Cash
ImBalance: Federal Courts
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Prepared by: Edward Fensholt, JD
Palmer & Cay Consulting Group
Kansas City, MO
Two federal courts recently sent shockwaves through the pension industry with rulings concerning innovative pension plans known as “cash balance plans.” This Special Advisory describes the courts’ rulings, and recommends a course of action for employers who sponsor or are prepared to implement cash balance plans.
Cash balance pension plans are traditional “defined benefit” annuity pension plans designed to look like “defined contribution” plans (such as profit sharing or 401(k) plans). The benefit is defined as a contribution to participants’ “accounts.” Account balances are then increased by interest credits at a specified rate, projected from the date of contribution to normal retirement age. However, the contributions, accounts and interest credits are hypothetical in that there really are not individual accounts to which cash contributions are made and interest credited. Rather, the “contributions” and interest credits are used to arrive at a fictional “cash balance,” which is then converted through a set of actuarial assumptions to a monthly benefit. Cash balance plans allow participants to forego the annuity form of payment, and receive their “cash balance” in a single lump sum, like defined contributions plans.
Cash balance plans have been adopted by corporations such as AT&T, Cisco Systems, EDS, Microsoft, IBM and Xerox, as well as many smaller corporations.
On July 31, a federal trial court in Illinois ruled that IBM’s cash balance plan violated federal age discrimination rules. The court found that the IBM plan (like all cash balance plans) provides interest credits on each year’s adjusted account balance, with the interest projected to normal retirement age. The court concluded that the credits—because they’re projected to normal retirement age—are more valuable to a younger employee than an older employee. Phrased another way, the value of each year’s benefit accrual (the “contribution” and the interest credits on it) declines with advancing age, assuming other variables in the benefit formula (such as compensation) remain the same.
The court further found that the interest credits are actually part of a participant’s accrued benefit, and noted that a plan is not permitted by federal age discrimination rules to reduce benefit accruals solely on account of age. Because the interest crediting scheme appeared to the court to have precisely that effect, the court concluded that the IBM plan violated the age discrimination rules.
A day after the IBM case was decided, a federal appeals court with jurisdiction over several midwestern States upheld a judgment against the Xerox cash balance plan for nearly $300 million. The Xerox cash balance plan, like the IBM plan, provided for hypothetical contributions and “interest credits” projected to normal retirement age, at a specified rate.
However, the Xerox plan also included a rule under which, if a participant took her “cash balance” prior to normal retirement age, the plan would determine her cash balance by projecting interest credits not at the rate that would otherwise apply, but at a special rate. This special rate just happened to equal the rate the plan used to discount normal retirement benefits to present value lump sums. In short, the plan would take the early retiree’s “cash balance” on the date of payment, credit interest at this special rate to normal retirement age, and then discount that benefit back to a present value lump sum, using the same rate. The interest credit and the discount cancelled each other out, leaving the early retiree with a lump sum benefit equal to her cash balance on the date of payment.
As a result, the court found that the early retiree does not receive proper interest credits at the potentially higher interest rate applicable to other retirees, and that practice is unlawful.
IBM has appealed the trial court’s ruling, and its chances on appeal appear favorable. The Internal Revenue Service and at least two other federal trial courts earlier declined to find age discrimination where the court in the IBM case found it, so there is significant precedent that cash balance plans do not violate federal age discrimination laws. Consequently, sponsors of cash balance plans may wish to take a “wait and see” approach before modifying the manner in which their cash balance plans accrue benefits.
The court in the Xerox case was at least the second federal court to reach a similar conclusion on similar facts. So it seems clear that a cash balance plan cannot project interest credits at one rate for persons who wait until normal retirement age to retiree, and a different rate for early retirees. A sponsor of a cash balance plan that provides interest credits similar to the way the Xerox plan did should immediately consider modifying its cash balance plan.