Continuing Clashes over Cash Balance Pension Plans

The fight over cash balance plans is proving to be one for the ages. A hybrid of defined contribution (DC) and defined benefit (DB) pension plans, cash balance plans have engendered both confusion and dispute over the appropriate framework for analyzing their compliance with applicable law. Two recent conflicting decisions issued by the same U.S. District Court in New York reveal a continuing absence of clarity about the plans' legality, despite support given in August by the U.S. Court of Appeals for the Seventh Circuit in the Cooper v. IBM decision and by Congress in the Pension Protection Act of 2006 (PPA).

This article reviews recent developments, focusing on features of cash balance plans that have proven problematic, and on the prospect for a solution under the PPA.

Overview of Cash Balance Plan Design

Cash balance pension plan benefits are determined by reference to a hypothetical account balance. This balance is calculated based on hypothetical annual allocations to the account ('pay credits') ' determined as a percentage of the participant's covered compensation for the year of accrual ' and hypothetical earnings on the account ('interest credits').

A common plan design grants interest credits on a 'front-loaded' basis. Under this design, when a participant accrues a pay credit with respect to a plan year, he or she will also accrue an associated right to future interest on that pay credit even if the participant separates from service with the employer before reaching normal retirement age.

Charges of Age Discrimination

Because of this front-loaded feature, a younger participant has a longer period of time over which interest credits accrue. Consequently, a pay credit granted in a plan year to a younger participant will produce a larger account balance (and therefore a larger monthly annuity payment at normal retirement age) than the same pay credit for that year will produce for an older participant. It is this attribute that has subjected cash balance plans to charges that they discriminate unlawfully on the basis of age. Specifically, challengers point to the provisions of Section 204(b)(1)(H)(i) of the Employee Retirement Income Security Act of 1974 (ERISA), which prohibits a defined benefit plan from causing an employee's 'benefit accrual' to cease, or the 'rate of an employee's benefit accrual' to be reduced, 'because of the attainment of any age.'

Treasury's Position

The IRS has given considerable attention to these charges of age discrimination in cash balance plans. In connection with the issuance of final regulations in 1991, the IRS stated that the 'fact that interest adjustments through normal retirement age are accrued in the year of the related hypothetical allocation will not cause a cash balance plan to fail to satisfy the requirements of section 411(b)(1)(H) [of the Internal Revenue Code, which parallel those of ERISA Section 204(b)(1)(H)], relating to age-based reductions in the rate at which benefits accrue under the plan.' Under regulations proposed in 2002, the IRS advanced a special rule that would permit a participant's rate of benefit accrual under a cash balance plan to be based on the rate at which pay credits are granted, rather than on the rate at which the participant's accrued normal retirement benefit increases.

Judicial Positions

A number of courts have also considered the charge that cash balance plans violate ERISA's age discrimination provisions. The results have been decidedly divided. Compare, for example, the following pre-PPA decisions:

• Tootle v. ARINC, Inc. 222 F.R.D. 88, 94 (D.Md. 2004): 'The potential claim of age discrimination arises only by applying a definition for accrued benefits which does not fit with the way cash balance plans are structured. The more sensible approach is to measure benefit accrual under cash balance plans by examining the rate at which amounts are allocated and the changes over time in an individual's account balance.'
• Hirt v. Equitable Ret. Plan for Em-ployees, Managers & Agents, 441 F.Supp.2d 516 (S.D.N.Y. 2006): Finding that age discrimination does not arise from neutral application of interest to yearly account balances;
• Richards v. FleetBoston Financial Corp., 427 F.Supp.2d 150, (D.Conn. 2006): Denying motion to dismiss claims that cash balance plan terms violate ERISA's age discrimination provisions; and
• Donaldson v. Pharmacia Pension Plan, 2006 WL 1669789, 38 E.B.C. 1006 (S.D.Ill. June 14, 2006): Denying motion to dismiss claims that cash balance plan violated ERISA's age discrimination provisions applicable to DB plans prohibiting cessation or reduction in the rate at which an employee accrues benefits on account of age.

