Seventh Circuit Rejects Age Discrimination Challenge to Cash Balance Plans; Second, Third, and Ninth Circuits Could Follow

 

Peter M. Varney & David R. Godofsky

Alston & Bird LLP

Atlanta, Georgia & Washington, DC

 

            Rejecting resoundingly a theory that has spawned lawsuits in federal district courts from coast to coast, the Seventh Circuit held that defined benefit plans employing a “cash balance” formula do not violate ERISA’s prohibition on age discrimination. Cooper v. IBM Personal Pension Plan, ___ F.3d ___, 2006 WL 2243300 (7th Cir. Aug. 7, 2006). The Seventh Circuit’s August 7, 2006 decision (authored by Judge Frank Easterbrook) reversed a 2003 ruling by the Southern District of Illinois that IBM’s pension plan discriminated illegally against older workers. Cooper v. IBM Personal Pension Plan, 274 F. Supp. 2d 1010 (S.D. Ill. 2003). This decision is of enormous consequence as the district court’s theory, if affirmed, would have applied to thousands of pension plans covering millions of participants.

Declaring IBM’s cash balance formula “age-neutral,” the Seventh Circuit is the first federal appellate court to address definitively age discrimination challenges to the validity of cash balance plans. Cooper, 2006 WL 2243300, at *6. The Seventh Circuit reasoned that, for purposes of the age discrimination prohibitions at least, cash balance plans and defined contribution plans should be treated similarly, and that under both of these pension plan varieties “benefit accrual” is measured according to what is put into the plan rather than what an employee draws out. Id. at *2-*3. Having construed “benefit accrual” in this way, the Cooper appellate court concluded that “[u]nder IBM’s plan any differences in pension benefits are a function of differing years of service, salary history, or the years the balance has been allowed to compound; age is not a factor.” Id. at *6.

The Seventh Circuit’s decision is consistent with the conclusions of most federal district courts and the Treasury Department. Age discrimination challenges to cash balance plans identical to the one repudiated in Cooper are presently before the Third and Ninth Circuits, and the Second Circuit is likely to have to resolve an internal district court split regarding the same theory addressed in Cooper. In addition, Congress recently addressed and resolved these issues in the Pension Protection Act, H.R. 4 (“PPA”), passed on August 3, 2006 (which, as of this writing, the President has promised to sign), declaring that cash balance plans are not age discriminatory, but only on a prospective basis. Thus, the Seventh Circuit’s decision with regard to the state of the law before passage of the PPA is of great importance for plan sponsors that have existing cash balance plans.

Background

Effective July 1, 1999, IBM amended its pension plan to create a cash balance formula. Pursuant to this formula, a participant’s benefit is determined by reference to a hypothetical account. Every month, each participant’s hypothetical account value increases with the addition of “pay credits,” equal to 5% of the employee’s salary, and “interest credits,” at one percentage point higher than the rate of return on one year treasury securities. Terminating employees are entitled to withdraw their account balances as a lump sum, convert their account balances to an immediate life annuity, or defer receipt of a lump sum or life annuity. After termination of employment, employee accounts no longer receive pay credits, but continue to collect interest credits until the balances are withdrawn or converted to life annuities.

On November 1, 1999, three former employees brought a class action lawsuit in the Southern District of Illinois challenging the cash balance formula as illegally discriminating against older employees in violation of 29 U.S.C. § 1054(b)(1)(H). A plan violates this section, entitled “Benefit accrual requirements,” “if, under the plan, an employee’s benefit accrual is ceased, or the rate of an employee’s benefit accrual is reduced, because of the attainment of any age.” 29 U.S.C. § 1054(b)(1)(H)(i). The Internal Revenue Code and the Age Discrimination in Employment Act contain substantially identical provisions. 26 U.S.C. § 411(b)(1)(H); 29 U.S.C. § 623(i).

The plaintiffs contended that because a cash balance plan is a defined benefit plan, every participant’s “accrued benefit” (including the interest credits) had to be valued as an annuity at age 65. The cash balance formula discriminated against older employees, plaintiffs argued, because when accrued benefits are calculated as age 65 annuities, the annuity for a younger employee would include more years of interest credits than the annuity for an older employee.. Thus, for two similarly-situated employees, “the rate of benefit accrual” was smaller for the older employee than for the younger employee. In essence, plaintiffs’ argument is that, if a younger employee leaves his account in the plan for a longer period of time, he will receive more interest, and therefore the older employee is receiving less.

