The investment losses of 2008 highlighted the importance of appropriate investing for cash balance (and other defined benefit) pension plans—and particularly those sponsored by “partnership-type” organizations like law firms, accounting firms, and medical groups.

Professional organizations—and other organizations with partnership-type ownership—usually expect each “partner” to be responsible for his “share” of the cash balance plan. (I use the term “partner” loosely in this article; it includes any owner of a partnership-type organization even if that organization is a corporation, LLC, LLP or other type of entity.) Generally stated, the benefit accruals and contributions to the plan are viewed as part of the total compensation package for each partner. That raises issues about whether a partner benefits from an overfunded plan or bears some liability for an underfunded plan. The most dramatic situation occurs when a cash balance plan has suffered significant investment losses and, therefore, the assets in the plan are substantially less than the benefit liabilities. For example, assume that a partner at a law firm has an $800,000 “account” in a cash balance plan. Assume further that, because of 2008’s investment losses, the proportionate share of the plan’s assets is only $500,000. As a final assumption, the partner leaves the firm in January of 2009, immediately following those investment losses, and requests a distribution of his full hypothetical account of $800,000.

When deciding to set up a cash balance plan, the general assumption usually is that the investment values and the benefit liabilities will always be approximately the same. In that situation, none of the partners would suffer significantly or benefit greatly, regardless of the performance of the markets. However, in our case, the departing partner gets $300,000 more than the value of the underlying investments, while the remaining partners are left to fund the $300,000 shortfall for that partner, as well as their own shortfalls and those for the rank-and-file employees.

Situations like this have actually occurred, and the remaining partners were upset, to put it mildly.

What should have been done?

First, the buy-sell and deferred compensation agreements of the organization should have taken into account—as a liability—the potential for an underfunded cash balance plan. There are technical issues on how the underfunding can be allocated, but the broad concept is that the liability to contribute to an underfunded plan should have been considered.

Secondly, the plan should have been invested differently. For partnership-type organizations, it is important that the plan’s assets be invested in a way that the investments and the benefit liabilities are, at all times, close in value. That will require a conservative investment policy and sophisticated investment thinking.

For example, in 2008 many types of bonds also suffered losses... so simply investing in bonds is not the answer. Instead, partnership-type organizations (and, for the matter, other companies that don’t want to be obligated to make large pension contributions in difficult economic times) should either invest in products that are specifically designed for this purpose or, alternatively, should work with an investment advisor who has experience in developing “all weather” portfolios.

This investment philosophy requires that the “partners” be willing to invest the cash balance “portion” of their portfolios conservatively. Properly explained, that should be acceptable. Also, the partners can compensate for that conservative investment philosophy—should they desire to do so—by investing their 401k accounts more aggressively.
Source: The Adviser Report