In order to manage its defined benefit pension plan, a company must make numerous actuarial assumptions.
The footnotes to financial statements will disclose the following key assumptions:
- The discount rate used to create present values (the interest rate);
- The compensation growth rate (projected salary increases); and
- The expected return on plan assets.
Changing the Discount Rate
The present value of the DBO has an inverse relationship with company changes to the discount rate.
- When the discount rate drops, the DBO increases.
- A company can alter its earnings by using an artificially high discount rate. Even though the interest cost component of the pension expense will be higher, it will be applied to a significantly lower defined benefit obligation base, which lowers the overall pension expense for the accounting period and falsely inflates the company’s net income.
- Theoretically, a company should base its discount rate on market rates for high credit quality bonds with maturities that closely mirror the timing of future pension benefit payments to retirees.
Changing the Compensation Growth Rate
The present value of the DBO and the current service component of pension expense both have a direct relationship with the compensation growth rate assumption.
- When a company increases is its compensation growth rate, the DBO will increase and the current service cost component of pension expense will increase.
- When an analyst reviews the company’s footnotes to financial statements, he/she must check to see that a rational compensation growth rate is assumed by the company.
- The compensation growth rate should be taken into consideration alongside the discount rate. Inflation expectations should have similar impacts on compensation and interest rates. When a company increases its discount rate by more than its compensation growth rate, the widening spread between the two tends to reduce the obligation and the pension expense.
Changing the Expected Return on Plan Assets
Management may be aggressive in its assumption of the expected return for plan assets.
- When the assumed return is too high, pension expense will be artificially low and net income will be artificially high.
- The expected return on plan assets presents an opportunity for management to manipulate earnings.
- According to modern portfolio theory, a pension plan’s expected portfolio return should be based on asset allocation. The analyst should be weary of a company’s reported pension expense, when the expected return is not consistent with the asset mix.
