GPSolo September 2007
LABOR AND EMPLOYMENT LAW
Cases and Issues in Cash Balance Plan Litigation
A cash balance plan is a defined benefit plan that possesses many of the characteristics of a defined contribution plan. Like a traditional defined benefit plan, participants do not typically contribute to these plans, and employers bear all investment risk. Like a defined contribution plan, however, a cash balance plan establishes an account for each participant, but that account is a hypothetical account for record-keeping purposes, whereas a defined contribution plan account reflects a participant’s beneficial share of the plan assets.
The most hotly contested issue involves what is known as the ‘whipsaw’ claim.
The “hypothetical account balance” looks like a § 401(k) account and is made up of two components: (1) a pay credit and (2) an interest credit on the account balance, which may be fixed or variable and tied to some index. Other characteristics that are often part of a cash balance plan include: (1) the benefit is somewhat “front-loaded” because the account balance earns compounding interest until the employee reaches normal retirement age; (2) the value of the hypothetical account balance is communicated to the employees at least annually; and (3) the benefit typically offered and paid is a lump sum upon termination.
In contrast, traditional defined benefit plans are typically heavily back-loaded because of a combination of factors: (1) benefits are tied to years of service; (2) for plans with early retirement subsidies, only those with substantial years of service qualify for those subsidies; and (3) many plans use “final career average pay” formulas that effectively tie the benefit to the pay earned in the final five to ten years of service. Also, traditional plans use a formula expressing the benefit in the form of an annual benefit commencing at normal retirement age. Thus, for those who are far from this age, the benefit that will be due can be calculated only by using significant assumptions regarding long-term future employment.
Legal challenges to cash balance plans. The vast majority of claims asserted against cash balance plans arise under the Employee Retirement Income Security Act (ERISA) and, to a lesser extent, the Age Discrimination in Employment Act (ADEA).
Many of the claims arising under ERISA are the result of accrued benefit issues. For example, ERISA § 204(g) prohibits an amendment converting a traditional defined benefit plan to a cash balance plan from decreasing the accrued benefit earned at the date of conversion. In order to comply with the ERISA provision, some cash balance plans offer a participant the greater of her cash balance benefit or her frozen accrued benefit under the traditional defined benefit plan. For some participants, the frozen benefit may be greater than the benefit under the new cash balance plan for a few years, which leads to a “wear-away” period of no benefit.
The most hotly contested issue in this accrued benefit area involves what is known as the “whipsaw” claim. This concerns whether and when the plan can pay the hypothetical account balance as the lump sum plan benefit at termination. Cash balance plans are typically designed to pay this benefit at termination, and this balance is also what is communicated to the employees as their benefit. ERISA, however, was not designed with cash balance plans in mind; instead, it is premised on the notion that in a defined benefit plan, the benefit due is an annuity beginning at the normal retirement age, typically age 65. This whipsaw issue has been raised in a number of the cases litigated to date. These cases stand for two basic propositions: (1) in determining the amount of a participant’s lump-sum distribution, the participant’s hypothetical account balance must be projected forward to normal retirement age and then discounted back to present value; and (2) if the interest credit rate is higher than the discount rate, distribution of the amount in the participant’s hypothetical account balance will cause a forfeiture under ERISA § 203(a) and a violation of the actuarial equivalent rules of ERISA § 203(e).
Pension Protection Act of 2006. The Pension Protection Act of 2006 addresses, on a prospective basis, several issues pertaining to cash balance and other hybrid plans, including, without limitation; (1) the rate of benefit accrual; (2) an interest requirement; (3) conversions; (4) elimination of the “whipsaw” effect; (5) vesting; and (6) mergers and acquisitions.
Since 1986 the Internal Revenue Code, ERISA, and the ADEA have contained parallel provisions prohibiting age discrimination in benefit accruals under a defined benefit pension plan by providing that “the rate of an employee’s benefit accrual may not be reduced, because of the attainment of any age.” The act makes it clear that hybrid plans will not be treated on a going-forward basis as violating the age discrimination provisions under the Code, ERISA, and ADEA if a participant’s “accrued benefit,” determined as of any date, would be equal to or greater than that of any similarly situated younger individual who is or could be a participant. To achieve this result, these statutes provide that, in determining whether a plan is age discriminatory, benefits may be calculated in ways other than as an accrued benefit, such as by using the balance of a hypothetical account or the current value of the accumulated percentage of the participant’s final average compensation.
The act further provides that in order to satisfy the benefit accrual rules, the interest credit under a cash balance or other hybrid plan cannot be at a rate that is greater than a market rate of return. A plan is permitted to provide for a reasonable minimum guaranteed rate of return or for a rate of return that is equal to the greater of a fixed or variable rate of return. Interest credits of less than zero cannot result in a participant’s account dropping below the aggregate amount of contributions credited to the account. The act permits the Treasury to issue regulations that will provide rules for calculating a market rate of return and may address some of these interest-crediting rules. Special rules concerning the interest rates and mortality tables apply upon a plan termination. Among other things, these rules require the averaging of interest rates over a five-year period ending on the termination date in the case of a plan that uses a variable rate.
The act effectively prohibits new hybrid plans from instituting a wear-away insofar as it requires that in a conversion to a cash balance plan the minimum benefit provided cannot be less than a participant’s benefit prior to the conversion plus the benefit earned after the conversion. In calculating the minimum benefit under the converted plan, early retirement benefits and retirement-type subsidies relating to preconversion service must be included if the partici-pant has met the requirements for entitlement to such benefit or subsidy. The act also calls for the Treasury to issue regulations designed to prevent plan sponsors from indirectly implementing wear-away provisions through multiple plans or amendments.
Addressing the whipsaw concern, the act eliminates whipsaw by allowing a hybrid plan to pay out a partici-pant’s account balance in a lump sum, provided that the plan uses a market rate of interest. The act also permits a plan to use a reasonable minimum interest rate without incurring a whipsaw problem.
Under the act, the cash balance or other hybrid pension plan must provide for three-year vesting with respect to the participant’s accrued benefit derived from employer contributions.
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This article is an abridged and edited version of one that originally appeared on page 19 of The Labor Lawyer, Summer 2006 (22:1). For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221 or go to www.ababooks.org.
Periodicals: The Labor Lawyer, journal, published three times per year; Labor and Employment Law, newsletter, published quarterly; substantive committee newsletters, published biannually.
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