CHICAGO - For corporate financial executives facing falling interest rates and rising pension costs from a seemingly inevitable cut in the discount rate used for valuing pension liabilities, William M. Mercer Inc. has developed a model that could enable a plan sponsors to raise the discount rate and defend it to the Securities and Exchange Commission.
The computer modeling process constructs a hypothetical bond portfolio that enables companies to use a higher discount rate - one that reduces expenses and is defensible to the SEC, Michael Young, principal in the Chicago office, noted.
In one actual case, he said, the model cut a manufacturing company's 1993 pension expense by $4.6 million and liabilities by $56 million.
It also justified an increase in the company's discount rate to 7.7% from 7.2%.
Mr. Young said the company did not want to be identified.
Both the SEC and auditing firms have stepped up scrutiny of the way employers pick their discount rate for valuing pension and retiree health-care liabilities (Pensions & Investments, Nov. 15).
The model could reduce substantially a company's expense for both its pension plans and its retiree medical plans, according to Mr. Young.
"We were looking for ways to help our clients in light of the SEC decision" directing corporations to use for their 1993 corporate reports, prepared for 1994, a discount rate that reflects that of AA- or AAA-rated bonds, Mr. Young said.
Mercer employees developed the model in response to the directive by the SEC, which suggests using an effective discount rate of 7% based on a general AA bond rating.
"A 7% discount rate is what you'd conclude, if you'd looked at the indexes of AA bonds," Mr. Young said.
But with the model, "we're consistently getting outcomes almost always above 7.5%," Mr. Young said, referring to the discount rate.
"But in some of the mega-pension funds" - those with more than $1 billion in liabilities - "we've gotten rates a little lower," he added.
"There may not be enough good, high-yielding AA bonds" to accommodate such large plans, Mr. Young said.
The way it works, the model tests every possible combination of AA bonds and picks off the higher-yielding AA bonds, he said.
Every AA bond, in theory, should offer the same yield, but Mr. Young pointed out ratings don't capture the latest information in the market, causing different yields for the same-rated bonds.