The Markets October 14, 2015

Managing Investment Risk in Cash Balance Plans

The features of cash balance plans that make them easier to understand and make costs more predictable also create opportunity for advisers with skill structuring DB investments.
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While a cash balance defined benefit (DB) plan design can be simpler and less risky than a traditional DB plan, it is not inherently a low-risk strategy, Segal Rogerscasey points out in an investment brief.   

“Many of the features of cash balance plans that help make plan costs more predictable and easier to understand can also create challenges when investing plan assets,” the brief says. Cash balance plans differ from traditional DB plans in that they use notional accounts for individual employees and define the retirement benefit in terms of the stated account balance. The account balance grows during employees’ working years, much like in a defined contribution (DC) plan, with periodic “pay credits” and interest at a specified rate, or interest crediting rate.

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Internal Revenue Service (IRS) regulations in 2010 defined safe harbor interest crediting rates for cash balance plans, including:

  • The yield on the 30-year U.S. Treasury bond;
  • A fixed rate up to 6%; and
  • An annual floor of up to 5% with any safe harbor rate, for example, the greater of the 30-year Treasury rate or 5%.

But, these are not the only interest crediting rates cash balance plan sponsors can use. And, plan sponsors want the underlying assets used to fund the cash balance plan to match participants’ notional account balances.

As explained in a paper by cash balance plan provider Kravitz, the risk is whether the investment returns fall short or exceed the targeted interest crediting rate. Additional contributions are required in the case of underfunding, and if returns are too high, contributions tend to be lower due to the surplus of assets. In that case, the tax deduction could be lower and contributions less consistent.   

With cash balance plans, sponsors still face investment risk and return tradeoffs that need to be professionally managed.

NEXT: Matching investment strategies with interest crediting

The Segal Rogerscasey investment brief says, “One challenge is that the interest crediting rate of a cash balance plan is often specified off the yield curve at a duration not consistent with the rate’s reset period. For example, a plan’s interest crediting rate could be based on a 10-year Treasury yield and reset annually. The relationship between a 10-year Treasury bond and a one-year Treasury bill may have significant basis risk. A constant maturity swap (10-year versus one-year) is actually the truer hedge.”

Dan Westerheide, senior vice president and Asset/Liability Modeling Practice leader with Segal Rogerscasey in Boston, explains to PLANADVISER, “It is tempting to think that the investment that hedges the cash balance plan in the example above (the notional cash balance account credits with a 10-year Treasury bond yield) would be an investment in a 10-year Treasury bond. But in fact, the price of the bond moves opposite the direction of interest rates, and thus the value of the assets would fall considerably in a rising rate environment while the cash balance plan would increase. In other words, the ideal hedge is an investment which credits at a 10-year yield but doesn’t have the duration (or price sensitivity) of a 10-year bond.”

Westerheide says a constant maturity swap is an example of an investment with those qualities. It is similar to a “plain vanilla” swap, but instead of exchanging a fixed rate for floating rate, it exchanges two floating rates. A swap is a contract between the retirement plan and another party, usually a swap dealer (see “Swap Meet”). When transacting a swap in its most basic form, the plan and the dealer agree to exchange certain cash flows or other rights to which each party is entitled before they enter into the swap. For example, the plan may own bonds that periodically pay cash based on a fixed rate of interest while the dealer owns bonds that periodically pay cash based on a floating rate of interest. Through the swap contract, the parties “swap” those payment streams without having to buy the underlying bonds.

Using an interest crediting rate floor can also create an investment challenge. Effectively, the plan sponsor has sold floating-rate debt to plan participants with an embedded interest rate floor; thus, adding an interest rate floor to the asset side of the pension balance sheet can offset much of the risk. “Interest rate caps and floors are investment products sold by the large investment banks to institutional investors,” Westerheide says. “It is common for corporate treasurers to limit the costs of their floating rate bank debt by buying an interest rate cap from one of the large broker/dealer banks. They are mostly over-the-counter products.”

