One of the most important aspects of a cash balance plan (CBP) for employees is its inherent and expected dependability and portability upon retirement. Under this plan, employers bear the responsibility for making sure the employee will receive the amount promised, no matter what.
Of the many risks to a cash balance plan, investment risk becomes a primary concern for plan sponsors. Due to funding and auditing requirements borne by the sponsor, it’s imperative to understand the effects of market volatility and risk in order to employ strategies to enable the plan to remain actuarially sound and viable.
Interest Rate Risk
Movements of interest rates can have a profound effect on the present value of “liability-driven investment” (LDI) values and the interest-crediting rate (ICR) used for traditional CBPs. I discussed the criteria of choosing a proper ICR in my last blog post.
Most of the time, changes in interest rates are gradual and, over the last several years, relatively predictable due to greater transparency of the FOMC about its policy intentions.
Yet as we saw in 2022 when the Fed rapidly increased rates to curtail inflationary pressures, rates that rocket upwards can play havoc with plans, especially those who use derivative hedging to mitigate interest rate risk and need to post higher collateral for those positions.
Conversely, when rates fall significantly (as we witnessed during the COVID-19 pandemic), actuaries may assume a long-term lower rate of return, necessitating additional funding by the plan sponsor to meet long-term liabilities (the promised payout to participants). As an example, a decrease in the discount rate from 4% to 3% is stating the rate of expected return will be 1% less each year for the life of the future liability (payout to the participant(s)). If this payout is 20 years in the future, this equates to a present-day underfunding of approximately 20% to meet future obligations.
Duration Risk
Traditional CBPs are often invested in fixed-income investments, which offer greater stability and predictability with which to apply ICR values to meet future liabilities. Analyzing the effective duration (or maturity) of the underlying fixed-income investments selected is critical since the market value of longer-duration securities, despite their usually higher yield, may be more sensitive to changes in fixed-income markets and interest rates than shorter-term selections.
Analyzing and balancing duration with appropriate yields is important to achieve expected liability obligations and satisfy actuarial criteria.
The Challenge of Market-Based Plans
Market-based plans are similar in that the pay credit and interest credit are both applied to the participant’s account each year. The difference with these plans is the interest credit is based upon the performance of the investments chosen by the plan sponsor (or by the advisor chosen by the sponsor). Market volatility plays a crucial role here. A more aggressive—and volatile—portfolio can cause both underfunding (when market advances rise above expectations, less funding may be assumed) and actuarial shortfalls (during market declines).
Prolonged declines, such as those seen during the bear market of 2000-2002, can cause severe shortfalls in funding, resulting in continued non-compliance with funding minimums or necessitating significant extra employer contributions. In either case, market-based plans may require additional monitoring and scrutiny by plan sponsors and their advisor over the smoother fluctuations of traditional plans.
In addition, as seen in the Great Financial Crisis of 2008, sudden liquidity needs may also cause plan advisors to sell off assets at undesirable market values to raise cash to meet higher-than-expected liability requirements.
Get Started Today!
For business owners, it’s crucial to seek out guidance from financial advisors who specialize in cash balance plans and ICR strategies. By partnering with a professional, you can feel confident you’re getting customized, precise, and thorough guidance to meet the challenges and risks described above.
At FinancialFocus Retirement Plan Services, we can help. We’re the industry leader in providing qualified retirement plan consulting and administrative services. Our experienced team partners with financial professionals to design and implement pension plans to optimally support their business clients.
Get in touch by emailing me today at info@ff401k.com. I look forward to speaking with you!
About Kenny Phan
Kenny Phan is a Managing Partner/Pension Consultant at FinancialFocus Retirement Plan Services. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses around the nation, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.