How are DB participants doing?

In our last article we concluded that, over the last five years (end-of-2020 vs. end-of-2025) in DC plans, the most significant factor determining the retirement income outcome for a DC participant is when she annuitizes. The reason: inflation during the period 2021-2025 significantly eroded the buying power of the (dollar-denominated) 2020 annuity. And over 2021-2025 (partly inflation-driven) increases in interest rates, combined with modest asset gains, doubled the amount of annuity the participant could buy if she delayed annuitization to 2025.

In this article, we consider how these same three market factors – inflation, interest rates, and asset performance – affected DB participants under different DB plan designs.

Bottom line

When you focus on retirement income (rather than how big the account balance is), it turns out that the most stable DB plan design is one where all those risks are (as in a DC plan) held by the same person: a market-based cash balance plan (MBCB).

What we are going to work through, the story the charts tell, is somewhat surprising. But the factors that drive the outcomes the charts map will be generally well-understood by financial professionals, especially those who have any experience with DB plans. For non-financial professionals, however, some of this may be new. So here, at the beginning, we are going to outline the basic concepts and how they interact in some detail, before we dive into the data.

A brief Guide for the Perplexed

Let’s start with the fundamental premise of this series of articles: in our analysis we are not asking how big the participant’s account balance is. Instead, we ask: How much retirement income can the participant’s account balance buy? That shift of focus, from account balance to retirement income, is what all of these charts map.

That question becomes a little more complicated when you look at DB plans, because their design is more complicated and somewhat less intuitive.

The three types of DB plans

There are three main types of corporate DB plans: traditional DB plans (TDBs); “traditional” cash balance plans (TCBs); and market-based cash balance plans (MBCBs). Here’s the simplest way to understand how they differ:

TDB plans operate like an annuity, providing the sort of lifetime income you would get from an annuity carrier.

TCB plans operate like a savings account, paying a stated interest rate on your account balance.

MBCB plans operate like a 401(k) plan, providing market returns on your account balance.

What follows is a more detailed breakdown of these principal distinctions and a discussion of the details of the examples we will be using.

• Traditional DB Plan – a plan that provides an annuity benefit that accrues each year. There is no participant account. Instead, there is a benefit formula, e.g., “for each year of service the participant is entitled to 1.5% of final average pay times years of service.” This benefit is then paid as a life annuity starting at retirement age (e.g., age 65).

How our TDB example works. In our example, we assume this traditional DB benefit is $1,297 per month (we explain why we use that annuity value in our discussion of our TCB example, below). This benefit is payable at age 65, although in our example the participant is age 50, so it will be another 15 years before this benefit will be paid. Finally, we note that, just as we did not provide for additional contributions to the 401(k) plan in our first article, in our example we’re not providing for any additional accruals. This is a frozen benefit.

• “Traditional” Cash Balance Plan – a plan that provides an account-based benefit equal to an annual “pay credit” (equivalent to the annual allocation to a participant’s DC account) plus an “interest credit” (ICR), in effect, stated (rather than actual) earnings. Thus, from the participant’s point of view, a TCB plan works something like a savings account.

How our TCB example works. In our example, we assume a 12/31/2020 account balance of $186,826, the same as the balance we used for the 401(k) plan in our first article. In a cash balance plan, that amount converts to an age 65 annuity of $1,297, almost 30% higher than the $1,000 per month age 65 annuity our 401(k) participant was able to buy. Why the bigger annuity? Because in this case, the annuity conversion takes place inside the plan, on a more favorable basis, producing a 15%-30% annuity conversion premium vs. the cost of a similar commercial annuity purchased with the participant’s 401(k) plan account balance. (We will be publishing an article later in this series focusing on this “DB annuity conversion premium.”) Keeping with our “frozen benefit” approach, there are no additional pay credits. There are, of course, interest credits. The ICR for our example plan is the prior December 30-year Treasury yield, and we credit that amount as of year-end for each year 2021-2025.

