Current events are seeing an unusual situation, in which interest rates are actually negative.
This can happen if people feel that it is safer to put their money in the investment than to keep it in a checking account, and they are actually willing to pay (hence the negative interest rate) in order to do that.
This has been a phenomenon in Europe in past years, but recently the negative interest rate has touched base on the shores of the United States as well.
Defined-Benefit Pension Valuation
This phenomenon raises a question in connection with defined-benefit pension valuation.
One of the factors in valuing the pension is the discount rate, which is generally interpreted as the interest rate on a safe security, such as a 20-year US Treasury Bill rate.
The question that arises is whether one should use a negative interest rate as the discount rate for purposes of calculating the pension value.
I’m going to propose that, even if the prevailing safe interest rate is negative, the lowest interest rate one should use for the purposes of pension valuation is zero.
Here is my reasoning:
- As we know, the value of the pension is inversely related to the interest rate.
- The higher the interest rate, the greater the discounting (reduction) of future payments.
- The greater the discounting of future payments, the smaller is the present value.
- So with a higher interest rate, you get a lower present value of the pension.
And the converse is true: with a lower interest rate, you get a higher present value.
A negative interest rate would increase the present value even further.
However, since there is always an option to leave money in a checking account, no one is forced to take a negative interest rate.
It does not seem reasonable to increase the value of dollars that are going to be received in the future on the theory that present dollars are necessarily earning negative interest.
Thus, we would suggest that the lowest interest rate one should use in valuing a pension is zero.
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