Recent Court Cases on Cash Balance Plans

Courts have recently decided a number of new cases involving cash balance plans. The issues involved are major, and the decisions, if upheld, could have drastic implications for all cash balance plans. This article analyzes the possible effects of the two most significant cases: Cooper v. The IBM Personal Pension Plan, 2003–2 USTC P 50,596 (D.C. S.D. Ill., July 31, 2003) and Berger v. Xerox Corporation Retirement Income Guarantee Plan, 338 F.3d 755 (7th Cir., Aug. 1, 2003).

Cooper v. The IBM Personal Pension Plan

IBM for some time has maintained a defined benefit plan that provides benefits for IBM employees. Since 1995, IBM has amended the plan twice. On January 1, 1995, IBM amended the plan to adopt a pension equity plan design. Effective July 1, 1999, IBM again amended the plan to create a cash balance plan formula.

The claimants argued that both the 1995 amendment and the 1999 amendment violated the age discrimination provisions of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). In each instance, the court granted summary judgment to the plaintiffs, finding that the amendments did violate the age discrimination provisions of ERISA. The court’s decision with respect to the amendment to a pension equity design may have relatively minimal impact, since it is based on provisions specific to the IBM plan. In contrast, the decision with respect to the amendment to a cash balance formula is much broader and more problematic. With respect to this latter amendment, the plaintiffs alleged that the cash balance formula violates Section 204(b)(1)(H) of ERISA which provides that “a defined benefit plan shall be treated as not satisfying the requirements of this paragraph 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.”

Under the cash balance formula, a participant’s defined benefit is determined by reference to a hypothetical account balance known as a Personal Pension Account (“PPA”). Each month, a participant’s PPA accumulates pay credits at a rate of five percent of the participant’s salary, and accumulates interest credits at a rate one percentage point higher than the rate of return on one-year Treasury securities. When a participant’s employment with IBM ends, he or she may withdraw the account balance as a lump sum, convert the account balance into an immediate life annuity, or defer receipt of a lump sum payment or a life annuity until a later date. While a terminated employee may not earn additional pay credits, he or she continues to earn interest credits until the PPA balance is withdrawn or converted into a life annuity.

The court began its analysis of the IBM cash balance amendment by noting that in 1998 IBM faced rising pension costs and diminishing pension income as a result of the benefits the company would be paying to its middle aged employees. The plan’s actuaries projected that conversion to a cash balance formula would save the company almost $500 million by 2009 as a result of reductions of up to 47% in future benefits that would be earned by older IBM employees. The court noted that IBM was aware of the age discrimination issues that would come with the new cash balance feature and that the company’s actuaries projected that the age 65 annuity benefit earned by a younger employee for a year of service would exceed the benefit earned by an older employee for the same service. The court also noted that, once implemented, the cash balance formula had its intended effect: plan income increased dramatically in 1999.

In reaching its decision that the cash balance formula violates ERISA, the court noted that, as amended, the 1999 plan is still a defined benefit plan and, accordingly, the plan must comply with all the statutory and regulatory strictures that govern defined benefit plans. The court stated that the mere fact that anomalies and absurdities arise in various arguments made by the plaintiffs does not undercut those arguments; the anomalies arise because cash balance plans simply do not work within the statutory framework governing defined benefit plans.

The court found that the amended IBM plan must meet the same requirements concerning vesting and accrual of benefits as any defined benefit plan: for each year of qualifying service, such a plan must provide a definitely determinable, nonforfeitable accrued benefit (ERISA section 203(a)). The accrued benefit must be expressed in the form of an annual benefit commencing at normal retirement age. Additionally, the interest credits that are projected and valued as an age 65 annuity must also be taken into account in determining whether a cash balance plan complies with benefit accrual requirements. This is where the court held that the cash balance amendment to the IBM plan violates ERISA’s age discrimination provisions:

Interest credits are a part of the accrued benefit specified in IBM’s 1999 Plan, and these count in determining whether the benefit accrual requirements of § 204(b)(1) are met. And, like in any defined plan, the interest credits must be valued as an age 65 annuity. At this point in the analysis, the result is inevitable. In terms of an age 65 annuity, the interest credits will always be more valuable for a younger employee as opposed to an older employee.

In light of the foregoing analysis, the court held that the cash balance formula violates the literal terms of ERISA section 204(b)(1)(H) as illustrated by IBM’s own age discrimination analysis:

A 49 year old employee with 20 years of service accrues at age 65 an annuity of $8,093 in the year 2000. The following year, he accrues an additional $622, and by 2010, his additional annual accrual is only $282. This 49 year old employee’s benefit has been reduced for each year he has aged, and this reduction violates ERISA § 204(b)(1)(H).

