Corporate Update – Fall 2008
Companies across America are breathing a sigh of relief as the Second Circuit essentially ended any debate on whether hybrid pension plans known as cash balance plans are age discriminatory. Prior to 2006, many believed cash balance plans would be banned, but Congress amended ERISA to specifically allow for these hybrid-type plans. Congress left the question of what to do with cash balance plans created prior to 2006 in the courts’ hands.This left thousands of companies who created cash balance plans fearing class action lawsuits for lost pension benefits. But with last month’s ruling, the Second, Seventh, Sixth, andThird Circuit Courts of Appeal have all agreed with Congress, “cash balance plans do not inherently result in an age-based reduction…” (Circuit Judge Katzmann, July 9, 2008)
Without the fear of age discrimination, companies can look to reduce pension costs by converting their pension plans to cash balance plans. This article briefly examines why opponents of cash balance plans claim age discrimination, how cash balance plans typically reduce company costs, and what the differences are between cash balance, pension,and 401(k) plans.
ERISA allows for two basic types of retirement plans: defined contribution plans and defined benefit plans. A defined contribution plan operates by having a company and/or individual deposit a specific amount or percentage of money each year in an account for the exclusive benefit of an employee, but there are no promises of a set monthly benefit at retirement. The 401(k) is the most common type of defined contribution plan. A defined benefit plan, on the other hand, does promise a specific benefit. The amount is typically based on a formula that considers one’s salary and how long they have worked. The formula is set up to pay a premium on loyalty because the benefits accrued are small throughthe early and middle years, but quite large towards the end of a career. Because defined benefit plans promise a benefit based on a formula, the employee does not bear the risks of the stock market. Whereas with a defined contribution plan, the employer promises to contribute a specific amount, but the employees account will fluctuate up and down with the stock market and the employee will never know exactly how much they will have come time to retire.
A cash balance plan is a newer type of retirement plan and it is designed to combine the attributes of both a defined benefit and contribution plan.The Second Circuit described the typical cash balance plan:
Under a cash balance pension plan, an account is established in each participant’s name. Benefits are credited to that account over time, driven by two variables: (1) the employer’s contributions,and (2) interest credits. Employer contributionsare usually expressed as a percentage of salary,while interest credits are usually a fixed interest rate. Each year an employee receives a statement of her account balance, and can therefore see the value of her pension benefit according to these variables.
Thus, cash balance plans are often described as hybrid plans because they create a structure that simulates a 401(k) (e.g. setting up employee accounts and contributing a certain amount), but they also share characteristics of a traditional pension (e.g. there is a formula, the employee bears no stock market risk and is guaranteed a certain benefit).
The age discrimination controversy starts in that the law treats these two types of retirement plans very differently. When ERISA was created, a hybrid pension plan was not contemplated.ERISA says a retirement plan is either a defined contribution plan or is by default a defined benefit plan. Cash balance plans, although similar to a 401(k), do not meet the strict definition of a defined contribution plan, thus the law that governs defined benefit plans controls. This lawsays a retirement plan “shall be treated as not satisfying the requirements of this paragraph if,under the plan, an employee’s benefit… accrual is reduced, because of the attainment of any age.”29 U.S. § 1054(b)(1)(H)(i). This is a convoluted way of saying there cannot be age discrimination in the way the plan provides retirement benefits.
Plaintiffs have sued with some success claiming that cash balance plans reduced their benefit as their age increased and were thus age discriminatory.Their argument was two employees who are in the same company, at same rate of pay, only different in that the one who was older,would not get the same benefit. The older employee, despite receiving the same dollar contribution from the company, would get a smaller pension because the older worker is closer to retirement. The money contributed to the older worker’s account has less time to earn interest than does the money contributed on behalf of the younger worker’s account – with less time for the money to earn interest – the smaller the pension.
The Second Circuit joining the Third, Sixth, andthe Seventh found that ERISA governs against age discrimination based on what the employer actually contributes to the plan, not what the benefits add up to at the end of their employment. In other words, so long as an employer contributes the same amount for those similarly situated employees and provides the same rate of interest there can be no age discrimination.The Court held that “any difference in output [ascompared to input of contributions] as a result of time and… interest does not violate ERISA §204(b)(1)(H)(i).” While the holding becomes hyper-technical, citing in part, Congressional intent for what the rate of benefit accrual means, the core of the holding revolves around what an employer contributes cannot be age discriminatory. The fact that the ultimate retirement benefit might grow to be larger for younger employees, who have more time before retirement, is not relevant to the comparison of accrual rates and is not age discrimination.
The importance of this ruling cannot be understated. Companies of all sizes have shown significant interest in wanting to convert their traditional pension plans to cash balance plans tosave money but were weary of age discrimination class actions. Without that threat, more andmore companies will examine if such a conversationis right for them.
Expert studies have shown that companies that convert their traditional pension plans into cash balance plans can save 15 to 35 percent. Cash balance plans can often have lower administrative costs due to reduced record keeping, distributions of funds are simple, and they have preferential funding which can make the corporation money unlike the funding requirements of a401(k). Cash balance plans can also provide large tax-deductible contributions when compared to a 401(k) plan, but without the worker costs of a traditional pension plan. Cash balance plans can also be combined with a 401(k) plan.For employees, cash balance plans offer formulas that are not loyalty based. Under a traditional pension plan, most of the benefits do not accumulate until the end of the employee’s career. But under a cash balance plan, the benefits are earned more steadily throughout their employ. In addition, the employee can usually take earned benefits and transfer them to a new employer’s plan or roll it over into an IRA.
