Liability-driven investing for cash balance plans

Cash balance plans now represent a large proportion of defined benefit pension liabilities. Unique to this style of pension plan design, there can be very different sensitivity to interest rates when compared to traditional final average pay plans. Given these two factors, and the backdrop of a paradigm shift in interest rates, we believe it is important for cash balance plan sponsors to better understand their unique exposures, and potentially re-evaluate their hedging strategies.

Cash balance plan designs have gained popularity since the 90s as a way to make “old school” defined benefit plans look like their more understandable and portable cousins, 401(k) Plans. The value of the cash balance benefit involves two components: 1) a service credit based on annual pay and 2) an interest accrual typically based on an observable market yield. The accumulated value to each participant is a lump sum payable when the employee leaves or retires.

As mentioned, cash balance plan designs present some interesting challenges when it comes to developing an LDI strategy. The actuarial liability for a cash balance plan, included on a plan sponsor’s financial statements, involves a number of economic assumptions. We will focus on the relationship between two key assumptions:

1. Discount rate (DR). This is the rate at which the future payments from the plan will be discounted back to calculate the present value of the pension liability. Consistent with traditional final average pay plans, accounting standards dictate that future expected benefit payments are discounted based on high quality corporate bond yields. This means the DR is an expression of interest rates and credit spreads.
2. Interest crediting rate (ICR). This is the assumed rate of interest that will be credited to the account balance on an annual basis between now and the date the plan will pay the benefit. A plan’s interest crediting rate for the year refers to a specific rate such as the yield on the 30-year Treasury or the third segment of the IRS segmented yield curve. The ICR is typically tied to interest rates but may not necessarily be influenced by credit spreads. In determining the plan’s liability, the ICR is an actuarial assumption which can be set based on the recent observations for the referenced rate at the time of the valuation and other factors such as outlook for interest rates.

Figure 1- Effect of ICR and DR assumptions on Cash Balance Liability

^{Source: BlackRock, for illustrative purposes only}

Liability driven investors of traditional benefit plans generally aim to reduce funded status risk by investing in assets which present similar interest rate sensitivity as their liabilities. However, in order to hedge cash balance plans, it is important to understand that liability interest rate sensitivity comes from both the DR and the ICR. Specifically, when interest rates rise across the curve, the ICR can increase and drive up the projected benefits of the plan. At the same time, the increase in DR reduces the present value factors applied to the cash flows. Taken together, the sensitivity of a cash balance plan to interest rates is typically close to zero as these two impacts offset¹.The result is a duration profile which looks very different for a cash balance than it might for traditional pension plan.

Figure 2 – Duration profile for illustrative plan with different benefit designs

^{Source: BlackRock, for illustrative purposes only to demonstrate different potential designs and not representative of any particular plan. This should not be considered a recommendation or advice to take any particular investment action.}

Plans with minimum or maximum ICRs (“floors” or “ceilings”)

Adding to the complexity of cash balance plans, some plan designs incorporate certain minimum ICR floors or maximum ICR ceilings to their defined interest crediting rate. For instance, it is not uncommon to see a cash balance design in which the ICR is defined as the yield on the 30-year Treasury rate with minimum of 3%. Given the historically low Treasury yields over the last several years, a minimum rate of 3% or higher will have been the effective ICR for quite some time. Liabilities would have shown very little sensitivity to the ICR because it was essentially fixed. However, as rates have climbed higher, a cash balance plan with this design would need to focus more on how impactful changes in the 30-year could be to its funded status as the ICR rose above minimum rate. Similarly, actuarial assumptions around the ICR would need to evolve in consideration of this new interest rate environment.

Hedging considerations

Liability driven investors are interested in developing a strategy which offers real-time information about how the DR and ICR are impacting the actuarial valuation of liabilities so that the asset portfolio can effectively hedge the interest rate risk. For instance, the illustrative plan in Figure 3 has an ICR defined as the 30-year Treasury yield, with a minimum interest rate of 3.85%. The effective ICR would have been at this minimum 3.85% rate for several years leading up to 2023.

Without further rate shock analysis, this plan may have employed a hedging portfolio using primarily long duration fixed income instruments to meet a liability which was expected to decrease as interest rates rose. However, as an example, as seen in Figure 3, during 2023 the 30-year Treasury rate would have breached this minimum floor, highlighting negative rate sensitivity at the 30-year part of the curve. The expected future payments from the plan would increase because the interest crediting rate will have increased. Heavy use of long duration instruments in this scenario could result in over-hedging the long end of the curve, subjecting the plan to unexpected changes to funded status.

Figure 3 – Consider key rate duration profile for an illustrative plan whose ICR is based on the 30-year Treasury rate with a 3.85% floor. During 2023 as yields rose, the plan’s duration profile would have shifted to show more sensitivity to changes at the long end of the curve.

^{Source: BlackRock as of May 2023, for illustrative purposes only and represents changes to US Treasury rates during 2023. Past performance is not a reliable indicator of future results.}

Putting it into practice

BlackRock’s approach to hedging cash balance plans starts with an analysis of a plan’s liabilities and their interest rate and credit spread sensitivities at the various key rate duration points. We then build a portfolio, considering investor constraints, that seeks to mimic the duration of the liabilities and recognizes the sensitivity across different points along the yield curve. Finally, we stress test the portfolio to quantify any residual risks to funded status. Over time, the LDI portfolio is adapted to mitigate risk coming from sensitivity to the plan’s defined ICR and floor, if applicable.

The rise in interest rates during 2023 combined with recent improvements in plans’ funded status have led more pension plans to focus on reducing volatility. Many want their LDI portfolios to do more than mimic the liability’s headline duration; they want asset performance to more closely align with the impact to liabilities as rates change and the yield curve takes on different shapes. Cash balance plans have unique risks imbedded in their design that requires a customized liability hedging strategy. It is important to collaborate with a provider that can combine actuarial expertise, technology for liability modeling and a broad investment platform for implementation.