The Promise of Resolution

Hope that the division of judicial opinion might be resolved was fueled by the issuance in August 2006 of the pro-cash balance decision in Cooper v. IBM Personal Pension Plan, 457 F.3d 636 (7^th Cir. 2006). In Cooper, the U.S. Court of Appeals for the Seventh Circuit held that the terms of a cash balance plan do not violate ERISA's proscription against age-based reductions in the rate of benefit accrual. The court reached this result reasoning that the plan terms are age-neutral because every participant receives the same pay credit and interest credit each year. The court expressly rejected the argument that cash balance plans inherently discriminate on the basis of age because younger workers are able to benefit more from the impact of time on the interest component of their benefit accrual. 'Interest is not treated as age discrimination for a defined contribution plan,' the court wrote, 'and the fact that [a DC plan and a DB plan] are so close in both function and expression implies that it should not be treated as discriminatory for a defined benefit plan either. The phrase 'benefit accrual' [in ERISA Section 204(b)(1)(H)] reads most naturally as a reference to what the employer puts in ' while the phrase 'accrued benefit' refers to outputs after compounding.' 457 F.2d at 638-39.

Further support for the cash balance camp was provided by the enactment of the PPA, which amended the Internal Revenue Code, ERISA and the Age Discrimination in Employment Act (ADEA) to authorize the use of cash balance plans if certain requirements are met. Under the PPA, a plan will not be treated as violating the age discrimination rules of the statutes amended if it provides for periodic adjustment of accrued benefits (other than benefits distributed in the form of variable annuities) by application of a recognized investment index or methodology ' so long as the adjustment may not be reduced or cease because of age. The legislative history of the PPA expressly warns, however, that no inference is to be drawn from the enactment of the PPA that cash balance plans in place before the Act's effective date comply with the rules of the Code, ERISA and the ADEA prohibiting age discrimination.

Observers at the end of August 2006 might well have concluded that the cash balance saga had been ended by the one-two knockout punch delivered on behalf of cash balance advocates by the Cooper ruling and the PPA. They would have been wrong.

A Subway Series

Barely 2 months after the PPA's enactment, the U.S. District Court for the Southern District of New York stoked the controversy by issuing separate decisions in September and October 2006 reaching opposite conclusions on the question of whether cash balance plans discriminated on the basis of age. In Laurent v. PriceWaterhouseCoopers, 448 F. Supp. 2d 537 (S.D.N.Y. 2006), the court concluded that PWC's cash balance plan did not violate ERISA's age discrimination provisions; but in In re J.P. Morgan Chase Cash Balance Litigation, 2006 WL 3063424 (S.D.N.Y., Oct. 30, 2006), the court found that J.P. Morgan's cash balance plan did. Differences in the legal analysis applied by the court, rather than in the facts of the two cases, are responsible for the divergence in results.

The plaintiff-participants in Laurent contended that the formula violated ERISA in several respects. First, they argued that the formula impermissibly ceased benefit accruals based upon attainment of age 65 because it failed to project earnings through age 70.5 (the age after which minimum distributions are required under Section 401(a)(9) of the Internal Revenue Code). Second, they claimed that the formula discriminated based on age because it caused the rate at which benefits accrue to diminish as one ages. Third, the participants alleged that the formula unlawfully failed to increase actuarially a person's benefit if he or she deferred distribution until after normal retirement age.

The court rejected all three arguments. ERISA, the court first concluded, does not require cash balance defined benefit pension plans to project the value of account balances beyond the time of normal retirement age for a participant who separates from service prior to that time. '[T]here is no case or statutory law,' the court observed, 'that requires a defined benefit plan to provide post-normal retirement age interest credits to participants or that considers such post-normal retirement age optional interest credits to be part of the accrued benefit owed to a participant taking a lump-sum distribution before normal retirement age.' Laurent, slip op. at 10.

Turning to the plaintiffs' second argument ' that the cash balance formula impermissibly reduced the rate of benefit accrual based on age ' the court noted that this position would result in a finding that all cash balance plans violate ERISA's age discrimination provisions. The plaintiffs' position was based on the fact that if two workers accrue the same pension credit with respect to a plan year, that accrual is actually worth more to the younger worker because the interest imputed to the credit will have a longer period of time to compound for the younger worker. Under this time-value-of-money theory, cash balance plans inherently discriminate on the basis of age. The court rejected this notion, stating that '[a]ge discrimination simply can not arise from the neutral application of interest to account balances.' Laurent, slip op. at 15. The court reasoned that, unlike traditional DB plans, cash balance pension plans define their benefit by reference to a notional account balance, rather than an annuity commencing at age 65 based on years of service and final average compensation. Consequently, the 'change in the account balance is the logical measurement because cash balance plans are defined in terms of an account balance that grows with pay credits and interest.' Laurent, slip op. at 13. In reaching this conclusion, the court relied in part on the Seventh Circuit's decision in Cooper.

