AdvisorNews - August, 2011
Cash balance plans make it harder to match assets and liabilities, study says
Converting to a cash balance plan may pose more risks than you believe. Plenty of plan sponsors like the increased stability in liabilities that a cash balance plan brings compared with a traditional defined benefit plan, but they may not realize a different investment challenge these plans have. "The liability for a traditional defined benefit plan is easily matched by bond investments, making risk-reduction cheap and easy," according to "Investment strategies for cash balance plans - more risk than you thought," a paper published by Vanguard in February.
"This isn't the case for most cash balance plans."
The industry does not understand this well, says Vanguard Chief Actuary Evan Inglis, who co-wrote the paper. However, as more sponsors face contribution boosts following the market downturn, they want to get a better handle on these plans" risk-management issues, says Kevin Armant, a Principal at consultant Mercer in Princeton, New Jersey. "A lot of plans have just started to look at this," he says. "They now are starting to realize what the risk is."
Un-hedge-able Crediting Rate
In a traditional defined benefit plan with a typical allocation such as 60% equities and 40% fixed income, Armant says, about half the risk comes from interest-rate exposure and the other half comes from capital-market exposure. In those cases, he says, "We can eliminate a large portion of the risk by using long-duration fixed income to have the assets move like the liabilities."
Defined benefit plans naturally lend themselves to matching assets with liabilities because a traditional pension plan is just a series of future payment promises to people - like a bond - and financial markets value any future payment promises by using interest rates, Inglis says. Matching can mean holding a lot of fixed-income assets with durations equivalent to liability durations; so, when interest rates change, it impacts assets and liabilities similarly.
However, interest rate changes affect the assets and liabilities in cash balance plans differently, in offsetting ways. Changes to the interest rate that get credited to participants' accounts offset the impact of changes to the interest rate used to discount the liability. About 70% of cash balance plan sponsors utilize a 30-year Treasury rate as the crediting rate for employees' accounts, and it changes annually just before the plan year begins to match the current market rate for 30-year Treasurys, Inglis says. "Matching a 30-year bond yield as the crediting rate is going to be tough, because the yield on a 30-year bond is going to bounce around," says Peter Austin, Executive Director of BNY Mellon Pension Services. "You have duration risk." If a sponsor tries to match liabilities by investing in 30-year Treasury bonds and interest rates subsequently rise, for instance, the value of employees' accounts rises due to the higher crediting rate, but the value of the 30-year Treasury's held as investments fell.
The upshot? "As plan sponsors de-risk plans, they will be unable to remove as much risk from 'un-hedge-able' cash balance plans as they can from traditional DB plans," says Chad Hueffmeier, a New York-based Principal at Buck Consultants. "There is no investment that is going to give you the 30-year Treasury bond yield and a guaranteed return for the next year, let alone the next 30 or 40 years. You could go out and buy 30-year Treasury's at the beginning of the year, but if interest rates moved by 100 basis points, you would have a huge loss in your assets.
There is really only one investment that an investor can be certain of the one-year return at the beginning of the year: one-year T-bills, which tend to have significantly lower yields than 30-year Treasurys," Hueffmeier continues. "Consequently, any interest crediting rate determined at the beginning of the year that exceeds one-year Treasury returns is essentially un-hedge-able."
The investment reality is even more complex for some cash balance plans, Armant says, as they have extra considerations like grandfathered defined benefit account balances. "There are very few pure cash balance plans," he says.
A Game Changer
The final and proposed regs on hybrid plans issued in October 2010 by the Internal Revenue Service will lead many cash balance sponsors to change their crediting approach. The regs allow market-return-based interest crediting rates, Hueffmeier says. "Sponsors can use the actual return on plan assets," he says. "Basically, you have a ton of options in terms of what interest crediting rate to use, so the interest crediting rate is investable. You can actually hedge interest crediting rates for future accruals. This is a game-changer for future cash balance accruals and assets tied to future accruals." Adds Austin, "There are provisions now that allow a plan sponsor to tie a crediting rate to an index or benchmark, so they have an opportunity for almost perfect hedging."
Issuing the new regs "made life much easier for cash balance sponsors," AllianceBernstein Director Stephen Lippman says. "They allow sponsors to say, 'We will choose a crediting rate that is equal to an actual rate returned.' Seventy percent of our existing plans have adopted the new rates. They like the flexibility."
The regs do not end the issue, however. "Plan sponsors must continue to provide interest credits on the prior accruals that are at least as large as the interest crediting rate defined under the current plan," Hueffmeier explains. "Consequently, the risk-management issues with cash balance plans are not going away very quickly."
However, the new regs could lead to some shifts in cash balance asset allocations. "If an allocation of 15% to 20% stocks made sense for many plans, now 25% to 40% in equities could be appropriate," Lippman says. While they sometimes go into more-exotic assets like hedge funds, most cash balance plans invest in a mix of stocks and bonds, he says. Those two asset classes probably make up 90% of the portfolio at most of these plans, he adds.
