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Converting To A Cash Balance Plan Can Be Risky Business

Over the past fifteen years, many companies have converted their traditional pension plans to cash balance plans. The Federal Reserve Board recently reported that approximately 25% of all participants in defined benefit plans and 40% of all defined benefit plan assets are in cash balance plans. Whether the decision to convert has been motivated by cost or the recognition of the current realities of the mobile workforce and the need for portable benefits, the prevalence of cash balance plans cannot be overstated.

Recently, the Plaintiffs' Bar has turned its sights on the impact that cash balance plans have on older workers. Class actions alleging age discrimination and other statutory violations have been waged against employers based on various aspects of their cash balance plans. Indeed, a recent decision from the Federal Court in the Southern District of Illinois, if not reversed on appeal, severely threatens the future of these plans.

In addition, other courts have rejected various cash balance plan designs, which have resulted in awards that have cost employers millions of dollars. How the courts have reviewed the issues regarding cash balance plans, the pitfalls to avoid in designing them, and the potential future for cash balance plans are the topics discussed in this article.

Defined Benefit and Defined Contribution Plans

The typical cash balance plan has some of the characteristics of both a defined contribution plan and a defined benefit plan. A defined contribution plan is a retirement plan (usually a profit sharing plan or a 401(k) plan) whose assets are generally comprised of employer contributions that are allocated to each participant's account based upon a percentage of that participant's annual compensation. These accounts are periodically adjusted to reflect investment gains (or losses) associated with the performance of the various investment vehicles selected.

Defined Contribution Plan Basics

Under a defined contribution plan, the risk of loss in the value of the employee's account is borne by the employee, unless the employer remains responsible for the investment of plan assets (very uncommon today).

Defined contribution plans are generally very simple for employees to understand, because the value of a participant's accrued benefit under such a plan is required to be provided periodically to the participant in the form of account statements (generally quarterly). Additionally, defined contribution plans permit portability when an employee moves to another employer by allowing the participant to roll over a distribution (usually a lump sum payment) into another defined contribution plan or individual retirement account.

Defined Benefit Plan Basics

Alternatively, a defined benefit plan has traditionally provided a participant with the payment of a set sum of money every month after retirement. This amount is in the form of an annuity that is usually determined by taking an employee's final average salary over the last year or years of his or her employment and multiplying it by a factor that is based on the employee's years of service. That being the case, benefits provided under a traditional defined benefit plan are not readily portable.

Also, benefits under a defined benefit plan are generally insignificant for employees who do not intend to stay with the same employer for an extended period. Still, under a defined benefit plan, the employer bears the risk of loss in the value of plan assets.

Cash Balance Plans

Cash balance plans were developed in an attempt to achieve the advantages of both defined contribution and defined benefit plans. Under a cash balance plan, a hypothetical account is created for each employee. This account consists of hypothetical contribution credits that are based on some objective criteria the plan sets (such as a percentage of the employee's salary), and a hypothetical interest credit (either a fixed or variable rate).

The individual account is hypothetical because the employer does not actually set money aside in individual accounts, but rather pools the funds with those of the other participants. Cash balance plans incorporate certain advantages of defined contribution plans that include the participant's receipt of periodic statements showing his or her account balance, and the portability of benefits from the account.

However, because these plans are defined benefit plans, the employer guarantees each participant's benefits, thereby adopting that critical aspect of defined benefit plans.

Do Cash Balance Plans Violate ERISA?

Under the Employment Retirement Income Security Act ("ERISA"), a defined benefit plan "must provide for a definitely determinable, non-forfeitable, 'accrued benefit.'" In addition, a plan violates ERISA if "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." Just this past July, a federal court, in applying these ERISA requirements, found that the cash balance plan IBM instituted discriminated against participants based on their age.

In Cooper v. IBM Personal Pension Plan, IBM's cash balance plan required the company to credit benefits into each participant's hypothetical account based on "pay credits" (5% of the employee's salary), and "interest credits" (set at a fluctuating rate of one percentage point above the interest bearing on one-year treasury notes). When a participant's employment with IBM ended, either at retirement or before, the participant could then elect an immediate lump-sum distribution, convert the balance into an immediate life annuity, or defer the lump sum or annuity until a later date. Further, although pay credits would cease as of the date the participant's employment with IBM ended, the participant would continue to earn interest credits until the benefits were withdrawn.

The lawsuit in Cooper was brought by a class of employees who claimed that the cash balance plan discriminated against them on account of their age, in violation of ERISA. Finding in favor of the Plaintiffs, the Court held that any accrued benefit "must be expressed in the form of an annual benefit commencing at normal retirement age," and that the interest credits earned under the plan "are a part of the accrued benefit," and must therefore comply with the benefit accrual requirements of ERISA. Under this reasoning, the Court stated that as the "interest credits must be valued as an age 65 annuity," and as the interest credits would always be more valuable for a younger employee than an older employee," the "result is inevitable." Therefore, the Court concluded that the plan violated the literal terms of ERISA, because an employee's benefit accrual from interest credits was reduced for each year of the employee's age.

