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

Vanguard

Vanguard | 08/31/2010

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

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.

Getting Tensions Right

How CEOs can turn conflict, dissent, and disagreement into a powerful tool for driving performance.

strategy+business magazine
by Ken Favaro and Saj-nicole Joni

Illustration by Lars Leetaru
Chief executives most often work in a pressure-cooker atmosphere where two kinds of tension are present. The first kind is the natural tension that exists among top teams, in which talented, driven people who have to work together are also competing with one another for results, power, and stature. The other kind is performance tension: the stress caused by three pairs of important objectives that, in many companies, come into conflict on a daily basis. These are profitability versus growth, the short term versus the long term, and the success of the organization as a whole versus that of its individual parts. …[The] most successful chief executives are the ones who get these tensions right. …Their mind-set is that having the “right fights” — embracing the right tensions and making them work for you — is the most effective way for companies and teams to move forward. As Brian Pitman, the former chief executive of Lloyds TSB, liked to put it: “You need real disagreement first to get true agreement later.”
The dynamics that exist within boardrooms and top teams vary widely, but most fall somewhere on what we call the relationship spectrum. At one end of this spectrum are the boards and teams that could be characterized as dysfunctional in a friendly way. The inclination to avoid conflict and to be in agreement is so strong that important issues never really get resolved. Consensus in these groups really means the absence of apparent disagreement rather than the presence of a shared commitment to decisions and actions. …
At the other end of the spectrum are the teams that are dysfunctional in an unfriendly way. This is where personal agendas, excessive pride, and turf battles over lesser issues get in the way of the real work that could improve a company’s performance and potential. … [People] are fighting against one another rather than for the company’s good.
The place to be is in between, as a productively tense team. Here there is enough like-mindedness on foundational matters (mission, goals, the facts, and so on) to allow the group to have the right fights in the right way over what matters most to the company’s current and future performance. …
Too little tension puts a company to sleep; too much bad tension diverts precious energy into the friction it creates. In our experience, creating a productively tense dynamic is essential to having a high-performance company. Therefore, instead of trying to eradicate tensions, leaders must choose to cultivate them productively.

Embracing the Right Tensions

… The three performance tensions — growth versus profitability, short term versus long term, and whole versus parts — provide fundamental energy that can be harnessed to deliver superior, sustainable results. The ability of the board, CEO, and executive team to navigate these tensions largely determines their company’s ability to both create wealth and serve society.
If the CEO, the top team, and the board aren’t spending the majority of their time on issues that address at least one of these three tensions, they are wasting their time on matters that are relatively unimportant. … Three examples — one for each tension — illustrate our point:
1. Profitability versus Growth. John Sunderland, the former CEO of Cadbury Schweppes, often responded with a parable when an executive argued that the business could increase either margins or sales, but not both. Sunderland would remind the executive of a time when people lived in mud huts and struggled to get both light and heat: Put a hole in the side of your hut, and you let the daylight in, but also the cold; block the opening, and you stayed warm, but sat in the dark. The invention of glass made it possible to have both light and heat. He would then ask, “Where is the glass?” … He found that it created more energy and raised the quality of thinking and debate.
2. Short Term versus Long Term. Norman Bobins was the chief executive of LaSalle Bank (now a subsidiary of ABN AMRO) in the 1990s and early 2000s, when it was one of the most successful middle-market banks in the United States. He tells this story …: “One of my managers came forward and proposed a [US]$180 million profit plan. I had in my head that $200 million should be possible. The manager’s response when I challenged him was, ‘Just tell me what you want and I’ll deliver it.’ I said to him, ‘You don’t get it. It’s not what I want; it’s how I want it achieved.’ The quality of earnings is as important as how much earnings are produced. ….”
Bobins’s approach was a masterful example of using the tension between short term and long term to improve the quality of management. He neither let the manager off the hook nor left him alone to sort out the tension for himself.
3. Whole versus Parts. Soon after Matthew Barrett became chief executive of Barclays PLC in 1999, he purposely introduced tension into a meeting of his executive committee (Exco), which included the executives who led different parts of Barclays. Barrett had become frustrated with how everyone put his or her part of the bank first. …“I took the Exco out for an away-day. Over dinner the night before, I said, ‘I’ve got some good news: I’m disbanding Exco.’ … I said, … ‘You either persuade yourselves that your first job is the co-management of the group and your second job is managing your piece, or I’m disbanding Exco.’ I wanted to create a sense of ownership for the [group’s most important] issues wherever they sat in the organization. It really turned things around. ….”
Barrett created a right fight over one of the most important tensions that exists in any large, complex company: how to make the whole more than just the sum of the parts. He used tension deliberately, aiming it squarely at improving the team’s effectiveness in driving the bank’s performance.
These CEOs have in common a focus not just on the right tensions, but also on using them in the right way: to move things forward, to energize, to spark new thinking, to wake people up! This is how they transformed their companies into great performers.
No business can escape the three performance tensions that pull it in different directions. Any top team or board that tries to ignore them is fooling itself and taking productive tension out of the company.

