Monday, August 31, 2009

Discounting pensions

The IASB proposes to modify the discount rate applicable to the valuation of pension liabilities in IAS19. The proposal would eliminate the requirement to apply government bond yields instead of high quality corporate bond yields where there is no deep and liquid market for such securities. The proposed modification is triggered of course by the massive expansion of the spread between corporate and government bonds in the wake of the crisis, which serves as an excuse for yet another instance of accelerated due process...

While I agree that applying government bond yields to discount pension liabilities makes sense in only a very limited set of circumstances, and definitely not as a generic fall-back position in the absence of a deep corporate bond market, the proposed discount rate suffers one important flaw. The Board argues (BC4) that comparability is served by reducing the range of rates used. Yet, the motive for not just fixing a single rate (maximum comparability in that sense) is probably that this would not reflect economic reality in any sense. But this purpose is not served by choosing high quality corporate bonds, either. What if the reporting entity is not of high quality (which is the rule rather than the exception nowadays)? The liability is overstated.

The economically correct discount rate to apply to the valuation of pension liabilities in my opinion is WACC. Cost of capital is calculated for each entity separately and thus cannot be compared uniformly, but it reflects the economic reality of financing decision making. As an analyst knowing about the many arcane ways in which pension liabilities are valued, I don't take the nominal amount of pension liabilities at face value anyway, so that comparison is of little interest.

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