Cash-balance liabilities: A new investment framework

Cash-balance plan liabilities have been growing as a percentage of overall defined benefit (DB) plan liabilities, yet relatively little attention has been paid to the unique characteristics of these liabilities and their investment implications. In this paper, we first offer an introduction to cash-balance plans and the various formulas used to calculate their benefits. We then consider how each of these formulas affects the choice of an appropriate liability measurement and investment strategy. In particular, we look at the challenges faced by plans using a variable interest credit formula and propose an investment framework focused on three pillars: capital preservation, consistent income, and liquidity. Our analysis concludes that a dynamically managed blend of Treasuries, agency mortgage-backed securities, and credit can seek to keep pace with a variable interest credit rate while maintaining low volatility. We also address the liability characteristics and investment needs of plans using fixed interest credit and minimum interest credit formulas.

Introduction to cash-balance plans

A cash-balance plan is very different from a traditional pension plan. In fact, it behaves a bit like a bank deposit. As Figure 1 illustrates, each plan participant has an individual notional account with an established balance at the beginning of the year. The balance grows over the course of the year based on the plan’s promised interest crediting rate, and the plan may make an additional contribution — called a “pay credit” — to the account as well.

Figure 1

Figure 2 highlights several key differences between cash-balance and traditional DB plans. The biggest of these is that the benefit of a cash-balance plan is expressed as the current account balance, while the benefit of a traditional plan is expressed as the annual benefit the participant is entitled to upon meeting retirement eligibility. This difference in how the benefit is defined and measured has implications for the interest-rate sensitivity, or duration, of the plan’s liability and, by extension, for the selection of an appropriate investment strategy that seeks to hedge or track the liability.

Figure 2

Further, cash-balance plans come in different flavors, depending on the plan’s choice of interest credit formula:

Variable interest credit (VIC) — The interest credit is reset each year based on an external market rate, such as the yield on the 30-year US Treasury bond. (Some newer plans set the interest credit based on the rate of return on plan assets.)

Fixed interest credit — The interest credit is set at a fixed level, such as 5%.

Minimum interest credit — The interest credit floats based on an external rate, but is subject to a floor. For example, the credit might be the greater of the yield on the 30-year Treasury bond or 5%. This formula has both VIC and fixed interest credit characteristics, driven by the relationship between the external rate and the minimum credit…

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