Interest Crediting Rate Used Key to Cash Balance Plan Outcomes

“Plan sponsors that have adopted or moved to market return design structures have reduced or eliminated market and cost volatility from their retirement program while providing participants with professionally managed investment returns that have produced better participant outcomes,” a report from October Three concludes.

Of the 1,069 single-employer plans with cash balance features, each of which cover at least 100 total participants (including participants who have no cash balance benefits), that October Three analyzed, 65% are actively accruing benefits, while 35% are frozen. Among “pure” cash balance plans, more than 90% are actively accruing benefits, whereas 57% of “mixed” plans (those with traditional defined benefit (DB) plan features as well as cash balance features) continue to provide ongoing cash balance accruals.

The consulting firm notes that movement to cash balance plan designs until the late 1990s primarily involved the conversion of larger traditional DB plans, while pure cash balance plans became popular in the early 2000s. “The hope for many sponsors that converted their traditional annuity plans to cash balance was that the plan change would stabilize and save the plan. But, as we will discuss, the average funded ratio for frozen plans is lower than for accruing plans, indicating that the cash balance design alone did not save the plan,” October Three says in its survey report.

For cash balance plans, the two key elements in determining plan benefits and costs are the benefit credits (typically based on participants’ pay, age, or service) and interest credits, which are determined by applying an interest crediting rate to participants’ cash balance accounts, October Three explains. “The basis for crediting interest is a key determinant of both plan costs and risks,” the report says. “Understanding the behavior of plan interest credits is crucial to understanding the behavior of plan liabilities as well as participants’ benefits.”

Among the surveyed plans, the firm identified over 50 distinct interest crediting rates, or ICRs, being used by plans, but divided plans into five groups: flat rate (approximately 10% of accruing plans and nearly 5% of frozen plans), short index (less than 5% of accruing and more than 5% of frozen), long index (approximately 23% vs. about 12%), index with minimum (18% vs. 12%), and market return (10% of accruing plans and 0% for frozen plans).

The report explains that a flat rate is a single rate that applies in all years, such as 5%. Of the flat rate plans, 85% provide an interest credit of at least 4%, and 57% provide a credit of at least 5%. The average flat interest credit provided is 4.60%. October Three notes that a flat interest credit has the virtue of simplicity, and it provides certainty to plan sponsors and participants regarding the value of the benefit at any payment age. If a cash balance plan sponsor can accurately estimate when benefits will be paid—which the firm says is “a big if”—these liabilities can be hedged in a manner similar to traditional pension liabilities. Also, plans with modest flat interest credits (e.g. 2% or less) can be more or less hedged even if the payment date is uncertain.

However, the real problem arises for plans with a generous flat interest credit (e.g. 4% or higher) combined with uncertainty regarding payment dates. This combination produces a valuable option for participants (the higher the flat interest credit, the greater the likelihood participants will defer receipt of the benefit as long as possible unless interest rates move sharply higher), making these liabilities difficult or impossible to hedge.

The report explains that a short index is a rate that varies from period to period based on yields on Treasury securities with less than 10 years to maturity, such as the rate on 1-year Treasury bills, or other short-term indices, such as the consumer price index (CPI). For plans using a short index, the interest credit promise is more or less “investable”—in other words, the sponsor can invest plan assets to move with plan liabilities (i.e., account balances), if desired. Alternatively, sponsors can invest in a riskier portfolio and hope to “beat” the relatively modest interest credit, thereby generating company costs that are below the total benefit credits under the plan, but at the expense of funded status and cost volatility. However, according to October Three, the downside to this design is that, all else equal, these interest credits will produce lower benefits over a retirement savings horizon than using other interest crediting bases.

A long index is a rate that varies from period to period based on yields on Treasury securities with 10 or more years to maturity, such as the rate on 30-year Treasury bonds or on corporate bond “segment” rates published by the Internal Revenue Service (IRS). Among these plans, the survey found the overwhelming majority (80%) base the interest credit on the yield on the 30-year U.S. Treasury bond. For a long index, there is no hedging portfolio available to immunize the promise, so sponsors have no choice but to live with funded status and cost volatility. Worse, if long-term interest rates increase, liabilities also increase (because accounts will grow based on higher long-term bond yields), while plan assets (particularly fixed-income investments) decline in value.

The index with minimum crediting rate design combines a flat rate interest credit of at least 3% with an index, providing participants with the greater of the two interest crediting rates. This category also includes plans that add more than 1% to a short-term index. Under current IRS regulations, a minimum rate cannot exceed 5% (4% if the index is one of the allowable corporate bond rates). Of course, the plan specified minimum can be highly beneficial to participants, especially during periods, like recently, when the index produces very low values. However, the combination of an index with a meaningful minimum poses a great challenge to pension risk management.

A market ICR means interest is credited based on the actual investment returns of assets specified under the plan, including the plan’s own assets, a designated portion (or portions) of the plan’s assets, or on one or more specified outside funds (e.g., mutual funds). Because annual market returns can be negative in some years, the law requires that the cumulative investment return must be at least 0% (i.e., the participant cannot receive less than the sum of the benefit credits). Regulations also permit plans to credit a minimum cumulative return of up to 3% per year (rather than the 0% statutory cumulative minimum). Since interest credits are based on actual market returns, plan assets and liabilities (i.e., account balances) tend to move together, producing an experience very similar to a defined contribution (DC) plan.

For plans using a market rate, financial volatility moves from the sponsor to participants, but, at the same time, participants can hope to earn higher returns than those from other ICR designs and therefore accumulate larger retirement benefits over the long-term. It is even possible for a plan to credit different market returns to different groups of participants, much like target-date funds in a DC plan. Since 2006, new cash balance plans have adopted market ICRs more often than any other approach.

Funded status of cash balance plans

October Three observed that cash balance plans are, on average, better funded than the broader pension universe, boasting a median funded ratio of 99%, compared to just 89% among all single-employer DB plans with at least 100 participants. Frozen cash balance plans are less well funded than accruing cash balance plans, with a median funded ratio of just 90% for frozen plans, compared to a median of 100% among plans that provide ongoing accruals.

For plans that provide a flat or short index ICR, October Three found funded ratios are dispersed fairly evenly, whereas plans that provide long index or index with minimum ICRs tend to be better funded, although even for these plans, more than 45% are at least somewhat underfunded. For plans that provide a market ICR, more than 90% are at least 100% funded, and funded ratios are generally tightly bunched around 100%.

Benefits for Participants

As for benefits to participants, plans that provide flat ICRs produce consistent interest credits from year to year, and plans that provide index with minimum ICRs have seen a similar experience, due to minimum rates applying in most years for many of these plans because of historically low Treasury rates at all durations. The plans that provide short index and long index ICRs have also produced broadly stable interest credits over the period reviewed, consistent with the recent behavior of short- and long-term interest rates, respectively.

October Three says market ICRs are the outlier here, producing both the highest ICRs among cash balance plans (9.3% in 2009) and the lowest (-0.6% in 2015), an experience similar to what participants in DC plans have seen.

The firm concludes that market interest credits address employer risk issues while producing benefits as good as or better than other ICR designs, but they introduce volatility into participant account balances similar to DC plans. However, most participants are arguably in a better position than employers to withstand short-term investment market fluctuations because they will not (or should not) tap those assets for a long time. “Plan sponsors that have adopted or moved to market return design structures have reduced or eliminated market and cost volatility from their retirement program while providing participants with professionally managed investment returns that have produced better participant outcomes,” the report says.