The Southern District of Illinois accepted the plaintiffs’ arguments and granted summary judgment in their favor. The district court reasoned: “The rate of a participant's benefit accrual diminishes as the participant closes on the age 65 target. And, age 65 is normal retirement age, and Congress did not intend the term ‘benefit accrual’ to mean something different from ‘accrued benefit.’ “ Cooper, 274 F. Supp. 2d at 1022. The district court thus concluded that “There may be policy reasons why Congress should specifically authorize [cash balance formulas] in the context of defined benefit plans. But the narrow question here is whether the 1999 Plan comports with the literal and unambiguous provisions of ERISA § 204(b)(1)(H) [29 U.S.C. § 1054(b)(1)(H)], and it does not.” Id.

The court’s age discrimination conclusion conflicted with several prior district court decisions, including the lengthy analysis of another district court within the Seventh Circuit. Godinez v. CBS Corp., No. SA CV 01-28-GLT (ANX), 2002 WL 32155542, at *3 (C.D. Cal. May 20, 2002), aff’d, 81 Fed. Appx. 949 (9th Cir. 2003); Engers v. AT&T Corp., No. 98-3660 (NHP), 2001 U.S. Dist. Lexis 25889, at *6-*10 (D.N.J. June 6, 2001); Eaton v. Onan Corp., 117 F. Supp. 2d 812, 822-26, 830-34 (S.D. Ind. 2000). Subsequent to Cooper, district courts continued to reject age discrimination challenges to cash balance plans, with only the District of Connecticut embracing the conclusion of the Southern District of Illinois. Hirt v. Equitable Ret. Plan for Employees, Managers & Agents, ___ F. Supp. 2d ___, 2006 WL 2023545, at *33-*33 (S.D.N.Y. July 20, 2006); Register v. PNC Fin. Servs. Group, Inc., No. 04-CV-6097, 2005 WL 3120268, at *4-*8 (E.D. Pa. Nov. 21, 2005), appeal pending, No. 05-5445 (3d Cir. filed Dec. 20, 2005); Hurlic v. Southern Cal. Gas Co., No. CV05-5027 R (MANx) (C.D. Cal. Oct. 18, 2005), appeal pending, No. 06-55599 (9th Cir. filed April 26, 2006); Tootle v. ARINC, Inc., 222 F.R.D. 88, 93-94 (D. Md. 2004). But see Richards v. FleetBoston Fin. Corp., 427 F. Supp. 2d 150, 164, 167 (D. Conn. 2006) (holding, consistent with the district court in Cooper, that “ERISA itself requires the court to compare annual benefits commencing at normal retirement age when considering age discrimination in a cash plan under section 204(b)(1)(H).”). See also Charles v. Pepco Holdings, Inc., ___ F. Supp. 2d ___, 2006 WL 1892672, at *3 (D. Del. July 11, 2006) (staying motion to dismiss § 1054(b)(1)(H) claim pending a ruling from Third Circuit in appeal in Register).

            In the wake of the district court’s decision in Cooper, the parties reached a monetary settlement contingent on affirmance of the district court on appeal. IBM also eliminated all defined benefit pensions for new employees.

The Seventh Circuit’s Reasoning

            The Seventh Circuit disagreed completely with the analysis of the Southern District of Illinois. According to the Seventh Circuit, the district court’s “approach treats the time value of money as age discrimination,” and “[t]reating the time value of money as a form of discrimination is not sensible.” Cooper, 2006 WL 2243300, at *2-*3. The “litigation went off the rails,” the Seventh Circuit explained, because the district court incorrectly equilibrated the undefined statutory term “benefit accrual” with the defined term “accrued benefit” (“an ‘amount expressed in the form of an annual benefit commencing at normal retirement age’ ”). Id. As the Seventh Circuit summarized, “Plug this back into § 204(b)(1)(H)(i), and the rule against discrimination then refers not to what IBM puts into the plan, but what the employee takes out on retirement.” Id. at *2.

The fatal flaw in the district court’s analysis, the appellate court concluded, was that “a phrase dealing with inputs was misunderstood to refer to outputs.” Id. Rejecting the district court’s statutory construction, the Seventh Circuit explained that “The phrase ‘benefit accrual’ reads most naturally as a reference to what the employer puts in (either in absolute terms or as a rate of change), while the defined phrase ‘accrued benefit’ refers to outputs after compounding.” Id. The appellate panel thus found “no statutory difference between the treatment of economically equivalent defined-benefit and defined-contribution plans. For defined-benefit plans, where the account is an accounting entry rather than cash, ‘benefit accrual’ matches the money ‘allocated’ to a defined-contribution plan.” Id. Moreover, the court opined that “All sorts of things go wrong unless we treat both § 204(b)(1)(H)(i) and § 204(b)(2)(A) [the section of ERISA addressing age discrimination in defined contribution plans] as addressing the rate at which value is added (or imputed) to an account, rather than the annual pension at retirement age.” Id. at *3.

