Cash Balance Plans — A Clearer Future?

The recently enacted Pension Protection Act of 2006 (“PPA”) provides important new provisions clarifying the legality of cash balance plans and certain other types of “hybrid” retirement plans. In addition, the U.S. Court of Appeals for the Seventh Circuit issued a recent decision holding that IBM’s cash balance plan — and the cash balance formula generally — was not inherently age discriminatory, as participants have alleged with some success in numerous cases. But while Congress and the Seventh Circuit have breathed new life into the cash balance approach, and the IRS has announced that it will finally begin processing some of the 1,200 cash balance plan determination letter applications that have accumulated at Treasury since the Service imposed a moratorium on cash balance plan rulings in 1999, other recent court rulings make clear that pre-PPA cash balance plans are not immune from legal challenges.

The PPA cash balance provisions are generally effective as of June 29, 2005, and the Act expressly provides that no inference should be drawn as to the legality of cash balance plans prior to the effective date. The key provisions are as follows:

  • Age Discrimination

    The Act establishes that cash balance plans are not age discriminatory, provided that:

    • interest credits do not exceed a market rate of return (effective for plan years beginning in 2008 or later); and
    • a participant’s accrued benefit — which the law permits to be expressed as a hypothetical account balance, an annuity payable at normal retirement age, or the current value of the accumulated percentage of the employee’s final average compensation — is not less than the accrued benefit of any similarly situated younger employee. In determining a participant’s accrued benefit for this purpose, subsidized early retirement benefits are ignored.
  • Vesting

    A cash balance plan must provide for 100% vesting within three years (effective in 2008).

  • Wearaway

    The Act prohibits wearaway of benefits for cash balance conversions that occur after June 29, 2005, by requiring that a participant’s accrued benefit under such a plan be not less than the sum of:

    • his accrued benefit under the old plan terms for years of service prior to the amendment; plus
    • his accrued benefit under the amended plan terms for years of service after the amendment.

    In determining the amount of a participant’s benefit prior to the conversion, the amount of any early retirement benefit or retirement-type subsidy for the plan year in which the participant retires must be taken into account if, as of that time, the participant has met the age, years of service, and other requirements under the plan for entitlement to the benefit or subsidy.

  • No Whipsaw

    The Act allows cash balance plans to pay lump sums that are equal to a participant’s hypothetical account balance, if the plan so provides. Thus, properly drafted plans will not have to perform a whipsaw calculation prior to paying out lump sum benefits. This provision takes effect on August 17, 2006.

The Seventh Circuit decision in Cooper v. IBM Personal Pension Plan and IBM Corporation on August 7, 2006¹, gave cash balance plan advocates even more reason to smile. The court reversed a lower court ruling that had held that the essential cash balance plan formula discriminates on the basis of age because younger participants who remain in the plan longer will necessarily receive more interest credits than will older participants who are closer to retirement age, and therefore the older participants’ “rate of benefit accrual” was reduced because of age. The Seventh Circuit categorically rejected this reasoning and concluded that the key statutory term “rate of an employee’s benefit accrual” referred to what an employer put in to the plan each year for a participant’s benefit, and did not refer to the amount that the participant would receive upon retirement, after many years of accruing interest credits. Any difference in “accrued benefit” for two participants who were exactly alike except for age could only be attributed to the time value of money which, the court held, was not illegal.

While the Cooper decision was written by the influential chief judge of the Seventh Circuit, Frank H. Easterbrook, in his uniquely accessible style, the fact that it is binding only on courts within the Seventh Circuit (comprising Illinois, Indiana and Wisconsin) was made clear by a decision this fall from a federal district court in New York. While Judge Easterbrook had written that “rate of benefit accrual” referred to “inputs” by the employer — and therefore a plan that provided the same initial input for similarly situated employees (but for age) did not discriminate when the time value of money resulted in a greater benefit for the younger employee — Judge Harold Baer of the Southern District of New York reached precisely the opposite conclusion in In re J.P. Morgan Chase Cash Balance Litigation,² and wrote that “rate of benefit accrual” refers to “outputs from the Plan,” i.e., the rate at which a participant accumulates retirement benefits, expressed as an annuity payable at normal retirement age. Because “outputs” were necessarily lower for older employees, who did not have as many years to retirement in which to accumulate interest credits, Judge Baer held that the J.P. Morgan Chase plan violated ERISA’s anti-discrimination provision. Until other circuit courts, or the U.S. Supreme Court, clarify the issue, sponsors of pre-PPA cash balance plans will have to contend with uncertainty about whether their plans violate ERISA’s anti-discrimination provision.


¹ 457 F.3d 636

² 2006 WL 3063424