Summary paragraph: Cash balance plans make it harder to match assets and liabilities, study says
Converting to a cash balance plan may pose more risks than you believe. Plenty of plan sponsors like the increased stability in liabilities that a cash balance plan brings compared with a traditional defined benefit plan, but they may not realize a different investment challenge these plans have. "The liability for a traditional defined benefit plan is easily matched by bond investments, making risk-reduction cheap and easy," according to "Investment strategies for cash balance plans -- more risk than you thought," a paper published by Vanguard in February. "This isn't the case for most cash balance plans."
The industry does not understand this well, says Vanguard Chief Actuary Evan Inglis, who co-wrote the paper. However, as more sponsors face contribution boosts following the market downturn, they want to get a better handle on these plans' risk-management issues, says Kevin Armant, a Principal at consultant Mercer in Princeton, New Jersey. "A lot of plans have just started to look at this," he says. "They now are starting to realize what the risk is."
Un-hedge-able Crediting Rate
In a traditional defined benefit plan with a typical allocation such as 60% equities and 40% fixed income, Armant says, about half the risk comes from interest-rate exposure and the other half comes from capital-market exposure. In those cases, he says, "We can eliminate a large portion of the risk by using long-duration fixed income to have the assets move like the liabilities."
Defined benefit plans naturally lend themselves to matching assets with liabilities because a traditional pension plan is just a series of future payment promises to people -- like a bond -- and financial markets value any future payment promises by using interest rates, Inglis says. Matching can mean holding a lot of fixed-income assets with durations equivalent to liability durations; so, when interest rates change, it impacts assets and liabilities similarly.
However, interest rate changes affect the assets and liabilities in cash balance plans differently, in offsetting ways. Changes to the interest rate that get credited to participants' accounts offset the impact of changes to the interest rate used to discount the liability. About 70% of cash balance plan sponsors utilize a 30-year Treasury rate as the crediting rate for employees' accounts, and it changes annually just before the plan year begins to match the current market rate for 30-year Treasurys, Inglis says. "Matching a 30-year bond yield as the crediting rate is going to be tough, because the yield on a 30-year bond is going to bounce around," says Peter Austin, Executive Director of BNY Mellon Pension Services. "You have duration risk." If a sponsor tries to match liabilities by investing in 30-year Treasury bonds and interest rates subsequently rise, for instance, the value of employees' accounts rises due to the higher crediting rate, but the value of the 30-year Treasurys held as investments fell.
The upshot? "As plan sponsors de-risk plans, they will be unable to remove as much risk from 'un-hedge-able' cash balance plans as they can from traditional DB plans," says Chad Hueffmeier, a New York-based Principal at Buck Consultants. "There is no investment that is going to give you the 30-year Treasury bond yield and a guaranteed return for the next year, let alone the next 30 or 40 years. You could go out and buy 30-year Treasurys at the beginning of the year, but if interest rates moved by 100 basis points, you would have a huge loss in your assets.
There is really only one investment that an investor can be certain of the one-year return at the beginning of the year: one-year T-bills, which tend to have significantly lower yields than 30-year Treasurys," Hueffmeier continues. "Consequently, any interest crediting rate determined at the beginning of the year that exceeds one-year Treasury returns is essentially un-hedge-able."
The investment reality is even more complex for some cash balance plans, Armant says, as they have extra considerations like grandfathered defined benefit account balances. "There are very few pure cash balance plans," he says.
A Game Changer
The final and proposed regs on hybrid plans issued in October 2010 by the Internal Revenue Service will lead many cash balance sponsors to change their crediting approach. The regs allow market-return-based interest crediting rates, Hueffmeier says. "Sponsors can use the actual return on plan assets," he says. "Basically, you have a ton of options in terms of what interest crediting rate to use, so the interest crediting rate is investable. You can actually hedge interest crediting rates for future accruals. This is a game-changer for future cash balance accruals and assets tied to future accruals." Adds Austin, "There are provisions now that allow a plan sponsor to tie a crediting rate to an index or benchmark, so they have an opportunity for almost perfect hedging."
Issuing the new regs "made life much easier for cash balance sponsors," AllianceBernstein Director Stephen Lippman says. "They allow sponsors to say, 'We will choose a crediting rate that is equal to an actual rate returned.' Seventy percent of our existing plans have adopted the new rates. They like the flexibility."
The regs do not end the issue, however. "Plan sponsors must continue to provide interest credits on the prior accruals that are at least as large as the interest crediting rate defined under the current plan," Hueffmeier explains. "Consequently, the risk-management issues with cash balance plans are not going away very quickly."
However, the new regs could lead to some shifts in cash balance asset allocations. "If an allocation of 15% to 20% stocks made sense for many plans, now 25% to 40% in equities could be appropriate," Lippman says. While they sometimes go into more-exotic assets like hedge funds, most cash balance plans invest in a mix of stocks and bonds, he says. Those two asset classes probably make up 90% of the portfolio at most of these plans, he adds.
These plans generally invest more in equities than traditional pension plans, Inglis says. "They really do not have the same incentive to match liabilities with bonds," he says. "One of the ideas that inspired the cash balance plan design is that an employer can credit this low rate of interest and invest in equities, then outearn the crediting rate and reduce costs." The Vanguard paper says that "most of the risk in a cash balance plan is related to equity exposure, whereas a traditional plan is sensitive to interest rate movements." Says Austin, "With a cash balance plan, once sponsors establish the crediting rate, the focus becomes, what is the proper asset allocation, and how much risk are they willing to take to outperform the crediting rate, or not?"
Cash balance plans often invest in a combination of cash and somewhat riskier assets like equities with the aim of making up the difference between cash rates (one-year T-bills) and the plans' interest crediting rate (equal to the 30-year Treasury yield), Hueffmeier says. Funding rules do not require the value of assets to be as large as the sum of the account balances, he says. "Consequently, most plan sponsors also rely on 'risky' assets to help close the gap between assets and the sum of the account balances. That is, assets do not only need to earn a return equal to the interest crediting rate, to keep pace with account balances, but also need to grow faster than the account balances, to help close the gap between assets and the account balances," he says. "The spread between the interest crediting rate and one-year T-bills, and the size of the gap between assets and the sum of the account balances, will drive what percentage of assets needs to be in cash and 'risky' assets. The wider the spread and gap, the larger the allocation to 'risky' assets."