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Methodology for Risk-free Discount Rates and CPI Assumptions for Accounting Valuation Purposes

1  Why do we need a discount rate methodology?

1.1  What is the methodology for?

1.1.1    This paper documents the methodology for determining risk-free discount rates and corresponding Consumer Price Index (CPI) assumptions. These assumptions are for use in certain accounting valuations that are reported to the Government for consolidation purposes. The methodology is not intended to apply to the valuation of traded securities.

1.2  Why is the Treasury publishing discount rates now?

1.2.1    The reason we are providing a central methodology and publishing discount rates is to ensure consistency and efficiency across accounting valuations that are reported to the Government. The issue of consistency with regards to risk-free discount rates used in the Government's accounting valuations was highlighted during preparation of the 2009 Financial Statements of the Government.

1.2.2    A number of reporting entities consolidated in the Government's accounts use discounted cash flow models to value various assets and liabilities for financial reporting. These valuations are typically attempting to measure obligation or rights incurred on or before balance date, but the settlement of those obligations or receipt of benefits will occur in the future.

1.3  Who should use these discount rates and CPI assumptions?  

1.3.1    The Treasury's central table of risk-free discount rates and CPI assumptions must be used in certain accounting valuations for the purpose of preparing the Financial Statements of the Government. Specifically the table of rates applies to all Government reporting entities submitting valuations to Treasury for:

  • valuing insurance claims liabilities under NZ IFRS 4 Insurance Contracts
  • valuing employee benefits such as pension obligations, long service leave and retiring leave under NZ IAS 19 Employee Benefits, and
  • building a risk-adjusted discount rate for valuing student loans.

1.3.2    Entities reporting financial results to the Treasury for consolidation purposes include departments, offices of parliament, State-owned enterprises and Crown entities.

1.3.2    As well as the accounting valuations noted above, these rates may be applied to other valuations where a risk-free discount rate or CPI assumption is used. The rates may either be used unadjusted or as a building block to calculate another assumption at the reporting entity's discretion.

1.3.4    You should consider if these discount rates and CPI assumptions are appropriate for your entity’s own annual report. Any potential differences in rates used in your own annual accounts and the ones used for Government consolidation purposes should be discussed with the Treasury.

1.4  Why are CPI assumptions for accounting valuations being published?  

1.4.1    Determining the nominal amounts to be settled or received in the future is likely to be impacted by inflation that is specific to the liability or asset being measured. We have only considered inflation as measured by the CPI in this exercise. Each valuation will need to consider the appropriate inflation index to use in relation to this CPI assumption.

1.5  When and where will the discount rates and CPI assumptions be published?  

1.5.1    The first table of discount rates and CPI assumptions will be published today for Government accounting valuations as at 30 June 2010. The Treasury also intends to publish these rates and assumptions four times a year for use in future accounting valuations.

1.5.2    The table of discount rates and CPI assumptions will be published on the Treasury's website under “Guidance and Instructions”.

1.6  Did the Treasury have help from external experts?

1.6.1    Yes. The Treasury, in developing this methodology, contracted PricewaterhouseCoopers to:

  • draft a methodology for determining risk-free discount rates and corresponding CPI assumptions for use in accounting valuations in accordance with generally accepted accounting practice and actuarial standards in New Zealand, and
  • issue an exposure draft document to key entities outlining the methodology and rationale for determining risk-free discount rates and corresponding CPI.

1.6.2    In drafting the methodology, the Treasury and PricewaterhouseCoopers consulted with entities that would be most affected by it. Submissions received on the exposure draft were considered as part of finalising this methodology.

1.7  How did the Treasury approach the development of this methodology?

1.7.1    A number of valuations recorded in the financial statements of the Government involve valuing cash flows 50 or more years into the future. The principles in accounting standards generally require that discounting should be at a rate that reflects the time value of money ie, the risk-free rate. Also, for valuing some assets the standards require risk-adjusted discount rates, (often built up from risk-free rates with adjustments for risk). Therefore, the main objective of this paper is to determine a suitable risk-free yield curve for discounting cash flows of extreme durations.

1.7.2    One of the challenges is that in practice, the risk-free rate cannot be directly observed; it is usually proxied by the return on a very safe asset. When selecting the risk-free rate, the first step is to identify a suitable observable proxy and then to determine if any adjustments to that proxy are required. Therefore, this methodology determines the most appropriate observable yield that provides the best proxy to a New Zealand risk-free rate.

1.7.3    An additional challenge is that New Zealand bonds and bank SWAP yield curves, generally accepted as suitable proxies for risk-free rates, are relatively short in duration compared to some of our obligations and assets. At extreme durations there are no observable market values for interest rates. In New Zealand the longest reliable market yields available are 10 to 12 years for government stock and 15 years for bank SWAP rates. In addition, there is a lack of market data for inflation and therefore, reliance has to be placed on forecasts instead, most of which have a short-term focus of three or at the most five years. For valuations with significant future cash flows, the discount rates and CPI assumptions used can make a significant difference to the value reported.

1.7.4    Given the short-term nature of market data on interest yields in New Zealand and the long-term nature of some of the Government's obligations, we have grouped the methodology under three headings which are:

  • short-term assumptions
  • long-term assumptions, and
  • assumptions for bridging the short and long-term.

1.7.5    We have also established eight distinct steps to determine a table of risk-free discount rates and CPI inflation assumptions that can be applied across extreme durations of cash flows. This overall framework, including these defined steps, is outlined in paragraph 2.1.1.

1.7.6    Under our approach short-term means the period in which market yields are observable in New Zealand to proxy risk-free rates and for CPI, five years. Long-term means the period beyond observable market yields and for CPI greater than five years.

1.7.7    A full review of the accounting and actuarial standards relating to setting discount rates and CPI assumptions can be found in Section 9, Review of Accounting and Actuarial Standards and Other Literature. Generally, the accounting standards provide principles but have limited specific guidance in a number of areas, particularly where there are market shortcomings such as mismatches between liability durations and the length of the market yield curves.

1.7.8    Reliance and limitations relating to this report are set out in Appendix 1.

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