Cash balance plan performance 2021-2024 – sponsor finance

In our last article we began by considering the amount of retirement income that a participant (age 55 at the beginning of 2021) would receive over the period 2021-2024 under four different plan designs:

• A traditional defined benefit plan providing a (monthly) benefit of $1,000

• A 401(k) plan with an account balance sufficient (at the beginning of 2021) to buy (from a carrier) a $1,000 a month benefit

• A “traditional” cash balance plan (with the same beginning balance) providing interest credits equal to the yield on 30-year Treasuries

• A market-based cash balance plan (with the same beginning balance) providing interest credits equal to the returns (gains and losses) on a 2030 target date fund

We tracked changes in the purchasing power of retirement income that a participant had or could buy at any time during our 2021-2024 period, reflecting changes in the account balance, interest rates and inflation.

We illustrated the difference in “output” of these four designs over the period with the following chart.

Takeaways: From this data we derive four takeaways for participants:

• Traditional DB plan participants did the worst. They are uniquely vulnerable to inflation, which is why they lost money (in real dollars) over this period. But even without inflation, they do not participate in (net) retirement income gains resulting from investment returns and increases in interest rates.

• Given our premises, cash balance plan participants did significantly better than 401(k) plan participants, because DB plans are able to provide a significantly better annuity “deal.”

• Over the four-year period, participant exposure to equities in the market-based CB plan provided more return than the simple (traditional CB) interest crediting rate – at the end of 2024 the market-based CB plan had around 6% more assets (annuity buying power) than the traditional CB plan.

• At the same time, in terms of retirement income, the market-based CB plan produced more stable and consistent growth.

How does the cash balance plan design choice affect sponsors/sponsor risk?

We now want to “turn this analysis over” and look at it from the sponsor’s point of view.

Generally, market-based CB plans are fully hedged – in this instance, the plan provides an “interest crediting rate” based on the returns on a specified target date fund, and the sponsor simply invests plan assets in that fund. Thus, assets always equal liabilities (assuming positive total returns), and the participant bears essentially all market risk, very much like a 401(k) plan.

There are (generally) two different approaches to financing a traditional CB plan – pseudo “arbitrage” and pseudo “hedging.”

• Under a pseudo “arbitrage” approach, the plan’s portfolio is operated like a hedge fund, investing plan assets to beat the interest rate obligation to participants. Any net gain reduces plan costs. In our case, we assume the “arbitrage” plan is invested in the same 2030 target date fund as the 401(k) and market cash balance plans.

• Under a pseudo “hedging” approach, the plan’s portfolio is invested in fixed income securities that (it is hoped) will track the interest rate obligation to participants. In our case, we assume the “hedging” plan is invested 100% in the Bloomberg Barclays U.S. Aggregate Bond Index.

The following tables summarize how these three different approaches to CB plan finance worked out for plan sponsors over the 2021-2024 period.

The table below illustrates the volatility experienced by traditional cash balance plan sponsors over the same period:

What these numbers tell us:

• As we have said in the past, there is no effective hedge for a traditional cash balance plan liability, except where the interest crediting rate is based on very short-term interest rates (e.g., one-year Treasuries). As a result, in the context (over our period) of rising interest rates, the value of the plan’s portfolio (the Barclays AGG) goes down, even as the value of the plan’s liability goes up.

• While, over the entire period, the “arbitrage” strategy “works out,” the sponsor suffered a substantial loss in 2022. On the other hand, as designed, the market-based cash balance plan remains fully “hedged” (that is, assets always equal liabilities)

• The 6% profit the sponsor makes by the end of the period – the traditional cash balance “arbitrage” – simply comes out of the participant’s benefit. That is, it’s a zero-sum game, and the sponsor – in return for a bank-deposit like interest rate promise – is simply taking the risk (and reward) that a participant takes in a 401(k) plan.

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We will continue to follow this issue.