• Market-Based Cash Balance Plan – a plan that provides an account-based benefit equal to an annual “pay credit” plus actual earnings – either on plan assets or on a designated investment company, e.g., a public S&P 500 mutual fund. Thus, from the participant’s point of view, a MBCB works like our example 401(k) plan.

How our MBCB example works. In our example, we (again) assume a 12/31/2020 account balance of $186,826 and no additional pay credits. The ICR is based on the same TDF investment we used for the 401(k) plan – averaged returns on the three top public target date funds (~55% equity).

• The fundamental difference between traditional DB plans vs. cash balance plans: It should be emphasized that, especially for our retirement income focused analysis, cash balance plans – both the TCB and the MBCB plans – are fundamentally different from TDB plans. TDB plans provide a benefit that is already stated as retirement income: a life annuity beginning at retirement age. Cash balance plans, like DC plans, provide a benefit that is stated as an account balance, which (like a DC plan participant’s account balance) must be converted to retirement income/an annuity. The only difference (from DC plans) is that that conversion happens inside the plan at, as noted, significantly more favorable rates.

The three critical financial factors

To repeat what we said up top, our goal in these articles is to understand how much retirement income a participant was able to generate under different plan designs – in this article, TDB, TCB, and MBCB plans – based on the last five years of market performance. To answer that question, we look at three variables:

1. Asset value/asset performance – even though this variable is not our ultimate concern, it still affects our calculation.

2. Interest rates – as defining the “cost of income.” At its simplest, the “cost of income” is how big an annuity the participant can buy with his account balance. The cost of income (e.g., annuity purchase rates) is primarily driven by interest rates. For example, take a participant who has an account balance of $150,000 and could (in this made-up example) in year one buy an annuity that pays him $1,000 a month. If in year two interest rates go up 2%, he can then buy an annuity that pays him $1,200 a month with that same $150,000.

3. Inflation – decreases in the buying power of a dollar. If you have $100 in your wallet, 5% inflation simply reduces the real buying power of that $100. If, before that inflation, you could buy 100 apples, after it you can only buy 95 apples. More theoretically, inflation reduces the value of all purely monetary (“dollar-denominated”) assets including, e.g., a savings account, a bond, or (critically for our purposes) an annuity. How it affects non-dollar-denominated assets, e.g., stock in your portfolio, depends on how inflation affects the firm issuing that stock. Does that firm hold assets that go up in value in response to inflation? Can it raise prices? If the portfolio company can adapt to inflation, that inflation may have no (or even a positive) effect on it.

How they are correlated

Now, it turns out, these three factors interact in critical ways:

1. Interest rates and asset performance are negatively correlated. For non-financial professionals this can be a difficult concept, but it is absolutely critical to understanding what is going on in retirement finance. This correlation is explicit for bonds: If market interest rates go up, and you purchased a bond at the “old,” lower interest rate, the market reduces the value of your bond, so that the yield on that bond is competitive. This relationship doesn’t just hold for bonds, though. When interest rates go up, there is (typically) a decrease in the equity market’s price/earnings (P/E) ratio (with earnings loosely functioning as equivalent to the coupon on a bond), with a (loosely) correlated decrease in equity values.

2. Inflation and interest rates are highly correlated. When the rate of inflation goes up, interest rates go up (and the cost of annuity income goes down). (Anticipated inflation is already baked into current rates.) And, in addition (as we just discussed), inflation subtracts value from dollar-denominated assets.

These correlations help stabilize retirement income performance

Now, consider how these factors interact when there is an increase in interest rates: asset values go down, but the amount of retirement income you can buy with your assets goes up. These two effects offset each other. With respect to a bond you hold, the value of the bond goes down, but you are still going to get the same amount of income.

This all matters because (as we said at the top) what we care about in retirement finance, ultimately, is income, not asset values. If an interest-rate-increase driven decline in asset values is offset entirely by an interest-rate driven increase in the amount of annuity income you can buy, then, notwithstanding that you lost money on your account, you will still get the same (nominal) income you were expecting before the interest rate increase/asset decline occurred.

