pension assets (EROA) often proposed as alternatives. We examine which of these rates best fits pension values as perceived by equity- and debt-market participants. For equity values, the EROA rate dominates, while for credit ratings, the AA rate dominates. For financially healthy firms, however, discounting at the EROA produces the best fit for both equity values and credit ratings. In contrast, for firms nearing financial distress, discounting at the AA rate provides the best fit. We also find that the accumulated benefit obligation measure consistently dominates the projected benefit obligation in explanatory power for credit ratings. Overall, we find that market participants adjust GAAP-recognized pension obligations in both amount and discount rate, in a manner that appears consistent with firm-specific economic realities.