These plans generally invest more in equities than traditional pension plans, Inglis says. "They really do not have the same incentive to match liabilities with bonds," he says. "One of the ideas that inspired the cash balance plan design is that an employer can credit this low rate of interest and invest in equities, then outearn the crediting rate and reduce costs." The Vanguard paper says that "most of the risk in a cash balance plan is related to equity exposure, whereas a traditional plan is sensitive to interest rate movements." Says Austin, "With a cash balance plan, once sponsors establish the crediting rate, the focus becomes, what is the proper asset allocation, and how much risk are they willing to take to outperform the crediting rate, or not?"
Cash balance plans often invest in a combination of cash and somewhat riskier assets like equities with the aim of making up the difference between cash rates (one-year T-bills) and the plans' interest crediting rate (equal to the 30-year Treasury yield), Hueffmeier says. Funding rules do not require the value of assets to be as large as the sum of the account balances, he says. "Consequently, most plan sponsors also rely on "risky" assets to help close the gap between assets and the sum of the account balances. That is, assets do not only need to earn a return equal to the interest crediting rate, to keep pace with account balances, but also need to grow faster than the account balances, to help close the gap between assets and the account balances," he says. "The spread between the interest crediting rate and one-year T-bills, and the size of the gap between assets and the sum of the account balances, will drive what percentage of assets needs to be in cash and "risky" assets. The wider the spread and gap, the larger the allocation to "risky" assets."
Three things every adviser (and provider) wishes plan sponsors understood about recordkeeping conversions:
- Everybody wants to change providers on January 1. Everybody can't.
If your plan year end is December 31 (and it is, for the vast majority of plans), there are some real benefits to making a provider change at that point in time. Plan reporting - both participant and regulatory (Form 5500) - is quite simply neater when you finish the reporting year at the same time you conclude your arrangements with a provider. Anything else is going to require someone somewhere to "splice" together reports at some point. Doing so doesn't have to be a big deal - but it can be "awkward."
There are some reasons not to make those kinds of changes at year-end, of course. First off, there's generally quite a queue wanting to do so. You may well be able to get in that queue, but your new provider will likely have their hands full with a lot of plans just like yours. More significantly, your soon-to-be-ex provider likely will as well - and guess who is likely to get the most/best attention?
Bear in mind also that a 1/1 change means that a lot of the preparation, review, and/or testing - not to mention participant communications - will happen during a time of the year when people are generally more inclined to be worrying about other things.
- Your provider search will take longer than you think.
Human beings are, generally speaking, poor judges of time requirements, particularly on things they don't have a lot experience with (like provider searches) and that require the involvement/input of committees (like provider searches). We tend to assume that we'll have more time available for such things than actually winds up being the case, and we tend to assume that such things will take less time than they actually do. We also tend to make those types of assumptions about the participation of other members of the team. It's not just that those assumptions tend to be optimistic, it's that, all too frequently, they are wildly optimistic.
Your provider and/or adviser will likely make a good faith effort to provide a timetable of events, and will likely take pains to emphasize to you the amount of time it will take to actually conduct this process. Doubtless they will remind you - and remind you more than once - just how important it is that you make the time commitment - and deadlines - noted in that timetable.
- My advice: Take whatever timetable they give you - and double it.
A big part of the reason your provider search will take longer than you think: is you.
Conversions generally involve providers - both new and soon-to-be-ex - and frequently involve an adviser in addition to the members of the employer team. Every one of these parties is, generally speaking, highly motivated to see the conversion take place. Now, one could argue that you, the plan sponsor, who set all this in motion, has as much motivation as anyone. However, the reality is that, unless you have some SERIOUS servicing issues, your motivation for change is probably somewhat less than the others.
Change, after all, is generally disruptive. A change of providers inevitably brings with it additional work, greater time commitments, and what sometimes feels like an incessant series of questions about things to which you never previously gave much thought. Moreover, you'll have to think about how to communicate this change to your participants - and deal with the inevitable flurry of questions from THEM about how to do things to which THEY never previously gave much thought.
However, these realities are generally not top of mind when we enter into discussions about making a provider change. So, while the search is generally set forth on a wave of optimism and hope, it can, before long, find itself bogged down in the inevitable administrative minutia that consumes so much of a plan sponsor's time. And the longer it takes, the worse it can become.
So, considering those issues, what should a plan sponsor thinking about making a provider change do? Well, I would suggest you start early, allow plenty of time for slippage in schedule, and be open to the possibility of making a mid-year change instead.
Partners or members of an LLC taxed as a partnership are considered employees for retirement plan purposes, and thus cannot have individual SEP plans, according to the IRS. Only an employer can maintain and contribute to a SEP plan for its employees.
The IRS notes that, in addition to the partners, the partnership's SEP plan must generally cover all employees who have:
- reached age 21,
- worked for the partnership in at least 3 of the last 5 years, and
- received at least $550 of compensation in 2011 (subject to annual cost-of-living adjustments).
The plan may use less restrictive participation requirements to cover employees.
Under the SEP plan, the partnership contributes to each eligible employee's SEP-IRA, which each employee owns and controls. The partnership deducts plan contributions for employees other than the partners as a business expense on Line 18 of Form 1065, U.S. Return of Partnership Income and reports plan contributions for partners in Box 13, using Code R, on each partner's Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc. Partners deduct plan contributions they make for themselves on Line 28 of their Form 1040, U.S. Individual Income Tax Return.
Source: IRS Retirement News for Employers, Spring 2011, May 17, 2011.