Cash balance pension plans have unique design features that need to be well understood before an investment strategy can be properly designed. The two main drivers for designing an investment strategy for a cash balance pension plan are:
- Understanding the interest crediting formula
- Comprehending how the liability of these plans is calculated, which has a direct impact on the duration of the liability, i.e., the sensitivity of the liability for a 1% change in interest rates
What are Cash Balance Pension Plans?
Cash balance pension plans provide a benefit to participants in the form of a “notional account” balance. Unlike traditional defined contribution plans, plan assets in cash balance pensions are not divided into individual accounts. The “notional account” is a paper account only.
Similar to other defined benefit pension plans, contributions do not face immediate taxation, investment earnings accumulate in a tax-free trust, and participants are only taxed upon cash withdrawal. Accumulated notional account balances can be rolled over into an IRA or another tax-favored plan at retirement or termination of employment. Finally, the investment of plan assets are governed by the same ERISA requirements as other tax-qualified plans.
The notional account balance grows each year with interest (even if the plan is frozen) and pays credits (if the plan is not frozen). However, the interest credit may or may not match the investment return on plan assets (more on this later). For example, consider a $100,000 account balance, an annual pay credit of $2,500 (i.e., 5% of a $50,000 annual pay) and a 4% interest credit formula. The notional account balance one year later would be $106,500 ($100,000 * 1.04 + $2,500). Note: the pay credit was assumed to be paid at year-end for simplicity.
Permitted Interest Crediting Formulas
The formula calculating the interest credit will drive the notional account balance projection to the assumed retirement age, which is the numerator of the liability calculation. Several commonly used approaches to calculating interest credit include:
- Fixed rate (cannot exceed 6%)
- Market yield rate
- U.S. Treasury yields: terms up to 30 years
- Corporate rates: 1st, 2nd or 3rd segment rate, MAP-21 (25-year average with corridor limits) or unadjusted (24-month average)
- Specific look-back rules can be used (i.e., average of daily 30-year U.S. Treasury yields for September of prior year)
- Investment returns
- Based on the return of plan assets: must be capped (5-8% usually) and the cumulative returns cannot be negative at the time of distribution
- Subset of plan assets
- Broad-based mutual funds
Other approaches include annuity contract rates and cost of living indices. Approaches for this formula cannot result in an interest credit that exceeds a “market rate of return” defined by the approaches shown above. As long as the interest crediting rate is capped by anything shown on the list above, it is compliant. In some cases, minimum rates are permitted. These minimum rates usually reflect 5% annual with U.S. Treasury yields or 4% annual with corporate bond rates.
Liability Calculation Methodology
As mentioned before, understanding how the liability is calculated is also very important, as it will have an impact on the duration of the liability.
On a “pure” economic basis, a cash balance pension plan’s liability is equal to the sum of the participants’ current notional account balances. It is similar to a bank account in the sense that whether interest rates rise or fall on a given day, the notional account balance does not change in value. In this case, the liability has no duration.
However, this is not the way that actuaries calculate the liabilities of cash balance pension plans. Instead, actuaries calculate liabilities using the following two steps:
- Step 1: Project the current notional account balance of each participant to the assumed retirement age based on an assumed interest crediting rate.
- Step 2: Discount back this projected notional account balance to each participant’s current age using the appropriate discount curve, which is set by the IRS for minimum funding requirements and based on high-quality corporate bonds (Aa-rated bonds) for accounting purposes.
Note that the liability could be lower than the sum of the participants’ current account balances if the discount rate (denominator) is higher than the assumed interest crediting rate (numerator).
Based on this calculation methodology, cash balance plan liabilities will usually have a greater than zero duration—but not always. If the discount rate (denominator) is the same as the assumed interest crediting rate (numerator), then the liability duration will be zero. A cash balance plan usually has a lower duration than a traditional DB plan because it is assumed that most participants will take a lump sum at retirement.
If a plan only requires the IRS liability calculation (no accounting liability needed), the duration of the cash balance liability can be murky because of the smoothing mechanism that is part of the discount rate formula.
Putting it All Together
Given these features, the investment strategies designed for a cash balance pension plan should try to match the interest crediting rate and reflect the duration of the liability.
However, according to a recent survey by the American College of Pension Actuaries, the common interest crediting rate is 5.5%, a level that is difficult to match in the current market environment without assuming additional investment risks.
The same issue is true when the interest crediting rate is based on the 30-year U.S. Treasury yield that is reset every year, which is another common interest crediting rate, or when there is a 4% or 5% minimum crediting rate. A 30-year U.S. Treasury bond will not be a good match because its annual return will reflect potential large gains or losses due to changes in interest rates given its long duration (close to 20 years currently). Only if the interest crediting rate is based on the 1-year U.S. Treasury yield can investing in 1-year U.S. Treasury bonds result in a very close match between the investment return and the crediting rate.
As a result, realistic expectations must therefore be set with clients about the expected return, volatility and potential for increased minimum required contributions. Cash balance plan sponsors need to understand that achieving a net 5% to 6% return is going to be difficult in the current environment of low interest rates, unless they are willing to accept additional, and in some cases unwanted, investment risks. Plan sponsors also need to be prepared to contribute additional amounts to the plan if it becomes underfunded.
If the plan sponsor is not comfortable with a riskier investment strategy, they may consult the plan’s actuary to find out if a high interest crediting rate formula can be changed and how.
In order to design investment strategies with appropriate risk/reward tradeoffs for cash balance plans, it is very important to have a keen understanding of the following: the interest crediting formula, how the liability is calculated and the duration of the liability. It is also very important to figure out the size of the cash balance portion of the total plan’s liabilities, as many plans still have a significant portion of their liabilities from a traditional annuity benefit formula (final average or career average formula). The larger the portion of the liability from the cash balance benefit, the more it needs to be taken into account in the asset allocation design, especially for plan sponsors who are in a de-risking mode.
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