Finally, the court rejected the plaintiffs' argument that cash balance plans violate ERISA because they fail to actuarially adjust the benefit for distributions deferred beyond normal retirement age. The court observed that since participants in a cash balance plan are entitled to the entire value of their vested account balances regardless of when they elect to receive benefits, they do not suffer any impermissible benefit forfeiture due to deferred distributions. The court contrasted this to traditional DB plans under which a participant's benefit is expressed as a lifetime stream of monthly payments commencing at normal retirement age. Under that annuity-based model, the court conceded that delaying benefit distribution beyond normal retirement age would cause a participant to lose the value of the missed monthly payments unless some adjustment was made to the remaining monthly payments.

Less than 2 months after issuing the Laurent decision, the same U.S. District Court issued a separate ruling in which it reached the opposite conclusion. In J.P. Morgan, the District Court ruled that employer's cash balance pension plan to be age discriminatory, finding that the 'unambiguous' statutory language of ERISA (along with ERISA's different regulatory requirements for DC and DB plans) 'compels this result.' The court reasoned that ERISA's age discrimination provision prohibits the reduction of the 'rate of an employee's benefit accrual' on account of age, and sided with the participant-plaintiffs in concluding that this phrase refers to the employer's contributions to the plan, rather than to the individual participant's retirement benefit. In doing so, the court expressly rejected the opposite interpretation reached in Laurent.

The court in the J.P. Morgan case found to be 'immaterial' the fact that the terms of the plan appear to be age neutral. Indeed, the court noted that '[d]espite the fact that every employee receives pay credits based on their completed years of service and the same interest rate is applied to each employee's account balance, that is not the yardstick by which to test, nor the means to avoid,' age discrimination in violation of ERISA. Instead, the yardstick must measure the retirement benefit produced under a plan for older and younger workers. Because participants who join the plan sponsor at a later age receive less under cash balance plans, the court concluded that they violate ERISA:

In sum, under a cash balance plan, all other things being equal, when we focus on the benefit that the employer promises at retirement, (as the statute instructs us to), a worker who begins employment at an older age will receive a smaller retirement benefit as compared to a similarly situated employee who begins work at a younger age, and this is violative of ERISA Section 204(b)(1)(H)(i).

J.P. Morgan, slip op. at 9.

The court acknowledged that its ruling was at odds with the Laurent decision as well as the Hirt decision (noted above), which had been issued by the same court in July 2006, referencing both when conceding that 'courts in this Circuit have found that cash balance plans are not age discriminatory.' But referring to the above-cited ruling in FleetBoston issued by the U.S. District Court for the District of Connecticut (which, along with the courts for the four federal districts in New York, is within the jurisdiction of the U.S. Court of Appeals for the Second Circuit), the court stated that it would 'join the court that found that cash balance plans are age discriminatory, although I reach this conclusion via a different path.'

Conclusion

The enactment of the PPA appeared to promise some closure to the debate over cash balance plans. The statutory framework that it provides for using interest credits under applicable defined benefit plans should, when supplemented with clear guidance from the IRS, enable plan sponsors to design cash balance plans with much greater confidence than has previously been the case. However, plan designers, administrators, advisors and service providers are well-advised to note the following observation of the court in the J.P. Morgan decision:

[T]he age discrimination arises because this [cash balance plan] is a defined benefit plan and older workers accrue their retirement benefits at a slower rate than similarly situated younger workers. As directed by the Supreme Court, my role 'is to apply the text [of ERISA], not to improve upon it.' [Citation omitted.] That is the province of Congress, and it addressed some of the tensions that arise when the binary statutory framework is applied to cash balance plans at the time they passed the Pension Protection Act of 2006 this summer.

J.P. Morgan, slip op. at 10 (italics added).

In short, stay tuned.

(Editor's Note: See our August 2006 edition for Rob Webb's first A&FP article, on the short-term costs of retiring a defined benefit pension plan.)