DB participant performance depends on who holds which risks

Why have we gone into such detail on this issue of the correlation of risks? Because in different DB designs, the sponsor and the participant hold different risks. Thus, the “natural” (offsetting) relationship between interest rates and asset values is broken when, in a traditional cash balance plan, you give interest rate risk to the participant but asset risk to the sponsor. And the “natural” relationship between inflation and interest rates and the resilience of (some) equity holdings to inflation costs is broken when, in a traditional DB plan, the sponsor holds asset and interest rate risk, but the participant holds inflation risk. (We should note that in final pay plans, which “update” past accruals for subsequent increases in pay, the sponsor may retain (indirectly and somewhat obscurely) pre-retirement inflation risk.)

So, to repeat: When you think about retirement savings this way – in terms of income – it turns out stability of asset returns (as in a traditional CB plan) is a bug, not a feature. And volatility of asset returns (as in “pure” account-based plans like a 401(k) or a MBCB) that are negatively correlated with/offset volatility of interest rates are a feature, not a bug. And, even if you stabilize “nominal” income (as when a DC participant annuitizes or as is provided in a traditional DB plan), you have, as we saw in our discussion of DC participants in our last article, left the participant totally vulnerable to inflation, in a way that he is not if he simply continues to hold a diversified (TDF) investment portfolio.

All the differences in outcomes in the charts we are now going to review can be explained by the interaction of these risk factors and their allocation to different actors in the retirement finance project.

With that background, let’s review what has happened to DB participants over the last five years.

DB participant performance 2021-2025

In our last article, we looked at the retirement income “performance” of a 55-year-old 401(k) plan participant invested in a 2030 target date fund over the period 2021-2025: How much age-65 retirement income the participant could “buy” with her 401(k) account balance at the end of 2020 vs. at the end of 2025, given the performance of assets, interest rates, and inflation over the last five years.

Here is a similar chart, showing (over the same period/on the same basis) participant “performance” in the three most common types of DB plans: a traditional defined benefit plan; a “traditional” cash balance plan (interest crediting rate = prior December 30-year Treasury yield); and a market-based cash balance plan, invested in the same 2030 TDF portfolio (~55% equities) that we used for the DC plan participant.

This is kind of a complicated chart. Here’s what’s going on with each line:

• DB annuity (orange) is simply a $1,297 monthly life annuity beginning at age 65, in “2020 dollars” – that is, reduced for inflation over the period 2021-2025. This result parallels the experience of a DC participant who annuitized her account balance at the end of 2020, as discussed in our prior article.

• MBCB (dark blue) uses the same formula as the DC design – 2021 account balance + TDF equivalent earnings + the (positive) effect on annuity income of interest rate increases, adjusted for 5 years of inflation.

• TCB (light blue) uses the same formula as the MBCB design except that the interest crediting rate, instead of tracking TDF returns, is based on the prior December 30-year Treasury yield.

Three simple lessons

We realize that all of this is, conceptually, a lot to process. We’ve gone into detail on the methodology simply to “show our work.” But the lessons from this chart are simple, given the different approaches to retirement benefit finance baked into these different designs and the performance of assets, interest rates, and inflation over the last five years:

• As with the chart in our last article comparing a DC participant annuitizing in 2020 to one investing in a TDF and annuitizing at the end of 2025, under any of these designs, the biggest factor affecting how much retirement income our participant gets is the timing of annuitization. That’s why the traditional DB plan produces such a bad result. Annuitizing at 12/31/2025 is way better than annuitizing at 12/31/2020.

• There are two reasons for that result – the positive performance (increase) in interest rates over the last 5 years and the spike in inflation, significantly eroding the “real” value of an annuity purchased at the end of 2020.With respect to the latter point, we have noted that annuities are uniquely vulnerable to inflation. Bottom line: Traditional DB plan participants are doing worse, cash balance plan participants are doing (much) better.

