Tuesday, October 15, 2013

Investment Strategies for Cash Balance Plans

Investment strategies for cash balance plans - Vanguard ...Author R. Evan Inglis, chief actuary Jeffrey Sparling, senior investment consultant Connect with Vanguard > vanguard.com > global.vanguard.com (non-U.S. investors) Executive summary. Cash balance plans are relatively common these days and may become even more so following the publication last Fall of IRS final regulations for hybrid plans (see Vanguard’s Regulatory Brief: Final and proposed regulations affecting cash balance plans). Plan sponsors often look to the cash balance design when the cost— and cost uncertainty—of their traditional pension plan has become unsustainable. Compared with the liability associated with a traditional plan, the liability of a cash balance liability is more stable. Sounds like a good thing, right? Well, not necessarily. The liability for a traditional defined benefit plan is easily

matched by bond investments, making risk-reduction cheap and easy. This isn’t the case for most cash balance plans. Vanguard commentary February 2011 Investment strategies for cash balance plans— more risk than you thought 2 The cash balance plan Cash balance plans are one of several types of “hybrid” pension plans that have characteristics of both defined benefit (DB) and defined contribution (DC) plans. They are DB plans because they provide a guaranteed level of benefit, with little or no invest- ment risk for the participant. The benefit payable to a participant is expressed as a lump sum amount— that is, the “cash balance” in an account. This differs from a traditional pension plan which expresses its benefit as an annuity payable for the lifetime of the participant. See Figure 1 for a typical cash balance plan account over the course of a plan year. The employer sponsor usually doesn’t contribute the pay credit amount for every employee to the pension trust because the pension assets are normally assumed to earn more than the interest credit rate. Thus, total contributions are expected to be less than total pay credits. This concept that actual contributions can be less than the credits to participants’ accounts is the reason for some of the original attraction of the cash balance concept. Most cash balance plans credit a market rate of interest which is changed each year. The 30-year Treasury rate is the most common interest rate. It is also the one used for calculating lump sum values in pension plans prior to the Pension Protection Act of 2006, making it convenient for both purposes. Some plans use a 10-year or a 1-year Treasury rate, while others use a fixed rate (one that doesn’t change each year), usually in the 3% to 5% range. The “typical” cash balance plan liability can’t be matched There’s a lot of variety among cash balance plans, which makes things complicated. For starters, let’s consider a plain-vanilla cash balance plan. The entire plan is a cash balance structure—no grandfathered benefits and no retirees. The interest rate credited to the accounts is a long Treasury rate which is changed annually to match the market rate for Treasuries just before the plan year begins. This typical cash balance structure offers virtually no possibility for matching the liability with assets, as illustrated in Figure 2. The cash balance account earns 5% interest based on...

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