By: Justin Harvey, ASA, Asset Allocation Strategist
JULY 2012
Strategies for hedging interest rate
risk in a cash balance plan
Issue: Over the past decade, the trend among public-sector and corporate
pension plan sponsors from traditional “pay x service” defined benefit plans to cash
i
balance (hybrid) plans has increased. What kinds of interest rate hedging
investment strategies should sponsors of cash balance plans consider as they seek
to manage funded status?
Response: A wide range of different cash balance plan designs exists, so a
hedging tool that will work well for one plan may not work as well for another. The
plan design elements that most impact the effectiveness of various hedging
strategies are:
1.
The interest crediting method;
2.
The amount of legacy/retiree liabilities; and
3.
The minimum interest crediting rate.
Depending on the plan design, some of the investment strategies available for
hedging interest rate risk are:
1.
Selling credit default swaps to gain exposure to high-quality corporate bond
spreads;
2.
Selling Treasury futures to reduce interest rate exposure;
3.
Purchasing duration-matching high-quality corporate bonds; or
4.
Using swaptions with strategically chosen expiration dates and strike prices.
While these strategies may help sponsors hedge interest rate risk, closely tracking
liability movements with a plan’s assets is more difficult in a cash balance plan than
in a traditional defined benefit plan.
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
Frank Russell Company owns the Russell trademarks used in this material. See “Important information” for details.
A wide range of
different cash
balance plan
designs exists, so a
hedging tool that
will work well for
one plan may not
work as well for
another.
Background
When plan sponsors first started implementing cash balance plans, there was some
concern that the plans’ designs discriminated against older workers, because the shorter
periods until retirement did not allow much time for interest earnings to compound.ii This
didn’t stop the adoption of cash balance plans as cheaper alternatives to traditional
plans. By 2004, 34 of the Fortune 100 companies were sponsoring open hybrid plans.iii
While some of these plans have recently been closed or frozen, as of 2010, 34.1% of
Pension Benefit Guaranty Corporation (PBGC) insured pension plans with 5,000 or more
participants were hybrid designs, the most common of which is a cash balance plan.iv
A cash balance plan is treated as a defined benefit plan for funding and regulatory
purposes, but is similar to a defined contribution (DC) plan in that a participant’s benefit
is an account balance. However, unlike in a DC plan, the plan sponsor still assumes the
investment risk, because the value of the cash balance account is usually not tied to the
return actually earned on the plan’s assets.
The participant’s hypothetical account balance is credited with a “pay credit” each year
(in an open plan) and an “interest credit,” which is essentially earnings on prior pay
credits. Even frozen cash balance plans still pay interest credits to participants’ account
balances. A participant’s retirement benefit at career end is equal to the account balance
on the retirement date. This cash balance benefit can usually be taken as a lump-sum
equal to the account balance or converted to an annuity. v
Closely tracking
liability movements
with a plan’s assets
is more difficult in a
cash balance plan
than in a traditional
defined benefit plan.
See Table 1 for an example of how a cash balance plan would grow for a participant in a
plan that paid a 3% interest credit (IC) and a 5% pay credit (PC) per year, assuming a
new participant with a constant annual salary of $50,000.
Table 1: Growth of a hypothetical account balance
Account balance
Beginning of Year (BOY) 1 account balance
Year 1 interest credit (3% x $0)
Year 1 pay credit (5% x $50,000)
End of Year (EOY) 1 account balance
(sum of BOY balance, IC and PC)
Year 2 interest credit (3% x $2,500)
Year 2 pay credit (5% x $50,000)
End of Year (EOY) 2 account balance
(sum of prior EOY balance, IC and PC)
Year 3 interest credit (3% x $5,075)
Year 3 pay credit (5% x $50,000)
End of Year (EOY) 3 account balance
(sum of prior EOY balance, IC and PC)
$
$
$
$
0
0
2,500
2,500
$ 75
$ 2,500
$ 5,075
$ 152
$ 2,500
$ 7,727
Calculation of a cash balance liability
Although it may seem counterintuitive, the liability associated with a cash balance plan is
usually less than the sum of the plan participants’ current account balances. This is
primarily due to the way a cash balance plan’s liability is calculated.
