IN FOCUS6-8 min read

A balancing act: Managing cash balance liabilities in a higher rates regime

Many corporate plans that have a cash balance liability would benefit from a more expansive LDI toolkit that includes securitized or shorter duration opportunistic fixed income strategies that can keep pace with high crediting rates without the interest rate sensitivity of long duration bonds.

05-25-2023
Balancing-act-tightrope

Authors

Ryan Miller CFA, ASA
Solutions Manager
Max Guimond, CFA
Head of North American Solutions

Introduction

Liability-Driven Investing (LDI) has become standard practice for most US defined benefit plans. Improvements in techniques mean that liabilities can often be efficiently and accurately hedged with a blend of long duration fixed income strategies. Well, traditional liabilities that is. As it turns out, many corporate plans maintain both a traditional and cash balance plan liability. The latter is often underserved by traditional LDI approaches, leaving sponsors to either ignore the unique risk profile of these plans or simply manage them in the same way as the larger traditional liability on their books.

The liability for cash balance plans poses many challenges that a higher interest rate regime accompanied by greater volatility often magnifies. We believe plan sponsors would benefit from considering this liability in a different light and exploring strategies outside of the traditional LDI toolkit to more effectively manage the risks associated with cash balance plans. This is especially important as plans reach fully funded status or above and look to improve precision in their hedging program as they enter the final stages of their de-risking journey.

Background

In 1985 Bank of America introduced the first cash balance defined benefit plan. Over the next 20 years, many other corporate plans began to adopt this benefit structure, believing that it catered to a more “mobile” workforce. When an employee leaves the company, the account balance of these plans can be taken immediately and rolled into another retirement vehicle such as an IRA. This contrasts with traditional plans that offer eligibility to receive an annuity only at retirement. 

Many regarded cash balance plans as inherently easier for employees to understand. In many ways, a cash balance plan looks like a 401(k). The employee has an account balance that receives an interest credit, similar to the return in a 401(k), and in a non-frozen plan a pay credit, which is similar to the employer contribution of the 401(k). 

However, the introduction of cash balance plans did not eliminate the traditional plan liability. Companies typically offered cash balance plans to new employees. Current employees either remained in the traditional plan or began earning new benefits under the cash balance plan. As a result, many corporate plans now have both liability types.

Why are cash balance plans hard to hedge?

Traditional plan benefits, defined as an annuity, produce an income stream for participants upon retirement. The liability is a stream of payments that looks like a typical bond and can be valued as such. The liability will increase when interest rates decrease and vice versa. The hedge is therefore straightforward. The plan is short the liability and thus can hedge it by going long a fixed income portfolio with similar characteristics.

Unfortunately while cash balance plans are simple to understand, they are much more complex to hedge for two main reasons. First, the cash balance liability may not be sensitive to interest rates in the same way as a traditional liability. Second, the cash balance benefit is defined as an account balance that can vary from the reported accounting liability. While the plan will offer annuitization, the majority of participants take the account balance as a lump sum, so this must also be taken into close consideration as well.

Cash balance sensitivity to interest rates can vary widely

The interest crediting rate (ICR) is the rate at which a participant’s account balance is credited with interest each year and is generally based on a market rate. Common ICR bases for corporate defined benefit plans are the yields on the 30-year (most used) or 10-year Treasury. From a pension accounting standpoint, a participant’s benefit is projected at the ICR assumption and then discounted using a standard discount rate (like FTSE) to arrive at a liability value.

ICRs are typically strongly correlated to the discount rate. In a cash balance plan, when the ICR increases, there is usually a proportional increase in the discount rate (and vice versa), which offsets any effect on the liability value as shown in Figure 1. Therefore cash balance liabilities tend to have little to no sensitivity to interest rates due to this relationship. This is in contrast to a traditional plan in which only the discount rate impacts the liability.

