Cash Balance Plans Have Risk Mitigation Challenges

September 3, 2010 ( – Plan sponsors who move to a cash balance plan from a traditional defined benefit (DB) program may not always realize they are trading interest rate risk for investment risk.

That assertion is from R. Evan Inglis, a principal in The Vanguard Group’s Strategic Retirement Consulting and the chief actuary supporting Vanguard’s clients, offered in a new report.

While cash balance plans are technically DB plans, the benefit is expressed as a lump-sum amount.  However, a traditional pension plan expresses its benefit as an annuity, payable over the participant’s lifetime.

As a result, Inglis argues, it is more difficult to invest in assets that match the liability of the cash balance plan than it is to invest in assets that match the liability of a traditional pension plan.

According to Inglis, a traditional plan’s liability acts as a long-term bond, which means long bonds can be used to hedge the risk inherent in pension funding levels. This can be a powerful risk-management tool because pension liabilities and bonds both change in value the same way when interest rates change.

On the other hand, Inglis contends, the liability for a typical cash balance plan is not very sensitive to interest rates. The liability itself is more stable and predictable, especially because final average pay and early retirement provisions add volatility to a traditional plan. However, because there are no specific assets that will match the liability, the funded status of a cash balance plan is difficult to control, Inglis maintains.

Inglis explains that the original concept for cash balance plans was to credit a relatively low rate of interest to participant accounts and invest in a balanced portfolio that would generate investment earnings higher than the interest crediting rate. That is likely (but not certain) to work over a very long time frame, but doesn’t allow for substantially eliminating uncertainty and volatility,   Inglis says.  The reason is that most cash balance plans invest in a traditional balanced portfolio and cannot take advantage of liability-driven strategies that effectively reduce risk, he says.

There are different ways, however, that cash balance plans can be structured, affecting the level of risk and ability to minimize risk.

Cash balance plans that use a fixed rate of interest for participant accounts are interest rate sensitive and allow for somewhat easier risk mitigation at higher rates of return, he says. Other plans have interest rate floors. “For example they may credit the 10-year Treasury rate with a minimum of 5%,”   Inglis adds. “When you do that you’ve introduced some interest rate sensitivity.”

“…there is little cash balance plan sponsors can do but accept that managing a cash balance plan means taking on investment risk they wouldn’t have to face managing a traditional DB plan,” Inglis says. “There’s just really no reasonable strategy you could adopt to minimize that risk other than to invest in cash or short bonds. That’s kind of the traditional efficient frontier approach.”

The Inglis report is here.