Test the Tensions within Your Board and Top Team

• How much time in your boardroom and with your top team is going toward the right tensions?
• How well are performance tensions being addressed by your strategy?
• How well do dissent, different views, and competing ideas surface, get discussed, and get productively decided?
• How good is your board’s or team’s alignment? Is it strong enough and focused enough to support right fights fought right?

Making Tensions Work for You

When CEOs, top teams, and boards are operating too close to either extreme of the relationship spectrum, at least one of three situations is nearly always present: The right tensions may be sitting under, rather than on, the surface. They may be recognized, but are not being resolved in the right way. Or there may be insufficient alignment around the foundations of high performance, such as vision, mission, goals, and facts.
… As we saw with Sunderland, Bobins, and Barrett, a productively tense dynamic at the top of a company keeps the most important tensions on the surface at all times for all to see. … This helps the entire company stay focused and prevents less-important matters from taking over the agenda.
But although keeping the right tensions on the surface at all times is the first step, it’s not the whole story. Right fights fought badly usually produce terrible results, leading to volatility, unpredictability, and the loss of energy and momentum. The idea is to pick the right fights, put them on the table, and then fight them in the right way.
For example, when Rolf Classon took over as CEO at a large health-care company, he unexpectedly found himself facing a very tough call. The company was far down the path of considering an acquisition that would make it a dominant player in its market. … Classon discovered that there were real doubters among the team members, including people whose opinions he respected.
Classon called together the team and told them he was uncertain about the acquisition. … He wanted to know what the team thought and to have them dig deeper into the substance of the reservations that many felt but hadn’t vocalized — questions for which there were no clear-cut right or wrong answers.
When the team members realized that Classon was engaging them in a new kind of inquiry — based on his belief that the relationships at the top had sufficient trust and respect to tolerate and even embrace dissent — a lot of new thinking came forward. … They decided to pass. Six months later, a much better acquisition opportunity came along, and the team had the resources, the time, and the mutual trust to act. The resulting acquisition took the company to another level.
In orchestrating this right fight, Classon had one important thing going for him: a strong foundation of alignment on which to build success. Another CEO, Douglas Conant, had no such foundation when he took the chief executive role at Campbell Soup Company in 2001. … Without a common view of what the organization was trying to accomplish, the leadership had become consumed with conflicting priorities and infighting, blaming one another for the financial mess they were in. The once revered American brand had lost its way and become the poorest-performing major food company in the world.
Conant faced each of the three performance tensions — in spades. But he was in no position to tackle them right away. He first had to build a foundation of alignment. So in his first 90 days, he worked with the leadership team to create a values statement, an “employees matter” promise, and a mission statement that defined Campbell’s purpose as “nourishing people’s lives everywhere, every day.” Fixing the company’s performance was important, but the mission had to come first.
At the same time, Conant knew he had to re-energize the organization and make it more innovative — and efficient. He started at the top, rearranging the hierarchy into a matrix to provide team members with broader lines of sight to facts (avoiding silos), and requiring them to “own” more than one perspective. …
Conant was candid about Campbell’s problems, telling his team that the company couldn’t “talk its way out of a situation it had behaved its way into.” He promised consistent, well-measured improvement, year over year. Slowly but surely, his focus on the future began to work. Pricing came into line. Product quality improved. The innovation pipeline became full again.
By the end of 2008, Campbell’s was ranked in the top 10 percent of food companies in financial performance and in the top quartile of Fortune 500 companies in employee morale.
By starting with building sufficient alignment on vision, mission, goals, and facts, and then structuring a way forward that made the lines of tension visible and safe, Conant stopped all the fighting about things that didn’t really matter and turned his team’s attention to fighting really well about the few critical things that did.

