Explaining the Discount Rate

One of the most significant assumptions we make when we complete an actuarial valuation, is setting the discount rate. The discount rate is the rate we use to value the current cost of future pension obligations. The discount rate is determined by estimating expected rates of return, from LAPP investments over the long term, and it includes a cushion for adverse deviation, known as margin.

A key indicator of future returns is the yield on government long bonds, which are often thought of as “risk-free” because the potential for default is low and the rate of return is expected to yield as promised. The chart below shows the widening gap between our discount rate and the risk-free rate of the long bond yields. The bigger the gap, the bigger the risk that our assets and liabilities will not line up.

To address this gap, we continue to bring our discount rate down with each valuation, keeping it more in line with long-bond yields. However, the cost of being prudent is expensive. Every time we decrease the discount rate it drives up the value of pension benefits and increases current service costs. For LAPP a 1% decrease in the discount rate raises Plan liabilities by about $5.8 billion.

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