United States: The Future of Cash Balance Retirement Plans after Cooper v. IBM and the Pension Protection Act of 2006

The fate of "cash balance" plans has been much debated over the last few years, and many of the more contentious issues surrounding their maintenance and operation have been settled prospectively under the recently enacted Pension Protection Act of 2006 (the "Act"). For existing cash balance plans, however, some key legal obstacles remained due in part to the holding in a single U.S. district court case, Cooper v. IBM Personal Pension Plan. The appeal in that case has now been decided in a way that is favorable to cash balance plans and their sponsors. This advisory describes the likely impact of the Act and this new appellate decision on the future of cash balance plans.

There are only two way to make a pension promise—one can specify either the amounts to be contributed ("defined contribution" or "DC") or the amounts to be paid upon retirement ("defined benefit" or "DB"). Under the DC approach, contributions, whether made by the employer or by the participant through deferrals of salary, are allocated to an account that is held in the name of the participant. The participant’s benefit is the value of his or her accumulated contributions as adjusted for earnings. The participant therefore bears the investment risk. Under the DB approach, the participant’s benefit is typically based on some combination of compensation and service. There is no separate account; rather, contributions are made annually in amounts necessary to satisfy the promised benefits. Thus, the plan sponsor bears the investment risk.

For decades, defined benefit plans dominated the pension landscape, but that began to change in the 1980s. Fueled by a leverage buyout mania, buyers took to terminating over-funded DB plans. Congress responded by imposing stiff excise taxes on reversions from terminated plans. At the same time, the workforce was becoming more mobile as expectations of lifelong employment with a single employer dwindled. The traditional defined benefit plan, under which a greater percentage of benefits accrued after many years of service and as salary grew, lost some of its luster. Moreover, employers have always struggled to explain traditional defined benefit plans in a way that employees would understand, and more importantly value, them.

Enter the "cash balance plan," which is a defined benefit plan with the look and feel of a defined contribution arrangement. As a defined benefit plan, a cash balance plan does not have an account to which contributions are allocated. Instead participants have a "notional account" that merely describes the benefit to be paid at retirement. A typical cash balance formula might call for a contribution called a "pay credit," which is credited with interest at some specified rate. The critical difference, however, is that the benefits promised under a cash balance plan are not affected by the performance of the underlying assets. If the assets underperform, then the employer will ultimately need to make up the difference.

Because cash balance plans are defined benefit plans, overfunded pension plans can be converted to cash balance arrangements without triggering near confiscatory excise taxes, and because they have the look and feel of a defined contribution profit sharing or money purchase plan, they are easy to communicate to employees. But most importantly, under a cash balance formula, a participant accrues relatively greater benefits earlier in his or her career, and because benefits are more often paid or at least made available in lump sums, benefits are considerably more portable. Because cash balance plans exhibit features of both defined benefit and defined contribution plans, they are often referred to as "hybrid" plans.

NOTE: Another popular hybrid plan is referred to as a "pension equity plan." Under a pension equity plan, a participant’s lump-sum benefit equals a percentage of his or her final average pay multiplied by the number of years of credited service. For example, a typical pension equity formula might be a fixed percentage multiplied by years of service multiplied by average salary for the final five years of service.

Cash balance plans had some detractors, however. Older workers with long service under traditional plans, who anticipated significant pension accruals as they neared retirement, had their expectations dashed when the defined benefit plans under which they were covered were converted to cash balance plans. This is so because, unlike traditional DB plans, cash balance plans do not build up most of their benefits in the later years.

Two other concerns also surfaced once cash balance plans began to gain acceptance:

• Whipsaw. Whipsaw relates to the manner in which lump-sum account balances are paid under defined benefit plans. While the lump sum under a defined contribution (i.e., account balance) plan is the then-current value of the account, the lump sum under a cash balance (i.e., non–account balance) plan is determined by projecting the benefit forward to retirement based on the plan’s interest crediting rate, then discounting back to the distribution date using an interest rate prescribed by law. If the plan crediting rate is higher than the discount rate, then the lump-sum benefit would be higher than the balance in the participant’s notional cash balance account.
• Wear-Away. Wear-away can occur in the process of converting from a traditional defined benefit plan to a cash balance plan depending on the conversion formula. One possible formula is "A plus B," where A is the old benefit based on the pre-conversion formula taking into account service up to the date of the conversion, and B is the benefit under the new cash balance plan taking into account only post-conversion service. Another way to accomplish the conversion is to use an "A or B" formula, where A is the frozen benefit under the old plan taking into account service up to the date of conversion and B is the new benefit formula based on service both before and after the date of conversion. Under the latter formula, where a participant has a significant pre-conversion accrued benefit, he or she might not accrue anything under the new formula for some time, i.e., until the excess benefit under the old formula "wears away."

