Based on Carson’s projections of the discount rate, what are the likely effects on the projected benefit obligation (PBO) and the pension cost?

Andrew Carson is an equity analyst employed at Lee, Vincent, and Associates, an investment research firm. In a conversation with his supervisor, Daniel Lau, Carson makes the following two statements about defined contribution plans.

Statement 1: Employers often face onerous disclosure requirements.

Statement 2: Employers often bear all the investment risk.

Carson is responsible for following Samilski Enterprises (Samilski), a publicly traded firm that produces motorcycles and other mechanical parts. It operates exclusively in the United States. At the end of its 2009 fiscal year, Samilski’s employee pension plan had a projected benefit obligation (PBO) of $320 million. Also, unrecognized prior service costs were $35 million, the fair value of plan assets was $316 million, and the unrecognized actuarial gain was $21 million.

Carson believes the rate of compensation increase will be 5% as opposed to 4% in the previous year, and the discount rate will be 7% as opposed to 8% in the previous year.

This past year, Samilski began using special purpose entities (SPEs) for various reasons. In preparation for analyzing the SPE disclosures in the footnotes to the financial statements, Carson prepares a memo on SPEs. In the memo, he correctly concludes that the company will be required under new accounting rules to classify them as variable interest entities (VIE) and consolidate the entities on the balance sheet rather than report them using the equity method as in the past.

Based on Carson’s projections of the discount rate, what are the likely effects on the projected benefit obligation (PBO) and the pension cost?
A . Both will increase.
B . Both will decrease.
C . One will increase and the other will decrease.

View Answer

Answer: A

Explanation:

A lower discount rate increases the PBO. It also increases the overall pension expense by increasing the service cost and, most likely, the interest cost. (For mature plans, a higher discount rate might increase interest costs. In rare cases, interest cost will increase by enough to offset the decrease in the current service cost, and pension expense will increase.) (Study Session 6, LOS 22.c)