In a new analysis of cash balanceplans, October Three, a Chicago-based actuary firm, identified morethan 50 ways sponsors apply the interest credit rates, or ICRs, toparticipants' accounts. (Photo: Shutterstock)

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Cash balance plans, a form of defined benefit pension thatemerged in the 1990s, have been used in combination with — and inlieu of — traditional pension plans to keep guaranteed incomepromises flowing to workers.

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Most commentary from lawmakers on the state of the country'sretirement system begins with a reflexive noting of the decline intraditional pensions.

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

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As traditional pension plans disappeared, cash balance featuresbecame more prominent in the plans that survived. By 2014, 40percent of pension participants were in hybrid plans thatincorporate cash balance features, compared to 20.5 percent in2011.

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But as cash balance plans have emerged to help save thetraditional pension from extinction, analysis from one actuary firmshows that many sponsors—and importantly, their consultants—may notbe taking advantage of a design feature that could both mitigatesponsors' funding volatility and get workers more cash forretirement.

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How cash balance plans work

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

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Ultimately, the investment performance of cash balance plansdoes not impact the benefits promised to workers. They are owedwhat they are promised, meaning the investment risks in the plansare borne by the employer.

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

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

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

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“Traditionally, plans have essentially borrowed money at Xpercent, and tried to beat that with the market return on a plan'sinvestments,” explained Brian Donohue, an actuary and partner atOctober Three. “If they give an interest credit at 4 percent, turnaround and invest it and earn 7 percent, the profits can be used toreduce the cost of the plan. Some version of that was at the heartof the traditional cash balance promise.”

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Essentially, that design credits a long-term interest rate on ashort-term basis, said Donohue. “That could work over time, butit's a risky proposition, and what pension sponsors have beentrying to move away from for more than a century.”

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Plan consultants not recommending market-based ICRs

A far less utilized ICR version—one that was only green-lightedby the IRS through the Pension Protection Act of 2006—ismarket-based, and fluctuates annually relative to actual investmentreturns on plan assets.

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In basing credits on actual returns on assets, sponsors can havegreater clarity on their obligations to cash balance accounts, saysDonohue. By law, the credit can't be negative in down-market years.But participants can benefit from greater credits when planinvestments benefit from strong market returns.

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The market ICR model is only used by 10 percent of the cashbalance plans analyzed by October Three, a fact that leaves Donohuenonplussed.

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

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Better funded than traditional pension plans

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

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

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But a breakdown of funded status by the ICR used by sponsorsshows that those using a market-based credit are most likely to bewell funded. Nine in 10 plans analyzed by October Three are atleast 100 percent funded.

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By contrast, plans that use an interest credit based on the30-year Treasury yield or apply a minimum index credit are lesslikely to be fully funded: 45 percent of the plans are “at leastsomewhat underfunded,” according to October Three's analysis.

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Basing interest credits on market returns comes with greatervolatility for participants. From 2009 to 2015, market-based ICRsposted both the highest and lowest returns compared to other ICRs—a9.3 percent return in 2009, and a negative 0.6 percent return in2015.

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

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But for sponsors, the benefits of a market-based credit are muchsmoother. October Three's analysis shows level year-over-yearfunding obligations relative to other ICRs.

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“Market-based plans have a natural hedge—plan assets andliabilities tend to move in tandem,” said Donohue. “It givessponsors the predictability of a defined contribution plan. Youknow what your contributions are year-to-year.”

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