An analyst is constructing a financial statement model for a manufacturing company. The company has a significant defined benefit pension plan. The analyst needs to project the company's pension expense for the upcoming year. Which of the following components of pension expense is LEAST likely to be sensitive to the assumed discount rate?
- AAmortization of prior service cost
- BInterest cost
- CExpected return on plan assets
- DService cost
Show answer & explanationAnswer & explanation
Correct answer: D. Service cost
Service cost represents the present value of the benefits employees earn during the current period. While the discount rate is used to calculate the present value, the primary driver of service cost is current employee compensation and benefit formulas, making it less directly sensitive to changes in the discount rate compared to interest cost (which is PBO * discount rate), expected return on assets (which is FVPA * expected return, often linked to market rates), or amortization of prior service cost (which involves actuarial gains/losses that are sensitive to discount rate changes).
Why the other options are wrong
- A. Amortization of prior service cost is part of actuarial gains/losses, which are sensitive to changes in the discount rate as they affect the PBO calculation.
- B. Interest cost is directly calculated as PBO multiplied by the discount rate, making it highly sensitive.
- C. Expected return on plan assets is calculated using the fair value of assets and an expected return rate, which is often influenced by market interest rates and thus indirectly by the discount rate.
Pension Expense Components & Discount Rate Sensitivity
Pension expense comprises several components. Interest cost, expected return on assets, and actuarial gains/losses (which include prior service cost amortization) are generally sensitive to changes in the assumed discount rate. Service cost, representing benefits earned in the current period, is primarily driven by compensation and benefit formulas, making it less sensitive to the discount rate.
- Service Cost: Benefits earned in current period.
- Interest Cost: PBO * Discount Rate.
- Expected Return on Assets: FVPA * Expected Return Rate.
- Amortization of PSC/Actuarial G/L: Affects PBO/FVPA, sensitive to discount rate.
- Discount rate directly impacts PBO, and thus interest cost and actuarial G/L.
Memory trick: PENSION is a SERVICE with INTEREST, ASSETS return, and ACTUARIAL adjustments.