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How to select discount rate for actuarial valuation

Posted by Megha Agarwal on 06-Mar-2017 11:00:00

Set discount rate for actuarial valuation

There is more to selection of discount rate than simply looking up the interest rates on internet. Many companies don't realise the complexities involved and need to do more than they are doing currently.

Any actuarial valuation involves the use of a 'discount rate', which is used to calculate the present value of future benefits promised by an employee benefit scheme.


This post only covers the selection of discount rate. Details on other topics related to actuarial valuation of employee benefits can be found here.


Accounting standards, such as AS 15, Ind AS 19, IAS 19 and US GAAP have prescribed rules on how the discount rate should be selected.
 
The significance of discount rate in any actuarial valuation cannot be over-estimated. It has a significant direct impact on the liability. This is one assumption that can be validated by looking at publicly available information and therefore undergoes the maximum scrutiny of the auditors and external analysts. 
 

whose responsibility is it?

Many companies have a perception that it is alright to leave the decision to set the discount rate to their actuaries. In the past, such an approach has led companies into severe problems. If an error or discrepancy in choosing the discount rate is revealed, companies cannot pass on the consequences to the actuary.
 
Discount rate, as with all other actuarial assumptions, remains the responsibility of the Board of the reporting enterprise. It is their responsibility to ensure that they have done enough to ensure the actuarial assumptions were set correctly with due attention to the work done by the actuary. Of course, this responsibility can be delegated by the Board to the managers in the company. In case of any issues, the Board and the delegated personnel will be held accountable. In most cases, the consequences on the actuary would be a disciplinary action by the Institute of Actuaries of India, which is unlikely to be of any significant benefit to the company.
 

WHAT IS PRESCRIBED UNDER the ACCOUNTING STANDARDS?

Most accounting standards prescribe that the discount rate should be set equal to the yield to maturity on Government bonds (Government securities, or GSecs) having term consistent with the term of liabilities, as at the date of valuation.

The reference made to 'term' is important. The yields on bonds vary with their term and when yields are plotted against their respective terms, the resulting chart is called the 'yield curve'. An example of a yield curve is shown below. 

Yield Curve-1-211869-edited.png
The accounting standards prescribe that the discount rate selected should be read from the yield curve that existed on the date of valuation.

The 'term' referred to in the accounting standards is generally agreed to be the 'duration' and the yield curve should be a 'Zero Coupon Yield Curve' or ZCYC, derived from the yields on GSecs.

CAN ONLINE SOURCES BE USED FOR SETTING DISCOUNT RATE?

Many websites provide estimates of discount rates. For example, Bloomberg displays Government bond yield of many countries, including India and can be seen here. Using online sources has advantages and disadvantages. The most obvious advantage is that these are easily accessible. The disadvantages are:

  • They are only available for select durations and do not show the full yield curve. This makes online sources of limited use if the duration of liability is long. In particular, it is generally not advised to rely on internet sources for assessing discount rates for pension or post-retirement medical benefit schemes because duration of these benefit schemes could far exceed the duration of any GSec being traded in the market.
  • Some of these websites use generic algorithms across various countries so may not allow adequately for the distortions that exist in the Indian market

For these reasons, it is usually the best to use online sources to cross-check the discount rate chosen by your actuary, rather than to directly relying on them. That said, the online sources may be used if the employee benefit liabilities are not material. The company, rather than their actuary, should make that call.


The yield curves produced by the Clearing Corporation of India Ltd (CCIL) circumvent both drawbacks encountered with other online sources. Their yield curves have been in use across the Indian financial services industry for more than a decade. At Numerica, we rely on them to deliver actuarial services.

We have published the yield curves produced by CCIL on our website and can be found here. This also includes a tool to check the correct discount rate to be used for AS 15 or Ind AS 19 actuarial valuations.

Refer to our quarterly discount rate reports to understand the movement of discount rates over each quarter and the impact that could have on your employee benefits liabilities.


What companies must do

Companies should always request a full explanation to be provided in the actuary's valuation report, including an explanation of the financial data, and the methodology the actuary has used in setting this assumption. Methods include Smith-Wilson, Nelson-Siegel, cubic splines, but a simpler method can be used on grounds of materiality. Whatever method is used, it is important that an explanation is provided.

Even when an actuary has used an external or an online source to set the discount rate, the actuary should explain the methodology that was used in the construction of the corresponding yield curve and why the actuary thinks that the discount rate chosen meets the requirements of the accounting standard.

A General approach to selecting discount rate

Companies should also be aware of the process of fixing the discount rate, which typically goes as described below. 
 
1. Source the financial data on traded GSecs from a stock exchange such as National Stock Exchange (NSE) or Bombay Stock Exchange (BSE). The data would show, as at the valuation date, which G­Secs were traded and at what price. With this information, the actuary would then calculate yield to maturity for each traded G­ Sec.
 
2. As noted above, the yields would be different for different types of G­Secs depending on the 'term' of that G­Sec. The actuary would produce a raw yield curve calculated from the traded G­Secs and then interpolate between them to produce a complete yield curve. As explained above, the actuary could use the yield curve produced by a reliable external source, deemed to carry authority over the matter; e.g. Clearing Corporation of India Ltd (CCIL).
 
3. The actuary would calculate the duration of the benefit obligations, which is usually an output of actuarial valuation. Let's say, the durationof obligations calculated to be 6 years.
 
4. The actuary would then look up the yield corresponding to the duration of 6 years from the yield curve produced in step 2.
 
The yield corresponding to the liability duration is the discount rate to be taken for actuarial valuation.
 
Most external sources would be using some variant of the generic approach described above.

Download our guide on how to set other actuarial assumptions and other basics of actuarial valuation. Click on the picture below:
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Topics: Employee benefits, Actuarial valuation, AS 15, Ind AS 19, Discount rate, Actuarial assumptions

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