In truth, the promises the pension plan has made to its participants don't really change much from year to year. They change only by the amount of additional benefits employees have accrued each year. What changes is the present value of those promises. What do we mean by present value?
If we promise to pay someone $1,000 ten years from now, what is our liability today? Certainly not $1,000. We could put a lesser amount in the bank today, and that would grow into the $1,000 we need 10 years from now. That lesser amount, realistically, is our liability today. The amount we need today—the present value—depends on what rate of interest we expect we can earn. And reasonable people can't agree on what rate of interest we should assume.
Financial accounting standards say the interest rate assumption should vary each year depending on the change in the prevailing interest rate on corporate bonds. That's the interest assumption that determines the present value of pension liabilities shown in a company's annual report. The Pension Benefit Guarantee Corporation, as an insurance company, uses an interest rate more closely related to the interest rate on long government
'If pension assets fall short and the sponsor becomes insolvent, then the risk falls upon the insurer—the federally chartered Pension Benefit Guarantee Corporation.
bonds. That results in a much higher present value of pension liabilities. For other purposes, other interest assumptions are made.
The key point is that pension liabilities change each year with interest rates. As interest rates go down, liabilities go up. And vice versa. So trying to maintain a level funding ratio—the ratio of assets to liabilities—is a moving target. The market value of assets may have risen nicely last year, but our plan's funding ratio might be down if interest rates have dropped sharply at the same time.
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