If you haven't heard of cash balance plans, you will soon, especially if you are well-compensated. Cash balance plans are the fastest growing of the defined benefit pension plan universe and could become as numerous as 401(k) plans within the next few years. But while the benefits of plan portability, reduced longevity and investment risks, and improved legal clarification are deservedly appealing to plan sponsors and participants, management of the plan assets can present a challenge.
The Pension Protection Act of 2006 and the current tax code are key reasons for the surge in interest in cash balance plans. Loosening of the regulatory framework in 2006 and 2010 has added considerable flexibility for employers looking to supplement 401(k) plans — and reduce taxable income — of higher-paid employees. Cost efficiency, asset protection and, in the case of employee-owned businesses, the ability for the employer-employee to catch up on delayed savings are key advantages.
Cash balance plans are a hybrid between a defined benefit and a defined contribution plan creating a hypothetical account for each employee to which the plan sponsor makes contributions that are based on a set interest crediting rate and a percentage of the employee's pay. This produces a plan that is easy to understand (unlike a traditional defined benefit plan), and one for which participants can withdraw the entire hypothetical account balance at any time after termination — they do not need to wait until retirement, and they do not need to take the benefit in the form of an annuity.
But establishing and managing a cash balance plan requires a deeper level of understanding of investment processes since several factors such as company type, size and risk tolerance can lead to very different investment policies. When formulating a cash balance plan investment strategy, key considerations are plan sponsor dynamics, interest crediting rate and variability of cash flow.
Investment strategy depends strongly on the characteristics of the plan sponsor. Public companies typically have a longer time horizon, and appointed personnel are responsible for weighing the concerns of a much larger interest group to determine an appropriate strategy. On the other hand, partnerships have more immediate personal concerns about risk, tax considerations and time horizon since they are both the plan sponsors and beneficiaries.
In 2010, tax regulations added clarity to interest crediting rates for cash balance plans providing a viable outline, even though most of these regulations are delayed until January 2014. Plan sponsors can choose from several interest crediting rates such as a fixed rate of up to 5%, a bond yield (most choose the 30-year constant maturity Treasury), or the actual return on plan assets or mutual funds. Depending on the selection, the investment outcome of the plan can vary providing very different returns.
While many, often complex investment approaches for cash balance plans have been proposed, we advocate a “common-sense approach” to liability matching where liability is viewed as simply the sum of the participants' “account balances,” and the investment objective is to meet or exceed the interest crediting rate.
Since their introduction in the early 1980s, cash balance plans have proved popular, especially in the last decade. According to the Department of Labor, there were more than 7,600 individual cash balance plans in 2010 with almost $800 billion in assets (compared to just under 1,300 plans with $426 million in assets in 2000). Kravitz, a cash balance management firm, projected that cash balance plan assets would total $1 trillion by the end of 2012. More than a third of these plans maintained assets over $1 million.
Cash balance plans have been incorporated across industries from health care to technology, legal and finance sectors, usually at small businesses with annual employee incomes exceeding $250,000. The plans often supplement 401(k) programs, providing an easy, low-risk alternative with which to boost tax-deferred savings.
Emerging as an aggressive competitor to existing pension plans while presenting a transparent and flexible option for investment savings, cash balance plans require a more strategic approach and are more complicated to invest than a traditional DB plan or a total-return strategy. As a result, it is crucial that highly trained and seasoned investors who are well-versed in accounting and funding regulations, plan sponsor dynamics and interest crediting rates, partner with the plan sponsor to smooth the transition.
Meghan Elwell and Alex Pekker are vice presidents of research and quantitative analysis at Sage Advisory Services, a Texas-based investment management firm.