By PETER KNOPP, J.D.
From Best Practices in Compensation & Benefits

Employers creating retirement benefit plans should become familiar with the terminology of ERISA (the Employee Retirement Income Security Act of 1974), the law governing employee benefit plans. Under ERISA, employee benefit plans are either pension benefit plans providing retirement income, or welfare benefit plans providing medical benefits.

Under ERISA, there are two types of pension benefit plans: 1) defined-benefit plans providing employees retirement income for life, with earnings guaranteed by the employer, and 2) defined-contribution plans providing employees with individual accounts and lump-sum payouts, but no guarantee of earnings by the employer. The 401(k) plan, where the employee makes the contributions, is the most famous example of a defined contribution plan. The cash balance plan (CBP) creates a defined benefit plan that operates very much like a defined contribution plan. Advocates of CBPs say they create the best of both plans for the employee and save lots of money for the employer. Critics of CBPs say they’ll shrivel your pension (and maybe even harden your arteries).

Dissatisfaction with defined-benefit plans. In 1985, Bank of America surveyed its employees to see how its defined benefit plan looked through their eyes. It looked good to longtime employees who were getting close to retirement and the receipt of a vast retirement income for the rest of their lives. It didn’t even show up on the radar screen of young, mobile employees who were not planning to stay with the company until retirement. They perceived the plan to be, at best, the promise of retirement income in a far distant future. The amount of this income was doubtful to them because it seemed to be based on a complicated formula.

Bank of America realized that this group of workers comprised a significant portion of its workforce and that its
traditional defined benefit plan was not motivating them to do a better job. Therefore, the company created a new kind of plan, a CBP.

The cash balance plan. Under a typical CBP, each plan participant has a hypothetical account. Benefits are credited to this account on the basis of hypothetical contributions and interest rates. The contributions are usually a percentage of salary, the rate of which may vary on the basis of tenure or other factors. The interest rate may be fixed, but is usually tied to a particular index. To understand the current value of his benefits, an employee need only look at the amount of the current account balance. Once the employee is vested, he or she may take this amount in a lump sum when he leaves the company and reinvest it somewhere else.

There is certainly nothing unfair about a company with no pension plan at all starting a CBP. The charges of unfairness are heard when a company with a defined benefit plan converts to a CBP. The conversion is accomplished by amending the existing pension plan. Its results are, if not unfair, certainly fiscally unpleasant for older workers. The first step is the conversion of already earned pension benefits into a lump-sum equivalent amount. This amount becomes their initial account balance under the CBP. Assuming this can be done fairly, the older workers then proceed to receive the same percentage of their salary into the retirement account each year as younger workers receive. However, under the old plan they would have been credited with much more retirement income in their final years because the retirement benefit was calculated on the basis of what they would be earning in their last years of service. Salaries, of course, are higher in these last years. So, these older workers had expectations of huge retirement incomes. What they were to receive under the CBP seemed paltry in comparison, sort of like Coney Island in winter instead of Florida. In a post-Enron world, where stock options have enabled the company’s bosses to buy bunkers on the Mediterranean, a frustrated pension expectation is no joke.

The conversions - and the lawsuits - begin. By the mid 1990s, many large companies such as AT&T and IBM started the process of replacing their traditional defined benefit pension plans with CBP. Older workers protested that federal age discrimination laws were being violated. Protests escalated to lawsuits.

For instance, a cash balance conversion instituted by CIGNA Corporation in 1998 resulted in the filing of a lawsuit in December 2001. Recently, a federal district court in Connecticut certified the suit as a class action. The class is comprised of 10,000 present and former CIGNA employees. (See Hartford Courant, 1/3/03.)

The IRS calls halt to conversions. As a result of the controversy swirling around cash balance conversions, the Internal Revenue Service (IRS), in the fall of 1999, temporarily ceased issuing determination letters regarding the conversions. (A determination letter from the IRS effectively blesses the structure of a plan and certifies its tax-exempt status.) The IRS did this in order to allow time for a consideration of whether the conversions do, in fact, violate provisions in the Internal Revenue Code relating to age discrimination.

This moratorium has drawn protests from many quarters. For instance, the American Society of Pension Actuaries (ASPA) has argued that the IRS’s moratorium not only ended cash
balance conversions, but also inhibited many companies with no pension plans at all from adopting CBPs. (See ASPA News Release, 10/25/2002.)

The proposed regs. On December 10, 2002, the IRS issued new proposed regulations that are expected to become final in April of this year. The new regs lay out steps to be taken to accomplish cash balance conversions that avoid any violation of federal age discrimination laws. (See REG—209500-86 and REG—164464-02, 12/11/02.)

The regs provide, among other things, that companies will be permitted to make cash balance conversions that reduce the benefits of some older workers if:

1. Reasonable interest rates and mortality projections are used in calculating the beginning value of the new cash balance accounts created for these workers, and

2. The percentage of each worker’s paycheck that is contributed by an employer to the worker’s cash balance account each year is no less for older workers than for younger workers.

It is not clear whether older workers will still experience a negative impact (whether large or small) from conversions to CBPs under the new regs. A few things are clear, however. Federal pension law protects benefits earned to date, but not projected benefits. On the other hand, some companies making cash balance conversions voluntarily gave its older workers a choice between the old and the new plans. Some members of Congress have promised to try to make such a practice a requirement of federal law.