Using Cash Balance to Improve Outcomes for Sponsors and Participants

In a recent Cash Balance survey from October Three, the focus to a large extent was on interest crediting rates used by plan sponsors in corporate cash balance plans. In large part, the study shows that those methods are mostly unchanged over the past 20 years or so, this, despite the passage of the Pension Protection Act of 2006 (PPA) that gave statutory blessing to a new and more innovative design. I look briefly at what that design is and why it is preferable for plan sponsors.

Prior to the passage of PPA, some practitioners and plan sponsors had looked at the idea of using market-based interest crediting rates to cash balance plans. But, while it seemed legal, most shied away, one would think, due to both statutory and regulatory uncertainty as to whether such designs could be used in qualified plans.

With the passage of PPA, however, we now know that such designs, within fairly broad limits, are, in fact allowed by both statute and regulation. That said, very few corporate plan sponsors have adopted them despite extremely compelling arguments as to why they should be preferable.

Why are they preferable?

For roughly 20 years, the holy grail for defined benefit plan, including cash balance plan, sponsors has been reducing volatility and therefore risk. As a result, many have adopted what are known as liability driven investment (LDI) strategies. In a nutshell, as many readers will know, these strategies seek to match the duration of the investment portfolio to the duration of the underlying assets. Frankly, this is a tail wagging the dog type strategy. It forces the plan sponsor into conservative investments to match those liabilities.

Better is the strategy where liabilities match assets. We sometimes refer to that as investment driven liabilities (IDL). In such a strategy, if assets are invested aggressively, liabilities will track those aggressive investments. It’s derisking while availing the plan of opportunities for excellent investment returns.

How exactly does this work?

I alluded to the new design that was blessed by PPA. It is usually referred to as market-return cash balance (MRCB). In an MRCB design, with only minor adjustments necessitated by the law, the interest crediting rates are equal to the returns on plan assets (or the returns with a minor downward tweak). That means that liabilities track assets. However the assets move, the liabilities move with them meaning that volatility is negligible, and, in turn, risk to the plan sponsor is negligible. Yet, because this is a defined benefit plan, participants retain the option for lifetime income that so many complain is not there in today’s ubiquitous defined contribution world. (We realize that some DC plans do offer lifetime income options, but only after paying profits and administrative expenses to insurers (a retail solution) as compared to a wholesale solution in DB plans.)

When asked, many CFOs will tell you that their companies exited the defined benefit market because of the inherent volatility of the plans. While they loved them in the early 90s when required contributions were mostly zero, falling interest rates and several very significant bear markets led to those same sponsors having to make contributions they had not budgeted for. The obvious response was to freeze those plans and to terminate them if they could although more than not remain frozen, but not yet terminated.

Would those sponsors consider reopening them if the volatility were gone? What would be all of the boxes that would need to be checked before they would do so?

Plan sponsors and, because of the IDL strategies, participants now can get the benefits of professionally and potentially aggressively invested asset portfolios. So, what we have is a win-win scenario: very limited volatility for sponsors with participants having upside return potential, portability, and wholesale priced lifetime income options.

The survey, as well as others that I have seen that focus on participant outcomes and desires, tells us that this strategy checks all the boxes. Now is the time to learn how 2018’s designs are winnersfor plans sponsors and participants alike.

The Fallacy of the Participant Outcomes Mantra

I read about them virtually every day. One fund manager/defined contribution recordkeeper (vendor for purposes of the rest of this post) or another is concerned about participant outcomes. In other words, the reason that a plan sponsor should choose that particular company is because if they do, employees of that company will be prepared to retire someday.

Balderdash! Fiddlesticks!

Almost all of those vendors are preaching the same things:

• Automatic enrollment
• Automatic escalation
• Target date funds
• Retirement education

These are all great concepts, but they are not actually preparing people for retirement. Let's consider Abigail Assistant who works for Zipper Zoomers. Abby just recently started with ZZ. ZZ has hired Abby with cash compensation of $30,000 per year, based on an hourly rate of about $14.50 per hour. When she interviewed, she asked ZZ if they had medical benefits and a 401 plan (yes, she left off the "k" part). When she learned that they do, she didn't ask about details.

It turns out that ZZ does provide health benefits, but they don't pay as large a percentage of the cost as many other companies do, and their plan is a high-deductible plan. Abby and her husband Anson had already decided that 2016 would be a good year for the Assistant family to have their first child and a quick scan of her Facebook page shows that she will, in fact, be delivering Archibald Assistant later on this year. We also learn from her Facebook page that she plans to take 6 weeks off and then put dear little Archie in daycare.

Abby and Anson are going to have really high health care costs in 2016. But, when she started with ZZ, she got all this paperwork and didn't know what to do with it. She accepted her auto-enrollment at 3% of pay ($900 if she didn't take maternity leave). She also accepted her auto-escalation that will kick her up to a 4%  deferral next year. With ZZ's 2% budget for pay raises, her 2017 pay is expected to be $30,600 resulting a deferral of $1224. So her take home pay reflecting only the deductions for the 401(k) plan has only increased by $276 (600 minus 324) or less than 1%. But Abby and Anson's expenses have gone up far more than that. How will they cope?

Always resourceful, Abby and Anson have the answers. They have credit cards with hefty credit limits. That's a source of funds to pay the bills with. And, they learned that they can borrow against Abby's 401(k) account.

Okay, you all know where this is headed. The Assistants are not on the right track and unless they can get off of it, they will never be prepared for retirement. But, how does this make their vendor wrong?

Auto-enrollment and auto-escalation work for those who can afford it. It doesn't work for those who are living day to day, and sadly today, that seems to be the majority of American families.

In the Pension Protection Act of 2006, Congress claims to have intended to protected pensions. They did take some very positive steps while they were at it though by statutorily legalizing what are known as hybrid plans (cash balance, pension equity, variable annuity, etc.) and while they were at it, statutorily legalizing market return hybrid plans.

If you really want to help to prepare your employees for retirement, these are better vehicles. With modern designs and investment strategies, you can control costs. In fact, you can budget your costs better than you can in a 401(k) plan where the amount of matching contributions that you have to make is dependent on the amount that employees choose to defer.

I've seen all the illustrations and projections. Yes, Polly and Peter Professional who both came out of college and got higher paying jobs and who don't plan to have kids until they have been in the workforce for 10 or more years, bought a house and saved both inside and outside their 401(k) plans will be well-prepared, but for all the Abby and Anson's of the world, the participant outcomes will defy what the vendors are saying.

It's not pretty.