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Plan Design and Investment Strategies for Market Rate Cash Balance Plans

Grant Verhaeghe
Senior Director | CAPTRUST Defined Benefit Practice Leader

Joe Litka
Partner, Enrolled Actuary, Member of the Academy of Actuaries | October Three, LLC

The Pension Protection Act’s (PPA) passage in 2006 clarified the legal framework for cash balance pension plans. Since then, the Internal Revenue Service (IRS) has provided further guidance on the interest crediting rates plan sponsors can choose from in new tax regulations.1 This article explores the merits of several cash balance plan designs available under the “market rate rules” relative to traditional cash balance plans and why corporations might consider this plan design. Further, we provide a brief perspective on the inherent risks of various cash balance designs and issues to consider when developing investment strategies for them.

Cash balance plans are a type of “hybrid” defined benefit plan that originated in the 1980s. Quite popular, their use has grown by over 500 percent over the last decade.2 During this time, many corporate plan sponsors converted their traditional annuity-based plans to cash balance plans, delivering tangible “account balance” benefits similar to popular and fast-growing 401(k) plans. Cash balance plans also became the preferred means for professional service firms to provide significant retirement benefits to their owners and partners.

While traditional cash balance plans reduce many of the risks associated with traditional defined benefit pension plans, they do not effectively address one important area — managing contribution volatility. This shortcoming is a result of the potential annual mismatch between the specified interest crediting rate on participant account balances and the actual return realized on underlying plan assets.

Most traditional cash balance plan sponsors set the interest crediting rate equal to a Treasury rate published by the IRS. Typically, plan assets are invested to meet or beat this rate each year. However, any deviation in plan asset return from the interest crediting rate in a given year results in contribution volatility. Plan sponsors with mature plans quickly learn that even a small deviation can result in significant contribution volatility. As a result, many plan sponsors opt to invest conservatively in an attempt to limit this volatility. 

The market rate cash balance plan design — the latest evolution of the cash balance structure — is quickly becoming the design of choice because it addresses the issue of contribution volatility. In addition to delivering all the beneficial features of the traditional cash balance plan, this design addresses investment risk by taking full advantage of the flexibility afforded under regulations.

PPA cleared the air on several cash balance legal issues. More importantly, it provided, for the first time, a framework for rationally sharing and apportioning retirement-related risks, rather than simply shifting them between employers and employees. PPA-related final regulations published in 20113 explained how plan sponsors can now provide interest credits based on “market rates of return” tied to external indices — such as mutual funds — or may be based on the pension trust’s rate of return. Now, plan sponsors no longer have to develop an investment strategy that attempts to match the way their plan liabilities move. They can structure market rate cash balance plans to invest plan assets to reflect their specific risk tolerance and base the plan’s interest crediting rate directly on plan assets’ underlying performance.

Advances in plan administration technology allow sponsors to credit interest daily — as opposed to monthly or even annually — further mitigating contribution volatility, while providing participants with a more 401(k)-like experience. Participant account balances, and therefore plan liabilities, now move in tandem with plan assets on a daily basis. Not only can this design structure substantially eliminate investment risk, but it also frees plan sponsors to adopt investment strategies that make sense for them and are not driven by an annual goal to achieve a predetermined bogey that has little or nothing to do with their plan objectives each year.


Figure One compares the hypothetical annual contribution requirements over a 10-year period for two plans that are identical except for the interest crediting rate. In this example, the index-based interest crediting rate is the 30-year Treasury yield, a common choice among non-market return cash balance plans; the market return interest crediting rate is based on historical data reflecting a hypothetical portfolio invested 80 percent in fixed income and 20 percent in equities. All yield data is based on the last 10 years, only in reverse, with the bond portfolio returns calculated to reflect the change in rates from the prior year.

The explanation for these two very different contribution patterns is quite simple. For the market rate cash balance plan, as long as the cumulative earnings of the plan are within a design-imposed corridor (typically zero to seven percent compounded annually), the plan sponsor is not required to adjust contributions. Meanwhile, for the traditional cash balance plan, any deviation of the actual earnings from the stipulated rate requires an adjustment to the contribution for the year to maintain desired funding levels. Given the attractive nature of this new plan design for partnerships and corporations, it is important to consider the implications when developing investment strategies.

Selecting the appropriate design and interest crediting rate for a cash balance plan is important, and no single solution is universally appropriate. The inherent risks in these choices are equally important when developing investment solutions. Plan sponsors often design investment strategies to hedge the capital market and economic risks inherent in the actuarial measurement of liabilities or crediting rates selected during plan design. While the new market rate rules go a long way to addressing these risks, hedging in cash balance plans can be far more complex than in a traditional final average pay pension plan for a variety of reasons.

Actuaries determine funding levels by making interest crediting rate assumptions about the future value of account balances and then discounting back the same value using a high-quality corporate bond rate similar to traditional pension plans. These assumptions and discounting methods create a clear disconnect by crediting a long-term rate of return on a short-term basis. They also introduce what is termed basis risk between interest rates on high-quality corporate bonds and the interest crediting rate selected. This is further complicated by the prevalence of floor and ceiling rates, which are very difficult to hedge. Plan sponsors who have legacy benefits from traditional plans also experience interest rate sensitivity in the measurement of plan liabilities from previous benefit structures.

Additionally, many partnerships have design features or employment contract features that override funding flexibility beyond statutory requirements. These provisions essentially force higher funding levels over shorter time horizons and are often set up to ensure consistent tax deferrals associated with plan contributions or to ensure equitable benefit cost burden with the addition or departure of partners. Positive or negative shocks to these contribution rates can be painful events for these organizations. 

While these are complex issues, the important takeaway is that cash balance plan design and investment strategy selected should be a function of each plan or plan sponsor’s unique combination of objectives, plan design, and interest crediting rate. Plan sponsors should design an investment strategy to address risks including but not limited to: interest rate risk, basis risk, and volatility in funding levels or deferrals.

The following list includes questions plan sponsors should consider when evaluating cash balance plan design and investment policy:

Is my investment strategy aligned with the interest crediting rate selected while addressing the associated risks?

Are we trying to optimize risk and return in the traditional asset-only context, relative to the interest crediting rate, relative to our actuarial liability, or relative to cash flow and funding concerns?

Are we trying to generate a rate of return that covers:

Interest crediting rate;

Interest crediting rate and plan costs;

Interest crediting rate, plan costs, and service credit; or

The disconnect between the interest crediting rate and the discount rate used for funding purposes?

While IRS regulations go a long way toward addressing criticisms of cash balance plan design and associated investment strategies, there is no universal hedging solution appropriate for all cash balance plans. The solution implemented should be customized and specific to the unique plan sponsor’s objectives, constraints, and risk tolerance. Only measured risks should be taken relative to these objectives, and there is no shortage in complexity in the potential solutions. Plans sponsors should balance the desire for return with the risks necessary to accomplish the objective. More conservative objectives generally create more certain outcomes, while more aggressive objectives often lead to more uncertain outcomes. 

While market rate cash balance plans are becoming more prevalent among professional service firms, it might be time for forward-thinking corporations to consider their advantages as well. Implemented properly, a market rate cash balance plan could form the core of a company’s retirement benefit package. Employers may wish to consider this design option — in conjunction with employee 401(k) deferrals — as a way to help produce stable, predictable costs while still providing crucial help to employees as they plan for retirement.