We begin a series of three articles on the ‘capital preservation rule’ applicable to cash balance plans that use a ‘market-based’ interest crediting rate – most commonly, a rate based on the performance of trust assets. (We refer to this sort of plan as a ReDefined Benefit (ReDB) plan®.)
ReDB™ plans present an interesting design alternative – because interest credits are typically based on trust performance, a ReDB™ plan generally looks a lot more like a DC plan than any other defined benefit plan design, including ‘traditional’ cash balance plans. As such, the ReDB™ plan design is an interesting alternative for traditional DB plan sponsors who want to transition to a more DC-like design but for one reason or another prefer not to go all the way to a DC plan.
In this context, the capital preservation rule is the ‘joker in the deck’ – it is the feature of a ReDB™ plan that makes it not like a DC plan. In these articles we are going to try to understand just how big a deal the capital preservation rule is or is not.
In this introductory article we discuss how the capital preservation rule works, the challenges it presents, and different design alternatives that may address those challenges. Our next article will analyze the risk that the capital preservation rule adds. Our last article will consider the implications of that analysis for the ReDB™ plan decision and for ReDB™ plan design.
ReDB™ plans and the capital preservation rule generally
We assume a general understanding of how cash balance plans work. Briefly: a cash balance plan is a defined benefit plan that walks and talks like a defined contribution plan. It defines a participant’s benefit in terms of a credit to a hypothetical account of a percentage of current pay (the pay credit) plus hypothetical earnings on that account at a rate specified in the plan (the interest credit). The pay credit functions like the employer contribution in a DC plan; the interest credit functions like earnings in a DC plan. Often, distributions are expected to be taken as a lump sum equal to the balance in the participant’s account at termination of employment (although, unlike most DC plans, annuity options are also available.)
Under IRS final regulations in 2014, a cash balance plan is permitted to use a market-based interest crediting rate tied to the rate of return on plan assets, provided that the plan’s assets are diversified so as to minimize the volatility of returns. (Plans are permitted to rely on this 2014 proposal for periods before the regulatory effective date.)
Put simply, this rule allows a cash balance plan to provide returns (interest credits) that look a lot like the returns provided by a DC plan. Trust returns flow to the participant’s bottom line, not the sponsor’s.
There is, however, a catch. The applicable law and regulations impose a preservation of capital rule on a ReDB™ plan:
So, under a ReDB™ plan, the participant’s benefit has to at least equal the sum of her principal credits (pay credits) – hence ‘preservation of capital.’ The DC equivalent would be an investment option that guaranteed that the account balance would, when paid out, at least equal total contributions.
It’s important to understand that this is a cumulative, not an annual, guarantee. And it is only triggered at the participant’s annuity starting date – in a cash balance plan, generally, termination of employment.
The capital preservation rule and sponsor risk
There are different points of view on how significant the preservation of capital requirement is. Some believe it presents significant risk – that, for instance, a one-time market event can cost the sponsor significant money over and above the explicit promise of contributions plus trust earnings. Others dismiss this risk because the participant has to terminate for it to actually come into play and, for a participant with any significant tenure, past earnings generally will provide an ‘earnings cushion.’
A threshold issue to consider is exactly how to conceptualize the risk added by the capital preservation rule. In this and subsequent articles we are going to look at that risk in the following way: We assume that, in a ReDB™ plan, the sponsor wants to come as close as possible to reproducing (1) the risks/returns for participants and (2) the stable cost to the sponsor that are available under a DC plan. So, if you can provide a benefit to a participant in a DC plan equal to 5% of pay plus trust earnings, with the participant bearing all risk (and returns) and the sponsor bearing none, how close to that result can you come with a ReDB™ plan that provides a pay credit of 5% of pay plus interest credits equal to trust earnings with a capital preservation guarantee? In the latter case – where you are using a ReDB™ plan design – how does the outcome for the participant and for the sponsor differ from the simpler DC design? (We will discuss this way of looking at capital preservation guarantee risk in more detail in our second article.)
What factors affect the cost of the capital preservation guarantee?
While the capital preservation rule looks simple, it presents a bundle of risks that make understanding somewhat complicated. We would identify the following factors as affecting the cost of the capital preservation guarantee:
Turnover. Because the capital preservation guarantee only comes into play at termination of employment, the guarantee cost depends (in part) on how many participants terminate at a given time. If turnover is relatively high, the ‘frequency’ risk of triggering the guarantee will also be higher.
Tenure. Because the capital preservation rule provides a cumulative floor, the longer a participant’s tenure, the less likely it is, generally, to come into play. In a ReDB™ plan, longer tenure participants generally have a cushion of prior earnings to offset losses in any one year.
