Guest Article

(From the July 20, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Five Years of Service is a Permissible "Normal Retirement Age" for Cash Balance Plan

In what appears to be a case of first impression, the 7th Circuit Court of Appeals ruled that a cash balance plan was permitted to define "normal retirement age" as the completion of five years of service in order to avoid a "whip saw" calculation of the participants' lump sum benefits. The case involved plan language that was in effect in 2003 and, therefore, did not address the validity of the 2007 Treasury Regulations that now restrict a plan's ability to define normal retirement age as lower than age 62. The distribution at issue also occurred before August 17, 2006, the effective date of new PPA rules explicitly eliminating the whip saw calculation for certain cash balance plans.

Participant Expected a Whip Saw Calculation

In Fry v. __________, No. 08-1135 (7th Cir. July 2, 2009), a 55-year-old participant terminated employment in 2003 and elected a lump sum distribution that year from his employer's cash balance plan. The participant expected his hypothetical cash balance to be increased by the interest that would have been credited under the plan until he would have reached age 65, and then discounted to a present lump sum value based upon the 30-year Treasury rate in effect for the month before the distribution.

Instead, he was simply paid the amount of his hypothetical account balance at the time of his termination. Internal Revenue Code (IRC) § 411(a) generally requires that a participant's lump sum benefit be actuarially equivalent to the pension payable at normal retirement age -- and, therefore, that the "whip saw calculation" be done. However, the plan's terms defined "normal retirement age" simply as five years of service (i.e., the plan's vesting date) without referencing a specific age (e.g., 65). As a result, the participant's virtual account balance at the time of his termination was also the value of his lump sum benefit.

The Court recognized the dilemma created by the "whip saw calculation:"

Not wanting to recognize the plan's unique definition of "normal retirement age," the participant sued in Federal District Court in the Northern District of Illinois claiming that his $500,000 hypothetical account balance should have been credited with interest credits though 2013 (when he would have reached age 65), and then discounted to present value using an interest rate of 5.16% (the 30-year Treasury rate in effect the month before he retired). The participant argued that ERISA Å 3(24) and its parallel provisions in IRC § 411(a)(8) prohibit a plan from defining "normal retirement age" as simply five years of service. The court denied the claim and held for the plan. The participant appealed to the 7th Circuit Court of Appeals.

Court of Appeals Upheld Plan Terms

First off, the Court of Appeals noted that the Pension Protection Act (PPA) of 2006 eliminated the need for a "whip saw calculation" effective for distributions made after August 17, 2006. Under the PPA, new IRC § 411(a)(13) and its parallel provisions in ERISA § 203(f) allow a plan that computes its accrued benefits by reference to a hypothetical account balance to treat the hypothetical account balance as the present value of the benefit. The current case before the Court arose before the PPA was enacted, however. The Court acknowledged that prior to the PPA many plans applied a "self-help fix" in order to eliminate the problematic "whip saw calculation," and the employer's plan was one of them. The plan's definition was clearly designed to work around the augment-and-discount process that has been required prior to the PPA.

The participant argued that the plan's definition of "normal retirement age" as five years of service was invalid both because it failed to designate an age and it was not normal. The Court quickly rejected both arguments. It explained that a formula that defines normal retirement age as the participant's age when first employed plus 5 years of service would constitute an age. It also explained that in 2003 there were no operative restrictions on how a plan could define normal retirement age -- that an age is a "normal retirement age" because the plan makes it so.

Treasury Regulations issued in 2007 did, in fact, impose restriction on how a plan could define normal retirement age. Effective May 22, 2007, the normal retirement age must not be earlier than the earliest age that is reasonably representative of the typical retirement age for the industry. A safe harbor is set at age 62. If an age younger than 62 is designated as the plan's normal retirement age, all of the facts and circumstances are examined to determine whether that age is representative. The employer's good faith determination is given deference if the normal retirement age is set no lower than age 55. Ages younger than age 55 will not be given deference, and the employer must demonstrate to the Internal Revenue Service that such a designated age is reasonably representative of the retirement age of the industry.

The Court observed that the 2007 Treasury Regulations, by their terms, did not become effective until May 22, 2007 -- and that the preamble acknowledged that the employer's choice of the normal retirement age had been honored in pre-2007 years. As a result, the plan's calculation of the participant's lump sum benefit -- which did not include a "whip saw" adjustment" -- was upheld as consistent with the valid plan terms, which defined "normal retirement age" as five years of service.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Deborah Walker 202.879.4955. Copyright 2009, Deloitte.