Tuesday, September 7, 2010

Vanguard - Cash balance plans can hold hidden risks for plan sponsors

Vanguard | 08/31/2010
Evan Inglis
Legislative and accounting changes that require faster funding and balance-sheet pension cost disclosure—not to mention a 2008 market that devastated funding ratios—have given rise to a new respect for risk and volatility on the part of defined-benefit (DB) plan sponsors.
Plan sponsors who move to a cash balance plan from a traditional defined benefit (DB) plan may not always realize they are trading interest rate risk for investment risk, Vanguard’s chief actuary maintains.
“Generally, cash balance plan sponsors have the same goals and desires as any other plan,” said R. Evan Inglis, a principal in Vanguard Strategic Retirement Consulting and the chief actuary supporting Vanguard’s clients. “They are looking into ways that they can reduce risk. But reducing investment risk is actually easier with a traditional plan.”
That’s because while cash balance plans are technically DB plans since they provide a guaranteed level of benefit payable to a participant, the benefit is expressed as a lump-sum amount.  However, a traditional pension plan expresses its benefit as an annuity, payable over the participant’s lifetime.
As a result, it is more difficult to invest in assets that match the liability of the cash balance plan than it is to invest in assets that match the liability of a traditional pension plan, Mr. Inglis said. A traditional plan’s liability acts as a long-term bond, which means long bonds can be used to hedge the risk inherent in pension funding levels, he said. This can be a powerful risk-management tool because pension liabilities and bonds both change in value the same way when interest rates change. Investing in long-term bonds minimizes risk, but also allows for potentially a relatively high return.
On the other hand, the liability for a typical cash balance plan is not very sensitive to interest rates, Mr. Inglis said. The liability itself is more stable and predictable, especially because final average pay and early retirement provisions add volatility to a traditional plan. However, because there are no specific assets that will match the liability, the funded status of a cash balance plan is difficult to control, he said.
The original concept for cash balance plans was to credit a relatively low rate of interest to participant accounts and invest in a balanced portfolio that would generate investment earnings higher than the interest crediting rate, he said. That is likely (but not certain) to work fine over a very long time frame, but doesn’t allow for substantially eliminating uncertainty and volatility, Mr. Inglis said.  The reason is that most cash balance plans invest in a traditional balanced portfolio and cannot take advantage of liability-driven strategies that effectively reduce risk, he said.
Cash balance plan features
There are different ways, however, that cash balance plans can be structured, affecting the level of risk and ability to minimize risk.
Most cash balance plans credit a market rate of interest, which changes each year. The most common interest crediting rate is the 30-year Treasury rate. … For a cash balance plan that credits the 30-year Treasury rate to participant accounts, however, investing in 30-year Treasuries doesn’t match the liability, Mr. Inglis said. Each year when the interest crediting rate changes, there would be a gain or loss on the 30-year Treasury assets that’s not matched to the accounts, he said.
Other common interest crediting rates are the 10-year or 1-year Treasury rates. Plans that use the 1-year Treasury rate to credit interest on participant accounts can match the liability pretty well by investing in 1-year Treasuries, Mr. Inglis said. Doing so, however, sacrifices quite a bit of return relative to a traditional portfolio made up of 60% stocks and 40% bonds, he said.
Cash balance plans that use a fixed rate of interest for participant accounts are interest rate sensitive and allow for somewhat easier risk mitigation at higher rates of return, he said. Other plans have interest rate floors. “For example they may credit the 10-year Treasury rate with a minimum of 5%,” Mr. Inglis said. “When you do that you’ve introduced some interest rate sensitivity.” It’s hard, however, to actually invest in anything that matches the liability, he said. There may be some complex derivative strategies that match such a structure, Mr. Inglis said.  But it’s unlikely that most sponsors of cash balance plans are interested in such complicated approaches….
Accepting the efficient frontier
Efficient Frontier. The hyperbola is sometimes...Image via Wikipedia

Beyond such strategies, however, there is little cash balance plan sponsors can do but accept that managing a cash balance plan means taking on investment risk they wouldn’t have to face managing a traditional DB plan.
“There’s just really no reasonable strategy you could adopt to minimize that risk other than to invest in cash or short bonds,” Mr. Inglis said. “That’s kind of the traditional efficient frontier approach.”
It’s a distinction that often goes unnoticed by many plan sponsors, he said.
“Plan sponsors with a traditional pension plan think: ‘Well, there’s a lot of volatility in this plan. We want to get rid of that and replace it with this cash balance plan because it is less risky, less volatile,’” he said. That’s true, however, only if both a cash balance and traditional DB plan invest in the same mix of stocks and bonds, Mr. Inglis said. Sponsors of traditional DB plans are more and more moving to a strategy when it can match its liability with long bonds.
It’s understandable that some employers have moved to cash balance plans. Many employees seem to understand the account balance concept offered in cash balance plans and appreciate the value of an account balance more than the value of a promised annuity. Also, younger participants may appreciate that the value of their benefit increases faster than in a traditional pension plan where much of the value accrues after age 45.
However, the potential to reduce risk and make costs predictable has to be considered alongside potential advantages.
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