• There is a significant spread in participant performance in TCB vs. MBCB plans.

Comparing cash balance designs

Let’s consider that last bullet in more detail. Here’s an interesting feature of the two different CD designs.

If you look at the account balance value below, the MBCB shows a lot of volatility, since it is synced with TDF returns, while the TCB (which simply credits the yield on 30-year Treasuries) increases in a stable, steady way.

But if you are looking at the amount of retirement income these account balances can buy over the 2021-2025 period you get the opposite result: the traditional cash balance plan shows significantly more volatility than the market-based cash balance plan.

Why did this happen? Because, in a traditional cash balance plan, the participant’s account/asset returns are no longer correlated with normal equity/bond portfolio performance but instead are provided an artificial “interest crediting rate.”

Why a traditional cash balance plan adds to retirement income volatility …

Consider what happened in 2022, when inflation and interest rates spiked up:

• In a normal equity/bond portfolio, such a spike in interest rates/inflation (in nearly all cases) causes a corresponding decline in asset/portfolio values, offsetting (to a greater or lesser extent) the gains from cheaper annuitization costs (because of the higher interest rates). That is what we see with the MBCB and DC performance (which tracks TDF values). This bundle of offsetting risks stabilizes retirement income performance/reduces volatility.

• But in a traditional cash balance plan, providing a stated crediting rate (in this case the yield on 30-year Treasuries), there is no “portfolio value adjustment.” The participant just gets, for each period, another ~4% credited to his “portfolio.” While, at the same time, because of the 2021-2022 increases in inflation and interest rates, the cost of buying income (the annuity conversion rate) went down dramatically. Hence the dramatic spike in retirement income value in the TCB at the end of 2022. (Of course, the interest rate increase does decrease the value of the plan’s portfolio, increasing sponsor costs – an issue we will discuss in our next article.)

The traditional cash balance plan de-correlates normally correlated risks

We are going to discuss this issue in more detail in a subsequent article, but it’s worth spending a little more time on it here, because it is complicated and (at the same time, as the chart shows) very significant.

As we discussed at the top, the (negative) correlation of Interest rates and asset values offset each other, moderating the volatility of market effects on retirement income, as shown in the effect of these changes on market-based cash balance plan retirement income: The real value of retirement income increases steadily in each of the past five years.

But in a traditional cash balance plan, this correlation is “unhitched,” generating substantial retirement income volatility. In a TCB, the sponsor holds the portfolio risk. All the participant gets is something like a savings account – an account balance plus a stated interest rate.

This feature of TCBs – the sponsor holds portfolio risk, and the participant holds interest rate risk (that is, the cost of buying an annuity) – exaggerates the effect of interest rate swings that would otherwise be moderated by asset value changes.

It gets worse … consider the post-2022 results

Thus, participants in traditional cash balance plans are especially vulnerable to interest rate risk/volatility. The increase in rates during 2022 produced a “windfall” for these participants in terms of retirement income. However, during 2023-2025, interest rates came down modestly from the late 2022 peaks, and the combination of meager interest credits and modest inflation since then has chipped away at the value of retirement income their accounts can purchase. As a result, in addition to enduring wild swings in retirement income, by the end of 2025 the traditional cash balance participant has fallen 17% behind the (less volatile) MBCB participant

Because, as we have been saying, inflation, interest rates, and asset values are all correlated: more inflation means higher interest rates; higher interest rates mean (generally) lower asset values; and higher interest rates mean lower annuity conversion costs. The MBCB plan, which tracks these market effects in the same way a DC plan does, reflects all of that, providing (as the chart shows) more “stability of income.”

Next up: How do all these effects manifest on the DB plan sponsor’s balance sheet – how are DB sponsors doing?

In our next article we are going to discuss how 2021-2025 market performance (assets, interest rates, and inflation) has affected sponsors under different designs.