To get the present value of an account balance, the actuary usually projects the current
account balance to the assumed retirement date with interest based on the plan’s
interest crediting rate, and then, using the appropriate spot rate on a discount curve,
discounts that balance back to today’s dollars. For U.S. plans, the discount curve is
either published by the IRS (for funding purposes) or created by use of the high-quality
corporate bond market (for corporate accounting purposes). To the extent that the plan’s
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p2
funding effective interest rate (which is also based on investment-grade corporate
bonds) or the accounting discount rate is higher than the assumed interest crediting rate,
the liability associated with a cash balance plan will be less than the sum of the plan
participants’ current account balances.
See Table 2 for an example of how a liability would be calculated with a 3% interest
crediting rate and discounted for a December 31, 2011 accounting valuation by use of
the Citigroup Pension Discount Curve (CPDC).vi
Table 2: Hypothetical cash balance liability calculation
Account balance
(projected at assumed 3% interest credit)
Present value
(discounted back at CPDC spot rate)
Year 0
$ 10,000
$ 7,707
Year 1
$ 10,300
$ 8,042
Year 2
$ 10,609
$ 8,392
Year 3
$ 10,927
$ 8,757
Year 4
$ 11,255
$ 9,138
Year 5
$ 11,593
$ 9,536
Year 6
$ 11,941
$ 9,951
Year 7
$ 12,299
$ 10,383
Year 8
$ 12,668
$ 10,835
Year 9
$ 13,048
$ 11,306
Year 10
$ 13,439
$ 11,798
Year 11
$ 13,842
$ 12,312
Year 12
$ 14,258
$ 12,847
Year 13
$ 14,685
$ 13,406
Year 14
$ 15,126
$ 13,989
Year 15
$ 15,580
$ 14,598
Year 16
$ 16,047
$ 15,233
Year 17
$ 16,528
$ 15,895
Year 18
$ 17,024
$ 16,587
Year 19
$ 17,535
$ 17,308
Year 20
$ 18,061
$ 18,061
In this example, the present value associated with the account balance payable in 20
years is 77% of the current account balance. This factor will change, based on the length
of time until the benefit payment is paid, the shape of the discount curve, and the interest
crediting rate; but the point is that the present value associated with an account balance
is rarely equal to the current value of that account balance.
One implication of this approach is that the “interest cost” on the cash balance liability in
the sponsoring corporation’s financial statements is calculated by use of the discount
rate, not the cash balance interest crediting rate. Since the projected cash balance is
converted back to today’s dollars by use of the discount rate, this is also the rate at
which the liability grows with the passage of time. This is particularly important in
calculating the “hurdle rate”vii a plan’s assets need to achieve (either through investment
earnings or contributions) to keep up with the liability growth.
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
The “interest cost”
on the cash balance
liability in the
sponsoring
corporation’s
financial statements
is calculated by use
of the discount rate,
not the cash balance
interest crediting
rate.
/ p3
Interest crediting method and calculation of a cash balance plan duration
Traditionally, most cash balance plans have set the interest credit rateviii in either of two
ways:
1.
By using a fixed rate that doesn’t change (i.e., 3% per year), or
2.
By tying the rate to a Treasury yield as of a “reset” date (i.e., the yield on 5-year
Treasury bonds on the last day of the current plan year will be the interest credit
for the next year).
A cash balance plan
sponsor in this
situation has very
little need to hedge
against interest
rates moving down,
but needs rather to
hedge against the
discount rates
decoupling from the
interest crediting
rate.
