I have been reading articles on liability driven investing, a technique used to increase the correlation b/w assets and liabilities of a pension plan. It appears that they use AA rated corporate bond yields to discount the liabilities. At the same time, the articles say that interest rate is the dominant influential factor for liabilities. So are interest rate and corporate bond yields(AA in this case) are the same thing? Or are they highly positively correlated?
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$\begingroup$ In which jurisdiction @Jun Jang? $\endgroup$– rrgOct 21, 2016 at 23:09
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2 Answers
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Anything that is used for discounting is by definition an "interest rate". But then the question arises what is the appropriate choice of interest rate to use for discounting pension liabilities. There are many possibilities (many interest rates).
Some want to use the expected return on the stock market as the interest rate. That is a very bad choice (although popular), because stock returns are quite risky while a pension is not supposed to be.
A reasonable choice is the AA corporate bond rate. After all a pension is a kind of "debt" (a promise to pay) that a corporation owes to its employees, so it make some sense that the discount rate should be similar to the rate that the corporation pays on its corporate bonds.
For state and federal government pensions the issue is more debatable. Since the federal government borrows at the long term risk free rate it may make some sense to use this rate in discounting Social Security and other government sponsored pensions. This rate is lower than the AA rate.
The whole question of which interest rate should be used is very delicate. Because pensions liabilities are long term, even a small difference in interest rate makes a big difference in the p.v. of the pension liabilities (as you said). Also, it is in the corporations interest to use as big a discount rate as they can to minimize the (reported) presen value, whileit is in the meployees interest to use a smaller interest rate so the company will set aside more money now and make their pension more secure.
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$\begingroup$ If one saw pension liabilities as corporate debt why should a BB company use AA spreads for discounting? $\endgroup$– g gMay 21, 2016 at 20:42
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$\begingroup$ It makes some sense to have a single standard if the government is going to impose a single rule on everyone. However, it is an open and hotly debated issue. The workers for the BB company would have a less secure pension, is that acceptable or is that unfair in some way... $\endgroup$– Alex CMay 21, 2016 at 20:50
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$\begingroup$ I would add that BB rated companies do not have defined contribtion pension plans, it is largely only the biggest companies in the US that have such plans (and many are phasing them out). $\endgroup$– Alex CMay 21, 2016 at 20:54
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1$\begingroup$ It's also a regulatory requirement: "SEC requires that discount rates reflect the yield at the measurement date of a cash-matched portfolio of securities that receive one of the two highest ratings given by a recognized ratings agency ... (for example... Aa or higher from Moody's)". $\endgroup$– HelinMay 21, 2016 at 21:07
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$\begingroup$ Alex C, Thank you very much for the detailed reply. I am currently working on a liability driven investing simulation on the u.s. corporate pension plans. Do you think it is reasonable to use AA corporate bond yields to discount all the pension plans in s&p 500? Also, Citigroup produced pension discount curve: soa.org/Professional-Interests/Pension/Resources/…. I am not really sure how they came up with these numbers, but do you think they are reasonable to discount the future liabilities? $\endgroup$ May 24, 2016 at 4:27
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You earn coupons on a corporate bond portfolio and in this sense corporate bond yield is an interest rate. But it is important (especially in liability driven investment) to recognise that corporate bond yield has two quite different components: credit spread and riskfree interest rate. To quote from Wikipedia Corporate bond: "High Grade corporate bonds usually trade on credit spread. Credit spread is the difference in yield between the bond and an underlying US Treasury bond (for US Dollar corporates) of similar maturity. Credit spread is the extra yield an investor earns over a risk free instrument (US Treasury) as a compensation for the extra risk."
The lack of interest in your question on this site might be explained by the fact that it can be answered by a straightforward look at Wikipedia.
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1$\begingroup$ Corporate bond yield IS an interest rate. Whilst Treasury yields represent a risk-free interest rate, corporate bond yield is the interest rate on riskier bonds. $\endgroup$– HelinMay 21, 2016 at 16:37
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$\begingroup$ hmm, you HAVE a point there, maybe I got slightly carried away. I will edit. $\endgroup$– g gMay 21, 2016 at 19:02
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$\begingroup$ If C = corporate bond yield, R = risk free interest rate, then C = (C-R) + R, where (C-R) is credit spread, much like risk premium in the CAPM framework? $\endgroup$ May 24, 2016 at 4:28