The shift to cash balance plans ultimately could mean higher allocations to equities, creating a boon for money managers.
"The nature of the liability changes with a cash balance plan, cutting the duration of the liability by half, which tends to lead to a more aggressive asset allocation," said Jay Kloepfer, director of capital markets research at Callan Associates Inc., San Francisco. A more aggressive allocation, in turn, means more equity exposure.
Consultants estimate at least 900 companies have cash balance plans, with plenty more on the way. If many of them increase their equity exposure by even five percentage points, it would funnel billions in new assets to equity managers.
Actuaries said that while traditional defined benefit plans typically have liability durations of between 12 and 20 years, the typical duration in a cash balance plan is between seven and eight years. The difference is due to the lump-sum feature of cash balance plans, which allows employees to take all accrued assets with them when they leave the company or retire.
Mr. Kloepfer said while the longer liabilities of a traditional defined benefit plan are more sensitive to changes in interest rates, the shorter liabilities of a cash balance plan are more sensitive to inflation. Stocks are a much better match for inflation-sensitive liabilities, and Callan's asset-liability modeling usually suggests an increase in equities of 5% or more, depending on the existing equity exposure of a plan at the time of conversion.
Plan sponsors have an added incentive to boost their equity exposure: "Any returns earned in excess of the promised annual interest (credited to employee accounts) can go to reduce future contributions and costs for the employer," said Mike Johnston, an actuary at Hewitt Associates LLC, Lincolnshire, Ill. "The potential to win and earn more (through equities) is greater than the potential to lose. If you want to manage for excess returns, you have to go to riskier equities."
"Since the liabilities (in a cash balance plan) are under fairly strict control, sponsors can actually manage those liabilities fairly well by taking on more risk than they could" in a defined benefit plan, Mr. Johnston said.
But plan sponsors tend to be conservative during cash balance conversions and often won't make asset allocation changes right away. Most cash balance plans still have "enough transitional issues to deal with, without thinking about the investment management side," said Mr. Johnston. In many cash balance plans now, for instance, only about half the liabilities are actually in the cash balance plan -- the rest are still in the traditional plan.
Actuaries project it could be as many as five or 10 years before companies are ready to adjust their investment management allocations. First, the plans have to pass through the bulk of the "grandfathering" of older employees and significantly reduce the size of the old plan.
But for a number of plans that actuary Sheldon Gamzon has reviewed over the years, no change in investment policy will be necessary, at least not right away. That's because so many traditional defined benefit plans aren't invested appropriately now, said Mr. Gamzon, who is a principal in the New York office of PricewaterhouseCoopers LLP.
"Most defined benefit plans have a duration of liabilities between 12 and 20 years. You would think, therefore, that a pension fund (sponsor) would consider that in formulating an investment policy. But I've found consistently that pension funds aren't managed efficiently and use investments that better match a seven- to eight-year liability duration. They often have a complete mismatch between liabilities and investments," Mr. Gamzon said.
But what was a mismatch for traditional defined benefit plans works well, at least short-term, for cash balance plans.
Cash flow problem
There is another "wacky thing cash balance plan sponsors are dealing with now -- they're running into a cash problem. Under a defined benefit plan, the cash flow was steady and outflow was rarely a problem. You could predict it pretty well. But the cash requirements are going up 10-fold a month in cash balance plans (as people leave the company and take their account balances with them). Some plans are having to sell assets to meet distribution requirements," said Callan's Mr. Kloepfer.
"But we counsel plans against going to a higher cash position and usually suggest they use dividends from stocks to meet cash requirements, rather than reinvest them," he said.
Another effective strategy plan sponsors use, Mr. Kloepfer said, is to move some assets into a money market fund and run an unleveraged Standard & Poor's 500 futures contract on it. When cash is needed, the sponsor can sell the S&P 500 contract, rather than the underlying assets.
Consultants said sponsors, especially larger ones with assets of more than $500 million, also are meeting liquidity needs through the 3% to 5% cash allocation within the plan and through interest paid on bonds. Some consultants noted, however, that by not reinvesting interest and dividends, plan sponsors ultimately are reducing the potential for accumulated asset growth.
But even Mr. Gamzon, who said sponsors he works with are handling cash flow needs without selling assets or upping cash, believes that "as you go further out, the liquidity needs will change. The need for more liquidity will increase as more people in a company begin to retire with their lump-sum distributions."