Cash Balance Plans: What You Need to Know

Oleg Gershkovich, A.S.A., M.A.A.A. LDI Solutions Strategist
Brett Cornwell, CFA Co-Head of Client Portfolio Management, Fixed Income
 

The cash balance plan is the fastest-growing plan design in the country, but they can be tricky for sponsors to hedge.

Executive summary

The adoption of cash balance (CB) plans has grown rapidly, positioning them as a transformative component of corporate retirement planning. Combining features of both traditional defined benefit (DB) plans and defined contribution (DC) plans, CB plans offer flexibility and predictability but introduce unique challenges, particularly in liability hedging and interest crediting rate (ICR) risk management.

This paper provides a comprehensive guide for a diverse audience:

• For plan sponsors new to cash balance plans: Gain an understanding of foundational concepts, mechanics, and the critical differences between CB and DB plans.
• For sponsors currently managing CB plans: Explore different approaches for managing fluctuations in the ICR, including how to navigate the ICR “floor” in low- and high-rate environments. 

Key insights include: 

1. Foundational mechanics: Cash balance plans, while legally defined benefit plans, express participant benefits as notional account balances, which require careful consideration of pay and interest credits. A common misconception is equating the account balance with the plan’s liability.
2. Interest crediting rate: The largest challenge plan sponsors face with cash balance plans is the interest crediting rate (ICR). Special LDI hedging techniques are available to hedge the account growth based on the sponsor-selected ICR. An emerging trend of sponsors selecting a market-based ICR in new CB plan designs has the potential to further ease this challenge.
3. Impact of lump sum take rates: Actuaries’ assumptions about lump sum take rates in CB plans are critical for estimating liability duration; high take rates shift focus to short-duration, liquid assets, while low take rates require long-term, duration-matched investments to fund future annuity streams.

A note about risk

Please note that liability valuations can increase due to falling interest rates or credit spreads, among other things, as the present value of future obligations increases with falling rates and falling spreads. Liabilities can also increase due to actual demographic experience differing from expected future experience assumed by the plan’s actuary. Please keep in mind that diversification or broad asset allocation, in and of itself, neither assures nor guarantees better absolute performance or relative performance versus the pension plan’s liabilities. In addition, investing in alternative investment products (e.g., derivatives) can increase the risk and volatility in an investment portfolio. Since investing involves risk to principal, positive results and the achievement of an investor’s goals are not guaranteed.