2 Summary of Proposed Methodology
2.1 Overall Framework
2.1.1 The framework for determining the Treasury risk-free rates and CPI assumptions can be summarised in eight steps as follows:
- Determine risk-free discount rates for the first year with reference to Treasury Bills and the Overnight Cash Rate (OCR).
- Determine the smoothed market forward rate curve with reference to New Zealand government stock yields.
- Determine any adjustments required to the New Zealand government stock yields to give short-term risk-free discount rates.
- Determine short-term CPI inflation assumptions.
- Determine long-term real risk-free discount rates.
- Determine the long-term nominal risk-free discount rate.
- Determine long-term CPI inflation from the above, cross-checked against available market and historical data.
Assumptions for bridging the short and long-term
- Determine the method of blending short-term and long-term rates.
2.2 Proposed Methodology Steps 1 to 8
2.2.1 Each of these eight steps is discussed in detail in the body of the report. Below is a summary of the methodology and principles that apply to each of the eight steps under the Framework. These will be applied consistently at each valuation date.
Short-term risk-free rates (Steps 1 to 3)
2.2.2 Government bonds and Treasury Bills will be the starting point for determining short-term risk-free rates. The relevant accounting and actuarial standards either require reference to government stock, or encourage reference to it in determining a proxy for risk-free rates. The use of government bonds as a suitable risk-free proxy is also widely accepted by current practice in New Zealand.
2.2.3 In the past, adjustments have been required to the government stock yields both internationally and in New Zealand to better proxy risk-free rates. There have been a number of reasons for this, principally a lack of liquidity in the market due mostly to inadequate supply or low levels of trading activity.
2.2.4 At present, government stock and Treasury Bills are liquid and so can be used directly to determine risk-free discount rates without any adjustment. At present there is no expectation that this will change in the medium term because of the increased levels of debt issuances forecast by the New Zealand Debt Management Office (NZ DMO) over the next five years.
2.2.5 The process for assessing any required adjustments to New Zealand government bond yields to proxy short-term risk-free rates in the future is described in section 3 of this report.
Short-term CPI inflation (Step 4)
2.2.6 CPI cannot be observed from a market in the same way yields on bonds can be. Instead, Statistics New Zealand publishes the actual CPI quarterly. Therefore, we rely on forecasts of CPI to set the short-term CPI assumption. There are five main sources of readily available CPI forecasts in New Zealand: the Treasury, the Reserve Bank of New Zealand (RBNZ), the New Zealand Institute of Economic Research (NZIER) Quarterly Predictions, the NZIER Consensus Forecasts and the Aon Economists Survey. All of these forecasts are published at different times of the year and for different projection periods. Short-term projection periods for the majority of sources do not go beyond five years.
2.2.7 The Aon and NZIER consensus forecasts, published quarterly, will form the basis of the short-term CPI forecast. We consider that together they provide a reasonable coverage for the first four years and they will incorporate, to some extent, the other published forecasts. However the Treasury forecast, published twice a year, and the RBNZ forecast, published quarterly, will be considered if they provide more up to date information. In this situation the consensus forecasts may be adjusted accordingly.
2.2.8 The process to determine short-term inflation rates is to:
- convert the relevant forecasts to a common year definition
- start with NZIER and Aon consensus forecasts for the first four years
- consider whether the Treasury and RBNZ forecasts provide any more up to date information and adjust accordingly, and
- use the long-term CPI rate from year five and onwards, determined as part of the long-term assumptions in this methodology, unless there is any compelling reason not to.
Long-term risk-free discount rates (Steps 5 and 6)
2.2.9 The methodology assumes that a single long-term real risk-free discount rate (ie, the real rate of interest that an investor would expect to earn from a very safe asset, after taking into account inflation expectations) can be set and this rate should be stable for a reasonable time.
2.2.10 The real risk-free discount rate is the most critical long-term assumption for accounting valuations using present value techniques. This assumption is the primary driver of the actual value of cash flows that are inflated.
2.2.11 Judgment is required in selecting the rate that proxies a long-term real risk-free rate. Recent historical real risk-free returns, returns on long-term New Zealand index-linked bonds (if any), returns on relevant offshore index-linked bonds and economic theory are all relevant to selecting the long-term risk-free discount rate.
2.2.12 We have concluded that a reasonable long-term real return assumption for accounting valuations is 3.5% pa.
2.2.13 While models use nominal risk-free rates and CPI assumptions, these assumptions are products of this real risk-free rate. Therefore, the difference in quantum between them (ie, the real-return assumption) is critical to the final valuation.
2.2.14 Having said that, these components are important individually in that they inform our views of an appropriate real risk-free return assumption and because the accounting standards place the most emphasis on the nominal risk-free rate. Minimal guidance is given on real rates of return and inflation assumptions in the standards.
2.2.15 The long-term nominal risk-free rate is determined from available data and historical market yields on long-term New Zealand government stock. The methodology concludes that a reasonable long-term risk-free discount rate is 6.0% pa.
