Does a discount rate rule ensure a pension plan can pay promised benefits without excessive asset accumulation?

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  • The choice of discount rate makes a substantial difference to the magnitude of the assets required to ensure a pension plan is fully funded. Finance theory suggests that the discount rate should equal the default-free rate, but pension plan administrators argue for a rate equal to the long run return on plan assets. We evaluate the ability of a fully funded pension plan to meet its promised benefit payments when the plan's liabilities are determined using different discount rate-setting rules. To account for the uncertainty of the return to plan assets and future benefit payments, we employ Monte Carlo techniques and estimates using U.S. data. Due to the volatility of pension fund asset returns and payouts, to generate a high probability of meeting promised pension payments, a plan must use a discount rate that leads, on average, to the accumulation of significant assets in excess of those required to cover promised benefits. The better-performing rules are a function of economic variables, such as the return on government bonds or the inflation rate. Two rules that yield a relatively high probability that pension obligations can be met, combined with the relatively low accumulation of excess assets, set the discount rate equal to a proxy for the corporate bond yield or an inflation forecast plus 3 percent. These rates are greater than the default free rate, but lower than the return on the plan portfolio.

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