A shift to using real market returns for interest crediting in defined benefit (DB) plans’ cash balance (CB) features is lessening volatility and making the supplementary retirement accounts more appealing to plan sponsors—especially because this type of formula is more responsive to changing market conditions, according to a recent study.
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CB features that use a plan’s real market returns for interest crediting help employer plan sponsors reduce financial risks associated with DB pensions “while providing sustainable and secure benefits with better participant outcomes,” said plan design firm October Three Consulting LLC in its 2018 survey of trends in CB plans released June 28. October Three engaged several actuaries who are CB plan experts to compile the report, along with some its own employees who set up CB plans.
“[C]ash balance liabilities and the resulting financial outcomes are typically more stable, although … the interest crediting basis can have a major impact on the degree of financial stability. That helps to explain why comparatively few pure cash balance plans have been frozen,” the October Three survey explained. It suggested full-market return interest crediting can allow long-term participants to earn more than with fixed-income-pegged returns, if they leave their money in the CB plan over time.
What’s a CB Plan?
A CB plan expresses benefits as account balances. (See related June column.) Each participant has a notional account that grows with benefit credits while actively participating—which typically are based on participants’ pay, age, and/or service, as with an employer-funded defined contribution (DC) plan. This account is adjusted periodically by plan-specified interest credits, analogous to DC plan investment returns, while the account remains in the plan or until an annuity commences.
As a result, this formula is called the interest crediting rate. In the past, a CB plan rate formula wasn’t commonly a function of the trust’s investment earnings. Interest credits may be based on a fixed rate, an inflation index, a bond yield, a corporate bond “segment” rate, the trust’s rate of return, or a combination of investable funds.
Plan sponsors have taken an increasing interest in CB plans because they are subject to DB plan compliance rules. DB plans can be structured to provide benefits greater in value than the maximum benefits available under DC plans.
Among the roughly 45,000 private-sector employers in the United States that sponsor DB plans, more than 15,000 also offer a CB plan, October Three said in the study. The majority of the CB plan sponsors are small, overseeing fewer than 100 participants, the firm said.
The October Three survey said that market interest crediting rates are gaining ground most with plans in the professional services, manufacturing, utilities, insurance, and healthcare sectors, where “pure” CB plans—without legacy traditional annuity benefits—have been adopted rapidly since use of the rates was affirmed by Congress in 2006.
Previously, most CB plans used a long-term index such as a 30-year Treasury bond to determine interest credit rates, but such indexes typically are volatile when plan liabilities move up or down in opposition to their assets.
Other Key Findings
Other notable findings of the October Three survey included:
- Plans that use a market interest crediting rate enjoy the best and most stable funded status among CB plans surveyed, with more than 90 percent of such plans being fully funded. These plans also experience the most stable funding pattern from year to year among CB plans.
- Overall, CB plans have been less susceptible than traditional annuity plans to the wave of DB plan freezes in recent years. Among utilities, for example, 90 percent of CB plans continue to provide accruals.
- More than 35 percent of CB plans provide interest credits based on yields on a long-term index, such as 30-year Treasury bonds. A further 30 percent use an index (typically either a short-term or long-term Treasury security) with a minimum crediting rate of 3 percent.
Originally, the movement to CB plans primarily involved the conversion of larger plans with traditional annuity benefits to mixed CB plans. In the late 1990s, however, negative media coverage of the conversions’ impact on older workers, and pressure on the Internal Revenue Service (IRS) from some advocacy groups and members of Congress, led the IRS to suspend determination letters for converted plans.
Adoption of new pure CB plans began in the early 2000s, spurred by the elimination of the so-called combined 415 limit, which enabled greater tax deferrals to business owners.
October Three’s analysis for the 2018 survey was based on publicly available information from IRS Forms 5500, released through February by the U.S. Department of Labor (DOL) and found in the Pension Benefit Guaranty Corp. (PBGC) historical premium database. It looked at 1,069 single-employer plans with CB features that together cover more than 9.3 million participants.