Pension Industry

Discount Rate Regulation for Canadian Private Defined Benefit Pension Plans

Author:

Sally Shen, Global Risk Institute


Executive Summary

 

In Canada, private DB plans follow the Canadian Institute of Chartered Accountants’ (CICA) guidelines for calculating their accounting liabilities. According to regulatory guidance CICA 3461, private DB plans should use the yield of high quality fixed income securities that generate cash flows matching the expected amount and timing of the plan’s benefit payments to discount pension liabilities.

This regulation is challenged by the incomplete long-term bond market. Since DB pension plans are often confronted with ultra-long-term commitments with maturities of more than 70 years, the valuation of DB pension liabilities rely on ultra-long term (30 years +) interest rates. The market for these ultra-long-term instruments is much less liquid and in Canada high-quality corporate bonds with maturities of more than 10 years virtually non-existent. 

Due to the incompleteness of the long-term bond market, it is necessary to extrapolate the term structure of the corporate bond interest rates beyond the maturity of the longest dated market-available instrument. The current extrapolation method (according to a CIA Educational Note)1 that extends the smoothed or regressed function beyond the LLP to complete the yield curve, can be very risky and chaotic. Under both interpolation and extrapolation, smoothing of the discontinuous bond prices is susceptible to both parameter and model risk.

This paper proposes to use an ultimate forward rate (UFR) method to extrapolate the corporate yield. This is a subjective method that extrapolates the liquid market interest rates such that they converge in the long run to an unconditional ultimate forward rate. Different from the UFR method adopted in Europe, the Canadian UFR includes additional default risk premium so as to adjust the spread between government and corporate long-term yields. Table below lists the five core components of the Canadian UFR. A survey study suggests that setting UFR to 4.7% is suitable to the Canadian market.

 

Component Rate chart

 

The adoption of UFR provides two possible benefits: First, it effectively shrinks the pricing volatility caused by model risk and it stabilize the liability valuation under different phases of business cycles. Second, it also reduces the required funding under the low rate environment. 

For additional detail, please see the full report below.


Footnotes

[1] The Canadian Institute of Actuaries (CIA), "Accounting Discount Rate Assumption for Pension and Postemployment Benefit Plans", (SEPT 2011)


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