Longfellow Group maintains a defined-benefit pension plan for all its domestic employees. The projected bene obligation (PBO) was determined using a discount rate of 7%. The expected rate of compensation growth is 5%, and the expected rate of return on plan assets is 15%. The pension plan is currently over-funded.
1.Indicate (higher, lower, no effect) and briefly explain the effect of an decrease in the discount rate on:
a.The PBO in the year of change
b.Pension cost in the year of change
2.Indicate (higher, lower, no effect) and briefly explain the effect of an decrease in the expected rate of compensation growth on:
a.The PBO in the year of change
b.Pension cost in the year of change
3.Indicate (higher, lower, or no effect) and briefly explain the effect of an decrease in the expected rate of return on plan assets on:
a.The PBO in the year of change
b.Pension cost in the year of change
1. PBO is the present value of the liabilities earned and the future expected increases in the compensation. If the discount rate decreases, the present value increases since the company now has to put in more money into the fund to satisfy the pension obligations. If PBO increases, pension cost in the year of change also increases correspondingly. Also lower discount rate leads to increase in service cost and decrease in interest costs resulting in overall increase in cost.
2. PBO is positively related to the expected rate of compensation growth. Higher the expected growth, higher the PBO and hence, higher the pension cost in the year of change.
3. With the increase in return on plan assets, the unfunded pension liability goes down but PBO as such do not change. Since the expected return on plan assets rises, pension costs also reduced.
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