Pension plans: Why is now a cash balance moment?

Editorial Note: This post originally appeared on our companion blog, Fiduciary Matters, on July 6, 2016.


Our team has written before on how the $20 billion club sets industry trends. To see what lies ahead for pension plans (also known as defined benefit or DB plans), one must only look back at what these massive plan sponsors have already done. Whether it is annuity purchases, lump sum programs, or dynamic asset allocation policies, this group tends to lead the way.

A seismic shift happening behind the scenes

A trend continuing to gain popularity in the industry, in perhaps a more covert way, is related to pension plan design—namely, cash balance plans. In an industry that has been dominated for years with headlines for plan freezes and buyouts (signs of a declining DB market), these “hybrid” plans are on the rise.

Their ease of understanding, portability, and potential for reduced risk appeal to sponsors and participants alike. Their share of the DB market (based on number of plans) has grown from being only 3% in 2000 to around 30% in 20151, a mind-blowing shift. We have noted this shift before, and the momentum has not let up.

Did the $20 billion club start this trend too?

As with other major DB trends, members of the $20 billion club have been leaders rather than followers in the cash balance surge. Several in their ranks were among the earliest adopters. Bank of America® (a former member of the $20 billion club), for example, adopted one of the first cash balance designs in the mid-1980s.

In the 1990s, several others followed with their own hybrid arrangements, including AT&T®, IBM, Boeing, Honeywell, HP®, and Dow Chemical®.2 These were not new plans—many were originally established over a half century ago—but instead were converted from traditional, final average pay-type arrangements.

Later, more of these massive sponsors adopted the new designs, with FedEx®, United Technologies Corporation, Northrop Grumman Corporation, General Motors (GM) and Verizon all using hybrid plan (usually cash balance) features in at least one of their major DB plans. These later shifts coincided with the swell in cash balance sponsorship by small businesses.3 In nearly all cases, their interest crediting rates vary widely, from using fixed rates to some variation of U.S. 10-Year Treasury bond rates, to some even adopting a recently popular option of using actual portfolio returns for interest credits. Most often, these plans sponsors maintain hypothetical account balances with a full lump sum option (which usually has a very high take-rate4) found in nearly all hybrid designs.

Different from traditional DB plans

Due to their benefit structure and high lump sum take-rates, cash balance plans do not fit neatly into the mold of traditional DB plans. One option for sponsors to consider that might help with cash balance plans is liability driven investment (LDI), a popular risk management strategy among DB plans. New designs that use interest crediting rates tied to actual investment performance are legal and offer much to sponsors hoping to share risks with their participants.

Of course, with new trends come new challenges, and for cash balance plan sponsors this means assessing the risks they are exposed to and carefully determining how to best manage them.

For more insights on the topic of risk management for institutional investors, consider reading a couple blog posts by my colleague Michael Thomas


1 According to publicly available 5500 filings
2 According to publicly available 5500 filings
3 We should note that while the shift to cash balance designs began among the very large sponsors, the surge in the number of cash balance plans is driven by the very small plans. In fact, the median size of all cash balance plans is now fewer than 10 participants. These much smaller companies often adopt this design as a means to maximize their tax-deferred retirement contribution.
4 Take-rate in this case means the number of participants who take the lump-sum option when offered as part of a defined benefit plan.

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