ATLANTA -- Employers converting their traditional defined benefit plans to cash balance plans might need to set aside more in cash and liquid investments -- because hybrid plans can significantly shorten the duration of the liabilities, according to a new study by Watson Wyatt Worldwide.
That is, in part, because hybrids such as cash balance plans offer employees benefits linked to their current average earnings. Traditional pension plans sharply increase benefits around retirement age.
Moreover, many companies that convert their plans might not previously have offered departing employees the choice of taking their money all at once; that lump-sum feature is a key element of hybrids such as cash balance and pension equity plans.
"Since cash balance plan participants accrue a larger proportion of their benefit in the early years of their career, high levels of early distribution can result in a significant outflow of plan assets. It is not impossible to see cash outflows of up to 8% to 10% of the plan's asset base in some years," the study notes.
The duration of liabilities in a traditional pension plan is about 12 or 13 years; it drops to about 10 years when companies convert to cash balance plans, the study notes. And it can drop even further -- to about six or seven years -- after the current generation of workers retires.
It is critical for company executives to study the impact of the change in the plan's structure on its assets and liabilities, said Brian Hersey, investment director at the firm's Atlanta office, who conducted the study.
Setting aside too much for these anticipated liabilities can cause a company to forgo investment returns on the money, and setting aside too little could cause the plan to incur high costs in selling securities needed to pay out cash.
"I believe it is very important to do an asset-liability study in conjunction with a plan design. If you haven't, you ought to," Mr. Hersey said, in order to analyze the impact on contributions, volatility and pension income.
Companies that need to set aside more cash might set up a cash pool and use a cash manager for paying out benefits from the hybrid plans.
Employers could get extra zip from the cash pool by using a futures overlay, the study suggests.
They also could sweep income such as from dividends from one or more investment portfolios into the cash pool, and set up a withdrawal schedule that lets investment managers know well in advance of any requirements for cash to pay benefits, the study suggests. What's more, companies expecting a big impact on their investments as a result of the conversion could rejigger their investment portfolios, allocating a greater percentage of assets to indexed strategies, or tilting the equity portfolio toward domestic large-cap stocks, which tend to be more liquid than other equities.
Companies also could tilt their fixed-income portfolios toward Treasury bills, which are the most liquid fixed-income securities, and use commingled funds for relatively illiquid asset classes such as small-cap stocks or international stocks.
Many companies that convert to cash balance plans have large retiree populations that will continue to receive pensions based on the old plan; many also allow older workers to stay in the traditional defined benefit plan. In those cases, the impact on their asset allocations might not be felt for years.
Sempra Energy, San Diego, is one of the few companies Pensions & Investments found that has made changes to its asset allocation as a result of converting to a cash balance plan. Even though the company offered all employees a five-year "grandfathering" choice of staying in the old plan, the duration of its pension liabilities was shortened to 7.5 years from 11 before the conversion, said Brian Chew, director of pension and trust investments,
The company also anticipated higher benefit payments because of voluntary retirement programs that followed the creation of Sempra through the merger of Pacific Enterprises and Enova Corp.
Shortly after switching to a cash balance plan, Sempra's $3.5 billion pension fund cut its target equity allocation (to 45% from 51%) and hiked its fixed-income exposure (to 30% from 21%). to reduce the riskiness of the fund's investments. The pension fund also bumped up its emerging market equity allocation by one point to 5%, and eliminated its 2% each exposure to real estate and alternative investments, Mr. Chew said.
The pension fund maintained its foreign stock exposure at 20% but split that between Europe and Pacific country stocks as opposed to being in the EAFE index previously.
Meanwhile, Clorox Co., Oakland, Calif., which converted to a cash balance plan in 1996, decided to "monitor how the cash-flow situation would change," said Nancy J. Roche, manager of benefits funding.
And although the pension fund, with $300 million in assets, experienced a lump-sum outflow higher than payments from the traditional plan, "it was well within the ranges we expected," Ms. Roche said.
Clorox is undergoing an asset-liability study and hopes to make changes in its asset allocation resulting from that by year end, Ms. Roche said.
The company's current asset allocation is 65% domestic equities and 10% international stocks, with the balance in fixed income and real estate.
