Page 45 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 15.d: Explain and calculate the effect of a defined benefit READING 15: EMPLOYEE COMPENSATION: POST-EMPLOYMENT AND SHARE BASED
plan’s assumptions on the defined benefit obligation and
periodic pension cost. – 3 assumptions must be disclosed!
MODULE 15.5: PLAN ASSUMPTIONS
Increasing the discount rate will:
• Reduce present values; hence, PBO is lower. A lower PBO improves the funded status of the plan.
• Usually results in lower total periodic pension cost because of lower current service cost. As current service cost is a PV calculation; thus, an
increase in the discount rate reduces the present value of a future sum.
• Usually reduce interest cost (beginning PBO × the discount rate) unless the plan is mature. Note that beginning PBO is reduced when the discount
rate increases. For a nonmature plan this decrease more than offsets the impact of the increased rate at which we compute the interest cost.

Decreasing the compensation growth rate will:
• Reduce future benefit payments; hence, PBO is lower. A lower PBO
improves the funded status of the plan.
• Reduce current service cost and lower interest cost; thus, total
periodic pension cost will decrease.

Increasing the expected return on plan assets
(under U.S. GAAP) will:
• Reduce periodic pension cost reported in P&L (but will leave the
total periodic pension cost unchanged).
• Not affect the benefit obligation or the funded status of the plan.

The assumptions are similar for other post-employment benefits except the compensation growth rate is replaced by a health care inflation rate
which is expected to taper off and eventually become constant (this constant rate is known as the ultimate health care trend rate).

All else equal, firms can reduce the post-employment benefit obligation and periodic expense by decreasing the near term health care inflation
rate, by decreasing the ultimate health care trend rate, or by reducing the time needed to reach the ultimate health care trend rate.
Analysts must compare the pension and other post-employment benefit assumptions over time and across firms to assess the quality of earnings.
Earnings quality deals with the conservatism of management’s financial reporting assumptions.

In addition, analysts should consider whether the assumptions are internally consistent. For example, the discount rate and compensation growth
rate should reflect a consistent view of inflation. Under U.S. GAAP, the assumed expected rate of return should be consistent with plan’s asset
allocation. If the assumptions are inconsistent, the firm may be manipulating the financial statements by using aggressive assumptions.