This holding is premised upon the unremarkable fact that money invested for a longer period earns more interest. That is, when valuing the interest credits as an age 65 annuity, the interest credit earned in the previous year will always be more valuable than the interest credit earned a year later, simply because the interest credit earned in the following year will have one less year to accrue value before the age 65 cutoff date. Indeed, the Court recognized this point, but determined that as a defined benefit plan such a method of benefit accrual violated ERISA.

Adoption of Cash Benefit Plans

Although IBM intends to appeal this decision, its impact upon cash balance plans is dramatic. More than 400 major companies have adopted cash balance plans, and, if these plans are illegal, the economic repercussions would be staggering. But even if IBM were to prevail on appeal, there are several other pitfalls affecting the viability of cash balance plans under ERISA.

[The case was appealled to the 7th Circuit. The district court's decision was reversed, and the case was remanded with directions to enter judgment in IBM's favor. The U.S. Supreme Court declined to hear an appeal from the 7th Circuit decsion. ]

Other Issues Affecting Cash Balance Plans

The "Whipsaw"

Aside from the Cooper decision, cash balance plans also have been subject to attack on other fronts. For example, a number of courts have looked at the issue of what has been coined the "whipsaw". As the Second Circuit explained:

In brief, distributions from defined benefit plans are framed in terms of the normal retirement benefit - typically, a single life annuity payable at normal retirement age. Any distribution in optional form (such as a lump sum) must be no less than the actuarial equivalent of such benefit. For a cash balance plan, this calculation involves projecting the cash balance forward and then discounting back to present value. The projection rates may be defined by the plan, but the discount rate is prescribed by statute.

If the plan's projection rate exceeds the statutory discount rate, then the present value of the accrued benefit will exceed the participant's account balance. Unless this higher figure is paid out, the IRS takes the view that an impermissible forfeiture has occurred in violation of ERISA § 203(a) and IRC § 411(a)(2). Esden v. Bank of Boston, 229 F.3d 154, 159 (2000).

In other words, a participant's actual account balance at any moment in time before normal retirement age will always be less than the discounted sum of the cash balance projected to normal retirement age whenever the interest credit applied to the account is greater than the statutory discount rate. For example, consider the final balance in an account that has accrued interest credit calculated at 10% per year up to normal retirement age.

Next, consider discounting that final balance at less than 10%, and one can readily discern that the discounted balance will always be greater than the actual balance in the account at any given time. This is the "whipsaw," and a plan that pays out an early lump-sum distribution based upon the actual balance in the account, instead of the discounted cash balance projected to normal retirement age, will most likely be found to have effected a forfeiture of the participant's accrued benefits in violation of ERISA.

In Esden , the cash balance plan set one rate of interest credit for account balances and a lower rate for determining the value of lump-sum distributions. The purpose in applying this different rate was to prevent a "whipsaw" by assuring that the lower interest credit projected forward would always be less than the statutory rate used to discount the projected balance to present value. The difficulty with this approach, however, was that the plan used different rates of interest depending upon the election a participant selected.

The court held that the effect of this resulted in a forfeiture of an accrued benefit that the participant would have otherwise retained. That is, in conditioning the right to receive additional interest credits upon the type of distribution the participant elected, the plan violated the forfeiture provisions of ERISA.

Exposure Can Amount to Millions

Although the difference between the sum the courts hold should be distributed to a participant and the one a plan issues in "whipsaw" cases is usually not very large, the exposure can amount to millions of dollars when considered in the context of a class action law suit.

In one case, the class plaintiffs obtained a $300 million judgment as a result of the plan's use of a different interest credit on early distributions, which was affirmed on appeal (subject to some reduction due to the lower court's use of an incorrect discount rate). In another case where the class plaintiffs were seeking approximately $20 million, the court held that the plan's early lump-sum distributions, which equaled the participant's hypothetical account balance instead of the discounted values of the benefit each participant would have received at normal retirement age, violated ERISA.

How to Avoid a Whipsaw Problem

Surprisingly, an employer can avoid the "whipsaw" problem by simply designing its plan so that the rate of the interest credit applied to account balances equals the statutory discount rate. Under this approach, the two rates would cancel each other, thereby making the current account balance equal to the discounted benefit a participant would receive at normal retirement. The problem that the plans in the referenced decisions had was that they sought to guarantee a higher interest credit on account balances; in other words, they sought to increase the overall retirement benefits participants would receive.

But, by setting a higher interest credit than the statutory discount rate, the plans were then required to pay early lump-sum distributions based on the discounted value of the benefit accruing to normal retirement age at the higher rate; by applying a lower interest credit on those distributions, the plans violated ERISA.