Unlike most traditional defined benefit plans, if the sponsor uses option 2, the projected
benefit payable on a participant’s retirement date is already partially indexed to interest
rates. Because of this relationship, a cash balance plan usually has a shorter duration –
i.e. is less sensitive to changes in interest rates – than a traditional defined benefit plan.
Even if a sponsor uses option 1, a cash balance plan will usually have a shorter duration
than a traditional defined benefit plan, because most cash balance plans pay significant
lump-sum benefits. This one-time payout at retirement is shorter in duration than an
annuity paid out over the remainder of a retiree’s lifetime.
To the extent that the instrument used for setting the interest credit and high-quality
corporate bond rates are correlated, the liability duration is reduced as shown in the
examples below.ix
Example 1: Cash balance plan with a fixed 3.00% interest credit rate (option 1)
After discount rate shock
3.00% interest credit, CPDC minus 0.50%
Account balance
Present value
Year
Baseline
3.00% interest credit, CPDC
Account balance
Present value
0
$ 10,000
$ 7,707
$ 10,000
$ 8,484
20
$ 18,061
$ 18,061
$ 18,061
$ 18,061
Liability duration
19.2
Example 2: Cash balance plan with floating interest crediting rate that moves half the amount
of the discount rate shock
Year
Baseline
3.00% interest credit, CPDC
Account balance
Present value
After discount rate shock
2.75% interest credit, CPDC minus 0.50%
Account balance
Present value
0
$ 10,000
$ 7,707
$ 10,000
$ 8,082
20
$ 18,061
$ 18,061
$ 17,204
$ 17,204
Liability duration
9.5
Example 3: Cash balance plan with interest crediting rate that moves the same amount as the
discount rate shockx
After discount rate shock
2.50% interest credit CPDC minus 0.50%
Account balance
Present value
Year
Baseline
3.00% interest credit, CPDC
Account balance
Present value
0
$ 10,000
$ 7,707
$ 10,000
$ 7,697
20
$ 18,061
$ 18,061
$ 16,386
$ 16,386
Liability duration
(0.3)
These examples show that the interest crediting method has a significant impact on the
liability duration. In Example 3, the interest rate shock hardly affects the present value of
the account balance, since the interest credit moves in tandem with the discount rate. A
cash balance plan sponsor in this situation has very little need to hedge against interest
rates moving down, but needs rather to hedge against the discount rates decoupling
from the interest crediting rate.
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p4
The interest crediting method will determine whether a cash balance plan most closely
resembles Example 1, 2 or 3. While a design as extreme as Example 3 is unlikely, the
most commonly used floating interest crediting designs do resemble Example 2. Plans
with a floating interest credit usually tie the interest crediting rate with the yield on a
Treasury bond of a certain maturity.
This does not, however, mean that investing in the same Treasury instrument the
sponsor uses for the interest crediting rate will hedge liability movement. In fact,
purchasing the same Treasury bond maturity as the cash balance reference rate will not
work as an adequate hedge. The change in liability is determined by the change in the
yield of a bond, but a bond owner earns the bond’s total return (both price return and
coupon return). Because price returns and yields on bonds are inverses, holding the
same underlying asset in the portfolio as the plan uses for interest credits could actually
compound the mismatch between asset and liability values. Liabilities may rise with the
increase in yield, while at the same time asset values would fall. The return on a cash
balance account using a Treasury yield does not generally correspond to the return on
any actual investable asset, which is why hedging for a cash balance plan can be quite
difficult.
Exhibit 1 shows the historical yields of six different Treasury maturities and the discount
rate from the Citigroup Pension Liability Index (CPLI). While none of the Treasury
maturities move exactly as the discount rate moves (in other words, credit spreads do
not remain constant; there are periods of decoupling), the movements are positively
correlated. Table 3 shows the historical correlations (R2) from January 1995 through
April 2012.
Exhibit 1: Historical Treasury yields and discount rates
9%
Yield
6%
3%
0%
3M Treasury
5Y Treasury
Citi Discount Rate
Year
6M Treasury
10Y Treasury
1Y Treasury
30Y Treasury
Holding the same
underlying asset in
the portfolio as the
plan uses for
interest credits
could actually
compound the
mismatch between
asset and liability
values.
