Creating Pension Stability in a Volatile World
It seems just about everyone in the retirement industry is writing articles about cash balance plans these days, from actuaries to investment managers to third party administrators. All agree they are a great way to create additional income deferral for business owners in professional service firms as well as other owner-operated businesses. High contribution limits, design flexibility and ease of understanding are among the features that make these plans such a good fit.
However, one of the most important aspects of a truly great cash balance plan design lies hidden in how the Interest Crediting Rate (ICR) is defined. A clear trend is emerging, especially among the country’s top law firms, toward the use of a Market Return crediting rate for this purpose. Under this design, participant accounts are credited with the actual return on plan assets, rather than a stipulated rate based on an external index (we’ll call the latter an Index Based crediting rate). The driving force behind this trend is the ability to create a more stable year to year contribution pattern for the owners of the business, especially as the plan matures.
Consider the following illustrations which compare hypothetical annual contribution requirements and projected accumulations over a ten year period under two plans that are identical except for the Interest Crediting Rate. In this example, the Index is the 30 year treasury rate (a common choice among non-market return cash balance plans) and the actual returns are based on historical data reflecting a hypothetical portfolio invested 80% in fixed income and 20% in equities. All yield data is based on the last 10 years, only in reverse, with the bond portfolio returns calculated to reflect the change in rates from the prior year.
As can be seen, both designs get the participant to roughly the same place after ten years, but with wildly different contribution patterns. Which would most partners rather budget for, a cash outlay that could vary from $40,000 to $150,000 over the span of several years, or one that rarely strays from the intended $100,000 contribution? The answer is obvious and shows why so many firms are quickly moving to this design enhancement.
Which would most partners rather budget for, a cash outlay that could vary from $40,000 to $150,000 over the span of several years, or one that rarely strays from the intended $100,000 contribution?
The explanation for these two very different patterns is quite simple. On the Projected Accumulations graph, the results under both designs are contained by an ever widening “corridor” (the solid gray lines). These lines represent minimum (imposed by law on all cash balance plans) and maximum (imposed by design on the Market Return plan) cumulative returns of 0% to 6% compounded annually. So long as the cumulative earnings of the plan are within this corridor, no contribution adjustments are required under the Market Return ICR. Under the Index Based ICR, any deviation of actual earnings from the stipulated rate will require an adjustment to the contribution for the year to keep the plan on track.
This causes the Market Return ICR design to produce increasing contribution stability as the plan matures due to this ever widening corridor, while the Index Based ICR design produces increasing contribution volatility due to the need for actual earnings to match the index against a continually growing asset base. The following graphs further illustrate this point, based on 10,000 trials of randomly generated investment returns over the ten year period. The Index is again the 30 year treasury rate but for simplicity is assumed to remain constant at 3.5% throughout. Actual yearly returns reflect a median value of 4%, and a range of -4% to +14%1.
1 Results are hypothetical, but these returns are generally representative of a portfolio composed of 80% fixed income
and 20% equity investments.
The solid portion on each graph represents the results of 80% of the outcomes over the ten year period while the thin vertical lines extend the range to 95% of the outcomes.
At this point, one might ask “Doesn’t this make the cash balance plan look and feel a lot like a defined contribution plan?” Well…in many ways it does. Of course, participants still don’t have individual investment control, but the expectations around contributions and account balances are very similar and consistent between the two basic plan types. And, isn’t that precisely the objective? With the proper technology platform, participant accounts can be updated to reflect market performance with almost any frequency, even daily.
With the proper technology platform, participant accounts can be updated to reflect market performance with almost any frequency, even daily.
If your cash balance plan is still using an Index Based ICR we encourage you to explore the advantages a change to a Market Based ICR can bring to your firm and its partners. And, the good news is the change is pretty simple to implement. Contact October Three for additional information.