If I were to offer you $1 today or $1 five years from now, which would you choose? I’m sure you’re thinking about taking $1 today, and that’s the correct choice. Reason being that you could take that $1 today and earn interest by investing it for the next 5 years, leaving you with more than the $1 you could have taken after 5 years. Even if you were to invest very conservatively to only earn returns equal to inflation, taking the $1 today still remains the better option. You may have heard of this concept before, time value of money. This is the purpose of the discount rate assumed in your actuarial valuation. Future benefits are “discounted” to reflect their value as of the measurement date, or in other words, the present value as of the measurement date.
A common question is, “How does the discount rate affect my liability?” Ultimately, it has an inverse relationship with the liabilities determined. A lower discount rate results in a higher liability, whereas a higher discount rate results in a lower liability. Keeping in mind the description of the discount rate above, this makes sense. A lower discount rate implies less “discounting”, which leads to a higher liability. Keeping all things equal, a higher discount rate implies more “discounting”, which leads to a lower liability.