Managing Investment Risk in Cash Balance Plans

The features of cash balance plans that make them easier to understand and make costs more predictable also create opportunity for advisers with skill structuring DB investments.

While a cash balance defined benefit (DB) plan design can be simpler and less risky than a traditional DB plan, it is not inherently a low-risk strategy, Segal Rogerscasey points out in an investment brief.   

“Many of the features of cash balance plans that help make plan costs more predictable and easier to understand can also create challenges when investing plan assets,” the brief says. Cash balance plans differ from traditional 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.

Internal Revenue Service (IRS) regulations in 2010 defined safe harbor interest crediting rates for cash balance plans, including:

  • The yield on the 30-year U.S. Treasury bond;
  • A fixed rate up to 6%; and
  • An annual floor of up to 5% with any safe harbor rate, for example, the greater of the 30-year Treasury rate or 5%.

But, these are not the only interest crediting rates cash balance plan sponsors can use. And, plan sponsors want the underlying assets used to fund the cash balance plan to match participants’ notional account balances.

As explained in a paper by cash balance plan provider Kravitz, the risk is whether the investment returns fall short or exceed the targeted interest crediting rate. Additional contributions are required in the case of underfunding, and if returns are too high, contributions tend to be lower due to the surplus of assets. In that case, the tax deduction could be lower and contributions less consistent.   

With cash balance plans, sponsors still face investment risk and return tradeoffs that need to be professionally managed.

NEXT: Matching investment strategies with interest crediting

The Segal Rogerscasey investment brief says, “One challenge is that the interest crediting rate of a cash balance plan is often specified off the yield curve at a duration not consistent with the rate’s reset period. For example, a plan’s interest crediting rate could be based on a 10-year Treasury yield and reset annually. The relationship between a 10-year Treasury bond and a one-year Treasury bill may have significant basis risk. A constant maturity swap (10-year versus one-year) is actually the truer hedge.”

Dan Westerheide, senior vice president and Asset/Liability Modeling Practice leader with Segal Rogerscasey in Boston, explains to PLANADVISER, “It is tempting to think that the investment that hedges the cash balance plan in the example above (the notional cash balance account credits with a 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 which 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. It is similar to a “plain vanilla” swap, but instead of exchanging a fixed rate for floating rate, it exchanges two floating rates. A swap is a contract between the retirement plan and another party, usually a swap dealer (see “Swap Meet”). When transacting a swap in its most basic form, the plan and the dealer agree to exchange certain cash flows or other rights to which each party is entitled before they enter into the swap. For example, the plan may own bonds that periodically pay cash based on a fixed rate of interest while the dealer owns bonds that periodically pay cash based on a floating rate of interest. Through the swap contract, the parties “swap” those payment streams without having to buy the underlying bonds.

Using an interest crediting rate floor can also create an investment challenge. Effectively, the plan sponsor has sold floating-rate debt to plan participants with an embedded interest rate floor; thus, adding an interest rate floor to the asset side of the pension balance sheet can offset much of the risk. “Interest rate caps and floors are investment products sold by the large investment banks to institutional investors,” Westerheide says. “It is common for corporate treasurers to limit the costs of their floating rate bank debt by buying an interest rate cap from one of the large broker/dealer banks. They are mostly over-the-counter products.”

NEXT: Using actual rate of return

Dan Kravitz, president of Kravitz, headquartered in Los Angeles, says it is important for cash balance plan sponsors to make sure the interest crediting rate picked is achievable. For example, some of Kravitz’s clients were using a fixed rate of 5% but they changed to a 30-year treasury rate, which is about 3%. 

“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 tells PLANADVISER. 

Kravitz notes that IRS regulations introduced in 2010 allowed plan sponsors can 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. 

In addition, regulations in 2014 created a new investment approach for cash balance plan sponsors to manage risk. 

The paper by Kravitz explains that plan sponsors can now offer multiple investment options within a single plan, tailored to suit different retirement goals and needs. One of Kravitz’s large law firm clients has a customized cash balance plan with three investment strategies. An ultra-conservative strategy includes longer-service participants and those already retired in a portfolio with 15% equities and 85% fixed income. A conservative portfolio of 25% equities and 75% fixed income covers mid-career participants and those with lower risk tolerance. A moderate strategy covers shorter service participants and those with higher risk tolerance in a portfolio with 35% equities and 65% fixed income. 

However, the regulations include a preservation of capital rule that still creates risk for plan sponsors. “While fairly unlikely, there could be cases where the cumulative interest credits were negative and therefore the participant would get the greater of the cumulative pay credits,” Westerheide says. 

He adds that the way to manage this risk is to dynamically adjust the equity hedge over time.  For example, plan sponsors would want to have equities in assets so that assets would go up in value as the notional accounts increase. But as the notional accounts decline in bear markets, plan sponsors would want to reduce equity exposure of the assets to reflect this lower bound. 

“I should also note that most cash balance plans do not have equity exposure in the interest credit rate, so this issue may not be as significant as you think,” Westerheide contends.

“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.