Cash balance plan performance 2021-2024

In our last article, we looked at the retirement income “performance” of a 55-year-old 401(k) plan participant invested in a 2030 target date fund over the period 2021-2024: How much retirement income the participant could “buy” with her 401(k) account balance at any given time (over that period), given interest rates at that time, and adjusted for inflation. We then compared that performance to the retirement income performance of a (traditional) DB plan participant over the same period, (again) adjusted for inflation.

Here is that same chart, with the addition of performance numbers (over the same period/on the same basis) for participants in a market-based cash balance plan (invested in the same 2030 TDF portfolio as the DC plan) and a “traditional” cash balance plan that provides interest credits tied to 30-year Treasury yields.

The value of in-plan cash balance plan annuitization: Note that the value of the cash balance annuity is 20-30% greater than the value of the 401(k) TDF annuity. This is due to the much more favorable annuitization basis available within a DB plan, due to the obstacles DC plans face when seeking to provide annuities. These obstacles include adverse selection, acquisition costs, carrier profit margin, and individual underwriting. None of these obstacles face employers that sponsor DB plans. As a result, DB plans (including cash balance plans) provide employers a unique legal ability to deliver substantially more retirement income per dollar to their employees.

Comparing performance under different cash balance designs

For the rest of this article, we want to consider the performance of the two different cash balance designs shown above, “traditional” and “market-based.”

Below is the performance of the cash balance account balances over the period 2021-2024 for these two different designs.

The traditional cash balance plan provides stable but modest growth tied to 30 year Treasury yields (1.67% to 4.15% during the years in question), while the market-based cash balance plan fluctuates based on returns on the 2030 TDF, just like the DC plan.

But, in this series of articles, we are not interested in the size of the participant’s “pile” (of assets). We’re interested in how much retirement income that pile can buy, adjusted for inflation (that is, adjusted for the loss in buying power), as shown in the first graph. Below we reproduce that chart, focusing on the experience of the two different cash balance designs over the period 2021-2024.

Overall, the market-based plan outperformed the traditional plan by 6% over the four-year period. Such outperformance is expected, given the modest 30-year Treasury interest credits provided under the traditional plan.

What is less obvious is, measured in terms of real retirement income, the market-based plan is much more stable than the traditional plan, as summarized in the tables below:

From this perspective, the market-based plan generated steady real increases in retirement income over the past four years, while the traditional plan lost ground every year aside from 2022, when it enjoyed a “windfall” gain in connection with the sharp increase in interest rates we saw that year.

Explaining the relative stability of market-based cash balance plan retirement income “returns”

How can this be, given the stable account balance growth under the traditional plan shown in the second graph?

The answer, as we discussed in the previous article, is that asset values (bonds especially but also stocks to some extent) correlate with changes in interest rates. As a result, retirement investors saw asset losses in 2022, but they were more than compensated for these losses by the higher prevailing interest rates.

Traditional cash balance interest credits are not correlated with changes in capital markets, so they don’t experience the offsetting impact of changes in interest rates on asset values and the cost of retirement income, increasing retirement income volatility compared to a market-based plan.

Apart from changes in interest rates, we expect a market-based plan will produce increases in retirement income over time, while a traditional plan is more likely to “tread water” in terms of retirement income over time. If inflation spikes, as we’ve seen in recent years, a traditional plan is vulnerable to declining purchasing power. While inflation takes a toll on the market-based plan as well, equity exposure on the asset side provides some help against this risk.

The better performance of the market-based plan over this period reflects an equity risk premium. Axiomatically, the longer the investment horizon, the more likely that an equity investor will realize that premium. In other words, “stocks for the long run.” If that is the case, then our market-based participant is getting equity returns that in fact prove to be a better hedge against changes in interest rates and inflation than does the traditional cash balance participant.

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Of course, unlike a DC plan, a cash balance plan, as a DB plan, has to be financed by the sponsor. And as we have discussed in the past, there is no hedge for the traditional cash balance interest crediting rate. Instead, sponsors either pursue a so-called “arbitrage” strategy (where they invest in order to “beat” the interest crediting rate and thus reduce the net cost of the plan) or use short term fixed income investments to mitigate risk associated with the interest credit promise (in our case, the promise of a return equal to the yield on 30-year Treasuries).

On the other hand, most market-based sponsors simply invest plan assets to hedge the market-based promise – in our case, plan investments would mirror the 2030 target date fund that defines the plan’s interest credits.

In our next article, we are going to (as it were) turn the above analysis over and look at the risk to the sponsor, and the performance of different traditional cash balance financing strategies over the past four years. And that article will provide takeaways about the pros and cons of these two types of cash balance designs.