Using Senior Secured Loans in Cash Balance Plans - Babson Capital

Babson Capital Perspectives December 2012 OVERVIEW Using Senior Secured As cash balance plans rise in popularity, the search for optimal investment allocations continues. According to the Bureau of Labor Loans in Cash Balance statistics, roughly one in three private-industry employees covered 1 by a defined benefit plan are enrolled in a cash balance plan . In Plans addition, many public pension funds are now utilizing cash balance plans as a means of funding their retirement obligations. We believe many current investment allocations for cash balance plans are not ideally aligned with the nature of their cash balance liabilities, and Many public pension plans are now that senior secured loans provide an attractive option for these utilizing cash balance plans

as a plans. means of funding their retirement obligations UNDERSTANDING CASH BALANCE PLANS While traditional defined benefit plans accrue retirement benefits to Cash balance plans are best served be paid as a series of monthly distributions beginning at retirement, by a diversified investment portfolio cash balance plans are individual retirement accounts with a stated that achieves an annual return that balance that ultimately will be paid out as a lump sum or a lifetime matches or exceeds the interest annuity. This stated balance is typically composed of annual “pay credit rate credits” from the employer along with an “interest credit” based on either a fixed or variable rate. Senior secured loans can offer Most of the differences among cash balance plans relate to the diversification, rate protection and choice or calculation of the interest credit. Fixed-rate interest credits yield for cash balance plans are now less prevalent than floating-rate interest credits. A commonly used floating-interest credit is the 10-year U.S. Treasury yield. The individual account would be credited annually based upon the prevailing 10-year yield at the beginning of each year. It is vital to note that based on these pay credits and interest credits, the account balance of cash balance plans can only increase over time. The economic liability of the plan cannot be hedged with traditional tools from the sponsor’s perspective. The goal of the asset allocation and investment decisions, therefore, is to achieve an annual return that matches or exceeds the interest credit rate while protecting principal. SENIOR SECURED LOANS IN CASH BALANCE PLANS Cash balance plans are best served by a diversified investment portfolio that achieves an annual return that matches or exceeds the interest credit rate. Investments that provide appropriate returns should avoid interest-rate risk because there is no liability match. With that in mind, senior secured loans are well suited for cash 1 Bureau of Labor Statistics, 2011. FOR INVESTMENT PROFESSIONALS ONLY For i Babson Capital Perspectives December 2012 balance plan allocations. They provide significant interest-rate environment. Loans, therefore, offer an current yield, have virtually no interest rate risk and opportunity to be an important component of the benefit from seniority within the capital hedging portfolio of a cash balance plan liability. structure.Senior secured loans have experienced strong growth over the past two decades, both in terms of new With current loan yields near 6% (Figure 1), the issuance as well as...

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