Impact of Discount Rates on Average Annual Renewal Annuities

There is considerable discussion on what discount rates should be used in developing Average Annual Annuities (AAA).

The discount rate used for calculating the AAA for large, mature infrastructure networks is often set at the current borrowing rate of the agency; however, there are other arguments for increasing this rate.

The key to the discount rates is the degree of confidence that we have in the renewal program that has been used to develop the annuity. That is, if we are very satisfied that the renewal program produced is optimized and represents the lowest cost renewal options and timing then we have a clear knowledge that the cash flow is minimal therefore the annuity will be the lowest possible.

Where the TAMP outputs consist mainly of replacement values being required at the end of the average effective life of the asset, then one must presume that detailed analysis would allow us to reduce or lower this figure.

In these circumstances a higher discount rate could be considered to derive a more appropriate annuity.

For average mature infrastructure network assets, an increase of 1% in the discount rate reduces the average annual annuity by approximately 10%.

In using these higher discount rates we need to be aware of the significant impact this will have in the annuity - e.g. raising the discount rate from 4% to 8% will trigger a 40% reduction in the annuity.

Another issue involves the effects that new technology and new developments will have on the capital improvements program. Current economic analysis principles require that the Total Asset Management Plan should only be constructed using current known and proven technologies.

Some organizations and economists believe that in determining the target break-even point to move from our existing position to the returns required by these annuity figures that a discount rate of 5 or 6% gives a more appropriate figure, one which makes some allowance for new technology impacts through the discount rate.

This could be used where the quality of the Total Asset Management Planning processes are poor.

Organizations should run their annuities at a series of different discount rates i.e. 2%, 4%, 5% and 6% to check the significance and the impact on the results. The most appropriate discount rate should then be chosen.