The Cost and Duration of Cash-Balance Pension Plans

by David T. Brown (University of Florida), Philip H. Dybvig (Washington University in Saint Louis), and William J. Marshall (NISA)

full article (308K PDF), which appears in the Financial Analysts Journal and is copyright by the Association for Investment Management and Research

Controversy about the fairness of early transitions from traditional definedbenefit plans to cash-balance plans may have overshadowed the subtleties of funding a cash-balance pension liability. Because crediting rates of cashbalance liabilities float with market rates, the same techniques used to value and hedge floating-rate bonds provide the present value cost and effective duration of a cash-balance liability. The present-value cost of funding a liability varies dramatically across the menu of IRS-sanctioned crediting alternatives. For example, given the yield curve from November 15, 1999, the present value per $1.00 of cash balance of funding a liability paying off 30 years from now varies between $0.90 and $1.48. The effective duration of a cash-balance liability also varies dramatically according to various crediting rates; the effective duration is typically positive but much shorter than the expected time until retirement or other payment and, depending on the choice of crediting rate, can vary by a factor of five or so. These findings are useful for comparing the costs of plans, for comparing how various groups are treated in a plan conversion, or for evaluating the riskiness of any mismatch between assets and liabilities for various funding alternatives.

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