Becoming Productively Tense

Many boards and top teams have too little good tension in them; … Many others have too much bad tension in them; … Both dynamics are dysfunctional and ultimately undermine a company’s ability to realize its full potential.
The sweet spot is the dynamic of being productively tense — where the fights are primarily about the right performance tensions, where the fights are conducted in the right way, and where there is sufficient alignment to make dissent and disagreement work in favor of better decision making, faster learning, and more effective solutions.
Every CEO must master the management of tensions, raising and lowering them. This is one of the most important tools a top leader can use to realize a company’s and team’s true potential. Chances are, there is at least one thing your team is fighting about that’s not worth the effort, and one thing the team has let pass that needs to be addressed now.
Reprint No. 10301

Author Profiles:

• Ken Favaro is a senior partner with Booz & Company based in New York. He leads the firm’s work in enterprise strategy and finance.
• Saj-nicole Joni is a business strategist and confidential advisor to CEOs and their top executives around the globe. She is the founder and CEO of Cambridge International Group.
• Examples in this article were drawn from The Right Fight: How Great Leaders Use Healthy Conflict to Drive Performance, Innovation, and Value, by Saj-nicole Joni and Damon Beyer (HarperBusiness, 2010), and The Three Tensions: Winning the Struggle to Perform without Compromise, by Dominic Dodd and Ken Favaro (Jossey-Bass, 2007).

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PSNC 2010 Benchmarking Fee Data Still a Challenge

August 3, 2010 (PLANSPONSOR.com) – While benchmarking your plan fees may be considered a basic part of carrying out your fiduciary responsibilities, it can be a bit easier said than done because of a shortage of strong plan fee databases.

That was one conclusion of a fee disclosure panel discussion at the recent PLANSPONSOR National Conference held in Chicago.
Panel members told attendees that comparing plan fees to their peers' plans can be helpful in determining whether such expenses are “reasonable” under the Employee Retirement Income Security Act (ERISA), but that the process depends on having a reliable database to use in the comparison.
Jennifer Flodin, Chief Operating Officer and Co-Founder Plan Sponsor Advisors, said the continuing issue of whether plan sponsors understand the nuances of plan fees means some will give bad answers to polls used to build the benchmarking databases.
“Eventually there will be better sources of information, but right now it’s a bit mystical,” agreed fellow panelist Stace A. Hilbrant, Managing Director 401k Advisors, LLC.
Stephanie Napier, Vice President & Senior Trust Counsel, Marshall & IIsley Trust Company, said the Form 5500 was originally intended to provide benchmarking data but that the business has gotten so complex that the form hasn’t lived up to its potential.
When it comes to revenue sharing, Hilbrant said for a sponsor or adviser to ask about the fees was considered extremely unusual at one point. “The business is coming full circle: what used to be a crazy question (about revenue sharing) is now part of the new (fee disclosure) legislation,” he said.
Panel moderator James E. Graham, partner, CapTrust Advisors, said particularly disclosing revenue sharing information could generate more than its share of problems. “I shudder to think about giving revenue sharing information to participants,” Graham said. “It’s like giving car keys and whiskey to teenage boys. It’s just not a good thing.”
Graham added: “They’re going to get all this information they don’t want and they don’t understand and they are going to make even worse decisions than they are now."
A sponsor who runs into problems getting revenue sharing data should consider it a bad sign of things to come. “You need know what they’re earning and what is being generated by the investments in your plan,” Flodin declared.
While the panelists agreed that the notion of further educating participants about fees was a good idea in concept, several expressed reservations about how it will play out.
“From a consultant perspective, we think it’s a step in the right direction to get everybody on the same page about what are the fees, who’s getting what, where do the revenue streams go?” Flodin said.”(But) it’s far from perfect. There are a lot of things we think are going to be missed on this (required fee disclosure) document.  While it helps with disclosure, at the end of the day, how is this information going to be utilized? We don’t think it’s been thought through about what everybody is going to do with this document now that everyone is required to report.”
Hilbrant added: “That the different governmental entities are not in lockstep about what the end point is going to look like is even more frightening.  If you’re a plan sponsor who doesn’t like to talk about these details and just meet with the vendor every once in a while to discuss how the investments are performing, this is going to be a big deal.”
The audio from the conference session is at http://www.plansponsor.com/MmediaContent.aspx?id=6442472847.
Fred Schneyer
editors@plansponsor.com

