The short history of cash balance plans has been a tale of extremes. Once the darling of consultants, cash balance plans became something of a pariah after a wave of lawsuits cast doubt on their legality.
The Pension Protection Act of 2006 (“PPA”) and a recent appellate court decision, however, may put cash balance plans back in the good graces of employers. The PPA sets forth clear rules – albeit on a prospective basis only – for cash balance plan conversions, benefit accruals, and distributions. The appellate court decision holds that a cash balance plan with a uniformly applied benefit formula does not impermissibly discriminate on the basis of age.
LITIGATION BACKGROUND
A cash balance plan is a defined benefit plan that, because it features a hypothetical account balance for each participant, acts more like a defined contribution plan. Beginning in the mid-1990s, these plans rapidly grew in popularity. Many companies believed that the structure and clarity of benefit accruals under cash balance plans were superior to those under traditional pension plans. Hundreds of major corporations adopted cash balance plans, often by converting traditional defined benefit plans. Some of these conversions included controversial “wearaway” provisions, which delayed the accrual of additional benefits for certain participants.
Many workers, especially older ones, felt disadvantaged by cash balance plans. Legal challenges to these plans developed quickly, although they typically spent years winding through the courts.
The legal theories behind these suits varied. Some plaintiffs argued that wearaway provisions discriminated against older works, or violated their right to notice of a benefit reduction. Others attacked the methods used by certain cash balance plans to calculate lump-sum distributions. Many plaintiffs struck at the heart of the cash balance concept by arguing that these plans violate an ERISA prohibition against the reduction of “the rate of an employee’s benefit accrual” based on age.
The result of this litigation was largely inconclusive until two notable adverse rulings in mid-2003. First, a federal district court in Illinois ruled in Cooper v. IBM that IBM’s cash balance plan discriminated on the basis of age. A day later, the Seventh Circuit Court of Appeals affirmed a district court’s ruling that Xerox’s cash balance plan improperly computed lump-sum distributions to early retirees.
CONGRESS INTERVENES … EVENTUALLY
After the rulings against IBM and Xerox, many companies either froze their cash balance plans or canceled planned conversions. The uncertainty surrounding cash balance plans caused many to call for quick congressional action. The debate within Congress was lengthy and complicated, however. Some believed that Congress needed to protect cash balance plans from age discrimination lawsuits to save defined benefit plans from extinction. Others believed that cash balance plans represented an attempt to enrich corporate America at the expense of older workers.
The result in the recently enacted PPA is a series of compromises. While the PPA does not provide retroactive relief from age discrimination and other suits, it does provide clear statutory guidance that sponsors of cash balance plans may use to avoid such suits in the future.
Most importantly, the PPA provides that a cash balance plan does not discriminate on the basis of age if a participant’s accrued benefit is the same as (or greater than) a similarly situated younger participant. The new statutory provisions also clarify that an accrued benefit may be expressed as a hypothetical account balance (and not necessarily an annuity commencing at normal retirement age). They clearly define “similarly situated” to mean identical in every respect – including period of service, compensation, position, date of hire, and work history.
The PPA also attempts to resolve the confusion over wearaway provisions. A new ERISA provision prohibits the use of wearaway provisions when converting a defined benefit plan to a cash balance plan. Instead, a plan must credit a participant with his or her accrued benefit under the old formula plus full credit for years of service after the adoption of the cash balance formula. Moreover, a participant who would have been eligible for an early retirement subsidy under the old formula is entitled to have the value of that subsidy credited to his or her cash balance account or plan.
The interest and discount rates that cash balance plans may use are also affected by the PPA. If a cash balance plan wishes to take advantage of the age discrimination protection provisions of the PPA, it may not credit participants with interest at more than a market rate.
A cash balance plan that credits accounts with no more than market interest also receives relief from the so-called “whipsaw” effect. The whipsaw phenomenon occurs when cash balance plans are required to make lump-sum distributions that are larger than hypothetical account balances. This happens when a plan projects an early retiree’s account balance to normal retirement age at the plan’s interest rate, but then discounts it back to present value at a lower rate required by IRS guidance. As with other contentious issues addressed by the PPA, this relief is prospective only.
Finally, the PPA also requires that cash balance plans provide for three-year cliff vesting (or better), beginning in 2008.
COOPER REVERSED
Only days after the PPA was passed, the Seventh Circuit issued the first major appellate court decision on age discrimination in cash balance plans. It reversed the 2003 district court ruling that IBM’s cash balance plan impermissibly favored younger workers. A unanimous panel rejected the plaintiffs’ arguments that the cash balance plan reduced “the rate of an employee’s benefit accrual” based on age.
The plaintiffs’ case was built on a fairly technical argument about the meaning of the phrase “benefit accrual.” They argued that “benefit accrual” was equivalent to “accrued benefit,” which is defined (for defined benefit plans) as an amount expressed as an annuity commencing at normal retirement age. Thus, reducing “the rate of an employee’s benefit accrual” means reducing the rate at which the employee’s benefit at normal retirement age grows.
Under this interpretation, a typical cash balance plan is inherently discriminatory against older workers. Most cash balance plans credit each participant with a certain “contribution” each year (usually a percentage of compensation), plus “interest” on the participant’s hypothetical account balance. Because younger participants have more years in which to earn interest before their normal retirement age, a contribution to a younger participant’s account will result in a greater retirement benefit than the same contribution made to an older participant’s account.
On appeal, the court rejected this technical argument with the following comment: “Under the district court’s analysis, compound interest becomes a scourge.” The appellate court noted that equal contributions on behalf of younger and older participants in defined contribution plans do not constitute age discrimination, and questioned why the same logic should not apply to defined benefit plans. The court repeatedly characterized the plaintiffs as arguing that the time value of money is age discriminatory.
Rather than getting mired in a comprehensive debate about the meaning of “benefit accrual,” the Seventh Circuit’s opinion emphasizes the need to look at the cash balance formula. IBM’s formula, it said, was age-neutral on its face. Because IBM used the same “input” formula for each employee, it did not need to worry about differing “outputs.”
IMPLICATIONS FOR EMPLOYERS
The PPA makes it possible for employers to create new cash balance plans – or to convert existing defined benefit plans to a cash balance design – with much less fear of litigation. While the PPA imposes some new restrictions on cash balance plans (especially regarding wearaways), the most desirable features of cash balance plans – clarity and a more equal distribution of benefit accruals over a participant’s career – remain intact. These features may make a cash balance plan a superior choice for certain employers.
Employers that already have cash balance plans should be relieved by the Cooper decision. While the PPA provides important prospective relief, it does not affirm the legality of any prior cash balance plan provisions. In this respect, the Cooper decision may represent the beginning of a victory for cash balance plans at the appellate level.