Guest Article

(From the March 28, 2011 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Cash Balance Interest Credits that Stop at Early Retirement Age Do Not Violate the Prohibition Against Reducing Benefit Accruals on Account of Age

The Supreme Court has declined a request to review a decision of the Seventh Circuit Court of Appeals that upheld an interest crediting formula in a cash balance plan that stopped crediting interest when the participant attained age 55. The court held that the formula at issue did not violate ERISA § 204(b)(1)(H)(i) - which prohibits a defined benefit plan from reducing an employee's benefit accruals because of the attainment of any age - because it determined the interest credits were not benefit accruals in this specific situation.

Early Retirement Benefits Preserved

In 1997 the employer had converted its traditional defined benefit plan to a cash balance plan that provided two accounts for each participant . one account reflected only new benefits earned after the conversion date, and the other account (the "prior plan account") preserved the age 65 normal retirement benefit the participant had earned under the traditional defined benefit plan at the time of the conversion. The participants' early retirement options under the traditional defined benefit plan were preserved and standardized (using the most generous options) under the prior plan account in the cash balance plan. The unreduced age-65 normal retirement benefit could be paid as early as age 55. Participants could elect to receive their benefit earlier, but it would be discounted by 8.5 percent for each year before age 55. For each participant, the opening balance of the prior plan account was calculated as the actuarial equivalent lump-sum value of the participant's accrued benefit under the predecessor defined benefit plan, discounted by 8.5 percent per year for each year younger than age 55 the participant was at the time of the conversion.

After the conversion, a participant's prior plan account would be credited with monthly "pay credits" (at the rate of 4 percent per year) while the participant continued to work or the employer. Similarly, monthly "interest credits" would be credited to the prior plan account (at the rate of 8.5 percent per year) until the participant reached age 55. Once the participant reached age 55, the "interest credits" would cease. The employer explained the interest crediting formula in literature it distributed to the participants before the conversion.

Time Value versus Benefit Accrual

In 2004, the participants filed a suit claiming that the cash balance plan violated ERISA § 204(b)(1)(H)(i) because the prior plan accounts were not credited with "interest credits" after a participant attained age 55. They argued, based on an earlier Seventh Circuit decision, that the interest credits were benefit accruals and thereby covered under ERISA's prohibition against age discrimination. The earlier case held that benefit accruals refer to "the rate at which value is added (or imputed) to an account, rather than the annual pension at retirement age."

The Seventh Circuit distinguished its earlier decision and recognized a difference between interest credits in a cash balance plan that operates in a manner similar to a defined contribution plan, and interest credits in a cash balance plan that mimics a defined benefit plan. In the former, interest credits must be treated as benefit accruals, the court reasoned, "to avoid treating compound interest as age discrimination." In the latter case, however, interest credits cannot be considered to be benefit accruals "because they do not increase the total accrued benefit - the amount of the annuity to which the employee is entitled at normal retirement age."

Applying that further-refined reasoning to this case, the court noted "the mechanism of discounting the opening cash balance of employees under age 55 and then crediting back that discount until the employee reaches age 55 functions like an early retirement discount, never changing the accrued benefit at normal retirement age but reducing the benefit if employees choose to receive payment early." As a result, the court concluded that the interest credits were not "benefit accruals" and, therefore, involved no violation of ERISA § 204(b)(1)(H)(i).

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, Bart Massey 202.220.2104, Erinn Madden 202.220.2692, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Deborah Walker 202.879.4955. Copyright 2011, Deloitte.