What Discount Rate Should be used to Valued Defined Benefit
Pension Liabilities?

Zaki Khorasanee


In defined benefit pension plans, the primary function of the actuarial valuation
is to determine appropriate contribution rates from the plan sponsor. For this
reason, the valuation discount rate is based on the expected return on the assets
of the pension fund and the definition of the actuarial liability can vary according
to the funding objectives. The valuation of pension liabilities for financial reporting
purposes requires a unique definition of the accrued liabilities and a unique discount
rate to value these liabilities. Equilibrium pricing theory can be used to derive a
formula for the discount rate that should be used to value final salary pension
liabilities. Based on UK data, however, the required risk-adjustment appears to be
small. Modern pension accounting standards make no allowance for market risk, but
use an ad-hoc approach to allow for default risk. Standards such as SFAS 87 and
FRS 17 appear to have adopted a hybrid position between fair value accounting
and actuarial funding methods.

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