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Professional Contacts Key to Finance Officer Visibility

August 24, 2010 (PLANSPONSOR.com) – Accounting and finance managers have the best shot at keeping up their visibility by staying active in professional groups, but they shouldn’t forget about using social media outlets as well.

Image via CrunchBase

Image via CrunchBase

A Robert Half Management Resources news release about its latest poll said 28% of chief financial officers recommended keeping up professional group contacts, while 22% said Web sites such as Twitter and Linkedin were also useful in this regard.

According to the news release, visibility enhancing moves recommended by poll respondents also include:

• Publish articles in trade/business journals, 15%
• Volunteer or participate in charitable work, 15%
• Speak at industry events or webinars, 15%

"An extensive base of business contacts is one of the most valuable assets a professional can possess," said Paul McDonald, executive director of Robert Half Management Resources, in the news release. "The most successful executives constantly cultivate a network of people -- through both in-person and online networking -- who will help build their reputation in the industry. As social networking continues to gain popularity, it's especially important to use online tools to build credibility and visibility in the business community."

The survey was conducted by an independent research firm and includes responses from 1,400 CFOs from a stratified random sample of U.S. companies with 20 or more employees.
Fred Schneyer
editors@plansponsor.com

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Retirement Plans: Former Employees Can Be Current Problems

SHRM

7/15/2010 
By Mark Sweatman, Keane Retirement Services 
There comes a time when employees leave the company for greener pastures or retirement. … Unfortunately, many companies don’t understand the full impact former employees can have on their retirement plan.

For example, most plan sponsors adopt procedures for locating former employees or beneficiaries who have not cashed out of the 401(k) or other defined contribution plan. What happens, however, when a plan sponsor is not able to track down a missing participant? …

Missing Participants and Unclaimed Property
If ex-employees leave contributed and vested funds of less than $5,000 in their former employer's 401(k) or other tax-qualified defined contribution plan, these funds are subject to automatic rollover into an individual retirement account (IRA) in the participant's name (see “Satisfying the 401(k) Rollover Safe Harbor”).

Participants with account balances above $5,000 who are no longer active employees become a continuing cost, …. Plan sponsors are obligated to maintain communication with ex-employee participants but run the risk of becoming disconnected, making it difficult to meet fiduciary obligations. In addition, it puts the organization at risk for problems with unclaimed property reporting.

Many abandoned property laws include dormancy periods for unclaimed amounts in tax-deferred retirement plans. Generally, the state of last known address of the missing participant is the one that benefits in an unclaimed property situation. …

The problem gets worse when a former employee dies. Death is a distributable event in a defined contribution plan. … But, if the plan sponsor doesn’t know that the former employee has died, it can’t initiate the distribution and might find itself in the awkward position of having to explain why the former participants’ account balances declined between the time their beneficiaries were due a distribution and the time they received it.

