As the costs and risks of providing traditional defined-benefit pension plans have increased over time, some plan sponsors have looked to alternative forms of benefit provision, with cash balance plans emerging as an increasingly attractive option.
Cash balance plans differ from traditional pension plans in that they maintain accounts for hypothetical individual participants and define retirement benefits in terms of the stated balance of each of those accounts. In contrast, retirement payments in traditional defined-benefit plans are based on the participant's final average pay and liabilities are calculated as a fixed amount at retirement. According to Employee Benefit Security Administration (EBSA) research, approximately 18 percent of all defined-benefit plans by number—and 11 percent by market value of liabilities—were cash balance plans in 2012. But a cash balance plan must be designed carefully.
At a theoretical level, cash balance plans might seem impervious to movements in interest rates: Although rising rates would require a plan to pay larger benefits in the future, they would also reduce the time value of money, which might be expected to offset the increased benefit payout. However, this perspective misses the complex interest rate sensitivities inherent in cash balance plans' liabilities. Selecting plan assets with the goal of hedging against shifts in interest rates is just as important for cash balance plans as it is for defined-benefit pension plans.
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