Risks and Returns.
Byline: Rebecca Moore
Summary paragraph: Cash balance plans carry investment risk that needs to be managed
Cash balance plans differ from traditional defined benefit (DB) plans in that they use notional accounts for individual employees and define the retirement benefit in terms of the stated account balance.
The account balance grows during employees' working years, much like in a defined contribution (DC) plan, with periodic "pay credits" and interest at a specified rate, or interest-crediting rate. Though this makes cash balance plans easier to understand-and costs more predictable-the plan sponsor faces the risk that the investment returns on plan assets could fall short of or exceed the targeted interest-crediting rate.
Plan sponsors want the underlying assets that are used to fund the cash balance plan to match participants' notional account balances. Dan Westerheide, senior vice president and asset/liability modeling practice leader with Segal Rogerscasey in Boston, explains: "It is tempting to think that the investment that hedges a cash balance plan with an interest-crediting rate of the 10-year Treasury bond yield would be an investment in a 10-year Treasury bond. But, in fact, the price of the bond moves opposite the direction of interest rates, and thus the value of the assets would fall considerably in a rising-rate environment while the cash balance plan would increase. In other words, the ideal hedge is an investment that credits at a 10-year yield but doesn't have the duration-or price sensitivity-of a 10-year bond." Westerheide says a constant maturity swap is an example of an investment with those qualities.
Using an interest-crediting rate floor can also create an investment challenge. For example, a plan's interest-crediting rate could be based on a 10-year Treasury bond yield, reset annually, but not lower than 4%. Adding an interest rate floor to the asset side of the pension balance sheet can offset much of the risk, in this case. "Interest rate caps and floors are investment products sold by the large investment banks to institutional investors," Westerheide says. "They are mostly over-the-counter products."
Dan Kravitz, president of Kravitz Inc., headquartered in Los Angeles, says it is important for cash balance plan sponsors to make sure the interest-crediting rate chosen is achievable. "It is important, when an employer sets up a plan, that investment advisers have good communication with plan actuaries, so investment managers truly understand what investment return is needed," he says.
Kravitz notes that Internal Revenue Service (IRS) regulations introduced in 2010 allowed plan sponsors to set the interest-crediting rate to the actual rate of return, or yield, on plan assets. "Changing from a 30-year crediting rate to actual rate of return has worked for a lot of our clients to minimize risk," he says.
However, the regulations include a preservation of capital rule that still creates risk for plan sponsors. Westerheide says the way to manage this risk is to dynamically adjust the equity investments over time.
"Cash balance plans minimize some risk plan sponsors would have in traditional DBs, but they still need to make sure the interest-crediting rate and assets are in line," Kravitz concludes.