The ERISA Factor
This is where the Employee Retirement Income Security Act (ERISA) comes in. ERISA requires that plans provide the following:

• Information about the plan, including important information about plan features and funding.
• Minimum standards for participation, vesting, accrual of benefits and funding of plans.
• Length of time a person may be required to work before the person becomes eligible to participate in a plan, to accumulate benefits and to have a non-forfeitable (i.e. “vested”) right to receive those benefits.

While the Internal Revenue Code generally prohibits the forfeiture of vested retirement benefits, a special provision allows the forfeiture of retirement benefits for missing participants, provided the benefit is reinstated if the participant is ever located. Furthermore, to protect ERISA plan administrators from having to comply with various state unclaimed property laws, ERISA supersedes state laws that relate to any employee benefit plan it governs.

Though ERISA is meant to help plan administrators and sponsors—and has alleviated many potential headaches around unclaimed property—plan sponsors and administrators still face the challenge of maintaining accurate data and keeping track of former employees.

Take for instance the 2008 U.S. Supreme Court ruling in LaRue v. DeWolff, Boberg & Associates. … It clears the way for individual participants in other plans to sue when they believe that fiduciaries are acting improperly.

Terminated Plans

To help plan sponsors and administrators terminate defined contribution plans smoothly, the U.S. Department of Labor (DOL) provides guidelines. … If a plan fiduciary is unable to reach plan participants, … any ERISA fiduciary must follow the following search methods:

• Reach out to participants via certified mail.
• Review related plan records.
• Make inquiries to designated plan beneficiaries.
• Employ the IRS letter-forwarding service.

Image via WikipediaAfter all search methods have been exhausted, the DOL acknowledges that plan fiduciaries must still distribute benefits in order to terminate plans. Employers with terminating plans should then consider rollovers into IRAs or transfers into federally insured bank accounts.

As with ex-employee accounts of under $5,000, the preferred distribution treatment for accounts of any size left in a terminating plan is rollover into IRAs. This technique is preferred because it preserves the benefit value by transferring the entire account balance and defers the consequences of income tax to the participant.

Although endorsed by the DOL, IRA rollovers still raise some issues. Choosing an IRA plan and a plan custodian/trustee is a fiduciary decision. As a result, it might be difficult to locate IRA providers that will accept missing participant rollovers.

Plan fiduciaries can consider establishing an interest-bearing, federally insured bank account in the missing participant’s name. However, this option isn’t without issue either. Rolling a benefit plan into a bank account has tax consequences for the participant and presents great potential for unclaimed property consequences. If the participant never learns about the rollover or the account and three to five years (depending on the state’s dormancy period) of inactivity have passed, the state of last known address for the participant can claim the funds if that state has inactivity provisions.

Don't Lose Touch
While there is no one-size-fits-all approach for plan sponsors and administrators, one thing is certain: Employee data needs to be analyzed on an annual basis and scrubbed for errors and outdated information. Create an internal system for assessing data quality to help cut down on the number of missing participants remaining in your retirement plans. In addition, when employees are leaving the company, provide them with instructions on how to roll over their benefit funds into an IRA or a new employer’s plan.

By staying on top of data quality and the whereabouts of former employees, you can control costs better, stay in compliance and fulfill obligations to keep participants abreast of pertinent plan information.

Mark Sweatman is president of Keane Retirement Services, a division of The Keane Organization, a provider of compliance and risk management solutions to Fortune 1000 corporations.
Related Articles:
Retirement Plan Sponsors Should Keep Track of Former Employees, SHRM Online Benefits Discipline, February 2009
Satisfying the 401(k) Rollover Safe Harbor, SHRM Online Benefits Discipline, October 2004
Quick Link:
SHRM Online Benefits Discipline

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