Setting your discount rate – what do you need to consider?

Angela Burns

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FRS 102 has come into effect for accounting periods beginning on or after 1 January 2015. This is the latest in a series of articles on the implications and you can access previous articles here.

Under FRS 17, if employer’s participating in non-segregated multi-employer schemes are unable to separate out their own assets and liabilities, they can account for their scheme on a defined contribution basis by recording the contributions paid in the P&L and taking no recognition of any deficit that may exist.  Under FRS 102 this option is no longer available and employers will now have to disclose a deficit in their balance sheet equal to the net present value (‘NPV’) of their future deficit contributions.

It’s relatively simple to calculate the net present value of your deficit contributions – many websites (including ours!) have this as an available resource.

What’s not so simple however is choosing the discount rate to apply in the calculation. The rate chosen will have a very significant impact on the deficit disclosed and could result in substantial variations from year to year.

The table below gives an example of this variation for a scheme with deficit contributions of £300,000 p.a. over a period of 20 years.

 Discount Rate Amount Recorded in Balance Sheet
3.25% £4.4m
4.00% £4.1m
4.75% £3.8m

In this example, using a discount rate of 4.75% p.a. would reduce the deficit to be recorded in your balance sheet by £600,000, as opposed to using a discount rate of 3.25% p.a.

It’s therefore important at outset to agree an approach with your auditor that they and you feel comfortable with and take whatever actuarial advice is needed.

Guidance confirms that under FRS 102, the discount rate should be set with reference to ‘high quality corporate bonds. The currency and term of the corporate bonds … shall be consistent with the currency and estimated period of the future payments.’

It would be arbitrary to set your discount rate by reference to a single bond and therefore as a starting point a bond index is normally used that measures the value of a specific section of the bond market – in this case, corporate bonds.

There are many indices to choose from however given the requirement that the bonds must be ‘high quality’ we would recommend an index that covers bonds that are AA rated or higher. So far, this is all relatively straight-forward but now it gets a little more complicated.

Your discount rate should reflect ‘the estimated period of the future payments’.  The average estimated time of future scheme payments (also known as the ‘duration’) is typically around 20 years.  As an example, the duration of the iBoxx AA Corporate Bond Index is around 13.5 years  so there would need to be an adjustment applied to allow for the difference in duration. As the yield curve is upward sloping (i.e. there are higher yields at longer durations) this often results in an addition to the iBoxx yield.

So once you’ve followed these steps you should have a derived yield to work with. If however you would like an independent expert viewpoint instead of adopting a DIY approach, and support in liaising with your auditor to agree a suitable process, we would be happy to provide specific assistance on setting an appropriate discount rate. For more information on this please contact us.