Guest Article

(From the October 1, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

More Victories in the Federal Courts for Cash Balance Plan Sponsors

The federal courts are continuing to issue decisions validating the legality of cash balance plans and cash balance conversions under the rules in place before the Pension Protection Act (PPA) of 2006 (P.L. 109-280). The Sixth Circuit Court of Appeals recently joined the Third and Seventh Circuits in ruling that cash balance plans are not inherently age discriminatory. Drutis, et al. v. ___________, No. 06-6380 (6th Cir., 2007). And a federal district court in a separate case has rebuffed the argument that cash balance plans offering certain participants the "greater of" two benefit formulas violate the anti-backloading rules. Wheeler, et al. v. ___________, 2007 U.S. Dist. LEXIS 65840 (S.D. Ill., 2007). The latter decision is noteworthy because it comes from the Southern District of Illinois, which usually is not the venue of choice for employers.

Age Discrimination

The age discrimination claim is based on ERISA § 204(b)(1)(H)(i) (and/or the parallel provision at IRC § 411(b)(1)(H)) as in effect prior to the Pension Protection Act of 2006. Under those sections, a defined benefit plan does not satisfy ERISA's benefit accrual requirements "if, under the plan, an employee's benefit accrual is ceased, or the rate of the employee's benefit accrual is reduced, because of the attainment of any age." The question is whether the rate of an employee's benefit accrual should be measured according to the year-to-year change in the value of the employee's age-65 annuity, or simply as the amount of the employer's pay and interest credits to the employee's hypothetical account. If the former is the answer, then cash balance and other hybrid pension plans are inherently age discriminatory because younger employees have more time to accrue interest credits before reaching retirement age than their older colleagues.

Numerous courts have addressed this question, and most have concluded cash balance and other hybrid pension plans are not inherently age discriminatory. One notable exception had been the U.S. District Court for the Southern District of Illinois, but the Seventh Circuit Court of Appeals overruled the district court's decision last year. Earlier this year the Third Circuit Court of Appeals addressed the same issue in a different case, and reached the same conclusion as the Seventh Circuit.

Now the Sixth Circuit Court of Appeals has joined the chorus. Like the Third and Seventh Circuits before it, the Sixth Circuit soundly rejected the argument that the time value of money is age discriminatory. However, a similar case currently is pending before the Second Circuit Court of Appeals, and that court is not bound by any of these previous decisions.

Anti-Backloading Rules and "Greater of" Formulas

The issue in the Wheeler case is a little less straightforward. Basically, the question is whether cash balance plans that offer certain participants the "greater of" the benefit provided by the cash balance formula or a traditional pension formula satisfy the IRC § 411(b) accrual requirements. The analysis begins with Treas. Reg. § 1.411(b)-1(a)(1), which provides:

The "alternative methods" are the 3 percent method, the 133 1/3 percent method, and the fractional method. These methods are used to determine if a defined benefit plan satisfies the IRC § 411(b) benefit accrual requirements, which are designed to prevent plans from concentrating -- or "backloading" -- benefit accruals at the end of participants' careers. The benefit accrual rules are intended to preclude plan designs that circumvent the minimum vesting requirements.

When converting traditional defined benefit formulas to cash balance formulas, some employers have used certain techniques to minimize or prevent any adverse effect on existing employees. One technique guarantees a class of workers will receive a benefit equal to the "greater of" the cash balance formula or a traditional defined benefit formula. Clearly, this technique is intended to protect employees. However, the IRS reportedly has refused to issue determination letters to certain plans that have used the "greater of" approach because it claims the plans are backloaded. The plaintiffs in Wheeler co-opted the IRS's position for purposes of their case.

The basis for plaintiffs' argument is the language in Treas. Reg. § 1.411(b)-1(a)(1), which states plans that use multiple formulas to calculate participants' accrued benefits must aggregate those formulas to determine compliance with the accrual rules. When this aggregation rule is applied to a cash balance plan using a "greater of" formula, the likely result is a technical violation of IRC § 411(b) -- even if the individual formulas, standing alone, would not violate the accrual rules.

Fortunately, the district court disagreed with the plaintiffs' assertion that Treas. Reg. § 1.411(b)-1(a)(1) requires aggregation of the "greater of" formulas in these circumstances. According to the district court, "It is clear from the regulation that the sense in which plan formulas must be aggregated for the purpose of evaluating plan backloading is that, when a participant's accrued benefit is calculated using a sequence of formulas over time, backloading must be tested by analyzing the total rate of benefit accrual as though all formulas are in place at the same time within a single plan year." However, the district court asserted the regulations specifically provide that, "where a participant's benefit is to be determined under alternative plan formulas, the accrued benefits produced under the competing formulas are not to be aggregated for purposes of testing backloading." Because the "greater of" approach involves calculating participants' benefits under alternative formulas, the district court decided aggregation is not necessary.

The district court cited the Third Circuit's decision in Register v. ___________, 477 F.3d 56, (3rd Cir., 2007) to support its holding, even though the district court is not within the Third Circuit's jurisdiction. In addition to the age discrimination claim, the plaintiffs in Register asserted a similar backloading claim. The Third Circuit rejected that claim using the same regulatory analysis employed by the district court. Both the district court and the Third Circuit also made the most obvious case for why these "greater of" arrangements do not violate IRC § 411(b). As the Third Circuit put it, "the objective of the anti-backloading provisions, to prevent a plan 'from being unfairly weighted against shorter-term employees,' ..., simply is not implicated" by these "greater of" arrangements.

Finally, the district court addressed the IRS's position on this issue. As noted, the IRS reportedly has used this backloading analysis to refuse to issue determination letters to some cash balance plans with "greater of" formulas. However, the district court found the IRS has not formally adopted this position pursuant to the usual rulemaking process. As such, the district court decided even if the IRS has taken this position, it is not entitled to deference.

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, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.