How does a change in the discount rate affect both the PBO and pension expense, and why is sensitivity analysis important?

Discount rate sensitivity is a favorite analytical topic because it tests your understanding of the mechanics and your ability to assess pension risk.

The Chain of Effects

A lower discount rate has multiple, sometimes offsetting, impacts:

1. PBO Increases (Dominant Effect)

The PBO is the present value of future benefit payments. A lower discount rate means less discounting, so the present value rises. Elkridge's disclosure confirms this: -50 bps → +$35M PBO.

This is the modified duration effect. The PBO's duration to a 50bp change:

Effective duration = $35M / ($480M x 0.005) = 14.6 years

That's a long-duration obligation — typical for mature pension plans.

2. Interest Cost: Ambiguous

Interest cost = Discount rate x Beginning PBO

If the rate drops from 5.0% to 4.5%, but PBO rises from $480M to $515M:

• Old interest cost: 5.0% x $480M = $24.0M
• New interest cost: 4.5% x $515M = $23.2M

The rate decrease slightly outweighs the PBO increase — interest cost falls modestly. But this is not always the case.

3. Service Cost Increases

Service cost is the PV of benefits earned during the current period. A lower discount rate increases this present value.

4. Funded Status Deteriorates

Funded status = Plan assets - PBO

Plan assets are unaffected by the discount rate assumption (they are at fair value). So the entire PBO increase flows directly to a worse funded status:

New funded status = Plan assets - ($480M + $35M) = worsens by $35M.

Why Asymmetric?

The PBO-discount rate relationship is convex (like a bond). A 50bp decrease raises PBO more than a 50bp increase reduces it. This is because:

The convexity means companies are more exposed to rate declines than they benefit from rate increases.

Analyst Application

When analyzing Elkridge:

1. Check the discount rate vs. peers — if Elkridge uses 5.0% while peers use 4.5%, its PBO is understated
2. Stress-test the funded status using the sensitivity disclosure
3. Consider the duration mismatch between plan assets (maybe 6-8 years if mostly bonds) and the PBO (14.6 years) — this is a significant risk
4. Assess whether the plan's asset allocation is appropriate for its liability profile

Exam tip: Sensitivity disclosures are required under both IFRS and US GAAP. If a vignette provides them, expect questions asking you to recompute the funded status or pension expense under alternative assumptions.

For pension analysis practice, explore our CFA Level II FRA materials.