We’ve read a number of articles recently that focus on the investment issues inherent in traditional cash balance pension plans. While they’re not all identical, as a group, they highlight that it is essentially impossible to come up with an asset portfolio that effectively hedges the cash balance liabilities. In an era in which chief financial officers increasingly seek both stability and predictability in benefit costs, this really does create a problem.
The reasons behind it are fairly technical, but if we examine any cash balance plan whose interest credits are set at either a fixed rate or a long-term bond yield, no financial instrument that we know can perfectly track traditional cash balance plan liabilities.
However, a cash balance plan gives employees a key combination of two elements they desire—a benefit they can understand and the ability to derive lifetime income at a fair price—that in combination are typically not available to them in either a traditional pension or in a defined contribution (DC) plan such as a 401(k). So, reframing the problem, it would be desirable to have a plan that still provides that key combination while allowing the employer to hedge the liabilities in the plan.
Such a structure exists. But we cannot start with the liabilities and find an investment portfolio to do the work for them.
Instead, let’s start with an investment portfolio and force the liabilities to behave like that portfolio. Rather than liability-driven investment (LDI) that we have heard so much about for the past 15 years or so, we can refer to this as investment-driven liabilities (IDL).
The plan design that allows us to use IDL as a hedging device is the market-based cash balance plan. It may be new terminology to many, but these designs were formally sanctioned by the Pension Protection Act in 2006 and were in place to a lesser extent before then.
To understand what a market-based cash balance plan is, let’s first explain what it’s not: It’s not a traditional cash balance plan. In a traditional cash balance plan, a participant gets pay credits (think of them as a contribution to a notional account balance) and those credits grow with interest credits. In the traditional plan, those interest credits are either a fixed rate of return or a rate of return tied to some bond index such as 30-Year Treasury Bonds or 1-Year Treasury Bills plus 1 percentage point.
In the market-based plan, on the other hand, interest credits are derived from a pool of real or hypothetical investments. As examples, they could be based on the actual return on plan assets or on a 50/50 mix of an S&P 500 Index Fund and a Bloomberg Barclays U.S. Aggregate Bond Index Fund. In the first case, the investment portfolio naturally tracks the growth in plan liabilities. In the second, by investing plan assets in that same 50/50 mix, plan assets also automatically track growth in liabilities. In fact, in both cases, we might even say that plan liabilities are tracking plan assets.
These plans are not for every company. Nothing is. However, if providing lifetime income opportunities for employees while still affording portability is desired and being able to predict and control an employer’s cash commitments to the plan through an automatic near perfect hedge are important, then this sort of design may be worth investigating. At the very least, it’s one more potentially very useful tool for an employer to have in its benefits tool kit.
John Lowell is an Atlanta-based actuary and partner with October Three Consulting LLC. He has more than 30 years of experience consulting on corporate retirement plans ranging in size from just a few participants to hundreds of thousands. John was also president of the Conference of Consulting Actuaries in 2018. He can be reached at email@example.com.
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