Berger v. Xerox Corporation Retirement
Income Guarantee Plan

The Xerox case involves what is commonly referred to as the “whipsaw” interest rate issue. As is the case with most cash balance plans, the Xerox plan provides for both pay credits and interest credits. Interest credits are made at the rate of the one-year Treasury bill rate plus one percent. The plan also allows participants to elect a lump sum or an annuity payable at retirement or at termination of employment. The plaintiff class consists of individuals who terminated retirement before normal retirement age and requested a lump sum. The claim is that the amount received was not the required actuarial equivalent of what the individuals would have received either as a lump sum or as an annuity if they had waited until normal retirement age to take the distribution. ERISA requires that any lump sum substitute for an accrued pension benefit must be the actuarial equivalent of that benefit.

The court identified the basic issue in determining the actuarial equivalence between a lump sum and an accrued pension benefit as the tradeoff between present value and future value; the method for equating present and future value is the application of a discount rate to the future value. Unfortunately, there is no single actuarial equivalence because there is no single discount rate. In the case of a defined benefit plan, the present value of the future pension benefit is relatively easily determinable through the use of prescribed mortality tables and interest rates.

In the case of cash balance plans, however, the situation is more complex. After a participant terminates employment, new pay credits are not added to his or her account; accordingly, the key issue is the addition of future interest credits. There is general regulatory and case law consensus that future interest credits are part of a participant’s accrued benefit under a cash balance plan. Accordingly, in order to determine a participant’s accrued benefit, a cash balance plan must add the future interest credits projected to normal retirement age to the participant’s cash balance account. The resulting balance, discounted at the prescribed discount rate back to the date on which the employee leaves the employ of employer and receives a distribution, would then be the correct lump sum to which the participant is entitled under ERISA. The Internal Revenue Service has provided guidance that in determining future interest credits projected to normal retirement age, a cash balance plan must use the plan’s interest crediting rate; in contrast, the discount rate for present value purposes is to be that set under Section 417(e) of the Internal Revenue Code (see Revenue Notice 96–8). If the interest crediting rate is higher than the discount rate, the effect can be significant: a cash balance plan, in such a circumstance, must pay more that the amount currently credited to the participant’s account.

The interest crediting rate under the Xerox plan is the one-year Treasury bill rate plus one percent; the prescribed discount rate at the time in question was the rate set by the PBGC. At times during the period in question, the plan’s interest crediting rate was significantly higher than the prescribed PBGC discount rate. However, the Xerox plan computed the lump sum by adding future interest credits at a rate exactly equal to the PBGC discount rate (instead of at the interest crediting rate set forth in the plan); the plan then discounted the resulting sum back at exactly the same PBGC discount rate. The two rates canceled, and the lump sum that departing employees received was exactly equal to their account balance.

The court held, in a decision written by Judge Posner, that the method used in computing the lump sum under the Xerox plan was a prohibited forfeiture. Xerox unsuccessfully tried to argue that its plan was not the sort of plan described under Revenue Notice 96–8, but rather a “hybrid” plan. Judge Posner summarily dismissed this argument by equating “hybrid” and “unlawful” in this particular circumstance.

Impact of the IBM and Xerox Cases

Taken together, the Xerox and IBM cases have the potential for a major impact on all cash balance plans.

The decision in Cooper v. The IBM Personal Pension Plan is very important because of the nature of the court’s reasoning, which would find all cash balance plans (new plans as well as conversions to cash balance plans) to be in violation of ERISA. IBM has stated that it intends to appeal the decision. If it does, the appeal will go to the Seventh Circuit, the circuit that just issued the Xerox decision. Presumably, if the decision were upheld, the only cash balance plans that would remain would be those that incorporate age-weighed factors for determining accrued benefits.

Important to note is the fact that the decision in Cooper v. IBM appears to be in direct conflict with an earlier federal district court decision: Eaton v. Onan, 117 F. Supp. 2d 812 (S.D. Ind, 2000). The earlier decision generally rejected a claim of age discrimination and held that rate differences for younger participants under a cash balance plan were permissible as long as accruals generally satisfied the rules of the Code and of ERISA. The court cited legislative history which seemed, in the court’s opinion, to indicate that the applicable age discrimination provisions in the Code and ERISA were aimed at post-retirement age participants. Moreover, the IRS in late 2002 issued proposed regulations (which were subsequently withdrawn) which also conflict with the IBM decision. The IRS has indicated that it will shortly issue new regulations.

Ultimate resolution of the issue at stake in the IBM case may take some time and may involve not only the Seventh Circuit, but also an appeal to the United States Supreme Court and clarification by Congress.

In contrast, the decision in Berger v. Xerox Corporation Retirement Income Guarantee Plan, although stated in forceful terms, is substantially narrower. The major impact of the case will be for those plans that do not provide interest credits and calculate lump sums distributed prior to normal retirement age in accordance with Revenue Notice 96–8.