Sources: Citi data from Society of Actuaries. Treasury data from US Treasury. Data as of April 30, 2012
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p5
Table 3: Historical R2 between CLPI and Treasury yields
Interest crediting rate
1995-1997
1998-2000
2001-2003
2004-2006
2007-2009
2010-Apr
2012
Entire
period
3-month Treasury
0.30
0.41
0.52
0.00
0.07
0.31
0.40
6-month Treasury
0.38
0.61
0.49
0.00
0.05
0.56
0.40
1-year Treasury
0.67
0.66
0.60
0.00
0.04
0.62
0.43
5-year Treasury
0.72
0.65
0.67
0.05
0.07
0.76
0.59
10-year Treasury
0.73
0.59
0.60
0.32
0.05
0.78
0.69
30-year Treasury
0.72
0.46
0.55
0.57
0.14
0.71
0.66
Sources: Citi data from Society of Actuaries. Treasury data from U.S. Treasury. Data as of April 30, 2012
The closer the maturity of the Treasury is to the weighted average of the plan’s cash
flows, the higher the correlation between the discount rate and the interest crediting
rate.xi To the extent that the plan’s interest crediting rule is correlated to discount rates,
plan sponsors do not need to hedge Treasury yield movements, but rather should focus
on hedging against narrowing spreads between the Treasuries and corporate bonds
used for discount rates.
The “perfect storm” for a cash balance plan sponsor with floating interest crediting rates
actually has not been the falling discount rates we have seen from January 2010 through
April 2012. Yes, discount rates have fallen significantly during this time, but so have
Treasury rates, with spreads staying fairly constant. If the actuary were using current
interest rates to value the account balance, a cash balance plan would not have seen as
significant a jump in liability as did traditional pension plan designs during this time. xii
January 2004 through December 2006 happened to be a more difficult time period for
these cash balance plan sponsors: Treasury rates increased at the same time that
discount rates were dropping. Cash balance plan sponsors should try to hedge against
time periods such as this, when the credit spreads narrowed.
CREDIT DEFAULT SWAPS AND SELLING TREASURY FUTURES
To hedge against spreads narrowing, two potential strategies are:
1.
Selling credit default swaps (CDX) on a basket of high-quality corporate bonds.
2.
Holding high-quality corporate bonds and selling Treasury futures.
By selling CDX on a basket of high-quality corporate bonds, the plan sponsor earns a
premium equal to the value of the contract, capturing the interest rate spread. The
contract value decreases as credit spreads narrow. If credit spreads do narrow, the
sponsor can then buy a CDX at the lower price and earn the difference between the
CDX premium earned and the CDX premium paid. This potential gain will offset the
increase in liability from the narrowing spread between the interest crediting rate and the
discount rate. While trading CDX is not without risks, they may be an appropriate
instrument for certain cash balance plan sponsors looking to hedge against tightening
credit spreads.
Many cash balance plan sponsors likely already hold investment-grade credit-matching
bonds in their portfolios, which are appropriate, especially when plans still have large
legacy and retiree liabilities (see next section). If a sponsor already holds credit bonds,
and wants to create a hedge similar to CDX, then shorting Treasury futures may be an
appropriate strategy. Holding a long corporate bond and then shorting a corresponding
Treasury will pay off if the corporate spread narrows and that payoff will help to offset the
increase in liability a cash balance plan experiences in these environments.
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p6
Determining an appropriate nominal exposure for both the CDX and shorting Treasury
strategies will depend on a number of factors, including:
1.
The correlation between the interest crediting rate and discount rates;
2.
The Treasury instrument used for the interest crediting rate;
3.
The composition, duration and spread of the plan’s current fixed income
portfolio; and
4.
The plan sponsor’s desired hedge ratio.