The Seventh Circuit found support for its conclusion in regulations proposed by the Department of the Treasury. These proposed regulations define the “rate of benefit accrual” for a cash balance plan as “ ‘the additions to the participant’s hypothetical account for the plan year.’ ” Id. at *3 (quoting 67 Fed. Reg. 76123, 76125 (Dec. 11, 2002)). “[T]he Treasury’s view, like our independent reading, looks at the rate of contribution (what goes into the account) rather than the annual rate of withdrawal at retirement.” Id.

The Seventh Circuit also identified three reasons why the plaintiffs’ “perspective misunderstands both the statute and the time value of money.” Id. at *4. First, the appellate court reiterated its conclusion that “benefit accrual” and “accrued benefit” are not synonymous: “ ‘benefit accrual’ refers to the annual addition to the pot, not to the final payout.” Id. at *5. Second, the court criticized the plaintiffs for making too much of the fact that different statutory provisions govern defined benefit and defined contribution plans. The Seventh Circuit explained:

Interest in a defined-contribution plan is real, while interest credits in a defined-benefit plan are bookkeeping entries (effectively debt obligations of the employer to the extent that the pension trust fund does not cover them). But so what? IBM does not contend that its plan is governed by § 204(b)(2)(A), just that § 204(b)(1)(H)(i) does not whimsically require a court to find age discrimination for a defined-benefit plan when materially identical statutory language allows fundamentally identical defined-contribution plans to operate without any taint of discrimination. To say that defined-benefit and defined-contribution plans are governed by different subsections of ERISA is not to say that what is lawful for one must be forbidden to the other. We conclude that § 204(b)(1)(H)(i) and § 204(b)(2)(A) indeed provide similar treatment with respect to claims of age discrimination.

 

Id. Finally, the appellate court faulted the plaintiffs for advancing an age discrimination theory without showing “that the complained-of effect is actually on account of age.” Id. at *6. Instead, according to the Seventh Circuit, any differences between the benefits of younger and older employers merely “correlated with age” and thus IBM’s cash balance formula “is age-neutral.” Id.

The Seventh Circuit therefore reversed the district court and remanded with instructions that the district court enter judgment in favor of IBM.

Consistent Provisions in the Pension Protection Act

            The Seventh Circuit’s analysis is fully consistent with § 701 of the PPA. Section 701 of the PPA amends ERISA, the Internal Revenue Code, and ADEA on a prospective basis to repudiate the age discrimination conclusion of the district court in Cooper. Specifically, pursuant to § 701, a plan would not violate the anti-age discrimination provisions “if a participant’s accrued benefit, as determined as of any date under the terms of the plan, would be equal to or greater than that of any similarly situated, younger individual who is or could be a participant.” PPA § 701(a)(1), (b)(1), (c). The PPA defines a participant as “similarly situated” if the participant “is identical to such other individual in every respect (including period of service, compensation, position, date of hire, work history, and any other respect) except for age.” Id.

            Moreover, pursuant to the PPA, “the accrued benefit may, under the terms of the plan, be expressed as an annuity payable at normal retirement age, the balance of a hypothetical account, or the current value of the accumulated percentage of the employee’s final average compensation.” Id. The PPA specifically provides that its amendments to ERISA, the Code, and ADEA shall not “be construed to create an inference” that pre-PPA benefit formulas were age discriminatory.

A New Landscape for Cash Balance Plans

            Between passage of the PPA and the Seventh Circuit’s decision in Cooper, the legal landscape for cash balance plans has changed dramatically. All cash balance plans were at risk under the district court’s decision in Cooper, as all cash balance plans credit interest in a manner similar to IBM’s plan. Cooper reverses the seminal case for a plaintiff’s age discrimination challenge to cash balance plans, one of only two district court decisions embracing that theory. The Seventh Circuit’s decision is critical not only because it repudiates the seminal pro-plaintiff district court opinion, but also because it expresses strong support for employers and their freedom to design pension plans according to their needs.

Nevertheless, although the Seventh Circuit joins the majority of district courts weighing in on the validity of cash balance plans, the legal battle over cash balance plans is far from over. Appeals from cases dismissing claims substantially identical to the plaintiffs’ claims in Cooper are presently pending in the Third and Ninth Circuits, and an internal split between district courts could soon bring the issue before the Second Circuit as well. Whether these appellate courts, or non-Seventh Circuit district courts, decide to follow Cooper remains anyone’s guess.

Moreover, the PPA provides definite cover for employers who wish to convert existing pension plans into cash balance plans in the future. But because the PPA is prospective in effect only, there remains some room for concern that courts could decide, despite the Seventh Circuit’s decision in Cooper and the legislative language forbidding courts from drawing a negative inference from the enactment of the PPA, that age discrimination existed in cash balance plans prior to the PPA. Thus, cash balance litigation may yet go on for years to come but August 2006 is clearly a turning point in the history of cash balance plans.