Long-term CPI inflation (Step 7)
2.2.16 Consistent with the long-term nominal risk-free rate the methodology sets a single CPI rate for the long term. This rate is calculated as the long-term nominal rate less the long-term real rate.
2.2.17 In the current, comparatively stable economic environment, this rate has been validated by reference to historic levels of CPI inflation and the historic relationship between CPI inflation and the RBNZ inflation target bands.
2.2.18 For some valuations, a single inflation rate may need to be used across all time periods. In this case the starting point should be the long-term inflation assumption.
2.2.19 While the mid-point of the RBNZ inflation target is currently 2%, the actual inflation has more often been above the mid-point than below, being below only five times in the last 20 years. Therefore, we have concluded therefore is that 2.5% pa, calculated by taking the difference between the nominal and real risk-free rates, is reasonable.
Bridging the short and long-term (Step 8)
2.2.20 The government stock yield curve currently finishes at 15 May 2021 (currently 11 years). In future the longest duration for government stock is likely to range from 10 and 12 years. This raises the question on how the government stock yield curve should be blended with the long-term assumptions
2.2.21 The methodology assumes the difference between short-term and long-term risk-free discount rates should be smoothed.
2.2.22 Smoothing should commence at the maturity date of the last government stock. The selection of the end date would be guided by:
- the difference between the long-term rate and the rate at the end of the yield curve, and
- forward rates on bank SWAPS at that duration.
2.2.23 The interpolation should attempt to be consistent with bank SWAP rates where they are available.
2.3 Proposed Parameters
2.3.1 The following is a table of the long-term parameters using the methodology summarised above:
|Adjustment to NZ Govt Stock||0||No adjustment required|
|Long-term real return||3.5%|
|Long-term nominal discount rate||6.0%|
|End of market observations||15 May 2021||Currently 11 years, expected to range
from 10 to 12 years as new stock is issued
|Start of long-term assumptions||End of yield curve plus 5 years
(15 May 2026)
|Bridging assumption||Linear between the end of market and the
start of long term
2.3.2 A sample table of annual rates from year one to year 20+, determined using this methodology, as at 31 May 2010 is shown in Appendix 3.
2.3.3 These rates are expressed as forward rates, ie, a different rate for each year of the projection. It is recommended that duration dependent rates are used.
2.3.4 The forward rates require that the valuation programme can cope with different interest rates each year.
2.3.5 There may be cases where the valuation programme can only handle a single rate. Spot rates have also been provided which are the single-equivalent interest rates for each duration in the table. In the case where a single discount rate is required then the appropriate spot rate can be selected to match the duration of the liabilities.
2.3.6 The appropriate inflation index or rate for assets and liabilities must be used for each individual case. Guidance on this has been explicitly excluded from the scope of this report.
2.3.7 It is however expected that inflation assumptions will be consistent with the specified CPI. All adjustments to the CPI should be supported by evidence, data or a reasonable argument.
2.4 Disclosures in Financial Statements
2.4.1 The Treasury applied judgments in setting discount rates that reflect the time value of money for accounting valuations. The appropriate discount rate is an area of international debate among accounting standard setters, regulators and the finance industry. There is also wide ranging academic and technical literature on setting discount rates.
2.4.2 Given the complexities of valuations using present value techniques and the wide ranging views about appropriate economic assumptions, such as discount rates, the Treasury recommends entities consider including additional disclosures in their individual financial statements such as:
- a table or graph of the undiscounted cash flows over time, and
- sensitivity analysis of the key economic assumptions.
2.4.3 These additional disclosures would provide readers with the ability to assess how sensitive a valuation is to a change in the discount rate and CPI assumptions.
2.4.4 These disclosures are not mandated in all accounting standards, but we would strongly encourage entities to include them if it would be useful to readers of their financial statements.
2.5 Ongoing Reviews Required
2.5.1 The inputs and parameters will be reviewed regularly, some more frequently than others. Minimum review periods are shown below. Significant changes in economic conditions or additional market instruments becoming available may result in an earlier review if appropriate.
Updated 30 June, 31 October, 31 December and 28 February
- Treasury Bills and OCR.
- New Zealand government stock yield curves, including any new stock.
Updated six monthly (30 June and 31 December)
- Short-term inflation forecasts.
- Impact of any new market instruments eg, long duration nominal or indexed stocks.
Updated annually (for 30 June year end valuations)
- Any adjustments required to the New Zealand government stock yield curve, eg, by referencing bank SWAP rates.
- Any new information regarding the long-term CPI and discount rate assumptions.
- Any new information regarding the bridging assumption.
Updated Two Yearly
- Any new information on the long-term real-return assumption.
2.6 Auditor Confirmation
2.6.1 The Office of the Auditor-General considers that the methodology for determining the risk-free discount rates and CPI assumptions is appropriate for the New Zealand Government to:
- value insurance claims liabilities under NZ IFRS 4 Insurance Contracts
- value employee benefits such as pension obligations, long service leave, and retiring leave under NZ IAS 19 Employee Benefits, and
- build a risk-adjusted discount rate used to value student loans.