Higher correlations between the interest crediting rate and the discount rate indicate less
of a need for a spread hedge using Treasury futures. Similarly, if a plan sponsor has a
strong inclination that spreads will widen, they will want to maintain a hedge ratio under
100% to potentially benefit from the expected interest rate movement.
Legacy/retiree liabilities
When plan sponsors made the decision to move from a more traditional pension plan
design to a cash balance plan, they generally treated previously earned benefits in either
of two ways:
1.
Some plan sponsors calculated the present value of those benefits already
earned in the old plan, and then used that value as an “opening” account
balance for the new cash balance plan. Because regulations prevent qualified
plansxiii from taking away pension benefits already earned, the prior plan
benefits were kept as a minimum in case the future value of the cash balance
account were ever to be less than the benefits earned at the time of the
conversion.
2.
Others sponsors elected to freeze the participants’ accruals under the old plans
and then add those benefits to any earned cash balances to arrive at the
participants’ total benefits at retirement. When the “old” benefits are added to
the cash balance benefit, there are no opening account balances: all
participants’ account balances start at $0.
When a sponsor converts to a cash balance plan via the second method, a large
percentage of the plan’s total liability will still be in projected annuity benefits. Since
interest rates have dropped significantly since the 1990s and early 2000s, many
sponsors who converted to cash balance plans by use of the first method are still
required to pay the minimum prior plan annuity benefits to some participants. Also, if the
plan is paying significant retiree annuity benefits, payouts will continue to resemble those
in a traditional plan design, even after the cash balance conversion.
DURATION MATCHING HIGH-QUALITY CORPORATE BONDS
To the extent that the plan’s liability comes from these legacy or retiree benefits, a cash
balance plan sponsor would want to consider hedging interest rate exposure in the same
way that most sponsors of traditional plans are hedging. The legacy benefits and retiree
annuities are not indexed to interest rates in the same way that the cash balance
benefits are, and thus an appropriate hedging instrument includes long Treasury and
credit exposure.
The most common way to get this exposure is through physical long-duration, highquality corporate bonds benchmarked to either the Barclays U.S. Long Credit Index or
the Barclays–Russell LDI Index Series. The benefits of hedging by use of corporate
bonds have been well discussed so I won’t dig into the idea too deeplyxiv. The main point
is that legacy benefits and retirees who have decided to convert their cash balances to
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p7
annuities exhibit the same cash flow characteristics as traditional plans. To the extent
that a plan’s liability is tied to retiree and legacy benefits, duration-matching corporate
bonds provide an appropriate hedge.
Minimum interest crediting rate
One other twist common among cash balance plan designs is the minimum interest
crediting rate.xv If the reference rate for the interest credit is lower than the minimum
interest crediting rate, sponsors will credit the participants’ accounts at the higher rate.
The existence of this provision could significantly impact liability movements and, thus,
sponsors’ investment and interest rate hedging strategies.
Example 4: Hypothetical plan with an interest credit rate tied to the fiveyear Treasury reset in December each year and an interest crediting
minimum of 2.50%.
Bold values indicate the rate a participant’s credit balance would have received for the next year.
Date
5-year Treasury
Interest crediting
CLPI discount rate
yield
minimum
December 2005
4.32%
2.50%
5.55%
December 2006
4.67%
2.50%
5.90%
December 2007
3.46%
2.50%
6.48%
December 2008
1.55%
2.50%
5.87%
December 2009
2.76%
2.50%
5.96%
December 2010
2.03%
2.50%
5.61%
December 2011
0.88%
2.50%
4.40%
By including an
interest rate
minimum in the
plan’s provisions,
the plan sponsor is
granting plan
participants an
interest rate option
that has value and
that, when
exercised, increases
the plan’s liability
Example 4 shows how valuable the interest crediting minimum can be to the
participants, and how it can significantly impact the liability. During calendar year 2011,
the CLPI discount rate dropped 121 basis points, and the yield on the five-year Treasury
dropped 115 basis points.