NEXT: Using actual rate of return

Dan Kravitz, president of Kravitz, headquartered in Los Angeles, says it is important for cash balance plan sponsors to make sure the interest crediting rate picked is achievable. For example, some of Kravitz’s clients were using a fixed rate of 5% but they changed to a 30-year treasury rate, which is about 3%. 

“It is important when an employer sets up a plan, that investment advisers have good communication with plan actuaries, so investment managers truly understand what investment return is needed,” he tells PLANADVISER. 

Kravitz notes that IRS regulations introduced in 2010 allowed plan sponsors can set the interest crediting rate to the actual rate of return, or yield, on plan assets. “Changing from a 30-year crediting rate to actual rate of return has worked for a lot of our clients to minimize risk,” he says. 

In addition, regulations in 2014 created a new investment approach for cash balance plan sponsors to manage risk. 

The paper by Kravitz explains that plan sponsors can now offer multiple investment options within a single plan, tailored to suit different retirement goals and needs. One of Kravitz’s large law firm clients has a customized cash balance plan with three investment strategies. An ultra-conservative strategy includes longer-service participants and those already retired in a portfolio with 15% equities and 85% fixed income. A conservative portfolio of 25% equities and 75% fixed income covers mid-career participants and those with lower risk tolerance. A moderate strategy covers shorter service participants and those with higher risk tolerance in a portfolio with 35% equities and 65% fixed income. 

However, the regulations include a preservation of capital rule that still creates risk for plan sponsors. “While fairly unlikely, there could be cases where the cumulative interest credits were negative and therefore the participant would get the greater of the cumulative pay credits,” Westerheide says. 

He adds that the way to manage this risk is to dynamically adjust the equity hedge over time.  For example, plan sponsors would want to have equities in assets so that assets would go up in value as the notional accounts increase. But as the notional accounts decline in bear markets, plan sponsors would want to reduce equity exposure of the assets to reflect this lower bound. 

“I should also note that most cash balance plans do not have equity exposure in the interest credit rate, so this issue may not be as significant as you think,” Westerheide contends.

“Cash balance plans minimize some risk plan sponsors would have in traditional DBs, but they still need to make sure the interest crediting rate and assets are in line,” Kravitz concludes.

The Markets October 13, 2015

Company Stock Decision Requires Two Hats

Including company stock as an investment plan option comes with pros and cons.
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Giving a workforce the chance to buy company stock can instill in employees a sense of ownership, says Krista D’Aloia, vice president of Fidelity Investments, and it may increase their incentive. “Employee ownership of company stock may contribute to improved employee morale, and financial benefits for both employees and employers,” D’Aloia tells PLANADVISER.

But recent lawsuits—among them, Fifth Third Bancorp v. Dudenhoeffer—may make retirement plan sponsors leery. “The Fifth Third Bancorp v. Dudenhoeffer ruling last year is certainly causing sponsors to evaluate whether or not they want to continue to offer company stock in their DC plan,” Stephen Moser, a retirement consultant for RetireAdvisers Services at Pension Consultants, tells PLANADVISER.

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A presupposition of prudence once protected plan sponsors when they hard-wired company stock into the plan by mandating the investments in the plan documents. “That’s no longer the case,” Moser says. “Now sponsors must show actual prudence and regularly examine the company stock to make sure it’s appropriate for their participants, just like they do with other investment offerings in the plan.” Understandably, plan sponsors have a stark reaction to the removal of that protection. “It scares many plan sponsors,” Moser says.

Company stock continues to be an important part of the U.S. DC market, according to Fredrik Axsater, global head of State Street Global Advisors in defined contribution—constituting about 10% of all DC assets. “What is changing is that plan sponsors are increasingly reviewing their company stock plan,” he tells PLANADVISER. Of SSgA’s retirement plan clients, only one is eliminating company stock, Axsater says, and many others are reviewing the option and considering the use of a third-party fiduciary.

Recent court cases have brought to life the additional layer of risk—on top of what is already a fairly risk-laden landscape—that can come from offering company stock as a DC investment option, says attorney Kyle Halberg, a research analyst in ERISA services at Pension Consultants.

