Opinions March 4, 2020

Solving the Cash Balance Investment Problem

John Lowell, with October Three Consulting, discusses how a market-based cash balance plan design provides for a less complicated way to hedge liabilities.

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We’ve read a number of articles recently that focus on the investment issues inherent in traditional cash balance pension plans. While they’re not all identical, as a group, they highlight that it is essentially impossible to come up with an asset portfolio that effectively hedges the cash balance liabilities. In an era in which chief financial officers increasingly seek both stability and predictability in benefit costs, this really does create a problem.

The reasons behind it are fairly technical, but if we examine any cash balance plan whose interest credits are set at either a fixed rate or a long-term bond yield, no financial instrument that we know can perfectly track traditional cash balance plan liabilities.

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However, a cash balance plan gives employees a key combination of two elements they desire—a benefit they can understand and the ability to derive lifetime income at a fair price—that in combination are typically not available to them in either a traditional pension or in a defined contribution (DC) plan such as a 401(k). So, reframing the problem, it would be desirable to have a plan that still provides that key combination while allowing the employer to hedge the liabilities in the plan.

Such a structure exists. But we cannot start with the liabilities and find an investment portfolio to do the work for them.

Instead, let’s start with an investment portfolio and force the liabilities to behave like that portfolio. Rather than liability-driven investment (LDI) that we have heard so much about for the past 15 years or so, we can refer to this as investment-driven liabilities (IDL).

The plan design that allows us to use IDL as a hedging device is the market-based cash balance plan. It may be new terminology to many, but these designs were formally sanctioned by the Pension Protection Act in 2006 and were in place to a lesser extent before then.

To understand what a market-based cash balance plan is, let’s first explain what it’s not: It’s not a traditional cash balance plan. In a traditional cash balance plan, a participant gets pay credits (think of them as a contribution to a notional account balance) and those credits grow with interest credits. In the traditional plan, those interest credits are either a fixed rate of return or a rate of return tied to some bond index such as 30-Year Treasury Bonds or 1-Year Treasury Bills plus 1 percentage point.

In the market-based plan, on the other hand, interest credits are derived from a pool of real or hypothetical investments. As examples, they could be based on the actual return on plan assets or on a 50/50 mix of an S&P 500 Index Fund and a Bloomberg Barclays U.S. Aggregate Bond Index Fund. In the first case, the investment portfolio naturally tracks the growth in plan liabilities. In the second, by investing plan assets in that same 50/50 mix, plan assets also automatically track growth in liabilities. In fact, in both cases, we might even say that plan liabilities are tracking plan assets.

These plans are not for every company. Nothing is. However, if providing lifetime income opportunities for employees while still affording portability is desired and being able to predict and control an employer’s cash commitments to the plan through an automatic near perfect hedge are important, then this sort of design may be worth investigating. At the very least, it’s one more potentially very useful tool for an employer to have in its benefits tool kit.

John Lowell is an Atlanta-based actuary and partner with October Three Consulting LLC. He has more than 30 years of experience consulting on corporate retirement plans ranging in size from just a few participants to hundreds of thousands. John was also president of the Conference of Consulting Actuaries in 2018. He can be reached at jlowell@octoberthree.com.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
Investing March 4, 2020

Serving Up Target-Risk Strategies for ‘Forgotten Participants’

The main reason target-risk gave way to target-date is not that target-risk strategies are inherently inferior; instead, target-date funds have benefited from the added perceived simplicity.

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Invesco has released findings from its new study, “The Forgotten Participant,” examining defined contribution (DC) participant investing behaviors and decisions regarding the core investment menu.

The research finds that DC plan providers have made significant progress in helping participants address the challenges of reaching a financially secure retirement through automatic enrollment, automatic escalation and auto-default into target-date funds (TDFs). At the same time, the retirement plan industry has overlooked a “significant segment” of participants that are actively making investment decisions—often ineffectively—across the core DC plan menu in an effort to diversify and fine tune their risk profile.

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John Galateria, managing director and head of North America Institutional for Invesco, tells PLANSPONSOR the best way to explain this new research is to make one thing abundantly clear.

“By no means are we advocating that target-risk strategies should come in and automatically replace target-date strategies,” Galateria says. “Target-date strategies have done a lot to provide diversified and professionally managed portfolios to participants that are relatively straightforward to understand and use. They give many people a much more stable and rationale way to approach their retirement investing.”

Instead, what the new analysis is about is looking again at the core menu and understanding some of the potential unintended consequences that have come about due to the radical simplification of core menus that has occurred in the last decade since the passage of the Pension Protection Act (PPA), which helped to normalize and popularize TDFs as default investments.

“We are asking whether we can see a world where target-date and target-risk go together on the same plan menu,” Galateria says. “What would that mean for these overlooked or forgotten participants who are trying to direct their own portfolios?”

Stepping back, Galateria says, the main reason target-risk gave way to target-date is not that target-risk strategies are inherently inferior. Instead, target-date funds have benefited from the added perceived simplicity.

“The fund you pick is simply based on your age, versus something more complex like your risk tolerance,” Galateria says. “We know that, for many people, their understanding of risk is somewhat challenged, but that’s not universally true. We did a series of focus groups as part of this research project, and we saw clearly that there is an informed population out there that is thinking deeply about risk, their time horizon, and more. These people are not asleep at the wheel and they don’t just want to invest in TDFs.”

Invesco’s survey finds 65% of all participants felt that a risk-based solution would be a good fit for them, personally, while 80% of higher income participants would invest in risk-based strategies. At the same time, 64% of plan sponsors are interested in adding risk-based strategies to the investment menu as they allow participants to take the amount of investment risk that meets their needs.

“The survey data and focus groups have proven to be really important in understanding what is going on here,” says Greg Jenkins, Invesco’s head of institutional defined contribution. “We observed a sizable group of people that didn’t want a TDF but weren’t 100% confident in investing on their own. They want more control and to be engaged more than a set-it-and-forget-it investor. They are great candidates for target-risk strategies.”

According to Jenkins and Galateria, older and wealthier participants voiced stronger support for target-risk strategies, as did participants who have multiple investment accounts within their household—say a pension, an individual retirement account (IRA) or even other 401(k) plans.

“They wanted to be able to dial in a particular level of risk for their current DC plan investments,” Jenkins explains. “We also saw a group of younger participants who really didn’t resonate with the whole concept of having a pre-defined, one-time retirement date. They don’t think about retirement as a single date, at all. So TDFs are confusing to some younger participants. Also, we heard from quite a few people that they actually wanted to be able to dial up risk beyond what is offered in the default TDF.”

Galateria says the industry has learned a lot from behavioral finance researchers since the passage of the PPA.

“This is starting to change, but until recently, there was a challenge associated with asking people to accurately assess their own risk tolerance,” Galateria says. “The old-fashioned quizzes could only go so far. But now, with all the tools of behavioral finance and with researchers being able to use digital tools to analyze the real behaviors and goals of participants, we are realizing that risk tolerance is not contained in the responses to a questionnaire. Risk tolerance is actually much more emotional and aspirational than logical, and we have come to understand this a lot better.”

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