When cash balance plans were first developed in the 1980s, plan sponsors were immediately drawn to them, says Alan Glickstein, a senior retirement consultant with Willis Towers Watson in Dallas.
“As many as 30% of large plan sponsors gravitated to them,” he says. “The thing that makes cash balance plans attractive is their simplicity. It is hard for a young person to relate to an annuity in a traditional pension plan. For the same reason that 401(k) plans have become so popular, with a cash balance plan, everyone knows how much is in their account. For many companies and participants, that transparency is crucial, and if you leave the company, the cash balance plan account is portable.”
Kevin Wagner, a senior retirement consultant with Willis Towers Watson in Detroit, adds: “If you go back 30 years, every defined benefit plan was a traditional pension plan.
However, nearly as soon as cash balance plans were developed, participants began suing them, with the majority of the cases based on age discrimination. With cash balance plans, plan sponsors set an interest crediting rate for accounts. “The plaintiffs said, if you look at the investment horizon of a 20-year-old and a 40-year-old, each of whom will retire at age 65, the 20-year-old has a 45-year trajectory for receiving interest, while the 40-year-old has only 25 years, so you are discriminating by age,” says David Godofsky, a partner and head of the employee benefits and executive compensation group at Alston & Bird in Washington, D.C.
When the Pension Protection Act (PPA) was passed in 2006, it specifically said that as long as the rate of interest you are delivering to the participants is not higher than the market rate, then you are not discriminating by age, Godofsky says. “If you had a guaranteed higher rate of interest, the degree to which it would be worth more for the 20-year-old than the 40-year-old is, in fact, age discrimination,” he says. “Shortly after the PPA was passed, appellate courts started saying that age discrimination doesn’t make any sense because the accounts are just receiving compound interest. If Congress had never passed the PPA, the courts would have eventually solved the age discrimination problem anyway, but the PPA came in with a clear solution.”
NEXT: Addressing other types of lawsuits
The second type of lawsuit that cash balance plans faced before the passing of the PPA was what is known as the “whipsaw” effect, which essentially had to do with how the beginning balance transferred from the traditional pension to the cash balance plan is calculated, says Daniel Schwatz, an employee benefits attorney and officer in the employee benefits practice group at Greeensfelder, Hemker & Gale, P.C. in St. Louis. He explains: “The PPA said that as long as the plan uses the market interest rate to calculate the balance, and not a higher interest rate, then the whipsaw effect is eliminated.”
Godofsky adds: “Shortly after cash balance plans came into existence 30 years ago, the Internal Revenue Service (IRS) issued guidance that said you may not be able to pay an individual in a cash balance plan a lump-sum equal to their account balance. Their logic was that there is a minimum lump-sum rule in the Employee Benefit Security Act (ERISA) and the Internal Revenue Code (IRC). The IRS said the lump-sum must be computed with a mortality and interest rate so that participants are not lured into taking a lump-sum that is lower than the annuity. The idea behind whipsaw is to take the balance and convert it into an annuity and then back to a balance, and if that number is greater than the original account balance, you have to pay them the larger amount.”
A third breed of lawsuits that cash balance plans faced regarded what is called “wear away,” which dealt with the transition from traditional pension plans to cash balance plans, says Jon Waite, chief actuary and director on the advisory team at SEI Institutional in Oaks, Pennsylvania. “The wear away happened when plans transitioned from a traditional pension plan to a cash balance plan,” Waite says. “Employers said, ‘We will give you and account balance to start off in your new cash balance plan, and it will be the better of the benefit in the frozen plan or the cash balance plan. Of course, the frozen pension plan would have a much higher balance, so you ended up with participants who, for several years, accrued no benefit because they were catching up to the old balance. The PPA came in to fix that anomaly by mandating that the frozen benefit be converted to an account balance plus new accruals so that everyone receives some accrual each year.”
Particularly by permitting cash balance plans to convert the hypothetical account balance into benefits other than a lump-sum, the PPA has successfully eradicated lawsuits against the plans, says Robin Schachter, a partner with Akin Gump Strauss Hauer & Feld LLP in Los Angeles. “That provision in the PPA resolved a lot of issues for both plan sponsors and participants and reduced a lot of litigation and uncertainty,” he says.
While the PPA essentially negated these three types of lawsuits against cash balance plans, there is a fourth type that these plans have faced that cannot be legislated, Schwartz says, and that is the failure to properly communicate to participants how their traditional pension plan is being converted to a cash balance plan. “It would be very difficult to legislate how you put this in your benefit materials,” he says. “While the other types of cash balance plan lawsuits—very technical cases dealing with age discrimination and conversion rights—have essentially disappeared since the passing of PPA, there could still be lawsuits alleging that a benefit was taken away without proper explanation,” and this is an area of which plan sponsors and their advisers need to be mindful.