As we discussed two weeks ago, the funded status of typical traditional defined benefit pension plans improved significantly in 2022 and 2023 (YTD), due to the increase of discount rate and hence the significant decrease in liability value. However, that is not the case for cash balance plans.
For example, based on FTSE pension index returns, the value of the FTSE full index would decrease by 36% from 12/31/2021 to 9/29/2023. That means that if the present value of the benefit of a generic traditional defined benefit pension plan participant was $100,000 on 12/31/2021, it would have dropped to about $64,000 as of 9/29/2023, as shown in the table at the bottom. The value of the FTSE intermediate index also decreased significantly, by about 29% in the same period, to about $70,948. The generic cash balance plan participant, on the other hand, would have seen the account value increase by 1.9% in 2022, and by an annualized rate of 3.97% in the first three quarters of 2023, assuming the credit rate is the prior year-end 30-year Treasury bond yield. The account balance would have increased to $104,934 on 9/29/2023,
The example above illustrates some fundamental differences between traditional defined benefit liabilities and cash balance liabilities. Therefore, plans with significant cash balance liabilities should design dedicated asset allocation strategies for cash balance assets. Even for plans with a lower percentage of cash balance assets, it is still important to understand the impact of cash balance liability on the overall liability profile and keep a close eye on the progression of the relationship. As we can see in the example above, the cash balance liability can grow rapidly as the share of total liability in a rising rate environment.
Here are some facts about cash balance plan:
- A cash balance plan is a defined benefit plan; Each participant has an account that grows over time via employer’s annual contribution and interest credit based on the plan’s interest credit rate that resets annually; Assets are managed at the plan level, and the investment risk is borne by the plan, not by the participants.
- Most cash balance plans behave like a bank account, except the interest crediting rates earned on the account balance are generally much higher than the rates earned on a bank account.
- Some examples of crediting rates are 1-year Treasury rate + 1%, or 3-year Treasury rate + 0.5%, or 30-year Treasury bond yield. Therefore, for these cash balance plans, the account balance will never go down regardless of the movements in Treasury rate nor equity market conditions. The rise in interest rates over the past 20+ months only means that the account balance of a cash balance account is growing faster than it did in the past.
- The funded ratio volatility of cash balance plans is determined by asset risk. This is quite different from the traditional FAP plans where the present value of a plan’s liability is highly sensitive to the changes in discount rates, as we have seen in the hypothetical example.
- I am focusing on the account balance as a measure of liability in the discussion. There are other metrics to measure liability value for cash balance plans, including economic value and GAAP value. Due to the higher credit rate than what is available in the financial market, the economic value of the cash balance benefit is, most of the time, higher than its account value. The GAAP value does not represent the benefits that participants would receive when they retire.
- There are other forms of cash balance plans. For example, plans could use the annual returns of invested assets as crediting rates, with or without a floor. Assets could be invested in any asset classes permissible by the plan. In this case, investment risks are borne by plan participants. This is like a defined contribution plan except all participants in the same plan have the same asset allocation.
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