Front- and Back-loading - Traditional Methods of Accruing Benefits

Another difficulty with cash balance plans involves the two traditional methods used to accrue benefits. Indeed, the use of one of the methods, known as "front-loading", led the court in the Cooper case discussed above to find that the plan discriminated against participants based on their age. Essentially, "front-loading" occurs when the future compounding of the interest credit is reflected in the account balance in the year the credit is earned. This method arguably decreases the accrual of benefits as the participant ages, and, according to the court in Cooper , is in violation of ERISA's age discrimination provisions.

The other means to accrue benefits is known as "back-loading," which occurs when interest is credited each year as it is earned. Under this formula, interest credits rise each year as a result of the increases in the account balance from previous accruals. Over time these increases can violate the provision in ERISA that prohibits the value of the benefit accrued in any year to exceed the value of a benefit accrued in any previous year by more than 33%.

While these two methods of accruing benefits are not unique to cash balance plans, the problem that they cause is a function of the fact that cash balance plans do not fit neatly within the current accrual rules under ERISA, which were geared to the traditional defined benefit plan wherein benefits are based on a participant's "career average pay" and "final average pay" formulas. Whether cash balance plans will be able to adjust to these roadblocks may ultimately depend upon the position taken by the U.S. Treasury with respect to these issues.


Yet another troublesome issue with cash balance plans is what is known as "wear-away." Wear-away can occur in plan conversions where the beginning hypothetical account balance is less than the benefit a participant has accrued under the plan prior to its conversion. Because ERISA prohibits the loss of an accrued benefit, each participant remains entitled to the accrued benefit as long as it is greater than the hypothetical account balance. This can result in a period of time (perhaps even several years) where a participant accrues no additional benefit until the difference between the hypothetical account balance and the accrued balance under the plan prior to its conversion "wears away."

Attacks have come from many fronts on this issue. For instance, wear-away chiefly impacts older workers, because they are more likely to have larger accrued benefits under the plan prior to its conversion, thereby lengthening the wear-away period. Thus, allegations of age discrimination have been presented that are based on the notion that wear-away impacts older workers in a disparate fashion. Courts that have considered this issue, however, have held that disparate impact is not available under the Age Discrimination in Employment Act ("ADEA").

Claims also have been raised that wear-away causes a loss of accrued benefits in violation of the anti-cutback provisions of ERISA. Courts have generally dismissed those claims, however, on the grounds that the conversion to another plan has only reduced expected, and not accrued benefits.

Claims Under the ADEA

While attacks on cash balance plans for violating ERISA provisions have met with some success, age discrimination claims under the ADEA have not been as fruitful. Although few courts have considered whether adopting such plans constitutes intentional age discrimination, those that have addressed the issue have found little support for such claims.

Further, whether cash balance plans will survive the claim that they adversely impact older workers has not been put to the test by the few circuits that recognize such a cause of action under the ADEA, i.e., the Second, Eighth and Ninth Circuits. Instead, only the circuits that do not recognize this theory have had to address it, and they have predictably found the claims devoid of merit.

Success for an ADEA Claim

The prospects for the success of an ADEA claim are hampered by several facts. First, demonstrating that an employer instituted a cash balance plan in order to discriminate against older workers may prove extremely difficult in view of the fact that the decision to adopt or convert to such a plan is often supported with documents that establish a vast array of reasons for the action other than age, e.g. lowering costs, providing a more understandable plan and enticing those who seek more mobility in their career options.

Second, it is undisputed that employers are neither required to establish any type of plan, nor prohibited from altering, freezing or terminating an existing one. As such, it appears incongruous to claim that a cash balance plan that applies the same pay and interest credits to all participants either was intended to discriminate or has the effect of discriminating against older workers when the employer was not required to have a plan in the first instance. Nevertheless, although the Cooper decision discussed above was premised upon ERISA, an ADEA claim could likely have equal success for plaintiffs under that court's analysis.


Aside from the present view of the courts on the impact of ERISA and the ADEA on cash balance plans, it appears that a perfect storm is brewing among the Executive and Legislative Branches, and influential lobby groups with respect to them. For, although the U.S. Treasury Department has promised that it will issue rules before the end of the year in support of cash balance plans, the inundation of lobbyists upon Congressional members has placed that prospect in doubt.

At the time of this article, the House approved a bill to block funding on the Treasury's work on these rules by a significant margin, and if the upsurge from these lobby groups can sway the Senate to do the same, even a presidential veto may not keep the Treasury's efforts afloat.

At the very least, the House's action on this issue bespeaks of the influence of these groups that disapprove of cash balance plans. Further, the IRS has placed a moratorium on issuing determination letters on converted cash balance plans until the Treasury's rules come out.

In summary, converting a traditional defined benefit plan to a cash balance plan at present bears a significant risk and employers who are contemplating such a step are strongly advised to have it reviewed by their counsel. Employers who currently maintain a cash balance plan or are contemplating instituting one are encouraged to do likewise.

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