Yet many cash balance plans offer a floor on the ICR (e.g., 30-year Treasury rate floored at 3%). During times of low interest rates, the liability for these plans will behave more like a traditional liability. In this case the discount rate will move but the ICR remains fixed at the floor. This has historically led many plans to hedge this liability using the same methods as used for their traditional plan liability. However, with currently elevated rate levels, these plans may find themselves over-hedged as the duration of the cash balance liability will now be close to zero (Figure 2).

Figure 1: Effect of a 1% increase in rates

effect of a 1 percent increase in rates

Note: CB is cash balance plans.

Source: Schroders. Shown for illustrative purposes and should not be interpreted as investment guidance.

Figure 2: 30-year Treasury yield vs. FTSE discount rate

30 year treasury yield vs ftse discount rate

Source: FTSE, Bloomberg.

A new regime requires a new framework

Sponsors with cash balance plans face an investment dilemma: how to keep pace with account balances that grow at a high crediting rate while hedging an accounting liability with varying and often close-to-zero duration. In a normal, upward sloping yield curve environment, low duration fixed income strategies typically fail to produce enough yield to meet the ICR. Long duration bonds from a traditional LDI toolkit, on the other hand, expose the cash balance plan to significant interest rate risk, especially in a rising interest rate environment.

While every cash balance plan is unique, there are two main considerations for plan sponsors. First, regardless of the size of the cash balance liability relative to the total liability, we believe that managing two distinct asset portfolios, each with a different objective, can help more precisely manage the risks inherent in each liability profile. 

Second, an ideal solution for managing the risks of cash balance plans would have the following three properties:

  1. Low or zero duration;

  2. High enough yield to cover the interest crediting rate; and

  3. A provision for enough liquidity to cover potential account balance withdrawals.

A solution to these conflicting objectives may be found in certain securitized fixed income or short-duration opportunistic strategies. Many of these offer low effective duration through floating rate exposures, deliver high income to cover the ICR and can be customized across the liquidity spectrum. While some strategies may not offer daily liquidity, monthly or quarterly liquidity can often be sufficient, at least as a component of the overall solution.

As Figure 3 illustrates, adding an allocation to a short-duration opportunistic strategy into the portfolio dedicated to hedging the cash balance liability can improve growth in account balances relative to the plan’s ICR, while adding diversification benefits that can reduce contributions to funded status volatility.

Figure 3: Cash balance efficient frontier

cash balance efficient frontier

Source: Schroders, Bloomberg, FTSE.1

Conclusion

Many corporate plans that have a cash balance liability would benefit from a more expansive LDI toolkit that includes securitized or shorter duration opportunistic fixed income strategies that can keep pace with high crediting rates without the interest rate sensitivity of long duration bonds. This is especially important in a regime of higher interest rates and increased volatility when cash balance plan duration can vary widely.

As funded statuses improve and plans enter the final stages of the de-risking journey, a closer evaluation of the risks inherent in cash balance plan liabilities can often reveal that traditional long-duration LDI techniques fall short of achieving an optimal hedge. For plans that have both types of liability profiles, managing two distinct asset portfolios, each with a different objective from an LDI perspective, can help more precisely manage the risks inherent in each liability profileand achieve better outcomes.

1Data reflects hypothetical back-tested performance results from December 31, 2012 through December 31, 2022. It is the result of a back-test using benchmark returns, gross of management fees. LDI portfolio is 20% Long Treasury, 15% 15+ STRIPS, 15 % Intermediate Corporate, and 50% Long Corporate. The cash flow profile of the traditional DB plan is kept evergreen by resetting each month. The Cash Balance plan returns are hypothetical and calculated based on a number of Schroders assumptions. The hypothetical results shown must be considered as no more than an approximate representation of a portfolio’s performance, not as indicative of how it would have performed in the past or may perform in the future. It is the result of statistical modeling, with the benefit of hindsight, based on a number of assumptions and there are a number of material limitations on the retrospective reconstruction of any performance results from performance records.

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.

Authors

Ryan Miller CFA, ASA
Solutions Manager
Max Guimond, CFA
Head of North American Solutions

Topics

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