Cash Balance Plan Asset Allocation, Part 2: Considerations When Constructing LDI Portfolios for Cash Balance Liabilities.

In part 1, I explained why plans need to develop separate LDI strategies for cash balance liabilities.  Now let’s discuss what a cash balance plan needs to consider when constructing LDI portfolios.  Please note that the discussion here only applies to plans with interest crediting rates as functions of the yield of US treasury securities, such as 1-year Treasury rate + 1%, or 3-year Treasury rate + 0.5%, or 30-year Treasury bond yield. Without loss of generality, let’s assume the crediting rate is the prevailing yield of the on-the-run 30-year Treasury bond as of the end of the previous year.

Here is what we know about the account balance progression of a generic plan participant:

• The interest credit for the year is known at the beginning of the year and is independent of the changes in market interest rates throughout the year. In other words, the account balance has an interest rate duration of 0.
• There is no financial instrument that is priced at 100 and pays the yield of the on-the-run 30-year US Treasury bond every year with 0 interest rate duration. Therefore, the crediting rate is not hedgeable.
• The account balance is the lump sum payment to the participant (or the value to be used to calculate the annuity payout if the participant elects such an option) when he or she decides to start receiving benefit payments. Hence, the account balance should be the target for the assets to be managed toward, not the accounting value.
• After retirement, participants can keep their cash balance accounts with the plan for as long as they wish and can take lump sum any time. As a result, it is very hard to forecast the cash flow patterns and liquidity needs. This makes PRT for cash balance liabilities nearly impossible.

Would a short duration strategy with a high alpha target be appropriate for cash balance assets? Maybe. How about absolute return fund? It depends. Could plans utilize float-to-float interest rate swaps to hedge the liability? Not really, due to the uncertain nature of the liability and the illiquidity of the IR structure. However, float-to-float IR swap should not be excluded from the toolkit for funded ratio volatility management.

Developing LDI strategies for cash balance plans with Treasury yield based crediting rates is a very complicated matter.  Happy to discuss in more detail offline.