Ignoring the interest crediting minimum, this plan would behave very similarly to
Example 3, above, with the change in interest rates having almost no impact on the
liability. However, since there is an interest crediting minimum, and since the actual rate
credited to account balances didn’t change during the year, the plan in Example 4
behaves more like the plan in Example 1, where the drop in discount rates increased the
liability significantly.
By including an interest rate minimum in the plan’s provisions, the plan sponsor is
granting plan participants an interest rate option that has value and that, when
exercised, increases the plan’s liability.
SWAPTIONS
To hedge against this increase in liability, a sponsor could purchase receiver swaptions
with expiration on future interest rate reset dates and a strike equal to the interest rate
crediting minimum. If the yield on the interest crediting rate instrument is below the
minimum on the expiration date (specifically chosen to be the “reset” date), the value of
the option would help hedge against the liability increase caused by the minimum
interest credit applying (net of the option premium paid).
The way to implement this strategy is to purchase multiple swaptions for future years
when pricing is particularly advantageous. This favorable pricing will occur during
periods of low volatility and high interest rates (such as 2007). A plan implementing this
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p8
strategy in 2007 would have fared better than most plans in the subsequent three to five
years, when many hit their interest rate minimums.
Conclusion
Hedging cash balance plan liabilities isn’t just different from hedging for a traditional
plan; it is also more difficult. The mechanics of cash balance plans require that plan
sponsors consider additional tools for their interest rate hedging programs. No currently
traded investment has a return pattern that mimics the return on a cash balance equal to
the yield of a bond. Similarly, calculating the duration of a cash balance plan is not as
easy as calculating a time-weighted maturity of the projected cash flows, since the cash
flows may already partially reflect interest rate expectations.
The interest crediting rule, the extent of legacy and retiree liabilities, whether or not the
plan uses a minimum interest crediting rate: all of these factors will impact the
appropriateness of different interest hedging strategies. As with any investment, all of
the strategies discussed in this paper have trade-offs. However, even though no perfect
solution exists, if implemented effectively, these strategies could help cash balance plan
sponsors more precisely manage their interest rate risk. Investment firms with a sound
understanding of cash balance liabilities and implementation capabilities are best suited
to help plan sponsors with these strategies.
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
Investment firms
with a sound
understanding of
cash balance
liabilities and
implementation
capabilities are best
suited to help plan
sponsors with these
strategies.
/ p9
i
Even as recently as earlier this year, Bobby Jindal, governor of Louisiana, proposed converting his state’s pension plan to a cash balance
formula. Source: Kozlowski , Rob; “Louisiana governor pitches pension changes.” P&I Online, January 26, 2012.
ii
In 2003, a judge ruled that IBM’s cash balance pension plan design was discriminatory against older workers, but the decision was overturned
three years later by a higher court. The Pension Protection Act of 2006 (PPA) removed this uncertainty by validating that cash balance plans
are not inherently age-discriminatory. Source: Cooper, et al v. IBM Personal Pension Plan, 3:99−cv−00829 ( S.D. Ill. ). July 31, 2003 and
August 7, 2006.
iii
Geisel, Jerry. "Wells Fargo latest firm to freeze cash balance pension plan." Business Insurance, May 10, 2009.
iv
Pension Benefit Guaranty Corporation 2010 pension insurance data tables:
http://www.pbgc.gov/res/data-books.html.
v
Many studies have looked into how many pension plan participants elect a lump-sum benefit payment instead of an annuity when given the
choice, either from a cash balance plan or from a traditional plan with a lump-sum provision. While studies’ results vary slightly, it is generally
accepted that a significant majority of participants (70% or more) will elect a lump-sum over an annuity.
vi
Assuming current balance of $10,000, payable in 20 years, ignoring the impact of mortality and other decrements, and assuming the actuary
uses current interest rates for cash balance interest crediting rates in future years.