The fight over cash balance plans is proving to be one for the ages. A hybrid of defined contribution (DC) and defined benefit (DB) pension plans, cash balance plans have engendered both confusion and dispute over the appropriate framework for analyzing their compliance with applicable law. Two recent conflicting decisions issued by the same U.S. District Court in New York reveal a continuing absence of clarity about the plans' legality, despite support given in August by the U.S. Court of Appeals for the Seventh Circuit in the Cooper v. IBM decision and by Congress in the Pension Protection Act of 2006 (PPA).

This article reviews recent developments, focusing on features of cash balance plans that have proven problematic, and on the prospect for a solution under the PPA.

Overview of Cash Balance Plan Design

Cash balance pension plan benefits are determined by reference to a hypothetical account balance. This balance is calculated based on hypothetical annual allocations to the account ('pay credits') ' determined as a percentage of the participant's covered compensation for the year of accrual ' and hypothetical earnings on the account ('interest credits').

A common plan design grants interest credits on a 'front-loaded' basis. Under this design, when a participant accrues a pay credit with respect to a plan year, he or she will also accrue an associated right to future interest on that pay credit even if the participant separates from service with the employer before reaching normal retirement age.

Charges of Age Discrimination

Because of this front-loaded feature, a younger participant has a longer period of time over which interest credits accrue. Consequently, a pay credit granted in a plan year to a younger participant will produce a larger account balance (and therefore a larger monthly annuity payment at normal retirement age) than the same pay credit for that year will produce for an older participant. It is this attribute that has subjected cash balance plans to charges that they discriminate unlawfully on the basis of age. Specifically, challengers point to the provisions of Section 204(b)(1)(H)(i) of the Employee Retirement Income Security Act of 1974 (ERISA), which prohibits a defined benefit plan from causing an employee's 'benefit accrual' to cease, or the 'rate of an employee's benefit accrual' to be reduced, 'because of the attainment of any age.'

Treasury's Position

The IRS has given considerable attention to these charges of age discrimination in cash balance plans. In connection with the issuance of final regulations in 1991, the IRS stated that the 'fact that interest adjustments through normal retirement age are accrued in the year of the related hypothetical allocation will not cause a cash balance plan to fail to satisfy the requirements of section 411(b)(1)(H) [of the Internal Revenue Code, which parallel those of ERISA Section 204(b)(1)(H)], relating to age-based reductions in the rate at which benefits accrue under the plan.' Under regulations proposed in 2002, the IRS advanced a special rule that would permit a participant's rate of benefit accrual under a cash balance plan to be based on the rate at which pay credits are granted, rather than on the rate at which the participant's accrued normal retirement benefit increases.

Judicial Positions

A number of courts have also considered the charge that cash balance plans violate ERISA's age discrimination provisions. The results have been decidedly divided. Compare, for example, the following pre-PPA decisions:

• Tootle v. ARINC, Inc . 222 F.R.D. 88, 94 (D.Md. 2004): 'The potential claim of age discrimination arises only by applying a definition for accrued benefits which does not fit with the way cash balance plans are structured. The more sensible approach is to measure benefit accrual under cash balance plans by examining the rate at which amounts are allocated and the changes over time in an individual's account balance.'
• Hirt v. Equitable Ret. Plan for Em-ployees, Managers & Agents , 441 F.Supp.2d 516 (S.D.N.Y. 2006): Finding that age discrimination does not arise from neutral application of interest to yearly account balances;
• Richards v. FleetBoston Financial Corp ., 427 F.Supp.2d 150, (D.Conn. 2006): Denying motion to dismiss claims that cash balance plan terms violate ERISA's age discrimination provisions; and
• Donaldson v. Pharmacia Pension Plan, 2006 WL 1669789, 38 E.B.C. 1006 (S.D.Ill. June 14, 2006): Denying motion to dismiss claims that cash balance plan violated ERISA's age discrimination provisions applicable to DB plans prohibiting cessation or reduction in the rate at which an employee accrues benefits on account of age.

