Prohibiting Cash Balance Plans will Jeopardize the Retirement Security of Millions of Workers
Issue: In response to a changing workforce, some employers have begun using cash balance plans to provide guaranteed retirement benefits to their employees. These plans have benefited workers and employers by increasing benefits and reducing costs. Critics of these plans contend that cash balance plans illegally discriminate against older workers, are bad public policy, and should be prohibited by Congress. This contention is misguided because cash balance plans merely compensate employees for the time value of money for the period before they receive their benefits, as explained more fully below.
Background: Cash balance plans are defined benefit plans that combine the advantages of a 401(k) plan with the advantages of a traditional pension plan. The basic cash balance formula consists of a compensation credit and an interest credit. Compensation credits will end after a participant terminates employment but the interest credits will continue until the participant withdraws his or her benefit. Thus, the cash balance design very much mimics the salary contribution and investment return of a 401(k) plan. The most important difference, however, is that in a cash balance plan, the employer Enot the worker Emakes all of the contributions and assumes all of the investment risk.
An employer may choose to implement a new cash balance plan, but a significant number of cash balance plans have arisen from "conversions." In a conversion, an employer converts a traditional benefit plan into a cash balance plan. All benefits that have accrued under the traditional plan are protected and cannot be reduced. For some employees close to retirement, however, the cash balance conversion may upset future expectations. It is this change in expectations that has led to accusations of discrimination.
Cash Balance Plans Respond to the Needs of Employees. Employers have implemented cash balance plans in response to the changing demographics of the workforce. In a traditional pension plan, most of the benefit accrues close to retirement and tends to favor senior employees by rewarding longevity and increasing compensation. In a cash balance plan, however, benefits accrue evenly over a participant's career. For an increasingly mobile workforce, steady accruals under a cash balance plans provide greater benefits than under a traditional pension plan. Moreover, employers prefer cash balance plans because they reward all aspects of workers' contributions and not just seniority. Workers desire cash balance plans because of the similarities to 401(k) plans. Workers are more easily able to determine their benefit and understand the amount of their benefit at any point during their career. These benefits are more portable than benefits under a traditional pension plan and allow for an even accrual of benefits over the course of a worker's career.
Cash Balance Plans Offer a Secure and Guaranteed Retirement Income. Although cash balance plans embody many of the advantages of 401(k) plans, they provide an important feature that 401(k) plans do not Ea guaranteed benefit. In a cash balance plan, the employer must make sure that the plan has enough to pay out the workers accrued compensation and interest credits - even if the plan investments do not perform well. This is an added protection for workers over 401(k) plans because workers do not have to worry about investment risks or fluctuations in the economy.
Cash Balance Plans Increase Benefits for Most Participants. In a Watson Wyatt report from 2000, research indicated that 78 percent of participants enjoy bigger benefits under cash balance plans than under their employer's previous plan. Also, the report shows that cash balance and other hybrid plan conversions reduce costs by less than 1.5 percent. In addition, benefits are shared more evenly by all workers and not just those with longevity.
Cash Balance Plans Are Based Upon a Widely Accepted Financial Principal. Even the district court judge who ruled against cash balance plans acknowledged that, "From an economist's perspective [supporters of cash balance plans] have a good argument. A dollar today is worth more than the promise of a dollar a year from now." To nevertheless find that cash balance plans are age discriminatory is contradictory and completely untenable. A simple example demonstrates how this principle works in a cash balance plan.
Example: A 25-year-old and a 55-year-old deposit the same amount of money in the bank on the same day. Each earns the same amount of annual interest. After 10 years, each person has the same balance, and the older person -- then age 65 -- withdraws her money. The younger person waits an additional 30 years -- until she turns 65 -- and then withdraws her money. Of course, the amount of the younger person's withdrawal is greater, in absolute terms, than that of the older person because the younger person waited an additional 30 years before withdrawing his money, but it is not greater in terms of purchasing power. The bank has not discriminated against the older person; it has merely provided interest to protect the value of the account from eroding due to inflation. Cash balance plans provide similar inflation protection.
Federal Regulators Have Determined that Cash Balance Plan
are Not Inherently Age Discriminatory. The IRS
has given determination letters approving cash balance plans and has
issued guidance on correctly designing cash balance plans. Most
notably, the IRS, with input from the EEOC and DOL, issued proposed
regulations (67 FR 76123) specifically addressing the issue of age
discrimination in cash balance plans. The proposed regulations
discuss how cash balance plans can be designed so as not to be age
discriminatory and provide important protections for older workers
in a number of ways. By providing a blueprint for cash balance
to fit within the framework of the age discrimination rules, the IRS
rejects the contention that these plans are inherently age
discriminatory. The IRS has received public comments on these
regulations and intends to issue final regulations in the near
future. Prohibiting the IRS from continuing its work would
cause great harm to the employer-sponsored pension system by leaving
plan sponsors in a state of suspended uncertainty. Such an
outcome could cause plan sponsors to freeze or terminate their cash
balance plans thus leaving millions of workers without a guaranteed
private pension.
The Case Law Concerning Cash
Balance Plans is Conflicting and Should Be Resolved Through Treasury
Regulation. There have been several cash balance
plans litigated, but only two that specifically address whether the
plans are inherently age discriminatory.(1) In 2000, the
Southern District of Indiana ruled that cash balance plans are NOT
inherently age discriminatory.(2) However, another case
recently decided in the same circuit, refused to accept this
precedent. The Southern District of Illinois, with very little
analysis or reference to relevant authority, ruled that cash balance
plans are inherently age discriminatory even while recognizing that
any disparity in benefits was based upon the time value of
money.(3) It is likely that this ruling will be
appealed. Nonetheless, this current judicial conflict creates
uncertainty for sponsors of cash balance plans. Allowing the
IRS to complete its work on final regulations would provide
assurance for plan sponsors and the protection of guaranteed
benefits for workers.
Prohibiting Cash Balance Plans Would Have a Devastating Effect upon the Defined Benefit Plan System. This area of the law is extremely complex, and has involved countless hours of study and analysis by experts from the IRS and several other federal agencies. The number of workers covered by a cash balance plan has been steadily increasing even though the number of workers covered by defined benefit plans generally has been decreasing. The percentage of full-time workers covered by a defined benefit plan has dropped from 32 percent in 1996 to 22 percent in 2000. But of those covered by a defined benefit plan, the incidence of cash account plans has risen from 4 percent in 1996 to 23 percent in 2000. These numbers confirm that cash balance plans are becoming an increasingly larger part of the defined benefit system. To discourage the continuation of cash balance plans would destroy the most vital aspect of the defined benefit plan system.
We urge Congress to allow the IRS to publish final regulations on age discrimination to provide certainty for plan sponsors and participants.
Footnotes:
(1) Other courts have rejected claims
of age discrimination as applied to any part of a cash balance plan
(see, Goldman v. First Nat'l Bank, 985 F.2d 1113 (1st Cir. 1993);
Campbell v. Bank Boston, 327 F.3d 1 (1st Cir. 2003)) but have not
ruled on the inherent nature of the cash balance formula.
(2)
Eaton v. Onan Corp., 117 F. Supp. 2d 812 (S.D. Ill.
2000).
(3) Cooper v. IBM Pers. Pension Plan, No. 99-829-GPM
, 2003 U.S. Dist. LEXIS 13223 (S.D. Ill. July 31, 2003). This
case was decided under age discrimination provisions in the Employee
Retirement Income Security Act ("ERISA") without reference to the
Age Discrimination in Employment Act ("ADEA"). However, the
ERISA age discrimination provisions are very similar to the relevant
age discrimination provisions in the ADEA.