Interest Cost – why?

This is the cost of an increase in the liability resulting from expected future benefits being one year/period closer to being paid at the current valuation date compared to the last valuation date.

The actuarial liability is the present value of the benefits that will be paid to employees at the time of their retirement or earlier termination. So, the opening actuarial liability at the start of the year is the present value (ie discounted value) of the liability that the entity owes to its employees as at the beginning of the year. By the end of the financial year, this liability is discounted for one year less, all else being equal, compared to the start of the year. This reduced discounting means a higher liability, which is the Interest Cost.

Another way of viewing of the Interest Cost is that it is an “unwinding” of the discount rate for one year, compared to the valuation one year earlier. The discount rate is applied to the liability at year start, to obtain the interest cost.

If a scheme has backing assets, matching exactly the liabilities, at year start, and those assets earned the assumed interest (ie discount) rate, then the earnings would exactly offset the Interest Cost and the net cost to the scheme would be zero.

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