Setting the Discount Rate
Discount rate is a critical assumption used in actuarial valuations. Let’s first consider why.
Actuarial liabilities are arrived at using Projected Unit Credit Method (PUCM). Simply put, PUCM involves projecting cash outflows expected to occur over long periods of time in the future. In the Indian context, the expected benefit projections for a single employee could span over two or three decades on average. For example, for a 35-year-old employee, expected benefit projections would span over 25 years assuming he/she retires at age 60. Since, the expected benefit are spread over a long time in the future, we use the discount rate to arrive at the present value of future expected payments.
This makes the discount rate a critical assumption because a single rate is used to discount all future expected cash outflows for all employees in a cohort.
Typically, accounting standards require the discount rate to be based on Govt. bond yields as on the balance sheet date. Govt. bonds are risk-free, therefore, we’re considering the risk-free rate of return, without any explicit loading, to discount payments expected to occur in the future.
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 government bonds.
Para 83 of Ind AS 19
Govt. bond yields are published on daily basis on various platforms. Typically, a yield curve, i.e. bond yields over varied durations, on a particular date is published.
As yields are published over varied durations, the next question is, how do we choose a single yield rate as a the discount rate. As the yield curve is upward sloping, a 3-year-bond fetches a different yield than an 8-year-bond.
The currency and term of the government bonds or corporate bonds shall be consistent with the currency and estimated term of the post-employment benefit obligations.
Para 83 of Ind AS 19
The key word here is estimated term of benefit obligations.
The most common query we get in the audit process is – if average age of an entire cohort is 33 years, given a retirement age of 60 years, then a 27-year bond yield is to be considered as discount rate. 27 years is the average future service of the entire cohort and not the estimated term of benefit obligations. Similarly, there are other probability-based metrics available which measure the expected tenure or expected future service of the employees.
If we take a first principles view, future tenure of employees is a different quantity than future tenure of benefit obligations. By definition, actuarial liabilities are present values of cash outflows expected to occur in the future, and hence, future tenure of DBO will vary significantly from the future tenure of the employee.
Duration is the closest metric that captures the essence of the term estimated term of benefit obligations.
Duration can be interpreted as expected average tenure of outstanding liabilities. As the liabilities are arrived at using assumptions such as discount rate, salary escalation rate, attrition & mortality rates, duration captures the impact of all actuarial assumptions considered in the valuation. Given its nature, duration captures not only the future potential service of each employee, but also the sensitivity of the employee’s liability to actuarial assumptions.
The standard approach to set a discount rate is to arrive at the duration of the entire cohort and trace the corresponding g-sec yield on the date of valuation. If the duration of liabilities works out to 7 years and the corresponding govt. bond yield as on the balance sheet date works out to 6.50% p.a., then the same is used in the actuarial valuation.