Mercer | Discount rate for IFRS/US-GAAP/HGB valuations

Mercer | Discount rate for IFRS/US-GAAP/HGB valuations

Discount rate for IFRS/US-GAAP/HGB valuations

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To assist companies in determining the discount rate, Mercer delivers monthly information on the discount rates for IFRS, US-GAAP and HGB (German Commercial Code) valuations of pension obligations. Furthermore, Mercer reports weekly on the development of the discount rates for IFRS and US-GAAP valuations during November and December of each year.

1. Discount rate for IFRS/US-GAAP valuations

To determine the discount rate recommendation Mercer uses its own approach, the ‘Mercer Yield Curve Approach’ (MYC). The MYC is being used for setting discount rates for valuations made for USA, UK, Canada, Eurozone and some other countries. According to this approach, Mercer creates a ‘Spot Rate Yield Curve’ based on bonds from the Thomson Reuter’s Datastream indexes (until 31.5.2015 from Bloomberg indexes) in the Euro area. Since the discount rate in accordance with IAS 19.78 is defined by the ‘time value of money’, which by definition does not incorporate any greater risk of default, Mercer consequently uses only those bonds, which have no interest rate-distorting options, like e.g. it would be the case with call or put options. Furthermore, the bonds with much higher or lower interest rates compared to the other bonds (statistical outliers) are also not considered. A detailed explanation of the method described above can be found here.

For the valuations according to international accounting standards (IFRS/US-GAAP/FRS), the discount rate should be determined according to the maturity of the liability based on "high quality corporate bonds". In the long-term average these rates were only around 0.5% points higher than the rates for (quasi safe) AAA rated government bonds. Therefore, the standard setters, auditors and actuaries typically used AA rated corporate bonds as ‘high quality corporate bonds’. E.g. the iBoxx corporate AA10+ is a commonly used benchmark index.

Due to the uncertainties in the financial markets, the spread between the yield on (quasi safe) AAA rated government bonds and the yield on AA rated corporate bonds had increased from earlier 0.5 percentage points up to about 2 percentage points in 2008. This results from the fact that the markets had yet equipped many AA rated bonds with a significant risk premium. In the meantime the spread has returned again nearly to the situation before the crisis of the financial markets.

The  relevant method used to determine the discount rate has a very strong impact.

The companies therefore have a certain  latitude in the choice of the discount rate (although the principles of continuity and consistency still must be followed).

Further information on the present uncertainties in the Eurozone (ECB‘s quantitative easing program, Brexit und Greek crisis) and the corresponding impact on yields of corporate bonds can be found here.

Our recommendation is based on durations of 10, 15 and 20 years. The discount rates for different durations can be determined by interpolating the values from the table below. It should also be noted that the current low level of discount rates may result in higher durations than those in the previous years.
 

 

 

 

Basis: Until 31.05.2015 Bloomberg indexes, since 30.06.2015 Thomson Reuters Datastream indexes. Discount rates Mercer Yield Curve 2006–2014 rounded to 10 basis points. Smaller adjustments in the calculation as of 30.06.2015 and 30.11.2016 (description here).

The effects of changes in discount rates lead to so-called actuarial gains / losses. These must be taken into account in equity immediately according to the revised version of ASC 715 (US-GAAP) released in the end of September 2006 or according to the version of IAS 19 (revised 2011) released in June 2011 and applicable from 2013. In ASC 715, gains and losses may lead to increased (for losses) or reduced (for gains) expenses in the next year when the so-called corridor approach is used and the corridor is exceeded.

The following interest rates can be derived from the MYC for different durations through an interpolation (as of: July 31st, 2018):


2. Discount rate for HGB (German Commercial Code)

The usage of a discount rate in the valuations according to the German Commercial Code is regulated by law. According to § 253 Abs. 2 of the Commercial Code, provisions for pensions are discounted with a rate determined by the German Central Bank (Deutsche Bundesbank). It can be either the discount rate for a 15-year period or the discount rate chosen according to the actual remaining term of the obligations.

The discount rates for different maturities are published monthly by the German Central Bank. The rate is determined using the yield curve for zero-coupon euro interest swaps increased by an additional spread. The average of the interest rates over the last ten years (seven years up to December 31, 2015) for pension liabilities and seven years for other liabilities like jubilees or pre-retirement part time (ATZ) is used to avoid strong short-term volatilities. The maturities of one to ten years, 12, 15, 20, 25, 30, 40 and 50 years are observed to calculate the interest rate. The spread is calculated using a broad index of returns for corporate bonds with high credit ratings.

A modification of the method for determining the discount rate used for pension valuations under German-GAAP (Generally Accepted Accounting Practice) was introduced early in 2016. The new method will extend the rolling average period to 10 years for pension liabilities, leading to a reduction in the reported pension liabilities at the point of change – so far a seven year rolling average of market rates is used (and continues to be used for other liabilities as e.g. jubilees and pre-retirement part time (ATZ). The discount rates used for a typical pension plan at December 31, 2015, would typically increase by around 0.42%-points, to 4.31% up from 3.89%.

Under German-GAAP, changes in pension liabilities from one year to the next are recognized immediately in profit and loss (P&L), so the change likely will benefit companies by smoothing P&L charges. The reduction in pension liabilities will not increase the maximum dividend payable by the German company.

A transitional regulation providing companies with a fiscal year starting and ending in 2015 will allow them to opt to apply the new standard retroactively for 2015.

For further details please visit our website (in German).

The following table is based on the 7-year-average and in addition 10-year-average (from December 31st, 2015):

 

Since the HGB discount rate is an average rate, at least the short-term trend is well estimable. Assuming that the current level of interest rates remains unchanged, the following forecasted interest rates can be determined as of July 31st, 2018:


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