Guest Article

Proposed IRS Regs Are Balanced Response to Cash Balance Plans

By Alvin D. Lurie

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Like a breath of spring air amidst the wintry blasts of December, the IRS proposed new rules for cash balance plans in mid-December that, if adopted, promise to thaw the deep freeze in which cash balance pension plans have been captured for the past three years, ever since the employees of IBM, using the company's vaunted intranet system, unleashed a storm of protest against the proposed conversion of the IBM defined benefit plans into cash balance plans. The employees' argument was the conversions were a form of unlawful age discrimination, because they would hit older employees when they were most vulnerable, as they approached their retirement age, by slowing, if not halting, the then anticipated escalating increments in their pension benefits.

Pejorative words like "wear away" and "plateau effect" came into common parlance, to describe the cap on disproportionate benefit growth that was a function of the typical final-average benefit design commonly in use in defined benefit plans, but not cash balance plans. The result was a flurry of critical - if not hostile - articles in the press (most especially the Wall Street Journal), flaming oratory and a welter of restrictive bills in the Congress, and a tent-circling mentality in the administrative agencies, culminating in a refusal by the IRS to issue determination letters approving the tax qualification of such conversions "pending study". Indeed, it appeared inevitable that constricting legislation would be enacted late last year, until the Enron frenzy engulfed all other pension concerns of the Congress and the Administration.

Since then cash balance plans have been in a state of suspended animation, waiting for one or the other shoe to drop. Suddenly, with the issuance of a proposed regulation by the Service on December 12th last, it appears that no shoes may drop after all. The long freeze might be about to end, because the Service will presumably, after the new rules become final, resume issuing determination letters in case of cash balance conversions, notwithstanding reductions or wearaways of benefits that might occur on the occasion of conversions from a defined benefit plan, so long as the calculation of converted benefits is predicated on the use of reasonable interest rates and mortality projections.

Cash balance plans are a curious kind of hybrid plan, looking for all the world like a defined contribution plan in their year-by-year aggregation of compensation-based credits, to which are added interest credits projected forward to normal retirement date, to calculate participants' notional account balances. However, these sums produce a defined benefit (there is no actual individual account balance, only a "notional" one), that is not subject to actual fluctuations of interest rates or vagaries of the stock and bond markets. So the plan is treated for tax and other purposes as a defined benefit plan under the rigid dichotomy of the pension rules dictating that if a plan is not an individual account plan, it must be treated as a defined benefit plan.

Most notable among the troublesome questions resolved by the proposed regulations was repudiation of the notion that a cash balance plan essentially cannot satisfy the age discrimination prohibitions of the Internal Revenue Code and ERISA because of a characteristic of such a plan that is inherent in its design, resulting in shrinking interest credits with each passing year. It is to be noted that this characteristic is not a function of a participant's increasing age with the approach of retirement, inasmuch as the interest credits for a 25 year old will likewise represent a smaller percentage of pay credits than those of a 24 year old.

It is thus difficult (impossible, I would submit) to make the argument, as opponents of cash balance plans have done, that the progressive shrinkage of interest credits has the effect of discriminatorily depressing the benefit accrual rates of older participants just because each successive year's credit decreases by one year's worth of interest with decrease of the interval between the crediting of interest and the attainment of retirement age. One could as well call the increasing probability of death with advancing age a manifestation of age discrimination. It appears that the IRS agrees that age discrimination, within the meaning of the governing statutes, is not involved in this time-value mathematical function, as long as the pay credits themselves are not a smaller percentage of salary of older workers than of younger workers.

Under the division of agency authority established by Reorganization Plan No. 4, these Treasury regulations will be dispositive of the parallel discrimination provisions in ERISA and ADEA. However, no reliance on the newly proposed regulations has been provided until they are finalized. When that occurs, it is to be expected that increasing numbers of employers will soon adopt, or resume sponsoring, pension plans of the cash balance design, as distinguished from 401(k) plans, thus providing protection against the market risks inherent in defined contribution deasigns such as K plans. That has to be good news for workers, as well as employers who are increasingly drawn to a design that has won growing favor among employees (particularly younger participants, not surprisingly).

It is not too much to postulate that the increased popularity of cash balance plans, which predated the long bear market but has certainly been enhanced by the declining Dow's damaging effects upon retirement accounts, will go a long way to reversing the desuetude of the defined benefit model, if not restoring it to a preeminent place in pension planning.

Alvin Lurie has looked at ERISA plans from both sides, having spent many years as a practicing pension attorney, appointed as the first person to administer the IRS' ERISA program in the National office in Washington, and now back in practice. He can be contacted at Alvin D. Lurie P.C. in New Rochelle, New York, at (914) 235-6575.

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