How are DB Sponsors Doing?

In our prior articles, we looked at how DC and DB participants did over the period 2021-2025. In that regard, our focus was on retirement income rather than asset accumulation. When we turn to how these plans performed for sponsors, we turn that lens around and look at assets – net surplus/funding shortfall – as the key metric. Doing so allows us to answer the critical question: how much does the participant’s (retirement income) benefit cost?

And, because our objective is to understand how market experience over the period 2021-2025 affected that cost, we start with a benefit of the same value for all plan types. That benefit is worth $186,826 at December 31, 2020 (the amount needed for a 55-year-old to buy a deferred to 65 life annuity of $1,000 per month from a commercial annuity carrier).

The Bottom Line up Top

We’re going to explain how we did our calculations and why these DB plan types behaved the way they did in detail below. But we thought it best to begin with the bottom line.

Let’s start with the easy part: like 401(k) plan sponsors, sponsors of market-based cash balance plans and fully LDI-ed traditional DB plans had no “experience” over the period 2021-2025. It cost them nothing, and they gained nothing. For this purpose, MBCBs function the same as 401(k) plans – all risk (gain/loss) is borne by the participant. And in a fully LDI-ed traditional DB plan, all sponsor risks (asset performance and interest rate) have (theoretically at least) been hedged out. In both cases, there is some noise. MBCBs carry a preservation of principal obligation, and, with respect to TDBs, “fully LDI-ed” is often more an aspiration than a reality. But for our purposes, that noise can generally be ignored.

The following chart graphs how the other DB plans – TDB plans that don’t use LDI, whose investment strategy is broadly return-seeking, and “traditional” cash balance plans (with a specified interest crediting rate) that either “hedge” (which, as we discuss below, is not literally possible) or “arbitrage” (which is, of course, a misnomer – these plans simply pursue a return seeking strategy). 

The short version:

·       Sponsors of traditional DB plans did very well during the period.

·       Sponsors of traditional CB plans pursuing “Arbitrage” had a mixed experience but ended the period with a modest gain.

·       Sponsors of traditional CB plans pursuing “Hedging” saw negative results throughout the period.

In the rest of this article, we explain in detail what happened and why, beginning with a discussion of the key features of different plan designs and how they allocate sponsor risk.

 Three Types of DB Design

Traditional DB Plan – a plan that provides an annuity benefit that accrues each year.

• The analogy here is to a commercial annuity carrier – the sponsor, in effect, functions (via its DB plan) as an annuity provider to its employees, providing an (e.g., age 65 monthly) income to covered employees.

“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 rate credit” (in effect, stated (rather than actual) earnings).

• The analogy here is to a bank savings account – the sponsor pays “interest” on the participant’s account (in our example, the interest crediting rate is equal to the 30-year Treasury yield for the prior December).

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)).

• The analogy here is to a DC/401(k) plan.

Sponsor Risk under Different DB Designs

Traditional DB plan – the sponsor holds both asset (portfolio performance) and interest rate risk. Thus, asset losses/gains and interest rate losses/gains (on liability valuations) affect the sponsor’s net obligation. As we discussed in our last article, however, the participant holds inflation risk. That is, inflation erodes the buying power of the participant’s fixed annuity benefit. (Ongoing final average pay pension plans protect active (but not terminated/deferred) participants from pre-retirement inflation. Frozen plans do not. As we discussed in our prior article, it is often the case that these two sponsor-held risks (assets/interest rates) offset each other, e.g., where interest rates go up, asset valuations go down, but liability valuations also go down.

• TDB plan hedging – Because the sponsor holds both asset and interest rate risk, there is an opportunity for the sponsor to hedge its TDB risk through liability-driven investment (LDI) – by holding in the portfolio financial instruments (an annuity, bonds, or interest rate derivatives) that match plan obligations. In that situation, where, e.g., interest rates go down, interest rate losses (higher liability valuations) are offset by asset gains.

“Traditional” cash balance plan – the sponsor holds asset risk but not interest rate risk. Asset values fluctuate with market performance, but interest credits are fixed at the beginning of each year (e.g., in our example, the yield on 30-year Treasuries). To the extent that actual asset performance exceeds that fixed ICR, the sponsor profits (via reduced contributions)/and vice versa.

• TCB plan “hedging” – There is (literally) no hedge for the TCB plan obligation (the market doesn’t sell “the prior year 30-year Treasury yield,” with no other asset attached to it). To approximate a hedge, some sponsors will invest plan assets in fixed-income securities on which the ICR is based. The problem is that the plan doesn’t just get the yield on those securities; it holds the securities themselves, which will go down/up in value as interest rates go up/down.

• TCB plan “arbitrage” – Alternatively, the sponsor may try to invest plan assets in a way that “beats” the (generally low) ICR. This is, in the TCB industry, called “arbitrage” (sic).

• Bottom line – For sponsors, there is a necessary volatility (risk) with respect to TCB performance that translates to volatile plan costs.  We chart that volatility over the last five years below.

The TCB sponsor, however, does not hold interest rate risk (in effect, the market interest rate used to convert (at the time of annuitization) the participant’s account balance into an annuity). That falls on the participant.

And, as with TDBs, the participant holds inflation risk, both before and after annuitization: the participant’s account is denominated in dollars, and as the buying value of dollars is reduced by inflation, the real value of her benefit is reduced. There may be some compensation for this in subsequent years, if the ICR is linked to a market yield which (in future years) increases in response to inflation.

Market-Based Cash Balance plan – as with a DC/401(k) plan, the sponsor holds no risk; the participant holds all of it.

What Happened and Why

Over the period we’re looking at, broadly, asset values went up (as discussed in our first article in this series).

And interest rates went up, driving down the “cost of income” (AKA plan liabilities).

Obviously, inflation was part of the story behind the increase in interest rates. And, if you adjust for inflation, real asset returns over the last five years were modest (about 2% per year). But we’re looking at sponsor performance in the DB system, and for (nearly all) sponsors in the DB system, inflation doesn’t count.

In these circumstances (and ignoring inflation), as the meme says: “asset line go up, cost line go down, always good.”

For a DB plan that has not hedged out risk (via LDI in a TDB plan or faux-hedging in a TCB plan), that combination – higher interest rates + higher asset values – is a home run. Those sorts of years will always be good for return-seeking DB sponsors. And even where the cash balance interest crediting rate is not correlated with anything in the market – the specified interest rate in a TCB – higher interest rates and positive asset returns will produce positive results.

For plans not seeking returns: while a fully LDI-ed plan’s experience will be flat (in a good way), attempts at hedging the unhedgeable risk in a TCB will necessarily result in losses. That is, as interest rates rise, the value of the fixed-income assets they hold as a hedge will necessarily decline in value.

Cost is Only Half the Story

For the sponsor, however, it’s not just cost that matters. Employers sponsor retirement plans for a reason – to provide a benefit to employees. Thus, the cost of benefits is only half of the story. It also matters how much participants got for the money (cost) that sponsors paid.

In our next article, we will put together the data we’ve developed in this and our prior articles to address the issue of “efficiency” of different plan design formats – how much benefit they deliver for the price paid.

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This is a publication of O3 Plan Advisory Services. If you have any comments, or have questions about regulatory developments, please contact your relationship manager or Mike Barry at mbarry@octoberthree.com. 

The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.

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