Amount of “capital” vs. amount of earnings. Obviously, the bigger the amount of capital to be preserved, the greater the magnitude of the risk. The greater earnings relative to capital, however, the smaller the risk that the guarantee will come into play – that is, the lower the frequency of risk. (Usually, this risk is the same as tenure. Where there is a conversion and participants start (enter the plan) with large opening balances (‘capital’), however, this becomes a separate risk.)
Trade-off between ‘frequency’ risk and ‘magnitude’ risk
These, generally, are the major factors that will affect the guarantee cost. Mathematically, the cost of the capital preservation guarantee is the product of the ‘frequency’ risk and the ‘magnitude’ risk. Generally, for short-service participants, the ‘frequency’ risk is highest, but the ‘magnitude’ risk is lowest. As the horizon increases, the ‘frequency’ risk declines while the ‘magnitude’ risk increases. It is an empirical question – one that we discuss in the next article – where the product of these risks is greatest. It is worth noting, however, that historically, the ‘frequency’ risk (the probability of negative cumulative returns) for diversified portfolios has been zero for horizons of fifteen years or longer.
Correlation of risks
But the risk situation is more complicated because some of these separate factors are correlated. Critically, a market downturn may be correlated with widespread layoffs (an increase in turnover). Moreover, such an event may correlate with poor sponsor performance, loss of access to capital/credit and a general ‘cash crunch.’ After two ‘once in a lifetime’ market events (in 2000-2002 and 2008), sponsors are reluctant to think of any risk that is dependent on such factors as asset allocation, layoffs, and sponsor performance as manageable.
It’s possible, generally, to design your way out of risk with respect to the guarantee, although doing so will generally make the ReDB™ plan look less like a typical DC plan.
‘Conservative’ asset allocation: You can, of course, eliminate all guarantee risk by investing trust assets in capital preservation assets – a guaranteed investment contract, short-term Treasuries or simply cash. The problem is, by reducing guarantee risk in this way you are also generally reducing returns. This doesn’t affect the sponsor – returns drop to the participants’ bottom line. But it doesn’t reproduce a typical DC asset allocation; in the DC plan you can optimize trust investments to reflect participant preferences and time horizon. Here, you are optimizing trust investment to reflect sponsor concerns about guarantee risks.
Three-year vesting: A three-year vesting rule excludes from guarantee protection participants in generally high turnover group (reducing the frequency of risk). It also, in effect, increases the tenure of those who are vested – after three years the participant may have had the chance to build up an earnings cushion. For some companies, at least, three year vesting may be a step back from the DC design they had in mind. (One solution to the latter problem may be to apply the three-year vesting rule only to the capital preservation guarantee; we express no opinion about whether IRS would allow such a design.)
Averaging in: Combining these two strategies, you could also or alternatively provide for a low-risk or risk-free asset allocation for participants with shorter tenure. In the context of a conversion, where some participants may have accounts with large amounts of principal (converted from a traditional DB plan benefit) and no or little earnings this sort of strategy may be essential to reduce short-term risk.
Lock-up period: Building on the vesting notion, plans that don’t permit distributions for, say, ten or twenty years, or until a specified age (e.g. 55) may dramatically reduce the ‘frequency’ risk. With such a provision, however, the plan looks less and less like a DC plan.
ReDB™ vs. DC, Finance vs. HR
One way to understand the challenge that capital preservation guarantee presents for ReDB™ design is to consider it in terms of the differing objectives of a sponsor’s finance and human resources functions. From the point of view of finance, the capital preservation guarantee adds risk. A DC plan that provides a benefit of 5% of pay will cost 5% of payroll. But a ReDB™ plan providing a 5% pay credit may cost more than 5% of payroll. As discussed, sponsors can design their way around this risk, addressing finance function concerns. But doing so may present problems for human resources. If HR wants to provide participants with a DC plan, a ReDB™ plan with ultra conservative investments or extended lock-up periods may present a problem.
“Target date” designs
ReDB™ plans are an emerging phenomenon; most cash balance plans still provide either a flat or fixed income-based interest crediting rate. Most ReDB™ plans that do exist credit trust returns generally – similar to the performance of a DC plan that maintains a balance fund. For this sort of ReDB™ plan, the market/asset allocation risk is dependent on the one asset allocation strategy that is determined for the entire plan.
ReDB™ plans can ‘mimic’ a target date strategy, where, e.g., short-service participants are credited returns on a more aggressive (e.g., 90/10) portfolio and longer-service participants are credited returns on a more conservative (e.g., 20/80) portfolio, but under current guidance, explicitly tying these credits to participants’ age may be problematic, so mid-career hires may get ‘riskier’ interest credits than they would prefer.