Cash balance plans: How they've changed, how they work

Cash balance plans, a form of defined benefit pension that emerged in the 1990s, have been used in combination with — and in lieu of — traditional pension plans to keep guaranteed income promises flowing to workers.

Most commentary from lawmakers on the state of the country’s retirement system begins with a reflexive noting of the decline in traditional pensions.

In 1985, there were 112,805 single-employer pension plans insured by the Pension Benefit Guaranty Corp. By 2016, there were just 22,333 total insured plans, with nearly 15,000 having fewer than 100 participants.

As traditional pension plans disappeared, cash balance features became more prominent in the plans that survived. By 2014, 40 percent of pension participants were in hybrid plans that incorporate cash balance features, compared to 20.5 percent in 2011.

But as cash balance plans have emerged to help save the traditional pension from extinction, analysis from one actuary firm shows that many sponsors—and importantly, their consultants—may not be taking advantage of a design feature that could both mitigate sponsors’ funding volatility and get workers more cash for retirement.

How cash balance plans work

Participants in cash balance plans are assigned an account value that they can either receive as a lump sum at retirement or draw down in the form of an annual annuity payment.

Ultimately, the investment performance of cash balance plans does not impact the benefits promised to workers. They are owed what they are promised, meaning the investment risks in the plans are borne by the employer.

In most cash balance plans, only employers contribute to the accounts. Each year participants get two “credits”—a pay credit, set at a percentage of salary, and an interest credit.

In a new analysis of cash balance plans, October Three, a Chicago-based actuary firm, identified more than 50 ways sponsors apply the interest credit rates, or ICRs, to participants’ accounts.

The most common form of ICR is a long index rate, which is typically based on the 30-year U.S. treasury yield. More than 35 percent of plans with more than 100 participants analyzed by October Three use the long ICR. Another 30 percent set an index rate with a minimum credit for participants, typically at 3 percent.

“Traditionally, plans have essentially borrowed money at X percent, and tried to beat that with the market return on a plan’s investments,” explained Brian Donohue, an actuary and partner at October Three. “If they give an interest credit at 4 percent, turn around and invest it and earn 7 percent, the profits can be used to reduce the cost of the plan. Some version of that was at the heart of the traditional cash balance promise.”

Essentially, that design credits a long-term interest rate on a short-term basis, said Donohue. “That could work over time, but it’s a risky proposition, and what pension sponsors have been trying to move away from for more than a century.”

Plan consultants not recommending market-based ICRs

A far less utilized ICR version—one that was only green-lighted by the IRS through the Pension Protection Act of 2006—is market-based, and fluctuates annually relative to actual investment returns on plan assets.

In basing credits on actual returns on assets, sponsors can have greater clarity on their obligations to cash balance accounts, says Donohue. By law, the credit can’t be negative in down-market years. But participants can benefit from greater credits when plan investments benefit from strong market returns.

The market ICR model is only used by 10 percent of the cash balance plans analyzed by October Three, a fact that leaves Donohue nonplussed.

“I’m surprised the market credit hasn’t gotten more attention,” he said. “So many pension plans are talking about how to reduce risk. The market ICR seems like a natural conversation to have with sponsors. But for whatever reason, large consultant firms have not been champions of this design.”

Better funded than traditional pension plans

Cash balance plans are better funded than traditional pension plans. October Three’s analysis shows a median funded ratio of 99 percent for cash balance plans, compared to 89 percent for traditional plans.

Plans that continue to accrue benefits have a median funded ratio of 100 percent, compared to 90 percent for those plans that have been frozen.

But a breakdown of funded status by the ICR used by sponsors shows that those using a market-based credit are most likely to be well funded. Nine in 10 plans analyzed by October Three are at least 100 percent funded.

By contrast, plans that use an interest credit based on the 30-year Treasury yield or apply a minimum index credit are less likely to be fully funded: 45 percent of the plans are “at least somewhat underfunded,” according to October Three’s analysis.

Basing interest credits on market returns comes with greater volatility for participants. From 2009 to 2015, market-based ICRs posted both the highest and lowest returns compared to other ICRs—a 9.3 percent return in 2009, and a negative 0.6 percent return in 2015.

“The experience of a market-based credit looks more like the experience for participants in a defined contribution plan,” said Donohue. “In any given year you can get a negative return. For the participant, it’s a bumpier ride. But overall, we expect they will end up with better benefits over time. If I’m 30 years old, what’s the benefit of getting a 4 percent interest credit when I could be getting much more.”

But for sponsors, the benefits of a market-based credit are much smoother. October Three’s analysis shows level year-over-year funding obligations relative to other ICRs.

“Market-based plans have a natural hedge—plan assets and liabilities tend to move in tandem,” said Donohue. “It gives sponsors the predictability of a defined contribution plan. You know what your contributions are year-to-year.”