vii
The hurdle rate is generally the rate a plan’s assets need to achieve to keep up with the liability growth. It is equal to the sum of the interest
cost, service cost, an amortization of the underfunded amount, plus an additional amount for the possibility of an actuarial/demographic loss.
viii
Recently the IRS approved “equity-linked” interest crediting rates, where plan participants’ account balances earn interest at the same rate as
plan assets, as long as over the course of a career the benefit is not less than the sum of the pay credits.
ix
Table 2 shows the present value of a $10,000 cash balance benefit payable in 20 years, using the CPDC as of 12/31/2011. This table will
serve as the baseline for the duration calculations. Examples show impact of CPDC spot rate lowered by 50 basis points.
x
In theory, a plan sponsor could use the accounting discount or PPA effective interest rate as the interest crediting rate for the next plan year,
but there are considerable administrative and legal issues with these approaches.
In conjunction with the auditor, the sponsor selects the accounting discount rate from a range of potentially justifiable rates. Tying participant
benefits to this rate could potentially expose the sponsor to liability, should plan participants (fairly reasonably) argue for a different interest
crediting amount.
Similarly, there are issues with using the PPA effective interest rate (EIR). The EIR is generally not known for several months after the plan year
begins, so administering retirements in the early part of the year would become difficult. One IRS safe harbor design is to use the third PPA
segment rate (“safe harbor” meaning this design is allowable under IRS rules). Plan sponsors may be hesitant to use this rate, since it is likely
that it would be higher than the effective interest rate (unless the yield curve inverts), which means the plan’s funding target liability would
actually be higher than the sum of the current account balances.
xi
A plan with a duration of 10 years and a 10-year Treasury interest crediting rate still would not have perfectly correlated discount and interest
crediting rates. Curve risk still exists, since the discount rate is calculated using the yield curve of corporate bonds across all maturities and the
10-year Treasury yield is just a single rate.
xii
This is assuming that no interest rate minimum is applied to the account balances. See “Minimum interest crediting rate” in this paper for
further discussion of the effect this plan design element may have on a cash balance plan.
xiii
“Qualified” because the plans qualify for favorable tax treatment for both the sponsor and the participant
xiv
Two recommended readings for more information on the topic are “Defined Benefit Pension Plans and Long Credit”, Russell Investments
Research, April 2009, and “Introducing a New Standard in LDI Benchmarking: The Barclays–Russell LDI Index Series”, Jaugietis, Hussey, and
Harvey, Russell Investments Research, April 2012.
xv
To remain qualified, pension plans also have to pass non-discrimination tests to ensure that they are not favoring highly compensated
employees over non–highly compensated employees. One part of this testing is an accrual rule test, meaning the value of benefits earned each
year has to be adequate. Including a minimum interest crediting provision helps cash balance plans pass this part of the non-discrimination test.
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
/ p 10
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grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk
and increase return could, at certain times, unintentionally reduce returns.
Yield is the percentage return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note.
Liability-driven investment (LDI) strategies contain certain risks that prospective investors should evaluate and understand prior to
making a decision to invest. These risks may include, but are not limited to, interest rate risk, counterparty risk, liquidity risk and leverage
risk. Interest rate risk is the possibility of a reduction in the value of a security, especially a bond or swap, resulting from a rise in interest
rates. Counterparty risk is the risk that either the principal or an unrecognized gain is not paid by the counterparty in a security or swap
transaction. Liquidity risk is the risk that a security or swap cannot be purchased or sold at the time and amount desired. Leverage is
deliberately used by the fund to create a highly interest rate–sensitive portfolio. Leverage risk means that the portfolio will lose more in
the event of rising interest rates than it would otherwise with a portfolio of physical bonds with similar characteristics.
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First used: July 2012 (Reviewed May 2016 for continued use; Disclosure revision: July 2016)
Russell Investments // Strategies for hedging interest rate risk in a cash balance plan
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