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Discount Rate Basis and Methodology for PAS 19 Reporting
The discount rate is arguably the most critical and controversial assumption in actuarial valuations. Consequently, the reference basis and methodology for arriving at the assumption has been thoroughly discussed in various actuarial and financial circles.
This paper addresses the discount rate (1) reference basis and (2) methodology we at KAI employ for post-retirement benefits.
1) Background
a) What is the discount rate for?
Since post-employment benefits, such as retirement, resignation, etc., are due to occur in the future then there is a need to take into account the time value of money and assess the value of those payments now. The discount rate is used in the present value calculations.
PAS19 paragraph 78 states: “The rate used to discount post-employment benefit obligations (both funded and unfunded) shall be determined by reference to market yields at the end of the reporting period on high quality corporate bonds. In countries where there is no deep market in such bonds, the market yields (at the end of the reporting period) on government bonds shall be used. The currency and term of the corporate bonds or government bonds shall be consistent with the currency and estimated term of the post-employment benefit obligations.”
In the Philippines setting, government bonds shall be used as the reference basis for discount rates. However, government bonds are generally coupon-paying bonds. Should these be used without adjustments? The next section discusses this issue further.
2) Reference for discount rates.
On June 2010, the Financial Reporting Standard Council (FRSC) approved the Philippine Interpretations Committee Q&A No. 2008-01(Revised) that discusses the reference basis of the discount rate. The general consensus in the said document was to use zero-coupon rates as opposed to coupon-paying bonds.
The said document mentions certain methods to derive zero-coupon rates from coupon-paying bonds. Among the listed methods, we at KAI use the bootstrapping methodology as this is justified by finance economics theory.
In summary, regulation requires the use of zero-coupon yield curve as the reference for discount rates.
3) Methodology
The ideal methodology, as expressed in the Actuarial Society of the Philippines (ASP) Practice Guide on PAS 19: “The approach that best meets the requirement of PAS19 would be to estimate the duration of each obligation and apply the appropriate discount rate to that obligation. However, this would entail the use of several discount rates in a single plan valuation. To cut down on the effort (and expense) of performing such detailed work, it acceptable to use a single-discount rate.”
In the same vein, PAS19 paragraph 80 states, “The discount rate reflects the estimated timing of benefit payments. In practice, an entity often achieves this by applying a single weighted average discount rate that reflects the estimated timing and amount of benefit payments and the currency in which the benefits are to be paid.”
At KAI, the single weighted discount rate is arrived at as follows:- The benefit payments – retirement, resignation, death and disability, etc. are projected for all future valuation years.
- After which, these stream of expected payments are discounted back using the bootstrapped zero-coupon bond yields (obtained from item 2 above) to determine the present value of benefits.
- Finally, a single-weighted discount rate is determined that will produce the same present value of benefits.
I am of the opinion that the discount rate reference basis and methodology discussed above are aligned with the spirits of PAS19, FRSC’s Q&A 2008-01(Revised) and ASP’s PAS19 Practice Guide.