NEXT: The duty of prudence isn’t one and done

Citing the Supreme Court decision in Tibble v. Edison, Halberg points out that the fiduciary to a retirement plan has more than just a duty to ensure that the investment decisions are prudent at the time that an investment option is added to the plan’s lineup. “The fiduciary also has a duty to continually monitor the investment lineup to ensure that those investment options are prudent on an ongoing basis,” he tells PLANADVISER. “Before deciding to add company stock to your DC plan’s investment lineup, ask yourself whether you will be able to fulfill that ongoing duty to monitor the investment, and in the event that its performance is suffering, replace it with a more prudent alternative.”

Halberg says it can be hard for a company official to separate the two functions, as the same person is likely both an employee of the company, whose stock is in the plan’s lineup, and fiduciary to that same retirement plan.

As questions mushroom around how companies evaluate their company stock option, Axsater emphasizes that the third-party fiduciary always has a process, so outsourcing this function can be a boon to the plan sponsor. This division at State Street Global Advisors has expanded over the last year and a half, and now oversees $60 billion in company stock assets as the third-party fiduciary.

Plan advisers and consultants are also growing more concerned about their own fiduciary role in the plan, Axsater says. Recently, a consultant working on behalf of a very large DC plan, with about a third of its assets in company stock, expressed alarm about the potential risk. “What if something happens to that company stock?” Axsater asks. With such a large exposure to company stock, it’s natural and sensible to imagine looking back, after an adverse event, and ask, “Why didn’t we have restrictions or controls around the company stock?”

NEXT: A decision that’s not always easy

The plan fiduciary’s paramount consideration, when weighing the offer of company stock, is the Employee Retirement Income Security Act (ERISA) duty of prudence and the duty of loyalty, Halberg says. The fiduciary must act as a prudent person would act in the same situation, and answering whether allowing company stock in the investment lineup is a prudent decision is not easy, “especially as someone who is going to be inherently biased toward an optimistic outlook on your company’s future,” Halberg says.

Halberg cites the recent appeals court case, Tatum v. RJR Pension Investment Committee, to highlight the complexity and potential liability of using company stock in a DC plan. The company chose to divest the stock of the recently spun-off Nabisco company, a decision that “seemed reasonable on the surface,” Halberg observes. “After all, isn’t it inherently risky to be offering an individual company’s stock in your investment lineup? The committee thought so, and decided to divest without giving it much more thought.”

But after the stock was removed, it increased in value by nearly 250%, moving some very unhappy participants to sue the plan. The 4th Circuit held that the prudence test requires a determination that a prudent person in the same situation would have made the same decision, rather than that they merely could have made the same decision, Halberg says, a decision that raised the bar with respect to the fiduciary duty of prudence. “It should give pause to any fiduciary who is considering adding company stock to their plan,” he says. “Again, it’s hard to take off those rose-colored glasses that led to that initial reaction, saying, ‘Of course my company’s stock is a prudent investment.’”

NEXT: Rulings could mean some silver linings

If there are any silver linings to some of the court decisions, Moser says the Fifth Third ruling adds some protection for plan sponsors. Regarding publicly traded stocks, it says that “allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances,” he points out.

A plan committee that takes no action based on inside information about company stock in the plan is also afforded some protection by the Fifth Third ruling, Moser says. “A plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”

The process for deciding whether to keep company stock in the plan or not resembles the way individual participants decide how to allocate investments in their accounts: it’s all about risk versus reward. “On the reward side, providing participants with company stock aligns their goals with those of the company, provides them with a sense of ownership, and helps increase loyalty and decrease turnover,” Moser says. “On the risk side, perceived exposure to fiduciary liability due to stricter standards for loyalty, prudence and diversification can be a powerful deterrent.” 

The recent court cases haven’t actually increased the overall risk of liability for most plans, Moser says, “but they have made it more important to pay attention to the policies, procedures and investments in the plan,” he observes. “Deciding what level of risk is acceptable in order to gain the rewards of company stock ownership by participants is an individual decision for each plan sponsor.”

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