As a finance professional, I often encounter questions about how to allocate assets in cash balance plans. These hybrid retirement plans combine features of defined benefit and defined contribution plans, making their asset allocation unique. In this article, I break down the key principles, strategies, and mathematical frameworks that govern asset allocation for cash balance plans.
Table of Contents
Understanding Cash Balance Plans
A cash balance plan is a type of employer-sponsored retirement plan where participants have hypothetical accounts that grow with pay credits (a percentage of salary) and interest credits (a fixed or variable rate). Unlike traditional pensions, cash balance plans provide transparency by showing an account balance, similar to a 401(k).
Key Features of Cash Balance Plans
- Guaranteed Returns: The plan promises a minimum interest credit, often tied to a fixed rate (e.g., 5%) or a benchmark like the 30-year Treasury rate.
- Employer Responsibility: The employer bears investment risk, not the employee.
- Hybrid Structure: Functions like a defined benefit plan but appears as a defined contribution plan to participants.
Why Asset Allocation Matters
Since employers must meet the promised interest credits, asset allocation must balance growth and stability. Poor allocation can lead to underfunding, requiring additional employer contributions. Overly conservative allocations may limit returns, while aggressive strategies introduce volatility.
The Core Challenge: Liability-Driven Investing (LDI)
Cash balance plans have liabilities tied to future benefit payouts. Asset allocation must consider:
- Interest Rate Risk: If rates rise, liabilities may decrease, but bond portfolios lose value.
- Credit Risk: Corporate bonds may default, impacting funding status.
- Inflation Risk: Unexpected inflation erodes purchasing power.
Mathematical Framework for Asset Allocation
To optimize asset allocation, I use a liability-relative approach. The goal is to minimize the surplus volatility, defined as:
\text{Surplus} = \text{Assets} - \text{Present Value of Liabilities}The volatility of surplus depends on the correlation between assets and liabilities. The optimal mix minimizes:
\sigma_S = \sqrt{w_A^2 \sigma_A^2 + w_L^2 \sigma_L^2 - 2 w_A w_L \rho_{A,L} \sigma_A \sigma_L}Where:
- \sigma_S = surplus volatility
- w_A, w_L = weights of assets and liabilities
- \sigma_A, \sigma_L = volatilities of assets and liabilities
- \rho_{A,L} = correlation between assets and liabilities
Example Calculation
Assume:
- Plan assets = $10M
- Liabilities = $9M (PV)
- Asset volatility ( \sigma_A ) = 12%
- Liability volatility ( \sigma_L ) = 8%
- Correlation ( \rho_{A,L} ) = -0.3
Plugging into the formula:
\sigma_S = \sqrt{(1.11)^2 (0.12)^2 + (1)^2 (0.08)^2 - 2 (1.11)(1)(-0.3)(0.12)(0.08)} \sigma_S \approx 16.1\%This shows how asset-liability mismatch impacts risk.
Strategic Asset Allocation Approaches
1. Matching Duration with Bonds
Since liabilities resemble bonds, fixed-income securities help hedge interest rate risk. I recommend:
- Long-duration Treasuries: Hedge rate changes.
- Corporate Bonds: Enhance yield while maintaining credit quality.
Sample Bond Allocation
| Bond Type | Allocation (%) | Duration (Years) |
|---|---|---|
| Treasuries | 40% | 15+ |
| IG Corporates | 30% | 10-15 |
| TIPS | 20% | 10+ |
| High Yield | 10% | 5-7 |
2. Equities for Growth
While bonds stabilize, equities provide growth. Historical data suggests:
- A 60/40 (stocks/bonds) mix reduces volatility while capturing upside.
- Over 20 years, a 6% equity return assumption is reasonable.
3. Alternatives for Diversification
Real estate, private equity, and infrastructure can enhance returns with low correlation to stocks/bonds.
Dynamic Asset Allocation
Markets change, so static allocations may fail. I prefer a dynamic glidepath where equity exposure decreases as funding improves:
| Funding Ratio | Equity Allocation | Fixed Income |
|---|---|---|
| < 80% | 50% | 50% |
| 80%-100% | 40% | 60% |
| > 100% | 30% | 70% |
Case Study: A Mid-Sized Employer
Scenario:
- Plan size: $20M
- Liabilities: $18M
- Current allocation: 70% equities, 30% bonds
Problem: High volatility risks underfunding in a downturn.
Solution: Shift to 50% bonds (mostly long-duration), 40% equities, 10% alternatives.
Outcome: Reduced surplus volatility from 18% to 12%.
Regulatory and Tax Considerations
- IRS Minimum Funding Rules: Underfunded plans may require corrective contributions.
- PBGC Protections: Cash balance plans are insured, but premiums rise with risk.
- Tax Efficiency: Employer contributions are tax-deductible, but poor asset allocation increases costs.
Common Mistakes to Avoid
- Ignoring Liability Hedging – Overweighting equities increases mismatch risk.
- Chasing Yield – High-yield bonds may default, worsening funding.
- Neglecting Rebalancing – Market shifts can distort allocations.
Final Thoughts
Asset allocation for cash balance plans demands a disciplined, liability-aware approach. By balancing growth-seeking assets with liability-hedging bonds, employers can meet obligations while optimizing returns. Regular reviews and dynamic adjustments ensure long-term stability.