The Promise of Resolution

Hope that the division of judicial opinion might be resolved was fueled by the issuance in August 2006 of the pro-cash balance decision in Cooper v. IBM Personal Pension Plan , 457 F.3d 636 (7 th Cir. 2006). In Cooper, the U.S. Court of Appeals for the Seventh Circuit held that the terms of a cash balance plan do not violate ERISA's proscription against age-based reductions in the rate of benefit accrual. The court reached this result reasoning that the plan terms are age-neutral because every participant receives the same pay credit and interest credit each year. The court expressly rejected the argument that cash balance plans inherently discriminate on the basis of age because younger workers are able to benefit more from the impact of time on the interest component of their benefit accrual. 'Interest is not treated as age discrimination for a defined contribution plan,' the court wrote, 'and the fact that [a DC plan and a DB plan] are so close in both function and expression implies that it should not be treated as discriminatory for a defined benefit plan either. The phrase 'benefit accrual' [in ERISA Section 204(b)(1)(H)] reads most naturally as a reference to what the employer puts in ' while the phrase 'accrued benefit' refers to outputs after compounding.' 457 F.2d at 638-39.

Further support for the cash balance camp was provided by the enactment of the PPA, which amended the Internal Revenue Code, ERISA and the Age Discrimination in Employment Act (ADEA) to authorize the use of cash balance plans if certain requirements are met. Under the PPA, a plan will not be treated as violating the age discrimination rules of the statutes amended if it provides for periodic adjustment of accrued benefits (other than benefits distributed in the form of variable annuities) by application of a recognized investment index or methodology ' so long as the adjustment may not be reduced or cease because of age. The legislative history of the PPA expressly warns, however, that no inference is to be drawn from the enactment of the PPA that cash balance plans in place before the Act's effective date comply with the rules of the Code, ERISA and the ADEA prohibiting age discrimination.

Observers at the end of August 2006 might well have concluded that the cash balance saga had been ended by the one-two knockout punch delivered on behalf of cash balance advocates by the Cooper ruling and the PPA. They would have been wrong.

A Subway Series

Barely 2 months after the PPA's enactment, the U.S. District Court for the Southern District of New York stoked the controversy by issuing separate decisions in September and October 2006 reaching opposite conclusions on the question of whether cash balance plans discriminated on the basis of age. In Laurent v. PriceWaterhouseCoopers , 448 F. Supp. 2d 537 (S.D.N.Y. 2006), the court concluded that PWC's cash balance plan did not violate ERISA's age discrimination provisions; but in In re J.P. Morgan Chase Cash Balance Litigation, 2006 WL 3063424 (S.D.N.Y., Oct. 30, 2006), the court found that J.P. Morgan's cash balance plan did. Differences in the legal analysis applied by the court, rather than in the facts of the two cases, are responsible for the divergence in results.

The plaintiff-participants in Laurent contended that the formula violated ERISA in several respects. First, they argued that the formula impermissibly ceased benefit accruals based upon attainment of age 65 because it failed to project earnings through age 70.5 (the age after which minimum distributions are required under Section 401(a)(9) of the Internal Revenue Code). Second, they claimed that the formula discriminated based on age because it caused the rate at which benefits accrue to diminish as one ages. Third, the participants alleged that the formula unlawfully failed to increase actuarially a person's benefit if he or she deferred distribution until after normal retirement age.

The court rejected all three arguments. ERISA, the court first concluded, does not require cash balance defined benefit pension plans to project the value of account balances beyond the time of normal retirement age for a participant who separates from service prior to that time. '[T]here is no case or statutory law,' the court observed, 'that requires a defined benefit plan to provide post-normal retirement age interest credits to participants or that considers such post-normal retirement age optional interest credits to be part of the accrued benefit owed to a participant taking a lump-sum distribution before normal retirement age.' Laurent, slip op. at 10.

Turning to the plaintiffs' second argument ' that the cash balance formula impermissibly reduced the rate of benefit accrual based on age ' the court noted that this position would result in a finding that all cash balance plans violate ERISA's age discrimination provisions. The plaintiffs' position was based on the fact that if two workers accrue the same pension credit with respect to a plan year, that accrual is actually worth more to the younger worker because the interest imputed to the credit will have a longer period of time to compound for the younger worker. Under this time-value-of-money theory, cash balance plans inherently discriminate on the basis of age. The court rejected this notion, stating that '[a]ge discrimination simply can not arise from the neutral application of interest to account balances.' Laurent, slip op. at 15. The court reasoned that, unlike traditional DB plans, cash balance pension plans define their benefit by reference to a notional account balance, rather than an annuity commencing at age 65 based on years of service and final average compensation. Consequently, the 'change in the account balance is the logical measurement because cash balance plans are defined in terms of an account balance that grows with pay credits and interest.' Laurent, slip op. at 13. In reaching this conclusion, the court relied in part on the Seventh Circuit's decision in Cooper.

