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1 November 2001 Financial Analysts Journal Volume 57, Issue 6

The Cost and Duration of Cash-Balance Pension Plans

  1. David P. Brown
  2. Philip H. Dybvig
  3. William J. Marshall

Controversy about the fairness of early transitions from traditional defined-benefit plans to cash-balance plans may have overshadowed the subtleties of funding a cash-balance pension liability. Because crediting rates of cash-balance 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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