The Cash Balance De-Risking Solution

March 26, 2014 (PLANSPONSOR.com) - One can’t talk about pensions today without discussing de-risking.
By PS

For traditional defined benefit (TDB) plans, there is a well-established de-risking playbook: (1) freeze the plan, (2) migrate to a matching bond portfolio and/or pay lump sums and/or buy annuities. The benefit of reduced or eliminated uncertainty comes at a cost of higher upfront or expected contributions, but with that caveat, the playbook works reasonably well.

While cash balance (CB) plans are generally less risky to employers than TDB plans, CB plan sponsors are finding that, when it comes to de-risking, the TDB playbook doesn’t work, and a fresh approach is needed.

The Risk of Rising Interest Rates  

CB interest credits are generally tied to long-term bond yields, such as the rates on 30-year Treasury bonds. Account balances reliably earn these interest credits, regardless of asset performance. This feature of CB plans does stabilize liabilities (relative to TDB plans), but it renders the TDB de-risking playbook ineffective. 

For example, assume plan assets are shifted to long-term bonds similar to those used for interest credits. Now, what happens if interest rates go up? An investment in a 30-year bond issued at 4% interest loses 11% in value if rates rise to 5% during the year, while the account balance grows by 4% – a 15% shortfall. This is basically what we saw in 2013.

For TDB plans, higher interest rates reduce the value of plan liabilities, offsetting the decline in asset value from a bond portfolio. But this doesn’t happen in CB plans, because of their stable liabilities.

This is a curious result: on one hand, CB plans, designed to pay stable account balances as lump sum benefits, significantly reduce the ‘duration’ of plan liabilities (and, as a result, the risk of decreasing interest rates) compared to TDB plans.  On the other hand, CB plans create a new risk – increasing interest rates.

Dawning realization 

As we’ve seen, a long-term bond strategy won’t work. Advisers have suggested various other investment strategies to de-risk CB liabilities. However, these strategies bump up against the inescapable fact that there is no investment that provides a return equal to the yield on 30-year Treasury bonds without the risk of capital loss (i.e., due to rising interest rates).

And now, with interest rates near 60-year lows, there's a growing consensus that the long-term decline in interest rates – which masked the risk in CB plans – is over. The greater risk is that interest rates will rise. And rising interest rates are bad news for CB plan sponsors. 

What Can Sponsors Do?  

Fortunately, there is a design-based solution to this problem: market-based interest credits. The Pension Protection Act of 2006 (PPA) and follow-on Internal Revenue Service (IRS) regulations make it clear that a CB plan can provide interest credits based on the rates of return on plan assets (subject to a 0% cumulative minimum return).

Given the linkage between asset returns and interest credits, the CB promise becomes hedgeable by definition. Liabilities are defined in terms of trust assets, and the only financial risk to the sponsor is the 0% cumulative guarantee (which is unlikely to be material).

Alternatively, market-based interest credits can be based on ‘proxy’ returns – e.g., a combination of mutual funds.  Such a promise is also readily hedgeable (by investing plan assets in the same funds used to credit interest), although sponsors are free to try to outperform the indexes, which could reduce plan costs. Proxy interest credits can even be tailored to vary by participant groups to reflect different investment horizons.

In all of these situations, the plan sponsor is left with the legacy liability. A CB plan that switches to market-based interest credits must include a minimum benefit equal to the existing account plus future interest credits using the prior interest-crediting basis – the unhedgeable promise.  However, any impact of this minimum benefit will generally fade away over a few years because the account balance that reflects market-based interest credits includes future pay credits.

Market-based CB vs. DC  

Compared with a ‘freeze-plus-DC’ strategy, a market-based CB plan enjoys many advantages, both for the employer and its employees:

(1)              Provides a path for de-risking of legacy active liability

(2)              Promotes cost stability without foregoing equity returns

(3)              Mitigates overfunding risk due to ongoing CB accruals

(4)              Avoids plan termination ‘sticker shock’

(5)              Alleviates nondiscrimination testing issues

(6)              Ensures broader coverage by not requiring  employee contributions

(7)              Delivers professional investment results

(8)              Combines downside protection with upside potential to participants

(9)              Provides cost-effective and easily accessible annuity payment options

(10)         Reduces pre-retirement ‘leakage’

(11)         Provides flexibility for ‘grandfathered’ and other transition benefits

    

Why wait? 

CB sponsors have been in limbo for over seven years since PPA was passed into law, pending the issuance of final IRS regulations.  Some employers, however, have moved ahead. For example, many of the largest law firms in the country – firms that understand the legal environment as well as anyone – have been adopting market-based CB designs since 2010.

These firms have concluded that current guidance provides a good road map for employers to proceed, and that the advantages of moving ahead outweigh the potential benefits of more flexible rules if and when they become available.

CB sponsors should take heed.  The prospect of rising interest rates and persistent equity market volatility pose significant financial risks to employers. Now is the time to consider shifting from a volatile design that promises an unhedgeable, yet modest, return, to one that actually delivers cost stability to employers and upside potential to employees.

 

Brian C. Donohue and Larry Sher are partners in Chicago and Morristown, N.J., respectively, at October Three Consulting LLC, an actuarial, consulting and technology firm. 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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