Finally, the court rejected the plaintiffs' argument that cash balance plans violate ERISA because they fail to actuarially adjust the benefit for distributions deferred beyond normal retirement age. The court observed that since participants in a cash balance plan are entitled to the entire value of their vested account balances regardless of when they elect to receive benefits, they do not suffer any impermissible benefit forfeiture due to deferred distributions. The court contrasted this to traditional DB plans under which a participant's benefit is expressed as a lifetime stream of monthly payments commencing at normal retirement age. Under that annuity-based model, the court conceded that delaying benefit distribution beyond normal retirement age would cause a participant to lose the value of the missed monthly payments unless some adjustment was made to the remaining monthly payments.

Less than 2 months after issuing the Laurent decision, the same U.S. District Court issued a separate ruling in which it reached the opposite conclusion. In J.P. Morgan, the District Court ruled that employer's cash balance pension plan to be age discriminatory, finding that the 'unambiguous' statutory language of ERISA (along with ERISA's different regulatory requirements for DC and DB plans) 'compels this result.' The court reasoned that ERISA's age discrimination provision prohibits the reduction of the 'rate of an employee's benefit accrual' on account of age, and sided with the participant-plaintiffs in concluding that this phrase refers to the employer's contributions to the plan, rather than to the individual participant's retirement benefit. In doing so, the court expressly rejected the opposite interpretation reached in Laurent.

The court in the J.P. Morgan case found to be 'immaterial' the fact that the terms of the plan appear to be age neutral. Indeed, the court noted that '[d]espite the fact that every employee receives pay credits based on their completed years of service and the same interest rate is applied to each employee's account balance, that is not the yardstick by which to test, nor the means to avoid,' age discrimination in violation of ERISA. Instead, the yardstick must measure the retirement benefit produced under a plan for older and younger workers. Because participants who join the plan sponsor at a later age receive less under cash balance plans, the court concluded that they violate ERISA:

In sum, under a cash balance plan, all other things being equal, when we focus on the benefit that the employer promises at retirement, (as the statute instructs us to), a worker who begins employment at an older age will receive a smaller retirement benefit as compared to a similarly situated employee who begins work at a younger age, and this is violative of ERISA Section 204(b)(1)(H)(i).

J.P. Morgan, slip op. at 9.

The court acknowledged that its ruling was at odds with the Laurent decision as well as the Hirt decision (noted above), which had been issued by the same court in July 2006, referencing both when conceding that 'courts in this Circuit have found that cash balance plans are not age discriminatory.' But referring to the above-cited ruling in FleetBoston issued by the U.S. District Court for the District of Connecticut (which, along with the courts for the four federal districts in New York, is within the jurisdiction of the U.S. Court of Appeals for the Second Circuit), the court stated that it would 'join the court that found that cash balance plans are age discriminatory, although I reach this conclusion via a different path.'

Conclusion

The enactment of the PPA appeared to promise some closure to the debate over cash balance plans. The statutory framework that it provides for using interest credits under applicable defined benefit plans should, when supplemented with clear guidance from the IRS, enable plan sponsors to design cash balance plans with much greater confidence than has previously been the case. However, plan designers, administrators, advisors and service providers are well-advised to note the following observation of the court in the J.P. Morgan decision:

[T]he age discrimination arises because this [cash balance plan] is a defined benefit plan and older workers accrue their retirement benefits at a slower rate than similarly situated younger workers. As directed by the Supreme Court, my role 'is to apply the text [of ERISA], not to improve upon it.' [Citation omitted.] That is the province of Congress, and it addressed some of the tensions that arise when the binary statutory framework is applied to cash balance plans at the time they passed the Pension Protection Act of 2006 this summer.

J.P. Morgan, slip op. at 10 (italics added).

In short, stay tuned.

(Editor's Note: See our August 2006 edition for Rob Webb's first A&FP article, on the short-term costs of retiring a defined benefit pension plan.)