In a number of instances, older employees negatively impacted by the loss of anticipated increases under traditional defined benefit plans brought suit against their employers claiming that cash balance plans discriminate on the basis of age. Because of the requirements of law that apply to benefit accruals under defined benefit plans generally, a participant in a cash balance plan is deemed to accrue each year not just his or her annual pay credit but also interest associated with that pay credit to normal retirement age. Therefore, the interest credits for a younger employee will always be greater than for an older employee because the younger employee has more years until retirement. It is this phenomenon that is the basis for age-based discrimination claims.

The essential facts of this case are simple: In 1999, IBM converted its traditional defined benefit pension plan to a cash balance plan. Under the new cash balance formula, IBM credited annually to each employee’s notional account a 5% pay credit, together with interest at 100 basis points over the rate of interest on one-year Treasury bills. A group of participants challenged the conversion under ERISA § 204(b)(1)(H)(i), which provides that a defined benefit plan may neither cease an employee’s benefit accrual, nor reduce the rate of an employee’s accrual of benefits, because the employee has reached a particular age. The district court, agreeing with the participants, held that the plan’s cash balance formula discriminated on the basis of age. According to the court, a 49-year-old employee with 20 years of service would have accrued an age-65 annuity of $8,093 in 2000. In 2001, she would have accrued an additional $622, but by 2010 she would only accrue an additional $282. Thus, said the court, the employee’s benefit accrual was reduced for each year that she aged. The district court’s reasoning, while aimed at the IBM plan, was sufficiently broad to call into question the very nature of the cash balance approach.

COMMENT: Many seasoned ERISA practitioners were surprised by this result. In their view, the district court appeared to be confusing the rate at which benefits accrue with the amount of benefits credited in a year.

IBM appealed the case to the Seventh Circuit Court of Appeals.

The appellate court held that IBM’s conversion of its pension plan to a cash balance plan did not violate ERISA provisions prohibiting age discrimination. According to the court, the plan did not stop making allocations or accruals to the plan, nor did it change the rate at which they accrued, on account of age. In arriving at this result, the court compared the language of ERISA § 204(b)(1)(H)(i), which applies to defined benefit plans, with ERISA § 204(b)(2)(A), which applies to defined contribution plans. It helps to compare these provisions (as the court did):

According to the court, these ERISA provisions both say the same thing, i.e., an employer may not stop making allocations or accruals to the plan or change their rate on account of age. In holding that the IBM plan violated neither provision, the court asked (rhetorically) why the IBM plan should be treated as unlawful merely because its account balances are book entries instead of cash. In the view of the appellate court, the district court erred by treating the "time value of money" as age discrimination. The court held that, rather, the term "benefit accrual" should be understood to mean what the employer imputes to the account, noting that the effect of interest is not treated as age discrimination for a defined contribution plan and should not be treated as age discrimination for a defined benefit plan. Although the Seventh Circuit also recognized that the older workers had a legitimate complaint since they were worse off under a cash balance plan as compared to a traditional years-of-service-times-final-salary plan, the court concluded that "removing a feature that gave extra benefits to the old differs from discriminating against them."

Going forward, the Act addresses the three major cash balance plan issues cited above.

• Age Discrimination. On the subject of age discrimination, the Act treats benefits having equal present value as nondiscriminatory, regardless of the ages of the participants. It also requires hybrid plans to adopt a three-year vesting schedule and places limits on the interest crediting rate, which may not exceed a market rate of return as defined by regulation. Thus, the Act essentially codifies the result reached by the Seventh Circuit in Cooper v. IBM to the effect that hybrid plans do not discriminate on the basis of age as a matter of design.
• Whipsaw. The Act provides that a participant’s hypothetical or notional cash balance account may be distributed at par, thereby resolving the whipsaw issue. This reverses the holdings under prior law, in which a number of courts had concluded, based on IRS regulations, that a distribution could not be less than the present value of the participant’s projected annuity at the plan’s normal retirement age.
• Wear-Away. The Act establishes new standards for conversions under which a participant’s accrued benefit post-conversion must equal the sum of the pre-conversion benefit under the prior plan formula and the post-conversion benefit under the hybrid formula. (This is the A plus B approach cited above.) The Act also has a special rule that preserves the value of early retirement subsidies associated with benefits accrued under the prior formula.

For a time, the Cooper case had a chilling effect on the adoption of new cash balance plans, and it subjected sponsors of existing plans to a great deal of uncertainty. The combination of the Act and the appellate court’s decision in Cooper should remove much of the doubt and uncertainty and pave the way for the adoption of hybrid plans. This is a potentially important development. Traditional defined benefit plans are a dying breed, and the Act’s funding requirements are likely to only hasten their demise. Much of the retirement universe has moved to 401(k) plans, but participants are finding them to be a poor substitute for defined benefit plans. It is beginning to dawn on the baby-boom generation, in particular, that they can’t retire on their 401(k) plans alone. Inevitably, they will demand something else, and hybrid plans are about the only remaining alternative.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.